Working paper 07-1 Christina Bjerg, Christian Bjørnskov and Anne Holm

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WORKING PAPER 07-1 

Christina Bjerg, Christian Bjørnskov and Anne Holm 

Growth, Debt Burdens and Alleviating Effects 

of Foreign Aid in Least Developed Countries 

Department of Economics

 

 

 

 

 

 

ISBN  87-7882-191-6 (print) 

ISBN  87-7882-192-4 (online)

 

 

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Growth, Debt Burdens and Alleviating Effects of 

Foreign Aid in Least Developed Countries 

 

Christina Bjerg, Christian Bjørnskov

*

 and Anne Holm 

 

 

Abstract: In this paper, we explore the potential growth effects of foreign aid when in 

conjunction with severe debt problems. We first argue that aid, when used to finance 

debt repayments, does not lead to Dutch Disease while still alleviating an economic 

problem. A set of empirical estimates show that while inflows of foreign aid in general 

are not associated with growth in a sample of 38 Least Developed Countries, an 

interaction term with the level of external debt is significant. We take this as suggestive 

evidence of an alleviating effect of aid in these countries and offer some tentative 

thoughts on the implications for future aid policies. 

 

Keywords: Economic growth, foreign aid, external debt 

JEL codes: O40, F34, F35 

 

                                                 

*

 Corresponding author: Department of Economics, Aarhus School of Business, Prismet, Silkeborgvej 2, 

DK-8000 Aarhus C, Denmark. Phone: [phone]; e-mail: 

[e-mail]

. This work originally arose 

as part of Bjerg and Holm’s undergraduate thesis, which was supervised by Bjørnskov. We are grateful 

for comments from Martin Paldam, Kim Sønderskov and participants at the 2007 Danish Public Choice 

workshop. The usual disclaimer naturally applies. 

 

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1. Introduction 

One of the most severe problems in the world is the widespread poverty in developing 

countries. While the Western world has grown remarkable affluent and a number of 

South East Asian countries have followed suit in recent years, large parts of the world’s 

population do not share the wealth. Consequently, one of the major questions in 

economics is how to foster development in developing countries, in particular since the 

depth of the problem calls for urgent measures. Developed countries have therefore in 

post-war years provided foreign aid to these countries as a means to further economic 

development on the assumption that this aid would be used to finance investments and 

the provision of vital public goods and infrastructure. Consensus in economics and 

political discussions was for a long time that this was a fair and efficient way of helping 

developing countries, despite early criticism of e.g. Friedman (1958) and Bauer (1971) 

that foreign aid could have such adverse economic and political consequences as to 

negate any beneficial effects. At the time, these arguments were broadly dismissed as 

extremist conservative and libertarian ramblings. 

However, in the mid-1980s, one of the first large-scale empirical studies showed 

that the data seemed to support Bauer’s most unpopular hypothesis (Mosley et al., 

1987). Since then, most studies have shown that foreign aid is not robustly associated 

with economic growth rates as the beneficial effects are either counteracted by adverse 

political and economic effects or do not arise when foreign aid is used to finance idle 

government consumption (cf. Boone, 1996; Remmer, 2004). While certain studies have 

argued that foreign aid works regardless of the conditions (Hansen and Tarp, 2000), 

other studies argue for a significantly negative effect (Ovaska, 2003). Yet, by applying 

 

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meta-analytical tools Doucougliagos and Paldam (2006, in press) summarize the 

findings of the entire aid effectiveness literature by showing that foreign aid is 

associated with neither growth nor increasing investment rates. 

The international community nevertheless continues to rely on foreign aid as its 

primary means of advancing development in the Third World. Most recently, the United 

Nations Millennium Development Goals, that include a number of aspects such as 

economic growth, poverty alleviation, schooling, gender equality, and governance, are 

meant to be achieved primarily by means of providing foreign aid to poor countries’ 

governments. Existing economic research nevertheless gives only limited reason to 

believe that these worthy goals can be reached through simply disbursing more 

resources to developing countries.  

Instead, in recent years the focus of the aid effectiveness literature has shifted 

towards exploring economic, institutional or political conditions under which foreign 

aid can have beneficial effects. Within this strand of the literature different studies argue 

for the necessity of having sound macroeconomic policies (Burnside and Dollar, 2000), 

a functioning democracy (Svensson, 1999), good governance (Burnside and Dollar, 

2004) and socio-economic stability (Chauvet, 2001). This paper extends the 

conditionality literature by exploring the conditional effects of debt burdens in least 

developed countries, which theoretically could be alleviated by inflows of foreign aid 

without the country experiencing some of the adverse effects of this aid. We restrict our 

attention to a sample of Least Developed Countries (LDCs) as these countries both 

experience the relatively worst problems and for technical reasons provide potentially 

more clear-cut results of our main hypothesis. 

 

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