Basic Economics

by Thomas Sowell

  Foreign Aid

  What is called “foreign aid” are transfers of wealth from foreign governmental organizations, as well as international agencies, to the governments of poorer countries. The term “aid” assumes a priori that such transfers will in fact aid the poorer countries’ economies to develop. In some cases it does, but in other cases foreign aid simply enables the existing politicians in power to enrich themselves through graft and to dispense largess in politically strategic ways to others who help to keep them in power. Because it is a transfer of wealth to governments, as distinguished from investments in private enterprises, foreign aid has encouraged many countries to set up government-run enterprises that have failed, or to create palaces, plazas or other things meant to impress on-lookers rather than produce things that raise the material standard of living in the recipient country.

  Perhaps the most famous foreign aid program was the Marshall Plan, which transferred wealth from the United States to various countries in Western Europe after the end of World War II. The Marshall Plan was far more successful than many later attempts to imitate it by sending foreign aid to Third World countries. Western Europe’s economic distress was caused by the physical devastations of the war. Once the people were fed and the infrastructure rebuilt, Western Europe simply resumed the industrial way of life which they had achieved before—indeed, which they had pioneered before.

  That was wholly different from trying to create all the industrial skills that were lacking in poorer, non-industrial nations. What needed to be rebuilt in Europe was physical capital. What needed to be created in much of the Third World was more human capital. The latter proved harder to do, just as the vast array of skills needed in a modern economy had taken centuries to develop in Europe.

  Even massive and highly visible failures and counterproductive results from foreign aid have not stopped its continuation and expansion. The vast sums of money dispensed by foreign aid agencies such as the International Monetary Fund and the World Bank give the officials of these agencies enormous influence on the governments of poorer countries, regardless of the success or failure of the programs they suggest or impose as preconditions for receiving money. In short, there is no economic bottom line constraining aid dispensers to determine which actions, policies, organizations or individuals could survive the weeding out process that takes place through competition in the marketplace.

  In addition to the “foreign aid” dispensed by international agencies, there are also direct government-to-government grants of money, shipments of free food, and loans which are made available on terms more lenient than those available in the financial markets, and which are from time to time “forgiven,” allowed to default, or “rolled over” by being repaid from the proceeds of new and larger loans. Thus American government loans to the government of India and British government loans to a number of Third World governments have been simply cancelled, converting these loans into gifts.

  Sometimes a richer country takes over a whole poor society and heavily subsidizes it, as the United States did in Micronesia. So much American aid poured in that many Micronesians abandoned economic activities on which they had supported themselves before, such as fishing and farming. If and when Americans decide to end such aid, it is not at all certain that the skills and experience that Micronesians once had will remain widespread enough in later generations to allow them to become self-sufficient again.

  Beneficial results of foreign aid are more likely to be publicized by the national or international agencies which finance these ventures, while failures are more likely to be publicized by critics, so the net effect is not immediately obvious. One of the leading development economists of his time, the late Professor Peter Bauer of the London School of Economics, argued that, on the whole, “official aid is more likely to retard development than to promote it.”{832} Whether that controversial conclusion is accepted or rejected, what is more fundamental is that terms like “foreign aid” not be allowed to insinuate a result which may or may not turn out to be substantiated by facts and analysis.

  Another phrase that presupposes an outcome which may or may not in fact materialize is the term “developing nations” for poorer nations, who may or may not be developing as fast as more prosperous nations, and in a number of cases have actually retrogressed economically over the years.

  Many Third World countries have considerable internal sources of wealth which are not fully utilized for one reason or another—and this wealth often greatly exceeds whatever foreign aid such countries have ever received. In many poorer countries, much—if not most—economic activity takes place “off the books” or in the “underground economy” because the costs of red tape, corruption, and bureaucratic delays required to obtain legal permission to run a business or own a home put legally recognized economic activities beyond the financial reach of much of the population. These people may operate businesses ranging from street vending to factories, or build homes for themselves or others, without having any of this economic activity legally recognized by their governments.

  According to The Economist magazine, in a typical African nation, only about one person in ten works in a legally recognized enterprise or lives in a house that has legally recognized property rights.{833} In Egypt, for example, an estimated 4.7 million homes have been built illegally.{834} In Peru, the total value of all the real estate that is not legally covered by property rights has been estimated as more than a dozen times larger than all the foreign direct investments ever made in the country in its entire history.{835} Similar situations have been found in India, Haiti, and other Third World countries. In short, many poor countries have already created substantial amounts of physical wealth that is not legally recognized, and therefore cannot be used to draw upon the financial resources of banks or other lenders and investors, as existing physical wealth can be used to build more wealth-creating enterprises in nations with better functioning property rights systems.

