Why Government Aid Programs Aren’t the Best Way to End Poverty

Based on the high standards of living enjoyed by their citizens, you might think that the governments of First World countries know how to create development. They don’t. Development isn’t created by anyone, not least well-intentioned politicians or development “experts”. The process of improving well-being only takes place in an environment that encourages constant innovation and experimentation.

Unfortunately, the state-led aid industry not only neglects the realities of development, but often takes actions that actively undermine it. For First World countries, development does not mean allowing other societies to go through the same messy process they did themselves. It entails top-down planning and grandiose promises that – this time – their plans will end poverty and suffering for good. Just consider the $9bn (£5.9bn) pledged to Haiti following its 2010 earthquake. Only a small portion was delivered, and even that has proven ineffective. Haiti’s President Michel Martelly recently concluded that aid “isn’t showing results”.

There are two reasons why state-provided aid cannot create society-wide prosperity. First, policymakers do not have access to the knowledge needed to allocate scarce resources to their best uses. In his critique of socialism in the 1930s and 1940s, Nobel Laureate Friedrich Hayek made this exact point, noting that even the most qualified and benevolent planners lack the knowledge to produce even the most basic items in a cost-effective manner.

Investor Thomas Thwaites recently embarked on a fascinating endeavour, the Toaster Project, which illustrates Hayek’s point. Thwaites tried to build a simple toaster from scratch. He quickly found the task was overly complex, involving hundreds of parts and materials from many locations. After much travel and effort to extract and process these materials, he constructed his (extremely ugly) toaster. Upon being plugged into an electric socket, it burned out within seconds. Thwaites realised that “the scale of industry involved in making a toaster is ridiculous, but at the same time the chain of discoveries and small technological developments that occurred along the way make it entirely reasonable.” No central planner determined the process, yet toasters are readily available. This is economic development.

The perverse incentives associated with aid are a second reason governments can’t create development. These exist both within the recipient and donor governments. For recipients, aid creates the incentive for already dysfunctional governments to remain ineffective. A cross-country study by Stephen Knack of the World Bank found that foreign assistance undermines the quality of political institutions in recipient countries through weakened accountability of political actors, more corruption, greater chances of conflict, and a weakening of the incentive to reform inefficient institutions and policies.

For donors, government agencies tend to focus on spending money as quickly as possible on observable outputs to signal their importance and the need for more money. In the absence of clear lines of accountability, money is often wasted. Consider that a recent report by the Special Inspector General for the Iraq Reconstruction (SIGIR) identified $8bn in funds that were either wasted or unaccounted for. When people are not held responsible for their actions, they tend to act carelessly. Aid efforts are plagued by similar issues.

Economic freedom, which requires general protections of person and property, avoids both of these problems. It does not fall prey to the knowledge problem that Hayek warned of because it recognises that attempting to micromanage economic outcomes is doomed to fail. Likewise, it avoids creating perverse incentives because it limits direct political interventions into voluntary interaction between people.

What can be done? Instead of looking to fix other societies, developed nations should focus on their own policies towards people living elsewhere. As the Toaster Project illustrates, increasing the extent of the market is the best means of delivering more and cheaper goods and services. If the desired end is to help the worst off, this provides a benchmark for judging policies: does it contribute to increasing the extent of the voluntary market? If the answer is “yes”, those policies will be most effective at improving living standards and removing suffering.