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Foreign Aid & Poverty: Why Hasn't It Worked? · Acedra
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Foreign Aid & Poverty: Why Hasn't It Worked?
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0:00
If foreign aid actually worked, shouldn't we have solved global poverty by now? It's a blunt question, but it's a fair one. Every year, developed economies spend hundreds of billions of dollars on foreign aid, and yet there's 692 million people living below the international poverty line. And what's worse, progress has slowed in the last 10 years. Beyond that, the most noticeable recent poverty reductions have actually been in countries
0:22
who've received relatively little foreign aid, like China and Indonesia. Meanwhile, countries like Malawi, the Democratic Republic of the Congo, and Kenya have received enormous sums of foreign aid for decades, and yet economic growth remains weak and at times even negative. Now, there is some selection bias here. Countries don't receive foreign aid because everything is going fantastic. So it's important not to make an assumption similar to concluding that advanced surgery
0:45
is pointless because people who've received it are on average less healthy than the general population afterwards. But the simple truth may be that foreign aid can't solve deep-rooted structural challenges within the economy itself. Some economists actually go even further than this. They believe that foreign aid is the root problem, trapping countries in a distorted economic system of dependency that kills the industry and incapacitates governments.
1:06
The assumption is, why develop industry and work to produce stuff when it's been offered to you for free? Foreign aid is an unintuitive topic that's worth understanding now more than ever. Governments in the West are rethinking their foreign aid budgets like never before, leaving aid-reliant countries extremely vulnerable to the life or death uncertainties that lie ahead. So, what economic concepts and evidence underpinned foreign aid? Why has foreign aid failed to deliver economic development?
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And finally, how will aid-reliant countries manage if and when the money stops?
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Whenever you dig into the economics of foreign aid, one thing becomes clear fast. What narrative is told and how data is framed depends on the agenda of who's telling it. This is a wider problem concerning the media reporting of political issues. Take the recent vote in the House of Representatives where Republicans narrowly passed Trump's bill that combines tax cuts with spending reductions. Depending on which outlet you read, it's either a necessary fiscal correction and economic rocket
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fuel or a reckless dismantling of vital public services and a tax scan benefiting the wealthy. News like this can be misleading, which is why I rely on Ground News, a news platform built to break you out of your bubble by showing you how the same event has been reported across the political spectrum. Ground News brings all of those perspectives together in one place, so you can actually compare how different sides cover the same issues side by side.
2:19
One feature I use all the time is the blind spot feed. It flags stories that are getting a lot of attention on one side of the political divide, but are barely mentioned on the other. It means I can stay up to date and well informed regardless of what my traditional media bubble is and isn't showing me. On top of that, every article on Ground News comes with data showing the bias, factual reliability and ownership of each source, or verified by three independent news monitoring organisations,
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so you can see how news has been spun and avoid factually inaccurate articles. If you want to challenge your own assumptions, cut through partisan noise, and get a full range of perspectives, Ground News is essential. Head to ground.news slash explain to get 40% off the vantage plan, the same one I use to keep up with stories on the economy and beyond.
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Foreign aid is a very, very broad term. We're not focusing on humanitarian assistance or emergency relief in this video. This type of aid is an essential means of saving lives in crisis. It's normally quite short and it's not meant to do anything other than to handle one specific problem. This kind of aid is also generally offered to all countries, even highly developed ones, as they deal with things like natural disasters. Instead, the real focus is on development aid.
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Essentially, it is the transfer of goods, services, money or technical assistance from a rich developed economy to a poor developing economy. Sometimes it's for free, sometimes it's a preferential low interest rate loan, and sometimes it's with conditions like political or economic reform. Broadly speaking, the donors send funds into the international development sector, which is a complex network of organisations, headquartered in developed economies,
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but with operations in less developed economies. This sector acts as the supposedly impartial middleman, which is very important for reasons that we will explore later. This development aid transfers to the recipient country, either through direct-on-the-ground operations, the country's government, other international organisations or smaller local-led organisations. Now that's great, but what is it meant to do exactly?
