Recently, Sachs et al. (2004) have argued in favor of a massive increase in foreign aid to Africa in order to escape from a supposed poverty trap. They propose to increase the capital stock in one step, through a large, well-targeted infusion of foreign assistance. (1) In their proposal "the flow of aid is targeted to a particular set of investments, and specifically public sector investments, so that the aid cannot be used for consumption" (pp. 144-45). This large amount of aid should be given in the form of grants rather than loans.
They believe that such a commitment can be enforced through "improved monitoring of budget processes and expenditures, perhaps with the help of local nongovernmental organizations" (p. 145). "Unconstrained aid flows would probably be consumed rather than invested. The strategy needs to be designed to ensure that the aid is properly invested, and there must be a credible mechanism for enforcing the strategy over a relatively long period" (p. 146).
However, the empirical evidence on the effectiveness of foreign aid is diseouraging. Recent literature on the topic provides ambiguous results on whether foreign aid helps or hinders developing countries. Foreign aid, however, may affect economic growth through indirect channels that cannot be captured by analyzing only the direct effect of aid on growth. Aid may alter the investment share of GDP, which indirectly affects economic growth, or may also affect government consumption, which is known to have a negative effect on economic growth. As Sachs et al. (2004) argued, unconstrained aid may increase public consumption rather than investment. The effect of aid on growth through these indirect channels is not captured in any of the studies on aid effectiveness.
There is a large body of literature that documents the so-called curse of natural resources. Foreign aid can also be understood as a sudden windfall of resources and, therefore, in principle could be subject to the same rent-seeking processes. Therefore, there may be also the "curse of unnatural resources." However, international donors argue that foreign aid has, in addition to the hypothetical benefit in terms of economic development, a positive impact on the process of democratization of developing countries. For this reason, they resist any attempt to impose conditionality in terms of the level of democracy in developing countries.
In this article we show that foreign aid has a negative impact on the democratic stance of developing countries, and on economic growth by reducing investment and increasing government consumption. Therefore, our empirical findings do not support the democratization effect of foreign aid nor the development effect. Because of these findings we propose and analyze other forms of helping poor countries. For example, the way in which aid is disbursed can also affect the effectiveness of aid. Maybe the mechanism to successfully encourage the government to invest rather than to consume has something to do with the way in which aid is disbursed. This topic has been largely omitted from the academic discussion of the effectiveness of aid, even though it is becoming the central topic in any international debate on aid effectiveness among policymakers. Indeed, a debate has recently emerged as to whether donors should give grants or loans. The G-7 called for an increased use of grants within IDA-13. Sachs et al. (2004) have also argued in favor of providing aid in the form of grants rather than loans. However, there is no empirical evidence that allocating aid in form of grants will improve economic development. We enter into the debate by considering the distinction between grants and loans, and we analyze their differential effect.
Finally, aid recipient countries also receive other resources in addition to foreign aid. Foreign direct investment (FDI) and remittances, for example, reach the private sector and the families of the recipient countries. …