It is widely assumed that to be effective, foreign aid should be linked to a needy country adopting sound institutions and policies. That belief lies behind the decision by the administration of George W. Bush to set up the New Millennium Challenge Account, intended to increase aid by 50 per cent in the coming years. However, in a new study in the Cato Journal, Harold Brumm, a government economist, finds that 'foreign aid has a negative growth effect even where economic policy is sound'.
He examined data for 53 underdeveloped countries and found a negative relationship between aid to countries with good policies and growth of real gross domestic product per capita. His results cast doubt on a much-cited study by World Bank economists Craig Burnside and David Dollar, who concluded: 'We find that aid has a positive impact on growth in developing countries with good fiscal, monetary and trade policies, but has little effect in the presence of poor policies.'
Last year, William Easterly, a former World Bank economist, co-wrote a study for the National Bureau of Economic Research (NBER) casting doubt on the Burnside-Dollar good governance argument. Using additional data, but the same model, the NBER study found that aid, even when conditioned on good governance, had no impact on growth. Mr Brumm goes one step further and concluded that using 'selective' aid to reward developing countries with good policies may actually reduce growth rather than simply have no impact.
Aid has perpetuated poverty in Africa, Latin America, and elsewhere. There is no reason to believe that 'selective' aid will be the elixir for poverty. Rather, what we now know is that the best way to move from poverty to prosperity is to increase economic freedom. Hong Kong received virtually no aid but found that its free-trade policies, limited government and protection of property rights were the key to wealth creation.
Hong Kong and other economically free countries have higher living standards than those countries that lack the institutional infrastructure conducive to a vibrant market system. That conclusion is well documented in the economic freedom indexes published annually by the Fraser Institute and by the Heritage Foundation in conjunction with The Wall Street Journal.
Leaders in underdeveloped countries have access to those indexes and are beginning to recognise the importance of economic freedom. They do not need more aid, they simply need to trade and eliminate interventionist policies that politicise economic life and lead to corruption.
