Foreign aid, geopolitics and perverse incentives
7 Nov 2014|

It’s a fair bet that the Republic of Somaliland isn’t well known to most Australians. That’s a pity, because it’s certainly an instructive case. Born in a separatist struggle against Mogadishu, the little statelet has received nothing in the way of recognition from the international community, which means—for one thing—that it can’t receive foreign aid. Yet, according to the World Bank, the little Republic has ‘made admirable progress in improving its infrastructure to foster trade’ as well as almost tripling the number of primary schools and increasing five-fold the number of universities on its territory. Neighbouring Somalia, which can get aid, is still ‘in sharp contrast, looking tense and dangerous’.

Is that actually a coincidence though? Some Australian charities have bemoaned stagnating aid budgets in the face of increased defence spending. They claim the Coalition is buying guns and bombs at the expense of the world’s poor. I’m all in favour of controlling defence spending, but that doesn’t mean I think the money saved should go on foreign aid. Because the evidence says it doesn’t work (see William Easterly’s exhaustive review of the economic research here), especially if donated for ‘strategic’ reasons. As with defence spending, the problem lies in the incentives.

Now AusAID’s past work may be light years away from the behaviour of some donor countries at some points during the Cold War (and I think we all know who they are) who may as well have saved on the handling costs by wiring their aid money straight into their favourite dictators’ Swiss bank accounts. The development community today recognises the importance of tackling corruption and aid often comes with strict conditions on what it should be spent on. But here’s the rub. Money doesn’t come in nice little packages you can track to ensure they aren’t being spent on bad things. In the jargon of economics, it’s ‘fungible’.

What does this mean? Well, insist that a recipient country politician spend the money on primary schools and they’ll do it. But the tax revenue that he would have spent on schooling if they didn’t have access to aid can’t be so easily accounted for. They can deposit that money with their friends in Zürich if they like, spend it on weapons or not even bother raising it at all.  In some ways, the latter is the worst option—leaders who can access easy money in the form of foreign aid have little incentive to develop their tax bases and hence economies. In fact, quite the opposite—they have an interest in keeping their nations poor so as to keep the aid flowing, an ‘international poverty trap’ if you will.

Why is it worse if you give aid for strategic (read geopolitical) reasons? Well, let’s perform a crazy thought experiment. Imagine you’re giving money to a foreign ruler who is corrupt, oppressive and doesn’t care about their economy but is anti-communist or anti-al-Qaeda (far-fetched scenario, I know). Suppose you now say to this individual that they had better institute far reaching economic and political reforms or you’ll cut off their aid. What are they going to say? ‘Go ahead, but you’ll miss me when I’m gone’, is my best guess. Threats to cut off aid absent liberalising reforms are utterly incredible if the aid is donated in the first place on geopolitical grounds. Thus donor countries have a choice—they can try (though probably still fail) to promote poverty reduction or they can look out for their own geopolitical interests. What they can’t do is promote both goals simultaneously.

Reducing poverty in the developing world is a laudable goal. But there are much better ways to do it than through foreign aid as it’s currently delivered. One radical approach pioneered by the charity Give Directly involves simply giving small sums of money straight to individual people—bypassing aid agencies and local political leaders altogether. Carefully crafted studies have shown this approach to bear fruit. Similarly, remittances from overseas workers have been shown to be highly effective (they are for the Republic of Somaliland). So if Australia really wants to help reduce poverty in the developing world, one of the best ways to do it would be to institute a guest-worker program for unskilled labour from the developing world. That might also have the effect of stopping the boats, by the way. But let’s just say I’m not holding my breath.

Charles Miller is a lecturer at ANU’s Strategic and Defence Studies Centre. Image courtesy of Flickr user G.A. Hussein.