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Korea and Taiwan allowed them to set forth on a journey of self-reform and became the "Asian dragons." And one of the most convincing reasons for failed aid is that the recipients do not use aid in accordance with its intended purpose. Foreign aid was found to be indeed fungible in many cases. Thus, it is better to assign adequate resources to crucial sectors considering that governments may often shift aid resources to other uses (Feyzioglu, Swaroop, and Zhu 1998).
2.2 Economic Growth
Economic growth is the most watched indicator when it comes to economic
development. Basically, economic growth means the increased amount produced by a certain economy in comparison to its former performance. When the economy is producing more, it leads to profitable businesses and rising stock prices. Thus, companies have more capital for hiring and investment. Then, more and more job opportunities are created. Consumers in turn have extra money and tend to spend on additional goods and services. All of these work together drive the economic growth higher and higher (Kimberly, 2016). Economy is the decisive actor in a country's development, and it is so influential that every country desires positive economic growth.
The concept that real resources and external capitals are central to growth can be traced back to the 1930s when John Maynard Keynes claimed that government investment could stimulate development during the period of Great Depression. The gap theory of development later was proposed from Harrod (1939) and Domar (1946), who identified the savings gap. Next, Chenery and Strout (1966) added the exchange gap to the theory of development gap and came up with solutions for filling the gaps.
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The former means a lack of savings for investment at the domestic level, which can be corrected by foreign direct investment (FDI). The latter means a shortage of foreign exchange due to an imbalance between imports and exports externally, which can be improved by foreign aid. Developing countries were found to lack enough revenues for their public investment, and foreign aid became an effective tool in funding the fiscal deficit (Bacha, 1990; Taylor, 1990).
Figure 2.1 is the outline of aid-growth channels, which portrays the link between aid and development with clarity. Aid can be categorized into two aspects, mainly
economic and social. Economic aid can give rise to the establishment or advancement of economic infrastructure and finally improve the economic productivity. Meanwhile, the quality of governance in a recipient country also has a lot to do with the impact of foreign aid on economic growth. As for the aid to the social sector, it is usually expected to better human capital and ameliorate living standards. All in all, the physical and human capital along with the level of government efficiency is what exactly affects the economic growth in a recipient country. The model reveals the implied connection between economic growth and good governance.
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Figure 2.1: Outline of Aid-Growth Relationship (Source: Akramov, 2012)
Foreign aid can function as an economic engine because it is capable of
supplementing domestic financial sources and increasing the amount of investment and capital stock. As Morrissey (2001) wrote, aid may contribute to economic growth due to a number of reasons. Aid increases investment both in physical and human capital, and it helps to build capacity of recipients to import merchandise and
technology. Moreover, development assistance is usually linked to technology transfer, and thus it empowers the recipient countries with higher productivity and technical skills. On the other hand, there are some arguments about the relationship of aid and growth. As a matter of fact, foreign aid may not have a big effect on the economic growth of the recipient countries (Roodman 2007).
The Cato Institute (a libertarian think tank for public policy research, headquartered in the Washington, D.C.) summarized five key facts about aid and development and placed an emphasis on the domestic contexts of the recipient countries: (1) There is no
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clear correlation between aid and growth. (2) Aid does not work but contribute to debt if it flows into countries with poor policy environment. (3) Aid fails to elicit market reforms in developing countries. (4) Countries that have adopted market-oriented policies are not driven by aid-related factors. (5) There is a strong association between economic freedom and growth. Massive development aid transferred from the rich countries to the poor ones is not necessarily result in progress and prosperity. There are loopholes in the government to government funding The main reason is that foreign aid is frequently used to finance the recipient governments without specific standards and requirements (Cato Institute, 2009).
Put simply, aid does not directly cause investment and growth, nor give rise to any improvement in human development indicators for the recipient countries, but it indeed makes the recipient governments stronger (Boone, 1996). For this reason, government plays a big part because aid may affect the government behavior, and then the governance will have an influence on a country's economy (Kodama, 2012).
Above all, the Cato Institute (2009) pointed out three valuable ideas about
development. It is impossible to escape poverty in the initial phase of development for all of the nations. Absolutely, there is no exception. Moreover, the socio-economic conditions vary greatly from country to country, so donor countries can not merely replicate aid projects across the developing world. Most importantly, a country's progress heavily relies on its domestic institutions and policies instead of external factors such as foreign aid.
For a long time, global financial institutions such as the World Bank and the
International Monetary Fund (IMF) has disbursed an astronomical amount of money
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to stimulate economic growth throughout the developing world, but it is disappointing to find that the effect of aid on growth appears to be little based on the past
experiences and consequences of aid distributions (Doucouliagos and Paldam, 2008).
However, every cloud has a silver ling, so things may not be so terrible. After all, the international community has dedicated so much to the development of poor countries.
It is found that the IMF involvement in assistance may not affect economic growth contemporaneously while there is going to be a positive impact on growth with a lag of up to three years. What's more, the degree of economic growth goes positively with the length of the lag (Fidrmuc and Kostagianni, 2015). So, foreign aid is still a useful means to economic development when its long-term effects are concerned.
It is very often that people make a direct association between the size of foreign aid and economic growth. However, a rapid increase in the amount of aid can be a potential crisis. One of the most prominent features of today's foreign aid, which is different from that in the 1970s, is the proliferation of donors and projects. In the last few decades, aid programs have been done haphazardly without careful consideration and the situation results in many negative side effects (Morss, 1984). Due to this, aid coordination has been hotly discussed in the global aid community. Coordinated aid may help reduce transaction costs and bring about economic growth, but in some cases growth may not be prompted through aid coordination because sometimes the issues of proliferation are caused by the existence of free-riders among donors (Kimura, 2012). Hence, it is necessary to have a careful analysis on the efforts of every individual donor in the future.