Theory and Practice of Foreign Aid: Introduction

The importance of foreign aid cannot be overstated. Unprecedented integration of the world economy in recent years has brought the issue of poverty back in the policy debate at the international level. Some of the recent initiatives such as the United Nation's Millennium Development Goals and the report by the Africa Commission (set up by the British Prime Minister Tony Blair) which was discussed at length at G8 meetings, recognize this fact. The analysis of foreign aid is however fraught with controversies and paradoxes. This applies to both the theoretical and the empirical literature. There are two broad strands in the literature. First, in international trade theory, researchers have examined the welfare effects of foreign aid and, in particular, if aid can be donor-enriching and recipient-immiserizing – the so-called Transfer Paradox. The main mechanism here is via changes in the international terms of trade. The primary benefit (loss) to the recipient (donor) can be offset by a secondary loss (gain) because of deterioration (improvement) in the international terms of trade. More recently, a number of studies have examined the possibility of strictly Pareto improving foreign aid, i.e., situations where both the donor and the recipient are better off as a result of the transfer.