Thursday, 6 October 2011

What aid might teach us about quantitative easing


In times past we used to think that one effect of international aid was to act as an economic stimulus. And, in orthodox economics, this rather makes sense – we get an increase in cash within the local economy thereby stimulating demand.

The main role of foreign aid in stimulating economic growth is to supplement domestic sources of finance such as savings, thus increasing the amount of investment and capital stock. As Morrissey (2001) points out, there are a number of mechanisms through which aid can contribute to economic growth, including (a) aid increases investment, in physical and human capital; (b) aid increases the capacity to import capital goods or technology; (c) aid does not have indirect effects that reduce investment or savings rates; and aid is associated with technology transfer that increases the productivity of capital and promotes endogenous technical change.

However, the research into the effects of aid on growth are mixed – there is no consistent evidence that international aid stimulates economic growth. For example:

(1) The effect of direct foreign investment and aid has been to increase economic inequality within countries. (2) Flows of direct foreign investment and aid have had a short-term effect of increasing the relative rate of economic growth of countries. (3) Stocks of direct foreign investment and aid have had the cumulative, long-term effect of decreasing the relative rate of economic growth of countries. (4) This relationship has been conditional on the level of development of countries. The stocks of foreign investment and aid have had negative effects in both richer and poorer developing countries, but the effect is much stronger within the richer than the poorer ones. (5) These relationships hold independently of geographical area.

There remains a debate about the effect of aid but it is very clear that the simple fact of stimulus – the mere presence of the aid money – is not sufficient to promote growth. Some argue that the policy environment is important (and here there is a debate as to whether macro considerations such as trade openness and fiscal policies are more or less important than micro considerations such as protection for property rights and labour market flexibility). But whatever the details, the fact remains that simply chucking in a load of new cash -  in return for absolutely nothing – won’t do the stimulus job.

Which begs a question – there’s ample evidence of ‘Dutch Disease’ resulting from aid transfers. In simple terms, aid creates inflation making it more expensive to export and therefore harder for the recipient country to grow.

It seems to me that any policy designed to promote inflation in an economy – for example quantitative easing – runs the risk of having the same effect as international aid. Namely a significant risk of inflation and its associated brake on real growth. If we pretend – by the use of legerdemain and jargon - that quantitative easing isn’t inflationary, then we are kidding ourselves that billions in new money can be created and poured into the economy without that money having any effect.

The latest bout of quantitative easing is akin to giving the economy – worn down by years of self-abuse – a large espresso and hoping that will do the job of waking it up. For a short while it will feel OK and then the underlying hangover will kick back in – maybe worse than before.


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