Essay

Title: Is Foreign Aid Leading the Way Out of Poverty?

Author: Andreas Bernhard
CIB 02/09
andreas_bernhard@vtxmail.ch
University: PHW, Zurich
Management Science

Lecturer: Bojana Lobe

Place, date: Zurich, March 1, 2010

1
Is Foreign Aid Leading the Way Out of Poverty?

Abstract

This paper's goal is to examine the effect of foreign aid on reducing poverty in third world countries. The
impact of foreign aid on reducing poverty is ultimately an empirical question and one that will be ad-
dressed in this paper. Poverty reduction has become an issue of great interest after the adoption of the
United Nations Millennium Development Goals (UN MDG)1 in which the international community has set
the goal to halve poverty by 2015.

The fact that so many countries register low per capita income after receiving enormous amounts of
foreign aid questions its effectiveness as an instrument of poverty alleviation (Abdiweli and Hodan,
2005).

Three important conclusions emerged from the analysis of the literature. First, it shows that the effect of
aid on growth is non-linear. Second, the results support Burnside and Dollar's findings that a good policy
environment is important for effective aid. Finally, there is big controversy over how to calculate aid effi-
ciency as Burnside and Dollar left several social components out of their equation.

1
In the literature it is also referred to as the eight International Development Goals, which are referring to poverty, education,
gender equality, child mortality, maternal health, combat diseases, environment and global partnership. For further information
see Appendix A.

Bernhard A. 2
Is Foreign Aid Leading the Way Out of Poverty?

Introduction

Ten percent of the world's population produces 70 percent of its goods and services and therefore, re-
ceives 70 percent of the whole world income. This means an average of USD 30,000 per person. At the
other extreme, half of the world's population lives on less than USD 2 per day. (Collier and Dollar,
2004).

Collier and Dollar (2004) find that differences in productivity and income across countries can be ex-
plained by differences in economic institutions and policies. Some countries have a good environment
for households and firms alike to save, invest and increase their productivity, while other countries have
poor environments. Primarily, rapid poverty reduction in low-income countries depends on these coun-
tries improving their own policies and institutions.

However, foreign assistance is also important. In the past 50 years, over 1 trillion US dollars have been
given in foreign aid, though millions of people in third world countries still live in abject poverty (Abdiweli
and Hodan, 2005). Since the first official development assistance (ODA)2 programs were instituted, the
question of the effectiveness of foreign aid remains an unresolved issue. Many papers have been writ-
ten on the macroeconomic impact of foreign aid reporting mixed results (Masud and Yontcheva, 2005).

According to Masud and Yontcheva (2005) most studies on the effectiveness of foreign aid focus on the
impact of flows on gross domestic product (GDP) growth and other macroeconomic variables, such as
investment or public consumption, referring that aid is meant to bridge the savings investment gap that
poor countries face. There has been less research conducted on the impact of foreign aid on the evolu-
3
tion of human development indicators (HDIs) though the objectives by the donors have evolved from
intensive industrialization programs advocated in the 1950s to more recent poverty-reducing objectives
such as the UN MDGs. This should lead to the examination whether aid flows have a positive impact on
selected HDIs.

Bahmani-Oskooee and Oyolola (2009) state that advocates of foreign aid such as Sachs and McArthur
(2001) believe that targeted aid can help eradicate poverty in developing countries. But others have
questioned its effectiveness in reducing poverty. Bahmani-Oskooee and Oyolola (2009) refer to Eiras

2
ODA: Official Development Assistance. Flows of official financing administered with the promotion of the economic develop-
ment and welfare of developing countries as the main objective, and which are concessional in character with a grant element
of at least 25 percent (using a fixed 10 percent rate of discount). By convention, ODA flows comprise contributions of donor
government agencies, at all levels, to developing countries (“bilateral ODA”) and to multilateral institutions. ODA receipts com-
prise disbursements by bilateral donors and multilateral institutions. Lending by export credit agencies - with the pure purpose
of export promotion - is excluded.
(OECD, http://stats.oecd.org/glossary/detail.asp?ID=6043)
3
HDI: Human Development Indicator. The Human Development Indicator was introduced in 1990 by UNDP (United Nations
Development Program) as a new way of measuring human development by combining different indicators into a composite
index. It offers a more comprehensive socio-economic measure than the GNP and makes it possible to compare countries in
a different way. The HDI is a composite of three basic components of human development: i) longevity: measured by life ex-
pectancy; ii) level of knowledge: measured by a combination of adult literacy index (two-thirds weight) and mean years of
schooling (one-third weight); ii) standard of living: measured by purchasing power, based on real GDP per capita adjusted for
the local cost of living (purchasing power parity) (UNDP, http://hdr.undp.org/en/statistics/indices/hdi/ and
http://www.medea.be/index.html?page=2&lang=en&doc=98)

Bernhard A. 3
Is Foreign Aid Leading the Way Out of Poverty?

(2004), for example, who argues that developing countries must first undertake profound economic and
institutional reforms that protect private property to participate in economic activities.

