Academic journal article The Journal of Developing Areas

The Long-Run Relationship between Foreign Aid and Labor Productivity in Sierra Leone

Academic journal article The Journal of Developing Areas

The Long-Run Relationship between Foreign Aid and Labor Productivity in Sierra Leone

Article excerpt

(ProQuest: ... denotes formulae omitted.)

INTRODUCTION

Early development economists (Rostow 1960, for example) viewed economic growth and development synonymously with capital accumulation. Because poverty and low incomes in Less Developed Countries (LDCs) cause low savings and, therefore, low capital accumulation, they concluded that LDCs have a financing gap that only foreign aid can fill.1 In the 1980s, a neoclassical counterrevolution in development economics cast doubt on this Financing Gap Hypothesis (FGH), arguing that, in spite of massive aid transfers to LDCS, especially in Sub-Saharan Africa (SSA), poverty has continued to grow because of poor governance and market-unfriendly statist policies of LDC governments. Therefore, for foreign aid to positively impact economic growth and poverty alleviation, they argued, it must be conditioned on good governance and macroeconomic policy reforms (Bourguignon and Sundberg 2007). The debate that followed this neoclassical critique made statistical estimation of the aid-growth relationship into a cottage industry. Unfortunately, the evidence produced by this literature is mixed. While some studies found positive aid-growth relationships (with or without good policies), others found it to be either significantly negative or insignificant.2 Moyo (2009) used the findings of these latter studies to conclude that foreign aid has not only failed to alleviate poverty in SubSaharan Africa. Instead, it has promoted bad governance and corruption, both of which have increased the level and rate of poverty in the region. She thus recommended that aid be replaced with non-concessionary loans.3

Much of the empirical evidence on the aid-growth relationship has been based on cross-sectional regression models, whose key drawback is that they do not allow for country-specific characteristics and policy environments. This is especially important for Sub-Saharan Africa, whose many countries have often followed radically different economic policies. Additionally, being snapshots at a given time, cross-country regressions are incapable of addressing long-run equilibrium relations among variables. However, economic growth is a dynamic process. Therefore, the long-run equilibrium aid-growth relationship is more important to the aid-growth debate than the static (shortrun) cross-sectional relationships on which the debate has been based. Ignoring the problem of aid endogeneity, which results from the fact that slow-growing countries tend to need and receive more aid than their fast-growing counterparts, is another weakness of much of the current literature. Because the explanatory variables in regression models are assumed to be exogenous, aid-endogeneity introduces bias into their results (Hansen and Tarp 2001).

Cointegration analysis addresses the above weaknesses in a number of ways. Firstly, it assumes that all the variables are endogenous, thus dealing with the aidendogeneity issue. Secondly, it estimates long-run equilibrium relationships between the variables, which makes it ideal for studying long-run phenomena. Thirdly, country cointegration studies avoid the bias that country-specific characteristics pose for crosssectional models. As such, they are most reliable for evaluating aid effectiveness (Riddell 2007). This paper uses four cointegration procedures to estimate the long-run relationship between foreign aid and labor productivity in Sierra Leone.4 Unlike much of the existing literature, which have focused exclusively on real GDP growth, it seeks to explain labor productivity growth because it is the most important cause of improvements in living standards. Finally, it studies the aid-growth relationship in a very aid-dependent country.

The remainder of the paper is organized as follows. A brief survey of the empirical literature follows this introduction. Thereafter, the model and data used are described. This is followed by the empirical analysis and a discussion of its results. …

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