The Economics of Foreign Aid Lecture 2 Political Economy of Aid

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The Economics of Foreign AidLecture 2
Political Economy of Aid

• Justin Sandefur
• Weeks 7 8, HT 2006
• Economics of Developing Countries Option

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Last week Poverty Efficient Allocation of Aid

• Building on Burnside Dollar (2001) If aid only
  works in a good policy environment, how should we
  allocate aid?
• Collier Dollar (2002) compute a poverty
  efficient aid allocation on the basis of the
  Burnside Dollar results
• Selectivity allocate aid to poor countries (as
  opposed to allies, etc.) with good policies
  already in place (as opposed to funding reform
  efforts).

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Poverty-efficient aid allocation
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Poverty-efficient aid allocation
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Key assumptions underlying Collier Dollar
allocation

• Impact of aid on growth depends on the policy
  environment
• Aid is fungible
• Conditionality doesnt work
• Growth is good for the poor (and policies which
  are good for growth are good for poverty
  reduction)
• Reasonable assumptions?

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Outline for Today

• Political Economy of Aid
• Fungibility
• Conditionality Contract Theory
• Moral Hazard
• Time Inconsistency
• Evidence on Conditionality
• Dependency Is Aid Oil?
• Conclusions

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Fungibility

• When a thing which is the subject of an
  obligationmust be delivered in specie, the thing
  is not fungible, i.e. that very thing, and not
  another thing of the same or another class in
  lieu of it must be delivered. (OED)
• If a donor gives aid for education, will it
  actually improve education in the recipient
  country?
• If a donor gives aid for education, will it
  increase gov. spending at all?
• NB This NOT (necessarily) corruption!

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Conditionality

• Underlying the litany of Africas development
  problems is a crisis of governance. WB 1989
• 1980s Washington consensus focus on getting
  prices/incentives right, rather than pouring in
  resources gt trend toward conditionality.
• 1990s/2000s Disillusionment
• It seems clear that the lending cum
  conditionality process works well only when local
  polities have decided, largely on their own,
  possibly with outside technical help, to address
  their reform needs, effect certain policy changes
  sequentially, and approach the international
  community for financial help in getting there.
  (Ranis, 1995)

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Analytical Framework to Analyze Conditionality
Aid as a Contract

• The Principal-Agent Problem
• Principal (donor) designs contract to achieve
  some end (poverty reduction)
• Contract is generally and aid/policy combination
  a,p.
• Agent (recipient gov) accepts or rejects
  contract and chooses actions in light of contract
  incentives
• Moral hazard, adverse selection, and time
  inconsistency all addressed in this setting.

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Moral Hazard

• Hidden action agents action (poverty reduction
  efforts) imperfectly observed by principal.
• Azam Laffont (2003)
• Donor utility
• Recipient utility
• Thetalt1 indicates recipient cares less about
  consumption of the poor

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Moral Hazard

• Autarky (no aid)
• Some benchmark level of consumption by rich cRA
  and poor cPA
• Full observability.
• Donor offers a conditional contract, a, cP gt
  cPA.
• Same is possible with imperfect observability, so
  long as recipient is risk neutral.
• Favoritism
• Interesting case recipient government has a
  preference for one sub group of the poor. Will
  allocate cP1 gt cP2 if unconstrained.
• Even with full observability, optimal contract
  will only reduce but not eliminate favoritism.
• Risk aversion?
• Standard result is moral hazard literature is
  that if there is a noisy signal of effort and
  agents are risk averse, the optimal contract will
  not achieve the 1st best. Not clear how this
  applies here.
• Main point Conditional aid well-suited to
  address moral hazard.
• Caveat Strong assumptions about commitment (time
  consistency).

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Time Inconsistency

• Over the past few years Kenya has performed a
  curious mating ritual with its aid donors. The
  steps are one, Kenya wins its yearly pledges of
  foreign aid. Two, the government begins to
  misbehave, backtracking on economic reform and
  behaving in an authoritarian manner. Three, a
  new meeting of donor countries looms with
  exasperate foreign governments preparing their
  sharp rebukes. Four, Kenya pulls a placatory
  rabbit out of the hat. Five, the donors are
  mollified and the aid is pledged. The whole
  dance starts again. (The Economist, 1995)

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Time Inconsistency

• Occurs when it is not in the best interest of a
  player (donor) to carry out a threat or promise
  that was initially designed to influence another
  players actions (recipient gov).
• If economic policymakers lack the ability to
  commit in advance to a specific decision rule,
  they will often not implement the most desirable
  policy later on.
• Familiar example Kydland Prescott, monetary
  policy and inflation expectations.
• Samaritans Dilemma special case where
  charitable urge undermines beneficiarys
  incentives to be cautious

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When is foreign aid policy credible? Svensson
(2000)

• Similar setup to Azam Laffont both donor and
  recipients have preferences for own consumption
  poverty reduction.
• 2 recipients competing for aid. Donor chooses
  an aid policy to encourage policy reform leading
  to poverty reduction. Nature creates noise
  between reform effort and poverty reduction
  outcome.
• Two key considerations
• Can the donor observe recipients reform efforts?
• Can the donor commit ex ante to a (conditional)
  aid allocation in the following period?

