Fallacy of Foreign Aid as Engine of Economic Development

The annual meeting of the World Bank and International Monetary Fund is set to start this weekend in Washington, D.C. An army of protesters from across the globe, who believe these institutions have done and are doing more damage than good through their ever increasing loans and misleading policy prescriptions to the poor countries of the world, have also gathered to demonstrate their opposition to what they consider to be economic rape of the world’s poor. And Ethiopia has sent an army of bureaucrats to plead for more loans.

Ethiopia has a long history of dependency on foreign assistance, whether that be in the form of food donations, military hardware, or loans for public investment. Although this history applies to all three recent successive regimes, loans contracted by the current government over the last eleven years exceed all non-military loans contracted by the two prior regimes combined in a span of over 50 years. And there has been negative correlation between the ever increasing loans and the level of poverty. As loans increased, the per capita income (a brute measure of the level of economic development) has stayed virtually unchanged, poverty has spread and deepened, and even by African standards, Ethiopia has lagged miserably and has become an excellent example of most things that are wrong in that unfortunate continent. Then why borrow more? And why do international lending institutions want to repeatedly extend additional loans (often for the same intended purposes) when previous loans did not have much positive impact?

The most common explanation given by the Ethiopian government to justify more borrowing is a fight against poverty. It usually quotes common statistics on widespread poverty, hunger, diseases, low level of agricultural technology, the AIDS epidemic, high level of unemployment, and such other indicators of a seriously ailing economy, and how foreign loans help in the fight against the ailments. Rarely does the government mention whether or not previous loans had generated more benefits than their costs. It also fails to mention the recent catastrophic consequences of high external indebtedness in countries like Argentina, Brazil, and other states in Latin America and Africa.

There is another less obvious explanation as to why countries need to borrow more despite the poor records of past loans, which is rooted in inferiority complex. Insecure governments usually consider their relationships with international lending institutions as a form of legitimization of their regimes, and believe that would help them prolong their hold on to power. They have opportunities to attend international meetings organized by such institutions to be seen as legitimate members of the international community, and use such forums to lash out at their domestic opponents. They can also use the staff of the international institutions to write reports favorable to their policies (similar to recent scandals in the US securities industry where research analysts have been caught writing favorable but misleading reports on companies in the hope that would give their brokerage firms competitive edges in accessing investment banking businesses with the companies), and use those reports as affirmations of their repressive political and economic policies. We have heard and read this many times before where the Ethiopian regime proudly stated the approval it has received from international financial institutions about the soundness of its policies of state ownership of land as well as ethnic regionalization under cover of decentralized administration. The lenders know all too well that they have the upper hand in their dealing with such insecure governments, and are prepared to capitalize on the insecurity to advance their own agenda; the more insecure a government, the better for the lenders.

Contrary to common perception, the primary interest of external financial institutions is to lend more for their own survival and to promote exports from the industrialized countries, rather than to help promote the economic development in the borrowing poor countries.
As amply demonstrated in Ethiopia, the long record of borrowing by successive regimes had been ineffective in promoting sustainable development and in alleviating poverty. In fact, the reverse was true where more lending had driven the country into deeper poverty. As export earnings from traditional sources (such as coffee) decline, ever increasing shares of those earnings would be used to pay the rising debt services, thus leaving ever diminishing proportions of foreign exchange earnings for economic development and poverty reduction. To add insult to injury, foreign aid can be used as an instrument of foreign policy, as demonstrated during the Ethio-Eritrean conflict, when donors attempted to withhold their funding as a leverage to get political concessions from Ethiopia. The more a country is dependent on foreign assistance, the more its exposure to international political arm twisting and blackmailing.

The typical response of the Ethiopian government to the above would be: you are only criticizing us for what we are trying to do, but what alternatives do you have to offer? Here are my suggestions.

The first suggestion concerns principle. The key principle must be that government control of resources and micromanagement of economic activities by the public sector have not worked anywhere in the world, and there are no convincing reasons to believe such a policy framework would work in Ethiopia. Instead, private sector based economic policy framework is a superior prescription for economic success. That key principle must be modified slightly while dealing in international trade, which these days is commonly referred under the general term of globalization. While recognizing that exports are the key to future economic prosperity (and hence policies should focus on improving the country’s competitiveness), allowing freely imports of goods that can kill domestic manufacturers would not be prudent. The most prudent approach should be to first promote competition among domestic producers while protecting them initially from outside competition. As the domestic producers mature, protection can be lifted gradually. All developed economies have used this policy (and are still using it) under cover of “infant industry protection”. Just see how domestic textile and leather manufacturers are being decimated by cheap imports from Asia and second hand products from North America and Europe. Of course, the lending institutions would not support protection to be extended to the domestic manufacturers, often at the urging of exporting nations from behind, because that would undermine imports of such products into Ethiopia.

And the second suggestion concerns fundamental policy measures the government should take including: (a) letting the private sector be the engine of growth, (b) privatizing all land ownership, including agricultural land, which is the foundation of the economy and a source of employment for about 80 percent of the labor force, (c) purging all other policies that have been designed to stifle entrepreneurship, such as political parties’ ownerships of businesses and their involvement in commerce (appoint a task force of professionals and entrepreneurs to collect and review all policies/activities that hinder private sector initiatives), (d) building strong financial system to promote saving, borrowing and investment. The nucleus for this exists since there are already many private banks which can be used as a base for strengthening the system, (e) maintaining small groups of highly paid professionals to manage the normal functions of government under a free market environment, and reduce the number of people working as government employees. These managers should contract with the private sector to handle as much as possible of the government work, (f) restructuring the federal system of government to organize regional administrations along geographic rather than ethnic groupings, with strong federal laws to protect the interests of minorities anywhere. This will promote free movements of capital and labor, exchanges of ideas; these are essential features of private sector based economy, (g) strengthening the rule of law to protect civil liberties and private property rights, and to strengthen commercial transactions, and (h) making it easier for citizens to manage their own affairs by, for example, eliminating bureaucratic bottlenecks that encourage corruption and taking other small but tangible pro-citizenry actions.

In summary, Ethiopia should proceed with vigorous programs of economic growth (which in due course would also reduce poverty) by harnessing her own resources first, supplementing those with foreign grants to the extent possible rather than with foreign loans. The government should refrain from investment in directly productive activities, and leave such undertaking to the private sector. Government investment should focus on improvement of infrastructure that would promote private sector investment and economic growth (such as in telecommunications, power, and transportation) and education. Under no circumstances should foreign loans be used to finance items that have dubious investment merit such as vehicles, studies by foreign “experts”, short-term trainings abroad, and any items that can and should be financed using domestic human, material, and financial resources. These should be supplemented by aggressive efforts to contain the population explosion.

The above suggestions, if implemented, would surely reduce the need for heavy external borrowing, while at the same time promoting mobilization of domestic resources. They would also provide a more solid basis for well-anchored, gradual, and sustainable development that would reduce poverty.

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