The Economics of Foreign Aid
In the immediate aftermath of World War II, almost all of the major economies at the time - United States, United Kingdom, Germany, Soviet Union, and Japan - were heavily reliant on the military-industrial complex to prop up their fragile economies. The defeat of the Axis powers created a vacuum in the global economy as demand for military equipment shrunk significantly. At the same time, the major markets of Europe and Asia were stripped of their workforce and productive capacity. The previous economic hegemon, the British Empire, lost its colonial riches; its prestige suffered irreparable damage. As a result, World War II marked the end of British economic dominance and ushered in the age of pax-Americana; only the relatively unscathed United States had the power to shape the postwar political and economic organization. Thrusted into a leadership role, the United States faced a challenge: structural adjustments had to be made to the military-centric global economy, which, during the war, abandoned the production of consumer goods in favor of military hardware.
Given the contemporary state of affairs in Europe and Asia - the destruction of infrastructure, industry, and manpower - the United States formulated a series of bold plans to rebuild the global economic system. The first step was through the Bretton Woods Agreement. It established supranational institutions such as the International Monetary Fund, International Bank for Reconstruction and Development (predecessor of the World Bank), and the International Trade Organization to govern financial and commercial relations among independent states. These organizations serve to extend loans and provide policy consulting to developing countries across the globe. Furthermore, the World Bank provides loans and grants to the governments of poorer countries to pursue capital projects, which benefited more than 170 countries to date. Despite the robustness of these institutions to protect the global financial system in the long run, the most significant initiatives at the time were a series of foreign aid programs such as the Marshall Plan and the Point Four Program to rebuild the economies of Europe and Asia.
The United States spent an astounding $12 billion (~$130 billion today) under the Marshall Plan and another $25 billion (~$265 billion today) under the Point Four Program. These programs extended technical and financial support to European and Asian countries devastated by the war in the form of a grant, allowing them to reinvigorate their industries and build infrastructure. As a result, European gross domestic product rose by 15% to 25% shortly after the grant was approved, while Gross National Product (GDP) per capita tripled. Japan also emerged as the world’s second largest economy within a few decades. Given these success stories, it is no surprise that many countries in the 21st century embrace foreign aid as a cheap, costless development pathway. Nonetheless, there are heated debates among economists, politicians, and scholars on the potency of foreign aid to elevate developing economies to join the ranks of other high-income economies.
In simple terms, foreign aid is the voluntary transfer of economic resources from one country to another. This can take the form of grants - such as the Marshall Plan and the Point Four Program - humanitarian assistance, or loans, just to name a few. The upside of receiving foreign aid is that a country could embark on larger scale development projects than it would be able to afford on its own. Under the classical Keynesian framework, the predominant philosophy for governments after WWII, government spending is crucial in levelling up domestic aggregate demand, which leads to even more investments from the private sector racing to fulfill them and spurs the whole economy in the process. Foreign aid, then, provides much needed ammunition for such fiscal expansions. Investment-heavy infrastructure projects, like building roads and healthcare facilities, often feature as the poster child of foreign aid. The benefits of these projects are manifold and easy to see: apart from creating new jobs and providing people with more money to spend, they also facilitate longer-term commercial activities and raise the standard of living.. Foreign aid can also be used to develop an economy's industrial base, which the economy could use to build an export-orientated economy. On another front, direct investments into education made possible by foreign aid funds could raise the population’s literacy rate and build up the domestic human capital to fuel the economy in moving up the economic ladder in the long term. Most developing economies rely on the primary sector - agriculture and other resource extraction industries - which only provide minimal value-added output. As an economy’s workforce becomes more educated and skilled, the country’s economic structure can gradually transform to reduce its reliance on the primary industry and move into the secondary (industrial) and tertiary (service) sectors, which adds a high level of wealth into the economy.
If all goes well, what then follow are increases in GDP per capita - the standard economic indicator of an economy’s performance - and Human Development Index (HDI), which measures life expectancy, education, and per capita income. It is important to note that all these positive impacts are not solely due to the presence of foreign aid, as they can occur without foreign aid. However, foreign aid expedites these processes and accelerates the pace of economic and social development. These theories were proven in the real world by Europe and Japan’s meteoric rise post-WWII; their successes are often cited as the model by which foreign aid should be measured.
Despite the apparent effectiveness of foreign aid in raising the incomes of developing countries, it has nevertheless been accused of harming developing countries' growth prospects. This is due to the over-reliance of developing countries on foreign aid as a source of income to fund their expenses. Without foreign aid, a country would rely mainly on its domestic savings forfor investing and pursuing economic growth. Given their low savings rates, this means that developing economies are often short-handed in carrying out development projects on their own. As foreign aid comes in, it acts as an artificial boost by enabling extra spending in the economy — that is, if it’s properly and efficiently distributed to the right sectors in the economy. If not, it could very possibly have the opposite effect of worsening the situation in that economy, such as disproportionally benefiting the rich and widening the income gap. Take Afghanistan for example: it received $35 billion in foreign aid between 2002 and 2009, which accounts for 90% of its national budget. Despite all its efforts to raise the standard of living for everyone in the country, Afghanistan’s GDP per capita still stood at a mere $520 in 2018, one of the lowest in the world.
Even if these countries succeed in raising the GDP per capita to the standards of a middle-income economy (~$12000 as defined by the World Bank), they often get stuck in what is known as a “middle-income trap”. Aptly named, this phenomenon takes place when , as developing countries get richer through investment and low-cost manufacturing, they lose their competitiveness in the global economy due to higher wages. This problem plagues any country that relies on cheap labour to develop its economy, such as South Africa or Brazil. The higher wages in line with economic growth results in foreign importers searching for other cheaper alternatives. This means that export-orientated economies can only suppress wages, halting any increase in the real income of workers, which may lead to an economic downturn if real wages fall below the inflation rate. Another possibility is that the developing economy can transition to a strikingly different economic structure, such as relying on the tertiary sector, but this cannot be done hastily because workers have to be trained and an educated workforce is required. None of these options are beneficial to the developing economy.
Thus, foreign aid can either help or harm local economies, though it is highly context-dependent. For foreign aid to be effective, an efficient bureaucracy is required to ensure transparency and accountability. After all, foreign aid is only as effective as a well-executed development strategy. If today’s developing countries wish to recreate the success stories of Europe and East Asia, then they ought to focus on improving the quality of development, and not solely on the quantity of development - that is, on metrics such as GDP or HDI. Governments need to identify their absolute and comparative advantages, exploit economic niches, and invest in capital goods to maximize growth.
Written By Amos Tong, Undergraduate Economics Student
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