When foreign aid undermines institutional development, aid recipients can exhibit the symptoms of aid "dependence" - benefiting from aid in the short term but damaged by it in the long term.
Azam, Devarajan, and O'Connell find that one equilibrium outcome can be high aid and weak institutions, even when donors and recipients fully anticipate aid's effects on institutional development, but don't take the drastic steps needed to put the country on the path to independence.
Another equilibrium outcome can be low aid and strong institutions. Their model encompasses such diverse experiences as those of Tanzania and the Republic of Korea.
When the development community ignores aid's effect on institutions, the outcome depends greatly on initial conditions.
Where institutions are initially weak (as in many Sub-Saharan African countries at independence), institutional capacity collapses and foreign aid eventually finances the whole public budget. Where they are initially stronger, the result can be close to the institutions-sensitive equilibrium.
The results suggest that, even for countries with similar per capita incomes, the foreign aid strategy should be designed to suit the country's institutional capacity.
In some cases a short-term reduction in aid may increase a country's chances of graduating from aid.
This paper — a product of Public Economics, Development Research Group — is part of a larger effort in the group to study the effects of foreign aid on the public sector. Copies of the paper are available free from the World Bank, 1818 H Street NW, Washington, DC 20433. Please contact Hedy Sladovich, room MC2-609, telephone 202-473-7698, fax 202-522-1154, Internet address hsladovich@worldbank.org. The authors may be contacted at jean-paul.azam@univ-tlse1.fr, sdevarajan@worldbank.org, or soconne1@swarthmore.edu. (14 pages)
The full report is available in PDF format.