Volume 1, Issue 2 2010 Article 5
Journal of Globalization and
Development
Aid, Growth, and Development: Have We
Come Full Circle?
Channing Arndt, University of Copenhagen
Sam Jones, University of Copenhagen
Finn Tarp, University of Copenhagen and UNU-WIDER
Recommended Citation:
Arndt, Channing; Jones, Sam; and Tarp, Finn (2010) "Aid, Growth, and Development: Have We
Come Full Circle?," Journal of Globalization and Development: Vol. 1: Iss. 2, Article 5.
DOI: 10.2202/1948-1837.1121
Aid, Growth, and Development: Have We
Come Full Circle?
Channing Arndt, Sam Jones, and Finn Tarp
Abstract
The micro-macro paradox has been revived. Despite broadly positive evaluations at the
micro- and meso-levels, recent literature doubts the ability of foreign aid to foster economic
growth and development. This paper assesses the aid-growth literature and, taking inspiration from
the program evaluation literature, we re-examine key hypotheses. In our findings, aid has a
positive and statistically significant causal effect on growth over the long run, with confidence
intervals conforming to levels suggested by growth theory. Aid remains a key tool for enhancing
the development prospects of poor countries.
KEYWORDS: foreign aid, growth, aid effectiveness, causal effects
Author Notes: We have benefited greatly from editorial advice and a careful anonymous
referee report. We also thank Tony Addison, Ernest Aryeetey, Pranab Bardhan, Bruce Bolnick,
Imed Drine, Jan Willem Gunning, Gerry Helleiner, Paul Isenman, Homi Kharas, Dirk Krueger,
David Roodman, Erik Thorbecke, Alan Winters, and Adrian Wood for encouragement and most
valuable comments. The same goes for the participants at conferences and seminars held by the
African Economic Research Consortium (AERC), the Bergen Resource Center for International
Development at CMI Norway, the Brookings Institution, central ministries in Mozambique,
Tanzania and Vietnam, Cornell University, the European Union Development Network (EUDN)
(organized by CERDI, Clermont-Ferrand, France), the Helsinki Center for Economic Research
(HECER), NORAD Norway, OECD Paris, the United Nations HQ (organized by UNU-ONY), the
University of Copenhagen, the University of Ghana, the UNU Conference of Directors
(CONDIR), and UNU-WIDER. Thanks are also due to Tseday Jemaneh Mekasha for excellent
research assistance and to Raghuram G. Rajan and Arvind Subramanian for sharing their original
data and STATA files. The usual caveats apply.
1. Introduction
The extent to which foreign aid can be a decisive factor in the economic
development of low-income countries remains controversial. In 1987, Paul
Mosley suggested that while aid seems to be effective at the microeconomic level,
any positive aggregate impact of aid is much harder to identify (Mosley, 1987).
He labeled this the “micro-macro” paradox. Now, after two decades of intense
analytical work using new theory, new data, and new empirical methodologies, it
would appear that the paradox has been revived. At the macro-level, Rajan and
Subramanian (2008) conclude “it is difficult to discern any systematic effect of
aid on growth”. Nevertheless, evaluations of aid effectiveness at the
microeconomic level continue to indicate positive rates of return (World Bank,
2008). Also, an increasing number of rigorous microeconomic impact evaluations
have demonstrated the potential for well-designed project interventions to
generate positive results (Banerjee and Duflo, 2009).
This paper has two objectives. First, we attempt to provide a balanced, up-
to-date assessment of the aid-growth literature. We observe that, while aid may
have very high returns in specific circumstances (Collier and Hoeffler, 2004),
expectations surrounding the average potency of aid have been excessive. Second,
we turn our attention to the fundamental empirical evaluation challenge:
identifying the counterfactual. Using observational data, there is no way of
identifying a plausible counterfactual without making assumptions that are bound
to be debatable, in theory and practice. Applying recent methodological advances
in the program evaluation literature to a macroeconomic question, we propose and
implement a number of empirical improvements. These include strengthening the
aid instrument, improving the model specification, and employing a new doubly
robust estimator. We show, contrary to other recent results, that there is no firm
basis on which to reject the prior that foreign aid exerts a modest long-run
positive effect on growth in developing countries.
The remainder of this paper is structured as follows. Section 2 provides a
literature review. Section 3 considers empirical strategies used to investigate the
aid-growth relationship. Section 4 implements our proposed enhancements and
presents results. A final section summarizes and concludes that there is no micro-
macro paradox.
1
1
Please refer to Arndt et al. (2010) for an earlier working paper version of this paper for further
details on background, analytical methods, data, sensitivity tests, and results.
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Arndt et al.: Aid, Growth, and Development: Have We Come Full Circle?
2. Literature review
Scholarship on the relationship between aid, growth, and development is
voluminous. This section provides a brief survey of how the aid-growth debate
has evolved.
