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Thursday, July 14, 2005

The Economics of Aid

SPIEGEL Interview with African Economics Expert: "For God's Sake, Please Stop the Aid!" - International - SPIEGEL ONLINE - News

Note to Bob Geldof et al: yes, you are all fighting for a very noble cause. However, more aid or debt relief is *not* the solution to the problem of world poverty. The Dismal Science explains why.

Let's think about debt relief for a moment. What is the consequence of removing debt? The naive argument is that it is going to free up resources for the poor countries that would be invested back in the economy for their development. What assumptions does this argument rest upon? Two critical assumptions are: 1.Financial resources is what these economies need for development. 2.Economic managers will efficiently deploy the resources to realize maximum development.

The first assumption is of tangential relevance at best: what these economies really need are skills, property rights, rule of law and access to rich markets much more than they need money. The second assumption is just stupid : social and political governance structures in these countries are abysmal, in fact, that is largely why many of them are poor to begin with. It is much more likely that the extra money will end up being "invested" in gold faucets in the "presidential" palace of the Dictator du Jour than in a world class engineering or business school. The said Dictator du Jour will, in fact, have even *more* incentive to raise more debt with their countries' higher credit rating made possible by the very debt relief, and then go on to waste it all over again. See the vicious cycle here? Economists have studied this for ages and given it a name : Moral Hazard. Unconditional debt relief did not work for teens in Illinois in 1800's nor did it work for Argentina in the late 1900's. I am betting that it won't work for Africans either.

Let's now turn to more aid. As the insightful comments of Mr Shikwati illustrate, aid does not go to those countries as free dollars with spending control, but mostly in the form of dumped goods from rich countries and little authority over how it iis spent or deployed. Disturbingly enough, it also tends to come with socio-political strings attached, such as this one for example. In fact, dumping goods through foreign aid has become a part of the marketing strategy of rich countries' politically connected producers such as pharma and agri-business companies. This then invariably ends up destroying local economies - say, by making local farmers uncompetitive against dumped food supplies as Shikwati points out, or by resricting the import of cheaper generic substitutes enforced by the donors to protect their suppliers' IP rights. The end result for a poor country is likely to be much more harm than benefit, as in this example. In fact, this is almost downright perverse: rich countries' drug and pharma industries get to collude with their venal politicians to rob rich countries' taxpayers and indirectly create captive markets in poor countries. Of course, restricting local and foreign competition in poor country markets is an added bonus. No wonder that rich country politicians are falling all over themselves to increase "aid" a.k.a. tax-payer funded handout to their pharma and agri businesses, but not giving an inch on reduction of agriculture subsidies in the Doha round.

What poor countries need is help in building up infrastructure, reform of governance structures, and skills and competence building to create human capital. Then they need to build their economies through entreprenurship and access to rich country markets in a fair trade regime. More aid and debt relief are just recipes for continuing the disaster in poor countries while presenting profiteering opportunities to well-connected rich country producers.

Update: I came across an article making similar arguments in Yale Global that I thought was interesting. A co-author of the article is Thilo Thielke, the interviewer of James Shikwati in the earlier link.

-- Mahashunyam // 7:16 PM // 2 comments


Great post!

However, I've just read a post on 'crumb trail' that has me half convinced the issue of agricultural subsidies is a red herring, and their removal would actually do more harm than good.

Care to give your view on this argument?
// Anonymous Anonymous // 11:41 PM

Thank you, I am glad you liked it. I do believe that ag subs is a real issue, in that getting market access will at least level the playing field somewhat. Clearly, not everyone will benefit equally and if US and EU removes ag subsidies, a large share of the benefits will go to the big 3 - India, China and Brazil. However, relatively better managed African countries like Kenya and Burkina Faso will also benefit from access to cotton and sugar markets. Even if the prices rise, the cost of higher imports will be offset by higher income and employment opportunities created by higher profit margins. The loss of livelihood to cotton farmers from Burkina Faso is well documented all over the Internet, for example.

In the long run, though, there is no other way but to build physical and social infrastructure in a stable and market-friendly political environment. That is the only macro-solution. Countries need to invest in their human capital and unleash the entrepreneurial genius of their populations and it doesn't matter if they are pursuing an export-led growth strategy or domestic market development strategy. The irony is that this really does not take too much money, but it takes considerable vision, political skills and strong leadership.

What's truly amazing is that solving poverty and hunger is actually among the easier problems in econ. We know today that poverty is nothing but the cost of poor governance. All that a society needs is property rights, clear rule of law and stable market-friendly government. Note that democracy by itself is *not* an important factor, but only to the extent the democracy tends to produce rule of law and political stability.

This has been proved over and over again with empirical data and repeated experimentations (remarkable in itself for a social science). Empirical data from all over the place, including North vs South Korea, China, India and East Asian tigers points to this. Remarkably, this is a factor even *within* national economies where regional economies starting from more or less the same position develop dramatically differently over a period of time. Compare, for example, the economic ruin in the states of West Bengal and Kerala in India with their neighbours. They have been run by democratically elected communist parties for many years that imposed soviet-style anti-business policies upon them and destroyed property rights which resulted in sustained impoverishment. It is just tragic to see politicans not understanding even the simplest of economic lessons needed to reduce poverty.

To see a fascinating example of a remarkable economic transformation engineered by en economist, see my old post on De Soto:
// Blogger Mahashunyam // 1:49 AM
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