ON T HE EMPIRICS OF FOREIGN A ID AND G ROWTH

The present paper re-examines the effectiveness of foreign aid theoretically and empirically. Using a standard OLG model we show that aid inflows will in general affect long-run productivity. The size and direction of the impact may depend on policies, ‘deep’ structural characteristics and the size of the inflow. The empirical analysis investigates these possibilities. Overall we find that aid has been effective in spurring growth, but the magnitude of the effect depends on climate-related circumstances. Finally, we argue that the Collier-Dollar allocation rule should be seriously reconsidered by donor agencies if aid effectiveness is related to climate. The usefulness of foreign aid in promoting growth in developing countries has been an area of controversy ever since Rosenstein-Rodan in 1943 advocated for aid to Eastern and South-Eastern Europe. Browsing through successive editions of a leading textbook in development economics provides a telling illustration of how the confidence in aid effectiveness dwindled over the years. In the first edition of ‘Leading Issues in Economic Development’, Meier (1964) dedicated a full 18-page section to the issue of foreign aid. He started out asking: ‘How much aid?’. By the time of the sixth edition (Meier, 1995), the treatment of foreign aid had been cut into half, and the questions in focus were ‘Why official assistance?’ and ‘Does aid work?’. In the 2000 edition (Meier and Rauch, 2000), ‘foreign aid’ is not even listed in the index. However, in the last few years the pendulum has swung, and a gradually forming consensus view has emerged that aid ‘works’. Indeed, panel-based empirical studies have repeatedly concluded that foreign aid does impact positively on growth. Nevertheless, controversy remains since it also seems clear from the data that foreign aid is far from equally effective everywhere. A key question is therefore what causes such differences in ‘the return to aid’? From a policy perspective, this issue is important as it ultimately influences the allocation of foreign aid across countries. Inspired by the work of Burnside and Dollar (2000) and Collier and Dollar (2001, 2002), which suggests that aid only works in places with ‘good’ policies, some donors are increasingly allocating aid to countries that perform well in terms of particular proxies for the policy environment. The motivation is clearly the desire to maximise the effectiveness of tax financed foreign assistance. However, if the variation in the effectiveness of aid on productivity is not policy induced but rather a result of other poor initial conditions a very different allocation rule would maximise the effect of aid donations on long-run productivity and poverty.