2.1. Earlier generations
Studies of the aid-growth relationship from the 1970s until recently have been
classified into three generations, each influenced by dominant theoretical
paradigms as well as available empirical tools (Hansen and Tarp, 2000). The first
two generations were inspired by simple models of the growth process, i.e. the
Harrod-Domar model and the two-gap Chenery-Strout extension. The underlying
idea behind the Harrod-Domar model is of a stable linear relationship between
growth and investment in physical capital. Assuming all aid is invested, it is
straightforward to calculate how much aid is required to achieve a target growth
rate. The impact of aid is positive and helps plug either a savings or a foreign
exchange gap. Empirical studies in this tradition consequently focused on the
extent to which aid increased savings and investment in recipient countries
(Papanek, 1972, 1973). Overall, first generation studies show that aid tends to
increase total savings, but not by as much as the aid flow. Quite reasonably, this
suggests a non-negligible proportion of aid is consumed rather than invested.
Retaining the focus on capital accumulation, a second generation of
literature explored the impact of aid on growth via investment. Using data for a
cross section of countries, a large number of studies of this kind were produced
during the 1980s and early 1990s. These studies consistently pointed to a positive
link between aid and investment. While a majority of the aid-growth studies of
this generation also suggested a positive impact, the result that captured attention
was Paul Mosley’s micro-macro paradox. An influential line of critique of the
Harrod-Domar and two-gap approach was the argument that growth is less related
to physical capital investment than often assumed (Easterly, 1999). If the
productive impact of aid depends more on incentives and relative prices, as well
as the policy environment more generally, then it becomes important to consider
these broader effects. The second generation of studies also introduced the
problem that poorly performing countries may receive more aid precisely because
of their poor growth performance. Empirical analyses that do not account for the
endogeneity of aid will not reveal aid’s causal impact. Most second generation
studies, however, did not deal with this issue.
From the early 1990s a third generation of more sophisticated econometric
studies came to dominate the discourse about aid. This was motivated by the
availability of panel data, allowing analysts to look at changes both across and
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Journal of Globalization and Development, Vol. 1 [2010], Iss. 2, Art. 5
DOI: 10.2202/1948-1837.1121
within countries over time. Insights from new theories of economic growth also
influenced the research agenda. Mindful of the weaknesses of previous studies,
the aid-growth relationship came to be perceived as (possibly) non-linear and the
endogeneity of aid was taken more seriously. Among the numerous studies of this
generation, the contribution by Burnside and Dollar (2000) came to exert a
significant influence on policy. These authors made an argument for conditional
aid effectiveness, specifically: “aid has a positive impact on growth in developing
countries with good fiscal, monetary and trade policies ... [but] ... in the presence
of poor policies, aid has no positive effect on growth” (2000: 847).
However, these results were subject to criticism. Hansen and Tarp (2001)
found that a story of diminishing returns to aid best captured the non-linear
relationship between aid and growth. In a later contribution, Easterly et al. (2004)
added that the Burnside-Dollar aid-policy result is fragile when the dataset is
expanded (by years and countries). Dalgaard et al. (2004) found that aid has been
less effective in tropical areas over the last 30 years and called for further research
to help disentangle the channels through which aid matters for productivity. In an
empirical review of these contributions, Roodman (2007) argued that the results
of this generation are extremely sensitive to methodological choices, concluding
that while some aid is likely to increase investment and growth, aid “is probably
not a fundamentally decisive factor for development” (2007: 275).
2.2. Recent studies
More recently, a fourth generation of literature has emerged. A distinctive aspect
of this generation is the view that aid’s aggregate impact on economic growth is
non-existent. A leading paper that appears to establish this result is Rajan and
Subramanian (2008). They find no systematic effect of aid on growth regardless
of the estimation approach, the time period. and the type of aid. Explanations for
non-positive aggregate effects of aid often refer to political economy dynamics.
For example, Djankov et al. (2008) argue that aid has effects that are analogous to
a natural resource curse. Similarly, Rajan and Subramanian (2007) find that the
rate of growth of value added by the manufacturing sector in developing countries
has been undermined by a detrimental effect of aid inflows on governance quality.
Fourth generation scholars have also become increasingly skeptical about
our ability to make valid causal inferences with respect to complex aggregate
phenomena, such as the determinants of economic growth. In particular, previous
methods used to deal with endogeneity have been subject to criticism. There is
increasing awareness that dynamic panel (system) GMM methods – frequently
employed in the third generation – are not a panacea. The concern that weak
instruments typically bias coefficient estimates towards their unadjusted
counterparts (e.g., OLS or panel fixed effects estimates) applies as much to panel
GMM as to cross-section estimators. Bun and Windmeijer (2010) show that the
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