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Foreign Aid: How to Improve its Effectiveness?

Md. Lutfur Rahman

1. Introduction

The wide gap between the rich and the poor countries has created the platform for the rich

countries to lead international relations for many years. This gap leads to the continual capital

influx from the rich countries to the poor countries for supporting the poor countries’

development. This capital influx into the poor countries is usually known as foreign aid

(Cassen 1984). The aim of foreign aid is to promote socio-economic development that

essentially includes economic, social and political freedoms and security (Sen 1999). To

measure this effect of foreign aid, the term aid effectiveness (Doucouliagos and Paldam 2009)

has recently been frequently used. The effectiveness of foreign aid in achieving its

development goal has been a major concern among development scholars.

The purpose of this paper is to review the literature of aid effectiveness and to focus

particularly on how to improve aid effectiveness. The review begins with a discussion of on-

going aid effectiveness debates that highlights the two conflicting views among development

scholars. The subsequent section critically reviews the available literature on how to improve

aid effectiveness categorising the literature into three schools of thought: the donor school,

the recipient school and the transaction costs school. Having considered the findings in the

aid effectiveness literature, the review concludes with recommendation for further research

in the identified areas for conclusive knowledge on aid effectiveness for the betterment of

the world as a whole.

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2. Current views on aid effectiveness

Some scholars (Cassen 1984, Hansen and Tarp 2000, Sachs 2005) argue that foreign aid mostly

works in supporting the development process of the poor countries. For example, one of the

leading advocates of foreign aid, Sachs (2005) reports the horrifying conditions of severe

poverty in the third world countries and argues that the rich world has the moral

responsibility to reduce this poverty. Sacs assumes that foreign aid has a positive association

with poverty eradication. Similarly, another study has found that foreign aid works for the

growth and development of poor countries even in the countries where governance is not in

a good position (Hansen and Tarp 2000), while Cassen (1984) concludes that foreign aid works

but the exact degree of its effectiveness is incomprehensible. However, these arguments in

favour of aid effectiveness become weak when Riddell (2014) correctly notes that some of

these studies were partly fuelled by foreign funds where donors were keen to show that

foreign aid works for the development of the poor countries.

Many scholars argue that foreign aid has been ineffective in achieving its intended goal of the

socio-economic development of a recipient country (Collier 2007, Dreher et al. 2009, Easterly

2002, Easterly 2006, Easterly and Pfutze 2008, Gibson et al. 2005, Moyo 2009, Raghuram

1999, Riddell 2008, Riddell 2014, Shiva 1989). When criticizing foreign aid and its

achievement, Easterly (2006), a distinguished mainstream professor of economics on aid and

development issues, perhaps accurately highlights the tragedy of the poor people in the world

by stating that the donors spent more than two trillion dollars on foreign aid during the last

fifty years but could not give “twelve-cent medicines to the poor dying children” (p.4).

Likewise, both Riddell (2008) and Collier (2007) put forward the same argument that foreign

aid does not work as the impact of foreign aid is mostly disappointing at country-level . Even

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the defenders of aid including Clemens et al. (2011) acknowledge that there is no evidence of

foreign aid as being the main drivers of development in the developing countries. Therefore,

Riddell (2008) suggests thinking over the key question-how to make foreign aid more

effective.

3. Current thoughts on how to improve aid effectiveness

Although aid effectiveness debates continue among scholars, they agree on the fact that aid

must work better (Howes 2013) to achieve the socio-economic development of the

developing countries. Several contemporary prominent authors including Collier (2007),

Easterly (2006) and Sachs (2005) have claimed that they have the answers to the question of

how to improve aid effectiveness. In order to make aid work better, each of them has offered

a different set of recommendations supported by a number of other studies. Therefore, each

of these three authors can be considered as the representative of one school of thought

(Howes 2013). These three schools on aid effectiveness, namely recipient school, donor

school and transaction costs school are represented by Collier, Easterly and Sacs respectively

(Howes 2013).

3.1 The Recipient School

Firstly, the recipient school argues that the recipient government is the key to improve aid

effectiveness. While this argument is strongly supported by many other scholars including

Nastios (2010), it has become popular with a World Bank (1998) publication that claims that

foreign aid works better in the countries with good governance. Although the assumption of

this argument has since been debated, it ties in the commonly accepted current development

approach that considers the recipient government agencies as the determining factor of

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development (Rodrik 2003). As this is now an accepted approach, the proper utilization of aid

towards the development of the recipient country is also a responsibility of that recipient

government and of its institutions. Therefore, improving the overall governance of the

recipient country in order to improve aid effectiveness is the main focus of this school.

To improve governance of the recipient country, the recipient school suggests two strategies.

One is offering more foreign aid to competent nations and the other is using aid conditionality

to improve governance (Collier 2007). The first strategy assumes that this will create a

competition among poor countries to improve governance but this assumption has been

weakened by Walle (2005) who argues that the fragile states should be given more aid instead

as aid can act as stimulus for them to change. The second strategy assumes that using reform

conditions that need to be met before disbursement of aid will improve governance in the

recipient country. However, this assumption has interestingly been weakened when Easterly

(2005) comments on African development, stating that Africa’s development does not

depend on the prescription of outsiders.