  The economic consequences of legal bottlenecks in many poor countries can be profound because they prevent many existing enterprises, representing vast amounts of wealth in the aggregate, from developing beyond the small scale in which they start. Many giant American corporations began as very small enterprises, not very different from those which abound in Third World countries today. Founders of Levi’s, Macy’s, Saks, and Bloomingdale’s all began as peddlers, for example.{836}

  While such businesses may get started with an individual’s own small savings or perhaps with loans from family or friends, eventually their expansion into major corporations usually requires the mobilization of the money of innumerable strangers who are willing to become investors. But the property rights system which makes this possible has not been as accessible to ordinary people in Third World countries as it has been to ordinary people in the United States.

  An American bank that is unwilling to invest in a small business may nevertheless be willing to lend money to its owner in exchange for a mortgage on his home—but the home must first be legally recognized as the property of the person seeking the loan. After the business becomes a major success, other strangers may then lend money on its growing assets or invest directly as stockholders. But all of this hinges on a system of dependable and accessible property rights, which is capable of mobilizing far more wealth within even a poor country than is ever likely to be transferred from other nations or from international agencies like the World Bank or the International Monetary Fund.

  Many people judge how much help is being given to poorer countries by either the absolute amount of a donor nation’s government transfer of wealth to poorer countries, or by the percentage share of that national income that is sent in the form of government-to-government transfers as “foreign aid.” But an estimated 90 percent of the wealth transfers to poorer nations from the United States takes the form of private philanthropic donations, business investments or remittances from citizens from Third World countries living in the United States. As of 2010, f
or example, official development assistance from the United States to Third World nations was $31 billion but American private philanthropy alone sent $39 billion to those nations, while American private capital flows to the Third World were $108 billion, and remittances from the United States to those countries were $100 billion.{837}

  People who measure a donor nation’s contributions to poorer countries solely by the amount of official “foreign aid” sometimes point out that, although “foreign aid” from the United States is the largest in the world, it is also among the smallest as a percentage of Americans’ income. But that ignores the vastly larger amount of American transfers of wealth to poor countries in non-governmental forms. Since the beginning of the twenty-first century, most of the transfers of wealth from prosperous countries in general to poorer countries have been in forms other than what is called “foreign aid.”{838}

  A much larger question is the extent to which these international transfers of hundreds of billions of dollars have actually benefitted the countries receiving them. That is a much harder question to answer. However, given the differing incentives of those sending wealth in different forms, official “foreign aid” may have the fewest incentives to ensure that the wealth received will be used to increase output in the recipient country and thus raise the standard of living of the general population of these nations.

  THE INTERNATIONAL MONETARY SYSTEM

  Wealth may be transferred from country to country in the form of goods and services, but by far the greatest transfers are made in the form of money. Just as a stable monetary unit facilitates economic activity within a country, so international economic activity is facilitated when there are stable relationships between one country’s currency and another’s. It is not simply a question of the ease or difficulty of converting dollars into yen or euros at a given moment. A far more important question is whether an investment made in the United States, Japan, or France today will be repaid a decade or more from now in money of the same purchasing power.

  When currencies fluctuate relative to one another, anyone who engages in any international transactions becomes a speculator. Even an American tourist who buys souvenirs in Mexico will have to wait until the credit card bill arrives to discover how much the item they paid 30 pesos for will cost them in U.S. dollars. It can turn out to be either more or less than they thought. Where millions of dollars are invested overseas, the stability of the various currencies is urgently important. It is important not simply to those whose money is directly involved, it is important in maintaining the flows of trade and investment which affect the material well-being of the general public in the countries concerned.

  During the era of the gold standard, which began to break down during the First World War and ended during the Great Depression of the 1930s, various nations made their national currencies equivalent to a given amount of gold. An American dollar, for example, could always be exchanged for a fixed amount of gold from the U.S. government. Both Americans and foreigners could exchange their dollars for a given amount of gold. Therefore any foreign investor putting his money into the American economy knew in advance what he could count on getting back if his investment worked out. No doubt that had much to do with the vast amount of capital that poured into the United States from Europe and helped develop it into the leading industrial nation of the world.

  Other nations which made their currency redeemable in fixed amounts of gold likewise made their economies safer places for both domestic and foreign investors. Moreover, their currencies were also automatically fixed relative to the dollar and other currencies from other countries that used the gold standard. As Nobel Prizewinning monetary economist Robert Mundell put it, “currencies were just names for particular weights of gold.”{839} During that era, famed financier J.P. Morgan could say, “money is gold, and nothing else.”{840} This reduced the risks of buying, selling, or investing in those foreign countries that were on the gold standard, since exchange rate fluctuations were not the threat that they were in transactions with other countries.

