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Timing – The Secret of Successful Foreign Aid

Foreign aid to help stabilize transition economies like Russia''s only works if the donor countries of the West get their timing right. Announcing transfers early and transferring them rapidly can accelerate the solution of large budget deficits and raging inflation. But aid approved or provided too late is counterproductive, destabilizing the recipient and encouraging further postponement of vital economic reforms. These are the conclusions of Alessandra Casella and Barry Eichengreen in an article published in the May issue of the Economic Journal. They may suggest that the West has failed in its assistance to Russia, perhaps hastening its potential return to communism.

Casella and Eichengreen aim to resolve the debate over whether Western aid improve the prospects for economic stabilization, notably in Russia. One side of this debate argues that aid supports living standards and defuses conflicts over the distribution of income, which otherwise hinder the transition to a market economy. The other side claims that, on the contrary, Western aid only endows vested interests with additional resources with which to resist the policies needed to contain inflation and balance government budgets.

Casella and Eichengreen find that the debate neglects one variable which alone determines whether foreign aid accelerates or retards stabilization: the timing of the aid itself. Transfers lead to earlier stabilization only if they are announced sufficiently early and disbursed sufficiently rapidly. Such criteria as the severity of the crisis, the institutions of the recipient country and the size of the transfer do affect the outcome, but none as crucially as correct timing.

For example, in an economy plagued by inflation and an unsustainable government deficit, stabilization demands an increase in taxes. But although everyone is aware that measures will have to be taken eventually, stabilization is postponed because competing groups within society fight to impose the tax burden on each other. From seeing what their opponents don't concede, each group learns information about their ability to live with inflation. When its relative weakness becomes clear, the group most vulnerable to inflation concedes: it will accept the larger share of new taxes.

This scenario illustrates a popular theory of the observed delays in introducing stabilization policies known to be inevitable (Alesina and Drazen, 1991). The central insight is that it is the lack of information that transforms the conflict over income distribution into a delay in policy. Hoping to be able to outlive the others, each group engages in a war of attrition because it does not know how long its opponents can resist.

Casella and Eichengreen introduce the announcement of a foreign aid transfer into the scenario. The aid will be delivered later and will reduce the severity of the fiscal measures that have to be taken. If the announcement is made after a long period of inflation, during which no one has conceded yet, it is clear that all groups are willing to sustain high costs in order to avoid shouldering the burden of the stabilization. In response to the announcement that aid is forthcoming, everyone will prefer to postpone a possible concession until after the disbursement itself when the required sacrifice is smaller.

In this scenario, no action is taken until the transfer actually takes place, typically after lengthy debate among the donor countries and the additional interludes that tend to accompany the process. Only then do the different groups reconsider the possibility of conceding. At this point, their relative position is unchanged and the war between them continues as before aid was announced. As a result, the final resolution of the conflict is unambiguously delayed. In contrast, when the need for painful measures has only recently become evident, each group thinks it possible that its opponents will be unable to sustain the fight for long. Once aid is announced, a group that cannot protect itself from inflation will concede immediately: even just waiting for the transfer to materialize is too costly. Thus, either the announcement of aid triggers stabilization or, if it does not, it helps to reveal that all groups are determined enough to sustain a fight. The transmission of information is accelerated and so must be the eventual timing of the stabilization.

''Can Foreign Aid Accelerate Stabilization?'' by Alessandra Casella and Barry Eichengreen is published in the May 1996 issue of the Economic Journal. Casella is Professor of Economics at Colombia University; Eichengreen is Professor of Economics at the University of California, Berkeley.