3.2 The Donor School

Challenging the above view on aid effectiveness, some contemporary studies (Easterly 2006,

Riddell 2014) argues that it is not the recipient government but donor agencies that can

improve aid effectiveness forming the second school. Easterly argues that improving the

governance of the recipient country is out of the aid’s capacity because the imposed reform

conditions do not work, rather it is important to start reforming donor agencies to deliver

satisfactory development outcomes. Easterly (2002) accurately notes that bureaucracy

performs well if it allows criticism from stakeholders and receives incentives in responding to

such criticism but he argues that none of these conditions is in favour of aid. Therefore, he

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concludes that aid bureaucracy completely fails. Along with a number of other scholars,

Easterly claims that reforms are essentially needed to minimize the problems associated with

aid bureaucracy.

These reforms suggested by the donor school are to be implemented in four areas of donor

agencies. Firstly, the donor programmes are guided by multiple objectives (Howes 2013)

reflecting a blend of altruism and self-interest (George 1990). This school suggests for the

donor agencies to have a single development objective rather than multiple objectives. In

addition, the performance feedback loop that serves to discipline the recipient country

institutions does not fit in the aid organizations as argued by both Easterly (2002) and

Svensson (2008). To overcome this problem of broken performance feedback loop, this

school suggests to focus on greater results, more independent and rigorous evaluations, and

more transparency (Gibson et al. 2005). Furthermore, the school identifies the knowledge

burden of donor agencies. The donor agency officials work across many countries and so lack

the local cultural knowledge of that particular country. Finally, the discretionary power the

donor agencies enjoy in aid decision is a major problem as the school explains. As a solution

to the donor agencies’ knowledge burden and discretionary power, the school suggests that

the donor agencies focus their work in some targeted countries and utilize the lessons

learned from the experiences (Howes 2013).

3.3 The Transaction Costs School

While the above two schools assume that foreign aid in a country is usually provided with

multiple donor agencies and even through many programs, the transaction costs school

argues that this arrangement increases transaction costs of aid reducing aid effectiveness.

Sachs (2005) points out that if every project incurs fixed expenditures, it is surely to be

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ineffective and so he emphasizes to reduce transaction costs in order to improve aid

effectiveness. Howes (2013) also puts forward the same argument while he attempts to find

a slogan for this school, “Too many cooks spoil the broth” (p.60). This disintegration of many

donors and projects leads to misuse of resources of both donors and recipient countries.

Tanzania, for example, annually prepares around 2000 reports for different donors and

welcomes more than 1000 delegations making officials preoccupied and thus distracting

them from doing main jobs (Reinikka 2008). To minimise this problem, the school offers a

simple reform agenda of reducing the number of independent aid programs.

This reform agenda of reducing the number of programs suggested by this transaction costs

school requires two important strategies. One is harmonization that indicates better

coordination among donors whereas the other is alignment denoting better coordination

between the donors and the recipient government (Sachs 2005). Harmonization can be

considered as helpful in focusing on small number of programs whereas alignment integrates

aid funded programs with the domestic initiatives (Howes 2013). The assumption is that both

the multiplicity of donor programs and their weak coordination with the recipient

government result in the increase of transaction costs. Therefore, the school focuses on both

harmonization and alignment to reduce transaction costs. Interestingly, although this is now

the donors’ explicit aid effectiveness initiative under the 2005 Paris Declaration that

encourages harmonization and alignment, it is championed by many scholars with Sachs

(2005) in the frontline.

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4. Conclusion

In summary, having investigated the foreign aid effectiveness, all these scholars cited above

have advanced the same argument that foreign aid could and should be more effective

although they put forward different ideas when suggesting ways to improve aid effectiveness.

The recipient school has suggested improving the recipient government and its institutions

for improving aid effectiveness. Challenging this view, the donor school has argued that the

problem lies not with the recipient government but with the donor agencies and assumes

that reforming donor agencies will result in improving aid effectiveness. Unlike these two

groups, the transaction costs school has emphasized more integration of donor programs

with those of the recipient country to improve aid effectiveness. However, while the bulk of

research on aid effectiveness has found that foreign aid is mostly ineffective and has

suggested ways to improve aid effectiveness, there is still a significant gap in the literature of

aid effectiveness.

This gap in the aid effectiveness literature is apparent in some specific areas (Howes 2013)

which need to be further investigated. Firstly, it offers incomplete direction as to what the

donors should allocate funds on and particularly, it mentions nothing about preferred sectors

of undertaking aid programs while underscoring aid effectiveness. Secondly, it correctly notes

the importance of harmonization and alignment; however, it ignores the country ownership

of aid funded projects and programmes whereas it is commonly and perhaps appropriately

assumed that donor programs succeed only when the recipient country takes their

ownership. Finally, the literature accurately notes that foreign aid aims at developing poor

nations but it makes no reference to the necessity and mechanisms of using foreign aid on

international public goods. This major gap in the literature paves the way for further research

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and therefore, this review recommends future research in these identified areas to have

comprehensive knowledge on aid effectiveness.

(2027 words)

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Collier, P. (2007) The bottom billion: Why the Poorest countries are failing and what can be done about it, New York: Oxford University Press.

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