Foreign Aid, Fungibility, and Growth

I've come across this fascinating paper which empirically demonstrates that one of the reasons why foreign aid hasn't resulted in much economic growth is that monies earmarked for development are often spent on things other than what they were intended for. That is, aid is often fungible--it can easily be spent elsewhere. Unfortunately, it is often spent on things which have less discernible developmental outcomes. This point might be obvious, but empirically demonstrating it has proven to be difficult in the past. In this paper, the authors determine that fungibility does serve as a mediator between foreign aid and growth. Forms of aid vary in their fungibility, and the extent to which aid is fungible has differential impacts on growth. Below is the abstract of the paper, which is available for download from the Institute for the Study of Labor (IZA) website. if you need more information on the concept of aid fungibility, do review this brief primer from Shanta Devarajan, who has written extensively about the topic.

The study uses a panel regression method as well. It seems panel regressions are all the rage these days in studies invovling the use of longitudinal data:

This paper examines fungibility as a possible explanation for the "missing link" between foreign aid and economic growth. The composition of aid plays a crucial role in determining the composition of government spending and, consequently, the magnitude of fungibility and its impact on growth. Embedding fungibility as an equilibrium outcome in an endogenous growth framework, we show that the substitution away from domestic government investment is higher than from government consumption. This leads to a reduction in domestic productive public spending and completely offsets any positive impact that aid might have on growth. The main predictions of the model are tested using a panel dataset of 67 countries for 1972-2000. We find strong evidence of fungibility at the aggregate level: almost 70 percent of total aid is fungible in our sample. We also find that investment aid is more fungible than other categories of aid. In the presence of fungibility, there is no statistically significant relationship between foreign aid and economic growth.