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Broadly speaking, the goal of development aid is to end the need for its existence. This means supporting the economic development of low-income countries to enable self-sustaining improvements in the well-being and quality of life of its citizens. This is underpinned by economic theory. In a traditional agricultural-based economy, output is at a subsistence level, producing enough for consumption, but nothing more. This means savings are low, and there's no taxable income.
4:26
Consequently, there's no cash to invest, which means low levels of productive capital, physical infrastructure and human expertise. The result is that the economy remains stuck in a low-income equilibria, where it never has enough savings to be able to invest in the productive capital it needs to develop. Basically, you can't invest without saving, but you also can't save without investing. So what comes first? This is, ideally, where foreign aid comes in.
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It breaks the low-income equilibria by providing the economy the startup investment needed to begin increasing its physical and human capital base, so that it can increase output, real incomes and savings, which can be reinvested back into accumulating more physical and human capital. It's like jump-starting a car when the battery is dead. To fix the problem, you need help from another road user who's generous enough to lend their time and jack their juiced-up car battery onto yours,
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but once your battery has enough power, you can turn on your engine and charge your battery yourself, no longer needing help from an external source. It's certainly a logical narrative and an enticing pitch. On a small scale, it's also how most startups work before becoming self-sustaining companies, but the problem with economic theory is that, well, it's just a theory. Models founded on unproven assumptions have limited power in explaining reality.
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Fortunately, foreign aid has existed and been studied for decades, so there's a large evidence base to determine whether foreign aid actually brings about positive economic outcomes. The two that economists really look at is poverty reduction and economic growth. It's important to look at these together. Poverty reduction without economic growth suggests foreign aid reliance, whilst growth without poverty reduction suggests that foreign aid is not benefiting everyone
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and instead being directed to well-connected people at the top. By and large, the evidence suggests that foreign aid has a positive impact on poverty reduction, especially when it's targeted on agriculture and social services like education and healthcare. There are many case studies that support the poverty reduction efforts of aid. In Ethiopia, aid has funded the Productive Safety Net Programme, which has helped millions of rural households escape food insecurity through paid work,
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all the while creating infrastructure for production and trade. In Rwanda, aid-backed investments in healthcare helped to achieve a 68% decline in mortality for children under 5 between 2002 and 2012, and in Vietnam, more wins. World Bank Aid has helped fund infrastructure and agriculture reforms that helped to reduce the poverty rate from 50% in the 1990s to below 5% today. These feats are obviously great. It means that foreign aid has helped to create healthier, less insecure,
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and more dignified lives. But this isn't to say that foreign aid has ended poverty, not even close. In fact, in sub-Saharan Africa, the number of people in extreme poverty has actually increased in recent decades, despite receiving well over a trillion US dollars worth of overseas development assistance since the 60s. So what about foreign aid's impact on economic growth? There are a lot of academic studies that have looked at this relationship taking
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real data from the past 60 years and examining it using econometric models. In 2010, researchers reviewed over 100 of these studies and found that, on aggregate, development aid has historically had a statistically insignificant effect on economic growth. This is supported by most other reputable studies too, so the evidence is pretty clear on this one. So much so that economists like William Easterly, Dan B. Somoyo, Hajun Chang,
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Angus Deaton, and many others have made bold critiques of foreign aid, which has forced the issue into mainstream discussion. The findings feel counter-intuitive and blows the previously discussed theory right out of the water. How can giving a country money to invest in expanding its production, healthcare, and education not help its economy grow? Well, there are a number of reasons. Perhaps the most direct reason is that, in practice, foreign aid has often ended up
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replacing domestic industry instead of supporting its growth. It's common for foreign aid to come in the form of providing products like fertilizers, construction materials, or basic tech items. When a country receives this form of foreign aid, it floods the market with free or heavily subsidized goods. And since the demand has been met by a free supply of foreign aid, the need for domestic production disappears. The existing local businesses in the domestic industry that could potentially
