The Welfare Economics of Foreign Aid

The purpose of this paper is to discuss the forces governing the demand for foreign aid by recipient countries, and the associated question of choice of domestic savings for financing economic growth, in a situation where foreign aid is available at an institutionally determined low rate of interest. The discussion rests on a highly stylized conceptual exercise in optimizing the time-pattern of investment, foreign aid, and (hence) domestic savings over a long but finite period of time, with a nonlinear social preference function to be maximized subject to the attainment of a target plan terminal level of national income1. The preference function to be maximized is assumed to be the sum (integral) of one-period (instantaneous) “utility” derived from aggregate consumption over the entire plan period, with marginal utility from consumption falling as consumption of any period (point of time) rises. The exercise brings out that in the absence of offsetting political and/or psychological forces, the demand for foreign aid at the prevailing low rate(s) of interest should far exceed what recipient countries are actually obtaining currently, and foreign aid would be used not only for increasing the rate of economic growth but also for directly increasing consumption. With such excesses on the demand side, the “market” for foreign aid must be in a state of “institu¬tional disequilibrium”, leading to “political lobbying” by recipient countries each trying to increase the allocation of a limited total amount of foreign aid in its own favour. This conclusion is contrasted with a recent theory, due to [3; 4], that emphasizes the welfare efficiency from the point of view of recipients of foreign aid of maximizing domestic savings and thereby keeping the flow of foreign aid to a minimum, a theory that we shall call the “maximum austerity”