Burnside and Dollar (2004) state that foreign aid is most effective in countries with good fiscal, monetary
and trade policies. Other papers go in the same direction. ‘Poverty reduction – in the world or in a par-
ticular region or country – depends primarily on the quality of economic policy.’ (Collier and Dollar, 2000,
32). These two findings suggest, that, before sending substantial funds into poor regions or countries,
the donating institutions and governments need to help the developing countries to improve their poli-
cies to establish a stable environment, both politically and economically, for households and firms to
invest.

Can foreign aid contribute to poverty reduction? Is aid effective in fighting poverty? If not, under what
conditions can it be? This paper investigates different channels through which aid can help accomplish
the UN MDGs set by the international community for poverty-plagued aid-recipient countries.

Bernhard A. 4
Is Foreign Aid Leading the Way Out of Poverty?

Theoretical background

Measuring Aid and Other External Resources

There are different ways to measure foreign aid, as Djankov, Montalvo and Reynal-Querol (2006) state.
Traditionally, ODA is used by the literature that analyses the effect of aid on development. ODA refers
to official financing or any other assistance given by governments to developing countries to promote
and implement development. ODA can be distinguished into two major categories: multilateral and bi-
lateral assistance. Multilateral assistance is meant, when help is channelled through multilateral devel-
opment financial institutions and United Nations agencies. Bilateral assistance is given directly by one
government to the developing country: Bilateral assistance may again be divided into two main catego-
ries: bilateral loans4 and bilateral grants, which, in turn, may be categorised in grant aid and technical
5
assistance. In contrast, Burnside and Dollar (2000) use the size of the EDA (Effective Development
Assistance).

ODA captures the flow of funds to the recipient country in a particular year minus what the
country returns, while EDA reflects the portion of ODA that corresponds with a pure transfer of
resources from donors to the recipient country (Djankov, Montalvo and Reynal-Querol, 2006)

Aid Effectiveness – Poverty-Efficient Allocation of Aid

Collier and Dollar (2002) find that the actual allocation of aid is radically different from the poverty-
efficient allocation. In the efficient allocation, for a given level of poverty, aid tapers in with policy reform,
but in the actual allocation aid tapers out with reform. If donors wish to maximize the reduction in pov-
erty, aid should be allocated to countries which have large amounts of poverty and good policy. Accord-
ing to Collier and Dollar (2002) the presence of large-scale poverty is necessary such that aid has a
large effect on poverty reduction. The good policy ensures a positive impact.

One concern that arises is whether there are in reality developing countries with good policies and mass
poverty. It is possible that the two variables are negatively correlated to a high degree. Collier and Dollar
(2002) found in their studies that there are 32 countries with good policy and a high poverty rate. More
remarkably, a large majority of the world's poor lives in these 32 countries: 2 billion people out of a total
of 2.7 billion poor people in the 113 countries they included in their study. Not surprisingly to Collier and
Dollar (2002), most of the countries classified with high policy and high poverty have reformed in the
past 10 years (for example India, Uganda, Ethiopia and Mali). In these countries the aid will have more
impact on poverty reduction where there are two billion poor people and policy makes aid effective. On
the other hand, in countries classified with poor policy and high poverty, where there are most of the
remaining 0.7 billion poor people, the effectiveness is hampered by poor policies. In countries classified

4
Loans whose grant element is at least 25 percent (Djankov, Montalvo and Reynal-Querol, 2006)
5
EDA: Effective Development Assistance. This is an aggregate measure of aid flows combining total grants and the grant
equivalents of all official loans. (World Bank, http://go.worldbank.org/JH8IWV0WJ0)

Bernhard A. 5
Is Foreign Aid Leading the Way Out of Poverty?

with good policy and low poverty, assistance is effective in promoting growth, but there is less aid
needed since these countries have low poverty already.

Burnside and Dollar's (2000) academic study on “Aid, Policies, and Growth” investigate the relationship
between foreign aid, economic policy and growth per capita GDP using a database on foreign aid de-
veloped by the World Bank. They run a number of regressions in which the dependent variable of
growth rates in developing countries depends on initial per capita national income, an index that meas-
ures institutional and policy distortions, foreign aid and aid interacted with policies. To avoid the problem
that aid and growth may be correlated over periods of a few years, but not on year-to-year-basis, they
divide their sample into six four-year time periods running form 1970-1973 to 1090-1993. They also use,
in certain specifications, variables for ethnic fractionalization, whether assassinations occurred, dummy
variables for certain regions and even a measure of arms imports. They find the interaction term be-
tween foreign aid and good policy to be significantly positive, and they summarize (p. 847):

We find aid has a positive impact on growth in developing countries with good fiscal, monetary,
and trade policies but has little effect in the presence of poor policies.

Easterly, Levine and Roodman (2003) use the exact same specifications as Burnside and Dollar (2003),
but simply added more data that had become available since their study was performed. In addition,
they hunted for more data on institutional quality in their original sample period of 1970-1993. Compared
to Burnside and Dollar (2003) they found that the coefficient on the crucial interaction term between aid
and policy was insignificant in the expanded sample including new date, indicating no support for the
conclusion that aid works in a developing country which has a good policy environment. The explained
part of the growth and aid-policy terms changes with the new dataset. The significance of the interactive
variable between aid and public policy is not robust to other, equally plausible, definitions of aid, policies
and growth. Easterly, Levine and Roodman’s (2003) findings is evidence against the Burnside-Dollar
findings.