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develop are crowded out of the market, and this removes the revenue from local businesses, eliminates any opportunity for growth, and can even cause closures and unemployment. This isn't just a theory. Africa's apparel industry has seen a major decline in recent decades as it becomes the largest destination for secondhand clothes from developed countries. These donations undercut local manufacturers and research in the Economic Journal found
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this explained half of the decline in unemployment in the industry from 1981 to 2000. From this perspective, foreign aid isn't fostering economic growth, it's replacing it, and with domestic industry weakened, the need for more aid in the future is reinforced. Now, nuance is important here because the decline of a resource-intensive industry isn't strictly a bad thing. High-quality donations and cheap imports have underpinned a lucrative second-hand
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market for local African merchants, bringing jobs and tax revenue, and ultimately, it represents a more efficient solution to the economic problem. While you use production inputs to make clothes when you can get them for free, and reallocate those inputs to other industries. The problem is that there's no evidence that this reallocation has actually happened. Even if it did, it's likely to have gone back down the industrial ladder
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into activities where African countries have a comparative advantage, like agriculture or raw material extraction. So, whilst immediate clothing needs have been met more efficiently, the long-term organic development of the industry has been blocked. On top of this, a lot of the donations are unusable and have been discarded immediately, which is polluting Africa's waterways, urban areas and reserves, and overall, the situation has got so bad that in 2015,
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the East Africa community banned the import of second-hand clothes, and since 2023, the trade of second-hand clothes within Africa has also been banned. This substitution effect, where foreign aid replaces domestic development, extends beyond just goods, though. Services and technical assistance that come from foreign aid often don't involve the local labour supply, which limits learning opportunities for less-developed economies.
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For example, Chinese companies are heavily involved in infrastructure development in Africa, often financed at preferential rates under the remit of development assistance. Sounds good, right? Well, yes. But these companies tend to ship over their own workers, technical experts and management staff from China, which prevents opportunities for skilled employment in the local labour market. The hands-on learning by doing experiences that are essential for knowledge transfer
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and improvements in the quality of domestic human capital are blocked. So, what happens when the Chinese leave after completing their latest mega-project? The local labour force remains, having learnt nothing about the intricacies of infrastructure design, planning, construction machinery, operation, project management, energy solutions, supply chain logistics or financing. Ultimately, this means the local labour force has not grown in its capacity,
10:34
and the country remains unable to independently take on new infrastructure projects in the future, reinforcing its reliance on foreign aid. This issue was recently highlighted by the 2024 African Youth Survey, which showed that Chinese companies only employing Chinese workers, taking employment opportunities away from locals and not training up or providing skills were all growing concerns around China's influence on Africa in recent years.
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On top of this, it also leaves the government with a great big steaming pile of debt, which they often cannot realistically pay off. Over 60% of African countries now allocate more funds for servicing debt than they do critical sectors such as healthcare. Infrastructure development is a key ingredient of economic growth, but who owns, manages, produces and learns from it is critically important. This recent history of infrastructure development being done to Africa,
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rather than being done by Africa, is a key distinction as to why foreign aid hasn't been as effective as it has in Southeast Asia, for example. But it's not just China that does development to low-income countries through its own organisations. When governments in the West earmark billions of dollars for aid, the common assumption is that most of that money would actually reach the people and local organisations who need it, right? Well, not exactly.
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Western governments tend to fund large international development contractors instead of local organisations who are actually in the poor developing countries. In 2024, just 12% of funds distributed by USAID went directly to local frontline development organisations. The majority of its funding went to just a handful of major industries based in the United States. USAID itself admitted that this is a problem.
