The Long-Run Relationship Between Foreign Aid And Labor Productivity In Sierra Leone

Abstract

The Financing Gap Hypothesis (FGH) proposed that foreign aid is needed to fill a financing gap created by low savings in less developed countries (LDCs) relative to the large investments needed for promoting economic development and poverty alleviation. In the 1980s, using the failure of foreign aid to alleviate poverty in LDCs as evidence, a neoclassical counterrevolution in development economics rejected this hypothesis. In its stead, they pointed to poor governance and anti-market statist LDC policies, not inadequate financing, as for the causes of LDC poverty and underdevelopment. The ensuing debate generated a plethora of empirical studies of the aid-growth relationship, whose findings remain inconclusive. While unconditional aid-optimist studies found significantly positive aid-growth relationships, with or without good policies, conditional aidoptimists found aid positively impacting growth in only countries that have good policies. Meanwhile, aid-pessimist studies reported insignificant or significantly negative aid-growth relationships. However, this literature was mostly based on regression analysis of cross-sectional data. As such, they do not address individual country characteristics that impact the aid-growth relationship. Secondly, they assumed aid-exogeneity, although aid-endogeneity seems more plausible. This makes those regression findings susceptible to endogeneity bias. Thirdly, cross-sectional regression estimates provide a snapshot of the aid-growth relationship at a given point in time. However, economic growth and poverty alleviation are long-run phenomena, which require an understanding of the long-run equilibrium aid-growth relationship. Cointegration analysis estimates long-run equilibrium relationships. Hence, it is appropriate for studying the aid-growth relationship. It also addresses endogeneity bias by assuming that all variables are endogenous. Finally, unlike cross-sectional analysis, individual-country cointegration analysis addresses country-specific characteristics. Given the above advantages of cointegration analysis, this paper uses Johansen's maximum-likelihood (JML) cointegration procedure and three single-equation cointegration estimators to investigate the long-run relationship between labor productivity and foreign aid in Sierra Leone. All four estimators find a positive and significant long-run aid-growth relationship. They also find that total factor productivity (TFP) is the most dominant factor in explaining labor productivity in the country. Consequently, it recommends using aid to promote TFP growth.