  The end of the gold standard led to various attempts at stabilizing international currencies against one another. Some nations have made their currencies equivalent to a fixed number of dollars, for example. Various European nations have joined together to create their own international currency, the euro, and the Japanese yen has been another stable currency widely accepted in international financial transactions. At the other extreme have been various South American countries, whose currencies have fluctuated wildly in value, with annual inflation rates sometimes reaching double or even triple digits.

  These monetary fluctuations have had repercussions on such real things as output and employment, since it is difficult to plan and invest when there is much uncertainty about what the money will be worth, even if the investment is successful otherwise. The economic problems of Argentina and Brazil have been particularly striking in view of the fact that both countries are richly endowed with natural resources and have been spared the destruction of wars that so many other countries on other continents suffered in the course of the twentieth century.

  With the spread of electronic transfers of money, reactions to any national currency’s change in reliability can be virtually instantaneous. Any government that is tempted toward inflation knows that money can flee from their economy literally in a moment. The discipline this imposes is different from that once imposed by a gold standard, but whether it is equally effective will only be known when future economic pressures put the international monetary system to a real test.

  As in other areas of economics, it is necessary to be on guard against emotionally loaded words that may confuse more than they clarify. Among the terms widely used in discussing the relative values of various national currencies are “strong” and “weak.” Thus, when the euro was first introduced as a monetary unit in the European Union countries, its value fell from $1.18 to 83 cents and it was said to be “weakening” relative to the dollar.{841} Later it rose again, to reach $1.16 in early 2003, {842}and was then said to be “strengthening.” Words can be harmless if we understand what they do and don’t mean, but misleading if we take their connotations at face value.

  One thing that a “strong” currency does not mean is that the economies which use that currency are necessarily better off. Sometimes it means the opposite. A “strong” currency means that the prices of exports from countries which use that currency have risen in price to people in other countries. Thus the rise in value of the euro in 2003 has been blamed by a number of European corporations for falling exports to the United States, as the prices of their products rose in dollars, causing fewer Americans to buy them. Meanwhile, the “weakening” of Britain’s pound sterling had opposite effects. BusinessWeek magazine reported:

  Britain’s hard-pressed manufacturers love a falling pound. So they have warmly welcomed the 11% slide in sterling’s exchange rate against the euro over the past year. ... As the pound weakens against the euro, it makes British goods more competitive on the Continent, which is by far their largest export market. And it boosts corporate profits when earnings from the euro zone are converted into sterling.{843}

  Just as a “strong” currency is not always good, it is not always bad either. In the countries that use the euro, businesses that borrow from Americans find the burden of that debt to be less, and therefore easier to repay, when fewer euros are needed to pay back the dollars they owe. When Norway’s krone rose in value relative to Sweden’s krona, Norwegians living near the border of Sweden crossed over the border and saved 40 percent buying a load of groceries in Sweden.{844} The point here is simply that words like “strong” and “weak” currencies by themselves tell us little about the economic realities, which have to be looked at directly and specifically, rather than by relying on the emotional connotations of words.

  It should also be noted that a given currency can be both rising and falling at the same time. For example, over the period from December 2008 to
April 2009, the American dollar was rising in value relative to the Swedish krona and the Swiss franc while falling in value relative to the British pound and the Australian dollar.{845}

  Chapter 23

  INTERNATIONAL DISPARITIES

  IN WEALTH

  Everywhere in the world there are gross inequities of income and wealth. They offend most of us. Few can fail to be moved by the contrast between the luxury enjoyed by some and the grinding poverty suffered by others.

  Milton and Rose Friedman{846}

  Any study of international economic activities inevitably encounters the fact of vast differences among nations in their incomes and wealth. In the early nineteenth century, for example, there were four Balkan countries where the average income per capita was only one-fourth that in the industrialized countries of Western Europe.{847} Two centuries later, there were still economic differences of a similar magnitude between the countries of Western Europe and various countries in the Balkans and Eastern Europe. The per capita Gross Domestic Product (GDP) of Albania, Moldova, Ukraine and Kosovo were each less than one-fourth of the per capita GDP of Holland, Switzerland, or Denmark—and less than one-fifth of the per capita GDP of Norway.{848}

  Similar disparities are common in Asia, where the per capita GDP of China is less than one-fourth that of Japan,{849} while that of India is barely more than ten percent of the per capita GDP of Japan. The per capita GDP of sub-Saharan Africa is less than ten percent of the per capita GDP of the nations of the Euro zone.{850}