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The former head of USAID acknowledged the aid industrial complex that concentrated too much foreign aid funding on just a handful of organisations, setting ambitious targets to increase the localisation of funding allocations. Now, to be fair, the funding these large organisations receive can still benefit recipient countries without having to be directly transferred into the country because the funds pay for projects that are expected to provide positive local outcomes,
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but this top-down approach still brings about problems of development being done to the poor country rather than being done by it. Whilst these large contractors do pass on some funding to the local frontline organisations, they retain a huge amount of the funding for themselves. Data compiled by the Centre of Global Development captures the problem well. It shows the destination of USAID funding from 2017 to 2021. Of the funds that these American organisations receive from USAID,
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only 14% of them went to local frontline organisations. The large portion of funding that doesn't enter the poor developed country's economy has been called phantom aid by critics. Now, there is still a place for this, especially when there's a crisis that requires fast solutions and capacity building in the local labour force will take too long, and beyond that, doing something like medical development in a low income country just isn't reasonable.
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But often these organisations aren't delivering. When the $9.5 billion health supply chain contract USAID had with the industry giant Chimonix began to miserably fail its targets, the department realised that it had no scope in its largest ever contract to penalise the poor performance and incentivise improvements. The problem is that funding for projects is based on reimbursements for work done. The more work created and time spent, the more funding given out.
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This creates a perverse incentive to drive up the billable hours, focusing on activities rather than results. 98% of USAID grants do not operate on a pay for results model. USAID literally admitted this obvious flaw themselves in a 2019 report, which says, and I quote, Regardless of award outcomes, USAID paid implementers essentially the full award amount for the underperforming awards. This is a classic example of the principal agent problem,
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where ill-designed contracts enable the agent to seek private interests that conflict with the principals. It explains why the international development sector is riddled with tons of bureaucratic hurdles and administrative paperwork that can be shown off but have unclear tangible value. Hefty 200 page reports, 12 months subcontracting procurement processes, third party stakeholder consultations, planning applications, risk assessments,
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monitoring and evaluation schemes, policy alignment and compliance reviews and outcome frameworks. These activities drive up billable hours, but they don't necessarily deliver tangible results. A USAID report from 2019 found that almost half of their awarded contracts did not achieve their intended results. Careful planning and management is essential, but too much and these activities stall the process, prevent adaptability and, as the evidence shows,
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draws a huge amount of resources and attention away from the on-the-ground frontline work that's required to effectively use the money and actually impact the economy. What's more is that all this grift and graft makes these efforts, including the fantastic work that does get done, a logical target for someone to come along and scrap the operation entirely in the interest of efficiency, hypothetically. When the baby and the bathwater are so intertwined, it's easier to just throw out the tub.
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And again, this crowds out local organisations from project management limiting skill development into local labour force. This is a major reason why the traditional foreign aid system hasn't delivered self-sustaining economic growth in low-income countries. In light of this, new approaches became more commonplace that sought to give impoverished people the funding more directly. Conditional cash transfers like Brazil's Bolsa Família and Mexico's Opportunidades began
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to crop up where poor families received cash in exchange for attending school and hospital appointments. Later programs were launched that went further by simply giving their funding straight to individuals living in poverty and no strings attached. These are called unconditional cash transfers and they've been proven to be an effective means of poverty alleviation. They allow recipients to increase food security and invest in productive assets,
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but evidence suggests that the effectiveness fades away in the years after the cash transfer ends. So there's no silver bullet to reducing foreign aid dependency and there's no evidence to suggest that they can create self-sustaining growth across an entire economy. But perhaps the most commonly cited reason for why foreign aid doesn't work is corruption. The idea is that weak and unstable political institutions have enabled foreign aid funding
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to be siphoned off by the political elite in aid-reliant countries. There's countless throws of foreign aid funds being embezzled and these are only the cases where it's actually caught. Politicians or the recipient country who are able to siphon off foreign aid funds are actually incentivised not to invest it into the economy because if their citizens are suffering then the international development sector will give the recipient government even more foreign aid money.
