Funding Self-Sustaining Development: The Role of Aid, FDI and Government in Economic Success

This article challenges a long-held development-policy assumption that aid and foreign-direct investment (FDI) serve as substitutes or complements in accelerating the development of the world's poorer countries. We show both theoretically and empirically that aid and FDI affect development differently. Aid contributes powerfully to both economic growth and human development, and the higher the level of human capital in a country, the more aid contributes. By contrast, FDI, at best, has no effect on economic growth and actually slows the rate of human development in less-developed countries. We find no evidence that the degree of democratic responsiveness in government conditions the effectiveness of either aid or FDI, although we do find that democracy independently increases human development in all but the most developed countries. Our results demonstrate that FDI and aid are not, and cannot be, substitutes in the development of the world's poorer countries. Nor even can they be thought of as complements—certainly not at mid to low levels of development. In the end, poor countries need democracy and aid, not FDI.We are extremely grateful to Susan Rose-Ackerman, Gustav Ranis, Frances Rosenbluth, Kenneth Scheve, and participants at the Leitner Political Economy Seminar at Yale University in December 2003 for very helpful comments. We also received valuable suggestions from two anonymous reviewers. Stephen Kosack would like to thank the National Science Foundation for the support of a Graduate Research Fellowship.