Burnside and Dollar’s (2000) definition of aid is the grant element of aid, excluding the loan component
of concessional loans6, which are made at extremely low interest rates, a measure of concessional
loans net of repayment of previous aid loans. Easterly (2003) states that this is a measure that treats
forgiveness of past loans as current aid which is called Official Development Assistance (ODA). It may
be a reasonable measure of the actual transfer to liquidity-constrained governments. But using this al-
ternative definition, the interactive terms with aid and policy is no longer statistically significant, not even
at a ten percent level in the Burnside-Dollar policy specification and country sample.

Burnside and Dollar (2000) construct an index number for what is meant by good policy that includes
the budget surplus, the inflation rand and a measure of openness of an economy. The weight of these

6
These are loans that are extended on terms substantially more generous than market loans. The concessionality (which
meant the extent to which the terms of a soft i.e. below market rates loan reduce a lender's returns in comparison with a loan
of the same amount and duration as the soft loan advanced at full market rates). is achieved either through interest rates be-
low those available on the market or by grace periods, or a combination of these. Concessional loans typically have long
grace periods. (OECD, http://stats.oecd.org/glossary/detail.asp?ID=5901)

Bernhard A. 6
Is Foreign Aid Leading the Way Out of Poverty?

three terms in the policy index were determined by a regression where these terms were used as inde-
pendent variables to predict growth, without including any terms for foreign aid or other variables. East-
erly (2003) tries out several policy indexes using combinations of these variables, where the variables
were weighted according to their power in explaining growth in a regression that left out all aid variables.
Running the Burnside and Dollar (2000) regressions with these alternative measures of policy, the in-
teractive term of aid and good policy was no longer statistically significant in any of the alternative defini-
tions of the index. Their definition of growth as real per capita GDP growth over four year periods may
capture business-cycle fluctuations and may not be long enough a period of good policy to set up bene-
ficial effects of aid. However, the coefficient on the interaction term between aid and policy no longer
enters significantly for periods of 12 years and for the pure cross-section of 24 years. Obviously, length-
ening the sample period decreases sample size and thus decreases statistical power. The result that
aid boosts growth in good policy environments is fragile to defining growth, aid and policy offer a suffi-
ciently short period. It is crucial to consider what is meant by seemingly commonsensical terms like aid,
good policy and growth when considering carrying out an empirical study on this subject (Easterly,
2003).

Burnside and Dollar's paper (2000) was the basis of a policy recommendation to increase foreign aid, if
only other policies were good, without further testing e.g. using alternative definition of “aid”, “policies”
and “growth”. Easterly (2003) states that The British Department for International Development argued,
based on the Burnside and Dollar's working paper, that developments assistance can contribute to re-
ducing poverty in countries pursuing sound policies. Easterly (2003) refers in his work to the Canadian
International Development Agency which confirmed in their paper that the World Bank researchers
Burnside and Dollar had provided compelling evidence that good governance and sound policy envi-
ronment are the most important determinants of aid effectiveness. According to Burnside and Dollar aid
does boost growth when the countries have reasonable economic policies.

Foreign Aid as an Engine of Economic Growth

However, the United States with the lowest aid-to-GDP ratio of any rich country was debating in 2002
about whether to increase foreign aid because of the propagated thesis by Burnside and Dollar that aid
can help but it should be concentrated on countries with good macroeconomic policy and governments
genuinely committed to improving public services and infrastructure, and stamping out corruption (East-
erly, 2003). Estimates by Burnside and Dollar suggest that 1 per cent of gross domestic product in aid
given to a poor but well-managed country can increase its growth rate by a sustained 0.5 percentage
points. Easterly (2003) quotes a speech given by the president of the World Bank from 1995 - 2005,
James Wolfensohn, who argued that corruption, bad policies, and weak governance will make aid inef-
fective and that donors had become more discriminating in directing aid to countries with good policies
and that therefore there should be a doubling of current aid flows. Easterly (2003) states that the
George W. Bush United States announced in 2002, based on Burnside and Dollar's report (2000), hat
they will reward nations that have more open markets and sustainable budget policies, nations where
people can start and operate a small business without running the gauntlets of bureaucracy and bribery.

Bernhard A. 7
Is Foreign Aid Leading the Way Out of Poverty?

Hence, according to Easterly (2003), there is a clear link running from a growth regression in an eco-
nomic study to a policy outcome due to Burnside and Dollar's paper (2000). Easterly questions about
the robustness and broader applicability of the results and asks what happens when alternative defini-
tions of aid, good policy and growth are used.

The logical foundation of providing external aid (other than specific purpose humanitarian assistance) to
developing countries is to facilitate improved economic development, including enhanced economic
growth. The presumption is that external aid generates investments and this leads to economic growth.
The technical approach for the assessment of the magnitude of external aid the main basis for this has
been the two-step-model, also called the financing model, which is also called the financing gap model.
It was developed in 1966 by Chenery and Strout. In early formulations relating the role of aid in effecting
economic growth, they suggested the two-gap formula: savings gap and foreign exchange
(Ramachandrarao, 2003).