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However, the issue of corruption might be over exaggerated. This 2020 study by the World Bank found that aid disbursements to aid-dependent countries coincided with sharp increases in deposits at shady offshore banks, but the leakage only amounted to 7.5% which is significant but not completely detrimental. On top of this, the evidence is mixed. Numerous studies actually found that foreign aid reduces the amount of corruption in recipient
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countries, but whether foreign aid fuels corruption or not, it could still make government and its institutions less effective. Evidence from 1980 to 2009 found that ODA grants had a negative effect on domestic tax revenues in low-income countries that had weak institutions, which suggests that ODA grants made collecting tax a redundant endeavour, reinforcing the need for foreign aid in the future. These are some of the key reasons why, despite many successes, foreign aid has been mostly
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ineffective in creating widespread economic growth. On a broader level though, realistically, the effectiveness of foreign aid was always going to diminish over time once the quick-win countries who had favourable conditions developed and a smaller pool of recipient countries with prohibitively challenging conditions were left behind. A paradox exists where the countries that need aid the most also happen to have the least favourable conditions for aid to actually work.
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It's extremely difficult, if not impossible, to solve intergenerationally embedded problems such as ethnic or religious conflict, cultural distrust, weak institutions and harsh climates with foreign aid, no matter how much you pump into the government and the economy. Syria, Afghanistan and Sudan are clear examples of this point. Look, there's major systemic issues with foreign aid, and its track record in terms of economic impact has been mixed at best.
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But it's clearly not a hopeless endeavour in its entirety. More recently, many economies in sub-Saharan Africa, especially the diversified ones, are showing stronger growth, which has come off the back of large infrastructure projects and debt restructuring. We shouldn't be asking whether it works, we should be asking when and how. Foreign aid should help build rather than replace more advanced domestic industries that can eventually become competitive and fund themselves.
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More agencies should reside with local-led organisations to increase skills development and pay for results contracts should have a larger part to play in the future. More aid also needs to prioritise effective governance and strong institutions, which are essential to a any-well-functioning economy. The entire international development sector is currently going through an existential crisis. Economic nationalism and government efficiency are driving 90% cuts in the US,
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whilst in Europe foreign aid cuts are making room for increased defence spending. So, what lies ahead for aid-reliant countries? The truth is, it's extremely hard to say with any certainty. This is the first time in modern history that foreign aid has been cut back at such a large scale. There's literally millions of lives on the line here, which means it's fair to say that the sudden cuts are pretty reckless, because while we've shown that foreign aid clearly isn't a perfect system,
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it still relied on for survival by millions of people across the planet. What's clear is that the withdrawal of aid is disrupting essential services like vaccination programs, maternal health initiatives and disease prevention efforts. It's straining the capacities of humanitarian organisations leaving vulnerable populations without necessary support. Make no mistake, this will cost lives and plunge millions of people back into extreme poverty.
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In some countries, it has the potential to spark political instability and even conflict. This is obviously a pretty bleak situation. But it's not all darkness. For countries that are able to manage the transition well, opportunity may lie ahead. Foreign aid cutbacks are creating room for local businesses, industry and supply chains to develop, creating organic growth and employment. It gives governments of low income countries more freedom to serve its citizens' interests
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rather than the interests of donors, which don't always align. The cuts necessitate fiscal prudence, so governments who are used to a plentiful flow of foreign aid will have to become more capable in designing and administering a fair tax system and their effective spending plans. This means stronger institutions and a potential clampdown on corruption. The switch from foreign aid to tax will also reintroduce the social contract between the
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government and its citizens, increasing accountability and responsiveness to citizens' needs. But foreign aid cutbacks are creating a vacuum that may very well get filled by other global powers. We can sit here and pretend that foreign aid is a purely philanthropic endeavour, but this simply doesn't capture the full truth. Geopolitical incentives are deeply woven into the system of foreign aid, which has long been used as a foreign policy tool ever since JFK opened USAID back in 1961.
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Since then, it's been leveraged to accommodate soft power and exert influence across the globe. So, is the West giving up this tool? How does this change international alliances, levels of democracy and security in geopolitical battlegrounds like Africa, where rival powers, China and Russia already have strong diplomatic ties? We have explored these erotifying ramifications of the West foreign aid retreat in our video over on our sister channel, Context Matters.
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You should be able to click to that video on your screen now. Thanks for watching mate. Bye.
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