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Time Inconsistency 1st Best

• If answer to both questions is yes
• i.e., observe effort and able to commit
• First best outcome
• High aid level (direct poverty effect)
• Higher reform effort than withot aid (indirect
  effect)
• Donor bears all risk (from natures shocks)
• Requires

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Time Inconsistency 2nd Best

• Suppose donor has only a noisy signal of reform
  effort, but can still commit. Whats the best
  they can do?
• Second Best Outcome
• Risk is shared between donor recipient
• Optimal effort lower than 1st Best, higher than
  autarky.
• Recipients better off than 1st Best Donor (and
  poor) worse off.

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Time Inconsistency 3rd Best

• Finally, return to perfect information, but
  suppose donor cant commit
• Third Best Outcome
• 1st Best allocation of aid is achieved GIVEN the
  level of policy reform
• But reform level is reduced. Recipient knows
  donor will give aid in second period regardless
  of effort.

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Potential Solutions to Time Inconsistency in Aid

• Analogy to Rogoffs Conservative Central Banker
  improve welfare by delegating allocation to an
  (international) agency with less aversion to
  poverty.
• Tied Aid. Sign contracts with private companies
  to implement projects. Ties donors hands cant
  reward economic mismanagement.

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Evidence on Conditionality

• Is conditionality enforced?
• Svensson (1997) examines data on WB loan tranche
  releases. Finds that in majority of cases when
  conditionality is violated, tranche is still
  released.
• When does conditionality work?
• Dollar Svensson (2000) examine the success and
  failure of structural adjustment programs (SAPs).
• Success WB OED grade inflation and bdgt
  deficit.
• Domestic political variables predict success (or
  failure) correctly in 75 of cases. (Democracy,
  gov tenure, ethnic fractionalization, etc.)
• Does aid reinforce reform?
• Sachs (1994) finds that while political factors
  set the stage for reform, aid has helped to
  reinforce successful reforms.

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Dependency

• Basic argument two reasons politicians listen to
  their constituents
• Constituents votes reelect them
• Constituents taxes pay their salaries
• Friedman 1957 by strengthening governments at
  the expense of the private sector aid will
  reduce pressure on the government to maintain an
  environment favorable to private enterprise.

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Variants of Dependency Argument

• Aid reduces incentives to adopt good policies.
• Aid overwhelms the administrative capacity of
  recipient governments.
• Aid reduces accountability to citizens.
• Aid works like welfare dependency, implicitly a
  high marginal tax rate.
• Aid flows are highly volatile and thus a source
  of volatility rather than sustained growth.

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Dependency continued Aid Governance

• Brautigam Knack attempt to test the basic
  Friedman Bauer hypothesis aid undermines good
  governance.
• Mechanisms (somewhat vague)
• Funds political patronage
• Creates moral hazard (see above)
• Soft budget constraints gt lack of fiscal
  discipline
• Econometric test
• Data on 32 sub-Saharan African countries,
  averaged over 1982-1997.
• Regress change in ICRG Corruption measure (and
  later, tax revenues as of GNP) on aid and
  controls.
• Find a signficant NEGATIVE effect of aid on
  governance, particularly after instrumenting aid.

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Dependency Is Aid Oil?

• Collier (2005) notes that aid and oil are the 2
  largest external resource flows to Africa.
• Large literature on the natural resource curse,
  both in terms of monetary economics, and
  political economics.
• Why is aid different?
• Technical Assistance.
• Projects knowledge transfer
• Conditionality

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Review Conclusions (1 of 2)

• Aid allocation (actual) primary driven by
  strategic considerations
• Aid and growth
• A weak positive relationship in cross-country
  data, subject to diminishing returns.
• Some evidence that this relationship is
  conditional on good policies though may be
  spurious.
• Aid allocation (ideal) taking the aid-x-policy
  result seriously, aid should be allocated on the
  basis of income and policy to achieve maximim
  poverty reduction.
• Political economy considerations
• Moral hazard conflict between donor and
  recipient (gov) preferences suggest a productive
  role for aid conditionality.
• Time inconsistency renders this result somewhat
  suspect.
• Dependency some weak evidence which should
  possibly cause concern.

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Conclusions (2 of 2)

• Overall message
• History of aid effectiveness is dismal. Has not
  lived up to expectations in terms of growth or
  poverty reduction.
• Past performance is no indication of future
  returns.
• Precisely because
• Aid has not been allocated for growth or poverty
  reduction
• Aid modalities have not necessarily been target
  at growth
• Aid policy has not been credible. Conditionality
  has not been enforced. Emphasis has been placed
  on large resource transfers, ignoring domestic
  political considerations.
• Inasmuch as we can recognize these failures, we
  shouldnt be forced to repeat them.