1. THE THEORY AND PRACTICE OF FOREIGN AID Dr. Boris Begović President of the Center for Liberal-Democratic Studies (CLDS) Professor of economics at the School of Law, University of Belgrade, Serbia

2. Analyzing foreign aid Normative analysis What is the rationale for foreign aid? Positive analysis What are the reasons why countries give foreign aid? Mechanisms of foreign aid Empirical results of the aid effects

3. Normative analysis: Poverty traps Vicious circle mechanism of poverty traps Poverty ➔ Low Savings and Investment ➔ Low Growth Rate ➔ Poverty (again) Described by Rosenstein-Rodan (1943), Rostow (1960), Sachs (2005) Similar two-gap growth model Low savings and hard currency gaps prevent dynamic growth in developing countries Key assumption in poverty trap theories Imperfection of international capital markets Appeal of foreign aid Simplicity of aid as an investment substitute Presumption of sustainability of growth once a country leaves poverty trap (Walt Rostow’s “take-off”) Poverty traps are the main rationale for foreign aid

4. Do poverty traps really exist? Some remain unconvinced: So what if poverty traps don’t exist? Increased investment through foreign aid is still good This rationale implies solving a problem without understanding its causes The crucial issues of increased investment Project selection Commitment of investors Efficiency of investment Kraay and Raddatz (2007) offered an empirical refutation of poverty traps For poverty traps to exist, subsistence levels across countries must be different – but they are the same

5. Positive analysis Supply side: Why donor countries give foreign aid? Alesina and Dollar (2000) show political considerations, e.g., 57% of France’s aid goes to its former colonies Kuziemko and Werker (2006) link aid to political support from recipient countries, e.g., U.N. Security Council membership increases aid from the U.S. by 59% Donors are not responsive to public policies of recipient countries, both good and bad Alesina and Weder (2002) show no link between the level of corruption and aid Demand side: Why countries receive foreign aid? Tornell and Lane (1999) demonstrate a voracity effect: the more aid you get, the more aid you need

6. Mechanisms of foreign aid: Funding of investment projects Weaknesses of this rationale for aid Marginal productivity (efficiency) is smaller than in investments funded by private capital No market criteria for investment project selection or demanded rate of return Issues of accountability in foreign aid Investors not accountable to the recipient country constituency More accountable to constituencies in donor countries, but those constituencies have no immediate interest in efficiency of aid projects

7. Mechanisms of foreign aid: Budgetary support Weaknesses of this rationale for aid The claim: aid reduces tax burden while keeping budgetary balance  increases private investment BUT this depends on the model of behavior of recipient governments Boone (1996): models of behavior Elitist government Egalitarian government Government oriented toward free market Budgetary support leads to increased public expenditure with the same or bigger tax burden and no increased private investment

8. Empirical results: The bigger aid, the smaller growth rate

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