Thursday, July 7, 2016

Trade Liberalization Does a Better Job at Alleviating Poverty Than Foreign Aid

Foreign aid is supposed to help the poor. It is something we hear often enough in political discourse. We give money to those in need, and the vicious cycle of poverty is solved. Think of foreign aid as wealth redistribution on the international level. With our increasingly global society, we have seen extreme poverty, which is now defined by the World Bank as living on $1.90 a day in 2011 dollars, drop considerably. We have also seen the role of developed nations in terms of providing foreign aid change considerably, particularly after the Kennedy Administration created USAID in 1961. Is it possible to contribute the success of global poverty reduction to foreign aid initiatives?

Before delving in, let's keep in mind that we are not talking about foreign aid given to alleviate humanitarian crises. That is a separate form of foreign aid that is out of the purview of this discussion, not to mention that the primary goal of humanitarian aid is not economic growth, but consumption of much-needed goods. We're not going to discuss military foreign aid, either, since that is based on geopolitical self-interest. What we are discussing here is foreign aid expenditures designated to help citizens from developing countries in development assistance, i.e., official development aid. What can we see based on the evidence out there?

  • A meta-study of 97 econometric studies (Doucouliagos and Paldam, 2007) shows that "after 40 years of development aid, the evidence indicates that...the correlation between aid and growth is essentially zero."  
  • A 2005 report (Nakamura and McPherson, 2005) found that foreign aid has "no significant effect" on poverty.
  • Research on income distribution suggests that countries that receive high amounts of foreign aid are more likely to have uneven income distribution (Herzer and Nunnenkamp, 2012). 
  • Although foreign aid to Africa soared in the 1980s and 1990s, African countries experienced less growth per capita as a result (Easterly, 2003).
  • Foreign aid is correlated with lower economic growth (Subramanian and Rajan, 2005).
  • In addition to these reports, the Heritage Foundation and the American Enterprise Institute points out foreign aid's ineffectiveness. 

This is not to say that there aren't studies that support foreign aid (e.g., Kerstering and Kilbing, 2014Clemens et al., 2012; Dunning, 2004) or success stories of foreign aid, but that on the whole, there is more evidence to show the overall ineffectiveness of foreign aid as a form of poverty reduction. Why is foreign aid overall ineffective in the first place? As U.S. Federal Reserve's Board of Governors member Lael Brainard pointed out, "The history of U.S. assistance is littered with tales of corrupt foreign officials using aid to line their own pockets, support military buildups, and pursue vanity projects." We would like to think that well-intended, benevolent architects of foreign aid policy have the insight to adequately implement such policy. However, the truth is that given the systemic nature of corruption, it is much more difficult to craft well-targeted foreign aid. Even with minimal corruption, governments simply do not have enough information to know what the best use of a dollar of aid is, which is why that more often than not, foreign aid goes to the one with the most connections, not the one who is most in need. More to the point, Nobel Laureate Angus Deaton uses research to argue that the ineffectiveness had to do with how foreign aid affects the relationship between the government and its people. Essentially, foreign aid incentivizes foreign leaders to be less accountable to its constituents. If foreign aid does not address the more systemic issues, it is hard to imagine how throwing cash at the problem will solve anything.

If foreign aid cannot have the desired effect, then what can? If India and China are to be instructive lessons, the answer to that question is freer trade. In spite of the chagrin of people like Bernie Sanders or Donald Trump, trade liberalization is the single greatest achievement in poverty alleviation. As I pointed out a few months ago, an economy with less trade barriers brings net gains for society. In 2010, the OECD wrote in a report that the evidence supports the theory that "trade liberalization reduces poverty on average and in the long-run (p. 32)." The World Bank followed suit by saying that less protectionist countries have better employment and wages outcomes (2014, p. 3-4). And here's a meta-analysis of 60 studies showing the positive effects of trade liberalization on poverty reduction. We should also consider how to couple trade liberalization with allowing for private donations to flow into these developing countries, instead of strictly relying on the government-to-government model that has been so pervasive in foreign aid.

Foreign aid was created to help foreign countries grow economically and be lifted from poverty, but the sad truth is that over 40 years of research shows that it does not fulfill its intended goal. While it might not be an easy endeavor, if you want to alleviate poverty in developing countries, you have to find ways to liberalize their economies.

3-20-2017 Addendum: I just came across this International Monetary Fund (IMF) study from 2016 that found that "large  aid inflows not only undermine garments' tax efforts, but also create a crowding-out effect on capital expenditures." They also found that reducing foreign aid had the reverse effect, and that those with low governance scores and low absorptive capacity have even larger problems. In short, another study showing that foreign aid doesn't help.

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