Dancing to the Donors' Tune? Policy Choice in Aid-Dependent Countries

Current aid rhetoric emphasizes the selective allocation of otherwise unconditional funds in support of the recipients' own plans, in contrast to the old donor practice of bundling money and policies. I show that when recipients have private information, policies reflecting their preferences and knowledge might result in such a regime. However, generous transfers can also induce them to conform to the outcome-oriented expectations of donors at the expense of lower aid impact. Such behaviour is consistent with an abundance of case-study evidence. Moderate disagreements over what the optimal policy is could actually produce better results. Certain forms of both donor competition and coordination might also eliminate this distortion, while a donor concern for need only removes incentives for aid-seeking in the least needy countries. In summary, optimal aid policies are highly context-specific, and donors should thus concentrate their efforts to practise more informed selectivity.