Masud and Yontcheva (2005) refer to the two-gap model, asking if focussing on whether aid improves
GDP growth can be traced back to the two-gap model and which developing countries face constraints
on savings and export earnings that hamper investments and economic growth. Aid flows are meant to
fill the gap between investments needs and domestic savings.

Foreign Aid as an Obstacle to Economic Growth

Masud and Yontcheva (2005) explain that the three disappointing results of most aid effectiveness stud-
ies are: aid is misallocated (donors give aid for strategic reasons to the wrong recipients), aid is misused
(recipient government pursue non-development agendas) and GDP growth is not the right measure of
aid effectiveness. First, while all aid effectiveness papers implicitly define the donors’ objective as solely
the promotion of economic growth or the reduction of poverty in the recipient countries, a parallel stand
of literature on aid allocation has shown that most donors often pursue a different underlying agenda
and allocate aid also according to their own strategic interest. If a significant part of aid is allocated for
strategic purposes, no positive impact in terms of growth or poverty alleviation should be expected. Sec-
ond, most studies on aid effectiveness assume that the recipient government shares the donor’s offi-
cially altruistic objective. But a recipient government and a perfectly altruistic donor can have conflicting
objectives, as the former represents a variety of stakeholders, including wealthy individuals who might
influence the aid distribution. As argued by Masud and Yontcheva (2005) this needs not be so. If foreign
aid is misallocated and misused, then it cannot be expected to have a significant impact on growth.
Third, as suggested by Boone (1996), aid effectiveness should not be measured by its impact on GDP
growth. Aid could be increasing consumption rather than investment, which would explain the disap-
pointing results of studies on growth, but still reduce poverty through either ‘higher consumption of the
poor or greater provision of services to the poor.’ Boone tested for this by examining the impact of aid
on changes in basic indicators of human development such as infant mortality, primary schooling ratios,
and life expectancy. Given the evolution in the avowed objectives of the donor community from industri-
alization programs to poverty reduction as reflected in the adoption of MDGs, my report will also show
the impact of aid on social indicators

Bernhard A. 8
Is Foreign Aid Leading the Way Out of Poverty?

Easterly (2003) refers to inconclusive and long literature on aid and economic growth in the 1960s,
1970s and 1980s, which was hampered by the limited data availability and considerable debate about
the specification and the mechanisms by which aid would affect growth. For example, if greater aid was
given in response to slower growth, then interpreting how aid flows affect growth could be difficult.
Boone (1996) finds that aid financed consumption rather than investment. Financing consumption of a
few poor people is not so bad, but the proponents of aid hopes for the kind of society-wide transforma-
tion that would come from aid financing investment and growth. Boone’s paper has introduced determi-
nants of aid as instruments to address problems of reverse causality. Easterly (2003) states that some
proponents have argued that aid could also buy time for reformers to implement painful but necessary
changes in economic policies. He emphasizes the fact that there were many reactions to the Burnside
and Dollar paper (2002) introducing variables such as aid squared, terms of trade shocks, variability of
agricultural output and exports. Some of these papers confirm the message of Burnside and Dollar that
aid only works in good policy environment, while others find that when particular variables are added,
the coefficient on the interaction between aid and policy becomes near-zero and statistically insignifi-
cant.

Millennium Development Goals and Human Development Indicators - Infant mortality and adult
illiteracy

Masud and Yontcheva (2005) complement the literature on the effectiveness of foreign aid by assessing
the impact of foreign aid flows on social indicators instead of on GDP growth. They empirically verify
whether foreign aid has had a positive impact on two human development indicators whose improve-
ment is part of the MDGs. They investigate the impact of aid on infant mortality and adult illiteracy. Be-
cause they differ in both motivation and implementation, they distinguish between bilateral aid and non-
governmental aid. They also test whether foreign aid reduces the efforts a recipient country government
makes in fighting illiteracy and infant mortality. Therefore, they assess the impact on aid on the share of
social spending of recipient countries. The focus on the two selected human development indicators
whose improvement is part of the MDGs, are for the following reasons: i) health and education indica-
tors are more concrete measures than poverty; ii) as indicated by Boone (1996), infant mortality indica-
tors respond quickly to improved health services and can therefore be considered as an indicator of im-
provement in the conditions of the poor.

Bernhard A. 9
Is Foreign Aid Leading the Way Out of Poverty?

Theoretical model – defining the problem (1000)

Hypothesis I:

Foreign aid does not help efficiently to reduce poverty.

Foreign aid, as put in place by the developed nations, following the studies of Burnside and Dollar
(2000), is not effective in reducing poverty. The help reaches the countries that, due to their political sta-
bility, would eventually find their own way out of their misery.

Hypothesis II:

Foreign aid does not reach the needy people.

Poverty and hunger often lead to political instability which in turn excludes the country of a foreign aid
program. Helping developing countries with good policy neglects the fact that the vast portion of the
poor population is to be found in developing countries with poor policy.

