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Monday, January 1, 2007

Aid, Trade, and Institutional Quality in Africa

Increased Aid in a Poor Policy Environment is Likely to Make Things Worse

Joshua Hall is pursuing his Ph.D. in economics at West Virginia University. Matthew Hisrich is a senior policy fellow with the Flint Hills Center for Public Policy in Kansas.

Screenwriter Richard Curtis received a great deal of attention for his 2005 movie The Girl in the Café. The film was the big-screen component of the Live 8 campaign, which included a deluge of media events and concerts around the world in an effort to increase aid to African countries and other developing nations at the approaching G-8 conference.

“I didn’t give my life to politics in order to say that I was part of a generation that succeeded in cutting the tariff on the import of processed coffee to 27.3 percent,” declares one of the movie’s characters. “I want to be a member of that great generation that for the first time had in its power to wipe out poverty, and did so.”

It’s a powerful message, but is aid truly the best way to wipe out poverty in Africa?

Africa’s growth problem is well documented. In a 1997 article in The Quarterly Journal of Economics, William Easterly and Ross Levine report that real per-capita GDP has been stagnant or declining in most African countries since 1960. Nearly all those countries had growth rates lower than the typical Asian country during this period, and many experienced economic decline. With the exception of some modest success stories such as Botswana and Lesotho, the view that Africa is a “growth tragedy” is sadly accurate.

This lack of growth has led to the impoverishment of hundreds of millions of people. Any attempt to remedy poverty in Africa must therefore focus on economic growth. The question of why some countries grow and others stagnate is at least as old as Adam Smith. In The Wealth of Nations Smith pointed to the quality of institutions, specifically economic freedom, as a factor in economic advance:

The natural effort of every individual to better his own condition, when suffered to exert itself with freedom and security, is so powerful a principle, that it is alone, and without any assistance, not only capable of carrying on the society to wealth and prosperity, but of surmounting a hundred impertinent obstructions with which the follow of human laws too often encumbers its operations; though often the effect of these obstructions is always more or less either to encroach upon its freedom, or to diminish its security.

Historical and empirical evidence validates Smith’s insight that economic freedom matters for development and prosperity. In a 2004 Cato Journal paper, for example, economists James Gwartney, Randall Holcombe, and Robert Lawson found that a one-unit increase in the economic-freedom index would raise per-capita GDP by 1.25 percentage points. Similarly, Jac Heckelman and Michael Stroup write in a 2000 Kyklos article that nearly half the differences in growth between countries can be explained by differences in economic freedom. Niclas Berggren surveyed the literature on economic freedom and growth in a 2003 issue of The Independent Review and concluded that an increase in economic freedom generally leads to growth.

This finding, however, does not give developed countries clear guidance on which policies to pursue. Even development economists who acknowledge the importance of institutions—such as Jeffrey Sachs—often remain vigorous proponents of increased government-to-government aid. Peter Bauer and other economists, however, have argued that foreign aid should be eliminated because of its deleterious effects on less-developed countries (LDCs) and that trade is the primary route to prosperity.

Both domestic and international trade are important for growth. Millions of Africans live at subsistence level, producing everything their households consume. Even where production above household consumption is possible, the absence of trading networks makes it impossible to convert higher production into a higher standard of living.

The opportunity to produce for the market creates an incentive to increase the supply of labor in a household. Given the low capital-to-labor ratio in most LDCs, a tiny increase in the supply of labor can result in a large increase in production. In addition, labor can be a form of capital formation. An example would be farmers forgoing leisure to clear and improve additional land for cultivation.

Trade also increases the supply of labor because of its reciprocal nature. In his 2000 book From Subsistence to Exchange, Bauer pointed out that trade is the impetus for economic advance because it brings the possibility of material improvement to people’s attention. The availability of inexpensive but desirable goods because of trade provides a strong incentive to increase production.

Perhaps more important, the ability to produce for trade allows citizens of LDCs to benefit from specialization and the division of labor. Farmers no longer have to be concerned with producing everything their households need and instead can focus on growing cash crops such as cocoa. Specialization and the division of labor allow for the emergence of other productive enterprises. A final benefit of increased trade is the creation of trade networks. Trade networks lead to improved transportation routes and help to facilitate communication and dissemination of new ideas and innovations.

