The Economics of Foreign Aid

Every year, 9 million children die before their fifth birthday - many of them of diseases easily preventable by modern medicine. For example, one in five children dies of diarrhea. As expected, the vast majority of those affected are underprivileged children from South Asia and sub-Saharan Africa. In June 2009, another shocking stat was given by the UN Food and Agriculture Organization (FAO) - more than a billion people are suffering from hunger.

How can the western world look at all of this from its superior pedestal without intervening? It can't. The concept of poverty is central and its relationship with hunger has been institutionalized in the UN’s first Millennium Development Goal (MDG), which is “to reduce poverty and hunger”. However, even if the amounts of foreign aid to poor countries seem huge, most programs targeted at the word’s poor are funded out of their country’s own resources. Introspectively, every one of us would support the notion of improving this situation. It has been proven that people would willingly agree to spend a lot of their money to save a child but sometimes these realities feel so far away from us that we either do not relate or do not comprehend the good that we can do. Donors would like to perceive their contributions as life changing events when they reach the hands of people in need.

However, it is not as easy as it seems… willingness to help, alone, will not suffice. There have been many studies on the effectiveness of humanitarian aid and along with them, the issue of answering the question: which is the most effective approach? Unfortunately, instead of discussing how best to fight individual matters such as illiteracy, debates are more focused on the big questions behind poverty, such as: What is its ultimate cause? Could democracy help? Does foreign aid have a role to play? And so on. How these questions are answered has a significant impact on the shaping of foreign aid plans.

Two Contrasting Views

On one side, we have Jeffrey Sachs, Adviser to the United Nation and Director of the Earth Institute at Columbia University. He seems to have an answer to all of these questions. He points to climate, geographic position and infertility of soil to the causes of poverty. Although these factors were proven as mostly irrelevant in the evolution of countries in Acemoglu and Robinson’s literature - Why Nations Fail, Sachs sees them as causes capable of trapping poor countries in a cycle poverty. He believes that for being productive they just need an initial large investment that, however, they cannot provide on their own. That’s why foreign aid is a key component to putting a stop to the vicious cycle of poverty, increase the number of investments and eventually increasing wealth. These reasons are behind the willingness of Sachs, the UN and the World Health Organization to provide them with useful things as fertilizers, insecticide-treated bed nets and much more.

The opponents of this activist view are the aid-skeptical economists. One of the most influential anti-aid public figures is William Easterly, member of New York University’s economic department and former World Bank senior staffer. He advocates the idea that aid does more bad than good by making people used to receiving help instead of pushing them to work towards a solution. The only things that aid creates are corrupted institutions and a self-perpetuating lobby of aid agencies. His pessimistic view turns surprisingly optimistic when talking about markets. He believes that free markets are what all these countries need to solve their problems. Free markets work and are able to produce the right incentives to push people to improve their situation. In his view, there is no point in distributing to people things that we believe are good for them because people value things that they pay for, not things given them for free even if they have a high intrinsic value. Moreover, we should also consider the fact that poor people probably know what they need so we should respect their freedom and, if they do not want something, not force it upon them. If they do not go to school, it might be because they know that for them the return on education is low so they are better off working.

Poverty Traps

These different views stem from the opposite answers they give to an economic question: is it possible to get trapped in poverty? Certainly, Sachs would give a positive answer and he recognizes traps not only related to the financial situation of individuals but also related to food and health. People can be trapped because of poor heath, that require constant funds and prevents individuals from working; or the trap could be symbolized by poor education, which limits future earnings potential, or by lack of access to formal financial services, therefore preventing them to invest and increase productivity in their businesses. A poverty trap is characterized by a situation in which someone's income tomorrow is lower than his income today. As compared to not being in a poverty trap, where one is able to rely on a higher income tomorrow. The big inequalities among people could thus be explained by initial endowments and someone’s income could be boosted through a small transfer that could be spent on fertilizer, for example, to make the field more productive. The idea of a nutrition-based trap stresses the fact that the underprivileged barely consume enough calories to survive, let alone work to earn money to purchase food again - hence, they are unable to break from this trap. The calories consumed are not enough to give them strength to work harder, produce more, earn more money and eventually buy more food. According to Sachs, all it is needed is the availability of short term services available either for free or with a substantial subsidy.

Easterly does not recognize the existence of poverty traps and he is skeptical on the value of top down social programs. On the food trap theory, he would argue that people have money that they could spend on more food but they rather spend it on village festivals, for example. This would mean that they do not have the necessity for more calories and so giving it to them would not make a substantial difference. But his favorite example concerns insecticide-treated bed nets distributed in Malawi for protection against malaria. When the nets were distributed for free, they were not put to their proper use. Nearly 70% of people didn’t use them or found them an alternative use, such as wedding veils. When people had to pay for them (in accordance with their income) and incentives were given to nurses, almost everyone used them properly. In his demand-based view, solutions to a problem have the greatest chance of success when they fulfill a need or desire of people, instead of being imposed from above. In conclusion, there is no need to take a decisive side on this debate. All that matters is that the ladders to get out of poverty exist and the solutions to practical problems, such as diarrhea and malaria, are affordable and easily implementable. The statistics quoted in the beginning of this article are shocking but once these figures improve, we could potentially move on to other concepts such as democracy, corruption and so on.

---

WRITTEN BY ELEONORA BARBIERI FOR BESA

PLEASE DIRECT ANY INQUIRY TO AS.BESA@UNIBOCCONI.IT

#ForeignAid