Bilateral aid has a large positive association with government consumption, whereas multilateral aid has
none. If aid is associated with donor interests, in most cases bilateral aid, it increases government con-
sumption and is therefore more effective (Burnside and Dollar, 2000). Burnside and Dollar (2004) reject
hypothesis I by referring to the Marshall Plan that accelerated European growth after World War II. It is
the model they have in mind with a significant volume of finance pumped into an environment of solid
institutions and social infrastructure. Referring to hypothesis II I suggest that Burnside and Dollar might
be right that foreign aid leads to growth in countries with a good set of policies, however, this does not
necessarily reduce the overall global poverty since the poorest most likely live in countries where the
policies are far from good and therefore aid does not reach them.

As mentioned earlier, more than two thirds of the poor live in countries with good policies like India,
Uganda and Mali. The term “good policies” in Burnside and Dollar (2000) refers to the economics and
does not relate to the social policies conducted by the recipient that would elevate their people from
poverty through the use of funds from foreign aid. The World Bank states that:

Since poverty is complex and multidimensional, the strategies should be comprehensive and in-
clude plans for rapid economic growth, sound macroeconomic policies, structural reforms, and
social improvement. (World Bank, 2000)

Not always does aid lead to reform. Although there are several particular instances where aid does in-
duce reform, in some cases aid actually delays reform. These results are consistent with other literature
(Collier and Dollar, 2002; citing Collier, 1997; Killick 1991; Rodrik 1996; Williamson 1994). Since aid in
those cases is not given as an incentive for reforms, the recipients do not comprehend the point for re-
form. Aid should not only be financial. Donors should help the recipient to reform. Svensson (1997)

Bernhard A. 10
Is Foreign Aid Leading the Way Out of Poverty?

mentions that the major aim of stabilization and structural reform assistance is to facilitate a move to-
wards a sustainable fiscal situation, where the recipient can finance its own social objectives. Given the
limitation of aid resources, an altruistic donor would like to allocate his aid to those in most need. Com-
petition among the receiving countries accentuates the problem of delay of reform. Recipients lower
their efforts in order to receive a larger share of the total aid budget. A large flow of foreign aid may
generate corruption and even civil wars. (Djankov, Montalvo and Rynal-Querol, 2006). Djankov,
Montalvo and Rynal-Querol (2006) as an example, examined a USD 180 million project of the World
Bank, one of its largest. The project was to finance the Chad-Cameroon oil pipeline. To avoid corrup-
tion, the revenue was supposed to go into offshore accounts and the government of Chad was required
to spend the money only on education, health, and infrastructure. Once the first USD 4.5 million was
paid, Chad used the funds to buy weapons. It is estimated, that as much as USD 12 million out of the
revenues from the oil pipeline was spend on arms. The World Bank has suspended all its loans to
Chad. (Djankov, Monalvo and Rynal-Querol, 2006)

Collier and Dollar (2002) found that the aid allocation is not very efficient. However, aid achieves much
in terms of poverty reduction. Collier and Dollar (2002) estimate that in their sample of countries the
present allocation of aid lifts 10 million people permanently out of poverty each year. A more efficient aid
allocation would increase this number to 19 million each year. In another paper Collier and Dollar (2000)
took the example of Africa to show how efficient aid allocation would shrink the poverty rate. With the
current allocation they estimate, that the poverty rate in Africa would decline from 72 percent in the year
2000 to 64 percent in 2015. The efficient aid, as Collier and Dollar (2000) proclaim, would double the
decline in poverty, which would let the poverty rate drop to 56 percent in 2015. In another example, the
poverty rate of ECA (Eastern Europe and Central Asia) would increase with the current aid allocation
from 28 percent in the year 2000 to 43 percent in 2015. With “efficient aid”, the poverty rate would still
reach 41 percent of the population. In fact, taking the developing world as a whole, efficient aid makes
only a small difference with the poverty rate only dropping from 31 percent to 30 percent.

Another restriction on growth by foreign aid is described by Przeworsky and Vreeland (2002). The Inter-
national Monetary Fund (IMF) attaches to the loans it grants to its members instalments. These condi-
tions consist of fiscal austerity (cutting government expenditures and increasing taxes), tight monetary
policy (raising interest rates and reducing credit creation), and currency devaluations. All these meas-
ures hinder growth.

Djankov, Montalvo and Reynal-Querol (2006) show that foreign aid has a negative impact on the de-
mocratic stance of developing countries, and on economic growth by reducing investment and increas-
ing government consumption. But receiving grants (free money) is negatively associated with future
growth, while receiving loans has an insignificant effect of economic development.

Making aid effective is difficult. The conditionality principle does not seem to work because of
the lack of credibility of the punishment. Empirical studies show that loans may help to induce

Bernhard A. 11
Is Foreign Aid Leading the Way Out of Poverty?

some discipline and a more effective use of the funds, since they have to be returned (Djankov,
Monalvo and Rynal-Querol, 2006).

Bernhard A. 12
Is Foreign Aid Leading the Way Out of Poverty?

