As I wrote in a recent post, the economic development first crowd is back. The crude version of this argument states “democracy does not fill stomachs, alleviate malaria, or protect neighborhoods from marauding bands of militiamen.” There is a basic flaw to this argument I thought we had put to rest. Apparently, I was wrong, so let’s go back to the basics.

The point of foreign aid, as I understand it, is to help facilitate economic development in poor countries. The basic idea is that because savings are low in poor countries, aid finances economic development through investment. The problem is that the theory doesn’t fit the data. The graph below shows aid as a share of GDP and the current account balance (CAB) as a share of GDP for all aid-recipient countries in 2006. The CAB is investment minus saving. Thus, a positive CAB means more money is flowing into a country than flowing out, while a negative CAB reflects the opposite. The data make the startling point that most countries receiving foreign aid have a negative CAB. What this essentially reflects is that domestic savings flows out of aid-recipient countries.

In 2006, donors provided about $36 billion in foreign aid. In aid-recipient countries, about $27 billion of domestic savings – 75% of the total amount of aid donors provided in that year – were invested abroad. The basic question is why people in developing countries choose to invest abroad rather than at home. One important reason is because poor governance in these countries, such as rampant corruption, lack of adherence to the rule of law, and predatory government, discourages local investment. There are lots of investment opportunities in developing countries (think local basic manufacturing such as food processing, for example), yet people with money in these countries choose to invest abroad, mainly in countries that have better business climates.

The development first crowd is right up to a point: elections are far less important than having enough food to eat. Yet, we can’t solve the latter until we can reverse the trend of savings flowing out of poor countries. This will not occur without significant governance reform. The development first crowd means well, I suspect, but misses the basic point than pouring foreign aid into countries where the locals won’t invest will not encourage development.