A retrospective on foreign aid

Harvard Business School recently released a revised version of an interesting paper entitled How is Foreign Aid Spent? Evidence from a Natural Experiment. Erik Werker, Faisal Ahmed, and Charles Cohen look at the impact of foreign aid that many Muslim-majority countries received from oil-rich OPEC countries in the 1970s. (Figure 1 below the jump, taken from the HBS paper, shows the overlapping spikes in oil prices and OPEC foreign aid.)   

This episode provides the authors an exceptional opportunity to test the impact of aid - typically, it's hard to do because aid may be targeted to those countries where poverty is the worst, or, conversely, those that have improved the most. (This is the familiar problem of endogeneity, for the econometricians out there). Werker et al. come to a pretty harsh conclusion: 

The petro-aid was largely consumed, nearly all in imports. It did not lead to a measurable increase in growth, prices, or an appreciation of the exchange rate. Imported goods during the aid surge shifted away from capital goods and towards non-capital goods, and aid crowded out domestic savings. A significant share of the aid fled the country in unaccounted transactions.

Their conclusion suggests, at the very least, that simply throwing aid unconditionally at countries without the proper institutions in place does not lead to much of a development impact. Now if only there were a similar natural experiment to test out the effectiveness of conditional aid!