Methods

Internet research
First, I will collect recent data about poverty and foreign aid from the World Bank website to see which
countries are the biggest spenders and which recipients are the biggest receivers. I try to get access to
different science data collections which provide detailed resource for the latest thinking of this issue and
conduct cross-national comparisons. An extensive bibliography is needed to research in the field.

Journals and papers

Scholarly journals are a good resource for peer-reviewed research in the chosen topic. Moreover, read-
ing research papers and being able to critically evaluate them as well as considering the methods used
by a paper’s author is essential. Starting from the research goals, analyzing quantitative and qualitative
data, interpreting and reporting results are needed for the essay.

Personal depth interviews

Rather than rely solely on data from the World Bank and other sources, I will confront donors and re-
cipients directly and get the data from themselves. First, I will conduct personal depth interviews with
important members of both donors and recipients. In that way I will be able to obtain complete and pre-
cise data. The personal interview, though very time consuming, provides the opportunity to clarify an-
swers given by the interviewee. To the donors the interview will include questions about their motivation
to send aid to the developing countries. What incentives do the donors expect from the recipients of
their aid? What prerequisite must a recipient meet? The recipients will be asked questions about the
way they would spend the funds provided. What is the biggest problem in your country that could be
solved with the funds provided by the donors? What incentives would you demand in order to reform
your policies?

Surveys
Out of the answers collected from the depth interviews I will create two surveys that I will send to all do-
nors and recipients of foreign aid. I will confront them with the answers of my interviews. The partici-
pants will have to determine for themselves if the statements provided are true for them (on a scale from
1 to 4). This scale prevents that everyone tends to tick the box in the middle between 100 percent true
and 100 percent false.

Variables
I critically analyze not only the methodologies of research but also the statistical results. The issues of
variable selection and control, reliability, and validity must be addressed even before testing any sub-
jects. The purpose of any research is to determine if a theory is supported or not, based on statistical
analysis. The variables must be defined and the methods of conducting the research must be deter-
mined.

Bernhard A. 13
Is Foreign Aid Leading the Way Out of Poverty?

A variable is simply anything that can vary. Every test has at least two types of variables: The inde-
pendent variable (IV) is often thought of as the input variable. It is called independent because it is in-
dependent of everything that occurs during the test. Once it is chosen it does not change. The depend-
ent variable (DV), or outcome variable, is dependent on the independent variable or input variable.
There is third type of variables, the confounding variables. Any variable that can potentially play a role in
7
the outcome of a study but which is not part of the study is called a confounding variable. To identity
variables that could be determinants of infant mortality and illiteracy, Masud and Yontcheva (2005), be-
sides testing for bilateral and nongovernmental aid, they ‘control for the level of development repre-
sented by per capita GDP, the poverty, headcount, the level of rural development, as indicated by per
worker agricultural value added, and female illiteracy.’ They examine the impact of government efforts in
reducing infant mortality represented by the per capita health expenditure. Moreover they verify the im-
pact of institutional variables, e.g. a governance index represented by the Freedom House policy indica-
tor (ICRG) and the degree of urbanization. I will test their calculations with the group of countries I select
for the survey.

Asra et al. (2005) divide the variables into two categories. Time variant and time invariant: Under time
variant they list

Poverty (used as the dependent variable, poverty is measured by the headcount index, when the pov-
erty line is set at USD 2 per day. They used USD 2 instead of USD 1 stating that the latter yields fewer
technically reliable estimates of poverty than the former.),

Aid (the volume of aid is indicated by effective development assistance (EDA) as a percentage of gross
national income (GNI), expressed as average of each 5-year period.),

Openness (trade as a percentage of GDP, expressed as an average of each 5-year period.),

Government Expenditure (government expenditure is percentage of gross domestic product (GDP), ex-
pressed as an average of each 5-year period.) and

Inflation (log (inflation), expressed as an average of each 5-year period

Under time invariant they list

Quality of Governance index (encompasses four dimensions: control of corruption, government effec-
tiveness; regulatory quality, and role of law.) and

Region Dummies: (includes six regional dummies: EAP: East Asia and Pacific; ECA: Europe and Cen-
tral Asia; LAC: Latin America and Caribbean; MENA: Middle East and North Africa; SA: South Africa;
and SSA: Sub-Saharan Africa.)

7
For review on further explanation of variables by AllPsych and Heffner Media Group, Inc., see
http://allpsych.com/researchmethods/variables.html

Bernhard A. 14
Is Foreign Aid Leading the Way Out of Poverty?

To verify the findings of Burnside and Dollar (2000) and Easterly (2003), I will calculate growth as real
per capita GDP growth over four years. With the same data I will lengthen the period and calculate
growth over 10, 12 and 24 years. Easterly, Levine and Roodman (2003) use the exact same specifica-
tions as Burnside and Dollar (2003), but simply added more data that had become available since their
study was performed. In addition, they hunted for more data on institutional quality in their original sam-
ple period of 1970-1993. In addition I will try to collect more original data from my survey. Using these
calculations I will determine if the controversy between Burnside and Dollar (2000) and Easterly (2003)
still persist.

With all these methods I am confident to prove or disprove of the hypothesises. The collection of own
data is crucial for coming up with an independent insight to the problem. The data collected by institu-
tions like the World Bank or the IMF have a big possibility of being subjective.

