Aid dependence reconsidered

If foreign aid undermines institutional development, aid recipients can exhibit the symptoms of “dependence”-a short-run benefit from aid, but increasing need for aid that is damaging in the long run. We show that this high-aid/weak-institutions state can be an equilibrium outcome even when donors and recipients fully anticipate the effect of aid on institutional development. However, a low-aid/strong-institutions outcome is also possible, so that the model encompasses the diverse foreign-aid experiences of countries like the Republic of Korea and Tanzania. When the development community ignores the effect of aid on institutions, the outcome depends strongly on initial conditions. Where institutions are already weak, institutional capacity collapses and foreign aid eventually finances the entire public budget. Where they are initially stronger, the result can be close to the institutionssensitive equilibrium. The results suggest that foreign aid strategies, even for countries with similar per capita incomes, should be differentiated according to their institutional capacity; and that a short-run reduction in aid may increase a country’s chances of graduating from aid.