...1 provides a vivid illustration of this fact, by plotting the cyclical component of consumption in several African countries against its counterpart in the United States between 1970 and 2003. Based on Obstfeld (1994), Dolmas (1998), and Pallage and Robe (2003), the welfare cost of such consumption volatility should be one to two orders of magnitude greater than in industrialized countries.

[FIGURE 1 OMITTED]

[FIGURE 1 OMITTED]

Recent evidence suggests that the shocks experienced by developing countries are mostly exogenous (Kose, 2002) and that developing countries' access to private international financial markets typically dries up precisely when their economies hit the doldrums (Kaminsky, Reinhart, and Vegh, 2004). Under such circumstances, changing the timing of foreign aid flows that average 10 percent of recipient gross national income--the representative figure for African countries (see Table 1)--has the potential for a first-order welfare impact. (1) Our objective is to prove this conjecture and to provide a measure of the welfare gain from switching to an aid policy that would aim at consumption smoothing in recipient countries.

In practice, aid has historically been given out by a large number of imperfectly coordinated donors, whose motives for providing aid range from poverty alleviation to disaster relief to growth promotion to political alliances (Alesina and Dollar, 2000). In most developing countries, the resulting mix of foreign aid strategies is associated with procyclical net foreign aid inflows (Pallage and Robe, 2001; and Bulir and Hamann, 2003 and 2006). (2) In this paper, we quantify the welfare benefit that would accrue to recipients if donors could coordinate on a single objective--consumption smoothing. Our question is whether using the current foreign aid budgets as an insurance device could indeed yield first-order welfare improvements in the recipient country.

Precisely, we quantify the potential welfare gains from changing the timing of foreign aid disbursements while keeping their average level constant. To keep the analysis transparent, we build a simple dynamic model of aid flows between two endowment economies with symmetric information sets: an altruistic donor country and a much poorer recipient country. Consistent with empirical evidence that foreign aid may not boost economic growth in practice (Easterly, 2003), we take each country's endowment growth path as independent of the aid flows. We approximate the fact that much of the aid to poor countries comes as outright grants by positing that aid is given out with no expectation of repayment. Finally, we assume that the donor adjusts aid flows each period to maximize a weighted average of its own expected utility and that of the recipient.

In this environment, the optimal aid policy is countercyclical. It does not merely dampen the variability of the recipient's consumption, it massively reduces it. For a poor recipient country, this policy brings the very large percentage volatility of per capita consumption down to the much lower level prevailing in the donor country. The effect of this policy on volatility in the donor country itself is negligible.

To obtain quantitative estimates of the effects of this aid policy on a typical recipient's welfare, we calibrate the model and numerically simulate it. We find that altering the timing of aid disbursements would be worth at least 0.2 percent, and quite possibly more than 8 percent, of permanent consumption in the recipient country. The magnitude of the recipient's welfare gain varies with the assumed level of risk aversion, the mean growth rate of consumption, and the magnitude and (especially) persistence of aggregate shocks. Strikingly, however, the fraction of the welfare costs of macroeconomic fluctuations that could be alleviated by merely changing the timing of aid flows always exceeds 75 percent. In short, changing the intertemporal pattern of foreign aid inflows does have the potential to create first-order welfare improvements through better risk sharing and increased consumption smoothing.

We deliberately abstract from the possibility of informational asymmetries or agency conflicts between donor and recipient or between various constituencies in the donor or recipient countries. (3) This approach allows us to keep the analysis simple despite the dynamic nature of foreign aid relationships. More important, it allows us to provide a quantitative sense of the full potential of using foreign aid as an insurance device, which has been advocated in both academic and policy circles in recent years. (4)

We are fully aware that the presence of moral hazard would likely reduce the extent to which it is desirable to offer insurance against macroeconomic shocks. We are also fully aware that implementing a countercyclical aid policy may be fraught with practical difficulties. Issues related to informational imperfections, however, arise with any insurance policy. What matters is that the insurance benefits be large enough. Our analysis shows that, in the presence of persistent macroeconomic shocks, these benefits could be of first-order magnitude. (5)

In the context of the ongoing debate about the apparent ineffectiveness of foreign aid in boosting growth and alleviating poverty, our results do not imply that donors should stop examining why some aid programs have worked and why many others have not. Neither do we suggest that donors should give up on growth and poverty altogether and instead focus on consumption smoothing. Rather, our results demonstrate that donors cannot ignore the insurance implications of foreign aid.

This paper is related to the large literature on the welfare gains from international risk sharing, which finds scope for additional risk sharing between different countries, mainly through financial markets and fiscal policy. (6) Estimates of the unrealized welfare gains from such opportunities range from moderate to massive, depending on the risk-sharing channel and on the modeling assumptions. Our contribution is to show that an existing policy instrument--foreign aid--has the potential to achieve very large additional welfare gains in recipient countries.

Closely related to our analysis is a contemporaneous study by Arellano and others (2005). These authors quantify the impact of exogenously given foreign aid flows on the production of tradable goods in developing countries. They also measure the welfare implications of observed aid patterns by contrasting welfare levels when aid is volatile and procyclical versus when aid is kept constant at the mean. Like us, they choose not to model issues related to possible informational asymmetries between aid donors and recipients. Our focus, however, is different. We do not seek to identify the impact of foreign aid on a particular sector of the economy. Instead, our goal is to highlight the consumption-smoothing potential of foreign aid. Therefore, rather than take the aid policy as exogenous and then compute its impact on the recipient country's economy, we take the recipient country's aggregate consumption process as given and then quantify the welfare gain from fine-tuning aid disbursements to smooth out that consumption stream.

I. Model

To study the insurance potential of foreign aid in a recipient country, we build a model of aid flows between two endowment economies--a rich donor and a poor recipient. Each country's endowment growth path is taken as exogenous. We abstract from modeling any impact that aid might have on GDP or on GDP growth.

Of course, development assistance is the largest component of foreign aid, and the welfare effects of even small improvements in growth prospects are generally very large. One might therefore worry that, by abstracting from the development objective of aid, we may underestimate the cost of reallocating funds from growth promotion and overestimate the net benefits from a reduction in consumption volatility. Such should not be the case, however, for the following reasons.

First, our approach reflects the fact that, after decades of empirical research, there is little consensus on whether foreign aid directly affects economic growth in practice (Easterly, 2003). (7) Accordingly, we focus on another direct effect of aid flows on welfare, through consumption smoothing. That is, we ask whether foreign aid could have a first-order welfare impact on recipients in spite of the fact that the growth channel is weak. Still, we do not assume that poor countries will forever experience low levels of consumption; in...

NOTE: All illustrations and photos have been removed from this article.



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