Bernhard A. 15
Is Foreign Aid Leading the Way Out of Poverty?

Conclusion

A turn-of-the-century review of the fight against poverty reveals a worrisome picture. While there has
been remarkable progress, particularly in China and other parts of East Asia, abject poverty persists
unabated in many developing countries. Generally those countries with a sustained policy record and
without major internal conflict have made significant headway on growth and poverty reduction (World
Bank, 2000). However, the current rate of progress is too slow to improve the lives of the poor signifi-
cantly within the next 15 years.

The gap between the rich and the poor is large and growing – not just in incomes but in education and
health outcomes as well. The latest assessment undertaken by the World Bank indicates that the
broadly supported UN MDGs – including reducing by half the proportion of people living in extreme pov-
erty by 2015 – will not be met (World Bank, 2000).

Burnside and Dollar (2000) as well as Collier and Dollar (2002) tried to find a way to more efficient for-
eign aid allocation. Their calculations lack of important variables. They are focused mainly on the eco-
nomical measures and leave out social indicators such as infant mortality and illiteracy. Only if foreign
aid shifts its focus towards education and health, can it be sustainable and lift people permanently out of
poverty. Foreign aid that only focuses on the economy is even slowing down the reform process. (Col-
lier and Dollar, 2002)

If aid is allocated efficiently or not does not have a real impact on the worldwide poverty rate. It only
shifts the reduction from one part of the world to another. Therefore, Collier and Dollar (2002) do not
provide an improvement on poverty with their findings. They left China and India out of their allocation
plan, which, considering their growing economical power, seams to be the right thing to do, since these
countries should be able to generate enough funds to reduce poverty among their own people. More-
over, donating countries are more and more reluctant to provide aid to emerging countries that become
a hard competitor to the donor’s economy.

Incentives for recipient countries have to be installed in order for them to improve the rights of their in-
habitants and fight corruption. As in many different fields the world community has to work together to
fight poverty. As long as the interests of the donating countries stay as self centred as they are now, it
will be hardly possible to fight poverty and to meet the UN MDGS of halvening it by 2015.

Poverty is complex and multidimensional. Different recipients have various needs. One model cannot
work for all. It seems to be important to determine what is needed and which donor is able and willing to
provide the right help to the right recipient. The interviews and surveys I described earlier are aiming in
the direction to bring to light what kind of aid is needed and what kind of aid the donors are willing to
provide. The UN could be the right institution to set up a pool in which projects are collected, rated, pri-
oritised and financed. The prioritisation and rating should then be related on the amount of poverty re-
duction and the degree of poverty in the respective region.

Bernhard A. 16
Is Foreign Aid Leading the Way Out of Poverty?

I feel that, with fiscal aid alone, poverty cannot be diminished. The findings of Burnside and Dollar
(2000), Collier and Dollar (2002), Easterly (2003) and others are based on figures and statistics pro-
vided mostly by the World Bank. Figures alone are not capable of showing the impact which aid has on
poor people. In order to reduce poverty it is essential to work in small projects directly with the people
concerned. Simply sending funds to the recipient bears the great risk of corruption and misuse of for-
eign aid. The world community has to show the poor that they are not forgotten and that it is in the inter-
est of the world that prosperity is distributed more fairly among the world’s population. Now in our global
financial system we have the situation of unequal distribution of money and wealth. Immigration is be-
coming a big problem. The only way to stop the huge flows of immigration will be to give the poor a per-
spective to prosper in their own country. Fair foreign aid is one of the mighty instruments with which this
could be achieved.

Bernhard A. 17
Is Foreign Aid Leading the Way Out of Poverty?

References

Abdiweli, A.M. and Hodan I.S. (2005), “An Empirical Analysis of the Effect of Aid on Growth”, Interna-
tional Advances in Economic Research, vol. 11, no. 1

Asra, A., Estrada, G., Kim, Y. and Quibria, M.G. (2005), “Poverty and Foreign Aid Evidence from Recent
Cross-Country Data”, ERD Working Paper no. 65

Bahmani-Oskooee, M., Oyolola M. (2009), “Poverty Reduction and Aid: Cross-Country Evidence”, Inter-
national Journal of Sociology and Social Policy, vol. 29

Boone, P. (1996), “Politics and the Effectiveness of Foreign Aid.”, European Economic Review, vol. 40,
no. 2, pp. 289-329

Burnside, C. and Dollar, D. (2000), “Aid, Policies and Growth“, American Economic Review, vol. 90, no.
4, pp. 847-88

Burnside, C. and Dollar, D. (2004), “Aid, Policies and Growth: Revisiting the Evidence“, World Bank Pol-
icy Research, Working Paper no. 3251

Collier, P. and Dollar, D. (2000), “Can the World Cut Poverty in Half? How Policy Reform and Effective
Aid Can Meet International Development Goals“, World Bank Development Research Group, Policy
Research Working Paper no. 2403

Collier, P. and Dollar, D. (2002), “Aid Allocation and Poverty Reduction“, European Economic Review,
vol. 46, pp. 1475-1500