Openness to Trade Leads to Growth

The empirical evidence that a country’s openness to trade leads to prosperity is clear. Jeffrey Sachs and Andrew Warner find in a 1995 Brookings Institution paper that countries open to trade have average growth rates around 2.5 percentage points higher than countries closed to trade. In the Economic Freedom of the World 2001 Annual Report, James Gwartney, Robert Lawson, and Charles Skipton found that a one-unit change in a country’s trade-openness index can increase long-term growth by two-tenths of a percentage point.

While developed countries that remove their import barriers cannot force LDCs to open their economies, they can increase the payoffs for doing so, thereby strengthening the incentive for institutional change.

As a matter of historical fact, aid is not a necessary condition for escape from poverty. Nearly the entire developed world was able to escape from subsistence level without aid. The important question for policymakers is the effect of aid on economic growth.

A review of the literature on aid and economic development shows that aid is unlikely to reverse Africa’s growth tragedy because of the incentives it creates for rulers of African LDCs. While it is true that there are many types of foreign aid, the focus here is on cash and loans made directly by governments or organizations such as the IMF and World Bank. Regardless of where the aid comes from, though, it ultimately goes from one government to another.

Recall that a poor institutional environment is the primary reason for the low economic growth of these countries. In the long run, aid would only lead to economic growth if it created incentives for positive institutional reform. Yet aid creates exactly the opposite incentives. Government-to-government transfers create a moral hazard where rulers have little to no incentive to improve institutions because bad institutions lead to aid. In fact, rulers have a reason to make things worse in order to keep the aid coming.

The presence of government-to-government transfers in poorly governed countries creates what Bauer called the double asymmetry of foreign aid. On the one hand, aid as a percentage of GDP in these countries is relatively small and thus aid can do little to improve their situations. As a percentage of discretionary spending, however, aid is generally high. Thus the bad incentives discussed earlier dominate any good incentives that may exist.

The empirical literature on this topic is large and varied, with the current debate focused not on the general importance of aid but when aid might play a positive role. For example, Craig Burnside and David Dollar write in a 2000 American Economic Review article that aid is beneficial only in a good policy environment. While Easterly, Levine, and David Roodman called this finding into question in a 2003 follow-up article, it is important to note that nearly all African countries have bad policy environments. Thus even if the research of Burnside and Dollar is correct, this does not imply that aid to Africa will be beneficial. Increased aid in a poor policy environment is likely to make things worse given the perverse incentives.

How best to reduce poverty in Africa is a difficult question. Given that foreign aid is less than 1 percent of most donor countries’ GDP, it seems like a simple and relatively inexpensive solution to African poverty. Calls for increased aid such as Live 8 therefore also seem reasonable. Considering the importance of institutions in economic development, however, maintaining or increasing aid hardly seems promising given the perverse incentives it creates for institutional reform. In fact, as Easterly shows in his 2001 book The Elusive Quest for Growth, experience demonstrates that aid does little to alleviate poverty and often retards economic development by making institutions even worse than they already were.

While the citizens of developed countries cannot vote to change the institutional structure of African LDCs, they can pressure for the removal of their own barriers to trade. Doing so will increase the payoffs to production for international trade in Africa, which should increase internal pressure to make these countries more open to trade. Only through external contacts with developing countries will Africa be able to go from poverty to prosperity.

Indeed, as if in anticipating Richard Curtis and the Live 8 movement, 40 years ago the late Milton Friedman issued a clarion call for the elimination of poverty that rests on far more solid economic grounds. In the classic Capitalism and Freedom he wrote: “We could say to the rest of the world: We believe in freedom and intend to practice it. No one can force you to be free. That is your business. But we can offer you full cooperation on equal terms to all. Our market is open to you without tariffs or other restrictions. Sell here what you can and wish to. Use the proceeds to buy what you wish. In that way cooperation among individuals can be worldwide yet free.”

  • Matthew Hisrich received his MDiv in teaching and theology from the Earlham School of Religion, where he now serves as Director of Recruitment and Admissions. Prior to enrolling in seminary, he worked in the public policy field, authoring numerous studies and articles.

  • Joshua Hall is an associate professor of economics and Co-Director of the Center for Free Enterprise in the College of Business and Economics at West Virginia University.