Djankov, S.; Montalvo, J. G.; Reynal-Querol, M. (2006), “Does foreign aid help?“, Cato Journal, vol. 26
no. 1

Eiras, A.I. (2004), "Why Economic Freedom, not Aid, is the Answer to Poverty”, Chapter 2 in Marc, A.M.
(Eds), The Road To Prosperity: The 21st Century Approach to Economic Development, Heritage
Book, pp. 29-51

Easterly, W. (2003), “Can Foreign Aid Buy Growth?”, The Journal of Economic Perspectives, vol. 17,
no. 3, pp. 23-48

Easterly, W., Levine, R. and Roodman, D. (2003), “New data, new doubts: A Comment on Burnside and
Dollar’s 'Aid, Policies, and Growth' (2000)." American Economic Review vol. 94, no. 3, pp. 774-780

Masud, N. and Yontcheva B. (2005), “Does Foreign Aid Reduce Poverty? Empirical Evidence from
Nongovernmental and Bilateral Aid.” International Monetary Fund, IMF Institute, IMF Working Paper
WP/05/100

Przeworski, A. and Vreeland, J.R. (2000), “The Effect of IMF Programs on Economic Growth.”, Journal
of Development Economies, vol. 62, pp. 385-421

Ramachandrarao P. (2003), Development Finance, Springer, Berlin

Bernhard A. 18
Is Foreign Aid Leading the Way Out of Poverty?

Sachs, J., McArthur, W.J. (2001), "Institutions and geography: comment on Acemoglu, J. and Robinson
(2000)", NBER Working Paper no. 8114

Svensson J. (1997), "When is Foreign Aid Policy Credible? Aid Dependence and Conditionality", World
Bank Policy Research Working Paper no. 1740

World Bank, (2000), “A New Approach to Country-Owned Poverty Reduction Strategies”, Publication no.
20374

Bernhard A. 19
Is Foreign Aid Leading the Way Out of Poverty?

Appendix A. United Nations Millennium Development Goals (UN MDGs) Indicators8

Goal 1: Eradicate extreme poverty and hunger

Target 1: Halve, between 1990 and 2015, the proportion of people whose income is less than

$1 a day

Target 2: Halve, between 1990 and 2015, the proportion of people who suffer from hunger

Goal 2: Achieve universal primary education

Target 3: Ensure that, by 2015, children everywhere, boys and girls alike, will be able to

complete a full course of primary schooling

Goal 3: Promote gender equality and empower women

Target 4: Eliminate gender disparity in primary and secondary education preferably by 2005

and in all levels of education no later than 2015

Goal 4: Reduce child mortality

Target 5: Reduce by two-thirds, between 1990 and 2015, the under-five mortality rate

Goal 5: Improve maternal health

Target 6: Reduce by three-quarters, between 1990 and 2015, the maternal mortality ratio

Goal 6: Combat HIV/AIDS, malaria, and other diseases

Target 7: Have halted by 2015 and begun to reverse the spread of HIV/AIDS

Target 8: Have halted by 2015 and begun to reverse the incidence of malaria and other

major diseases

Goal 7: Ensure environmental sustainability

Target 9: Integrate the principles of sustainable development into country policies and

program and reverse the loss of environmental resources

Target 10: Halve, by 2015, the proportion of people without sustainable access to safe

8
The Millennium Development Goals and targets come from the Millennium Declaration, signed by 189 countries, including 147
heads of State and Government, in September 2000 (http://www.un.org/millennium/declaration/ares552e.htm) and from fur-
ther agreement by member states at the 2005 World Summit (Resolution adopted by the General Assembly - A/RES/60/1,
http://www.un.org/Docs/journal/asp/ws.asp?m=A/RES/60/1). The goals and targets are interrelated and should be seen as a
whole. They represent a partnership between the developed countries and the developing countries "to create an environment
- at the national and global levels alike - which is conducive to development and the elimination of poverty".

Bernhard A. 20
Is Foreign Aid Leading the Way Out of Poverty?

drinking water and basic sanitation

Target 11: Have achieved, by 2020, a significant improvement in the lives of at least 100

million slum dwellers

Goal 8: Develop a global partnership for development

Target 12: Develop further an open, rule-based, predictable, nondiscriminatory trading and

financial system (includes a commitment to good governance, development, and poverty

reduction—both nationally and internationally)

Target 13: Address the special needs of the least developed countries (includes tariff-and

quota-free access for exports enhanced program of debt relief for HIPC and cancellation of

official bilateral debt, and more generous ODA for countries committed to poverty

reduction)

Target 14: Address the special needs of landlocked countries and small island developing

states (through the Program of Action for the Sustainable Development of Small Island

Developing States and 22nd General Assembly provisions)

Target 15: Deal comprehensively with the debt problems of developing countries through

national and international measures in order to make debt sustainable in the long term

Target 16: In cooperation with developing countries, develop and implement strategies for

decent and productive work for youth

Target 17: In cooperation with pharmaceutical companies, provide access to affordable,

essential drugs in developing countries

Target 18: In cooperation with the private sector, make available the benefits of new

technologies, especially information and communication

Source: Masud and Yontcheva (2005)

Bernhard A. 21