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November 6, 2009

Climbing Out of the Aid Trap

Glenn Hubbard discusses how an old plan can become a new solution to help the world’s poorest nations lift themselves out of poverty — by putting business first.


What is the aid trap?
The aid trap refers to the problem that most development aid, though well-intentioned, actually hurts the poorest countries because it ultimately prevents the growth of local business sectors. History shows that local business development has been the source of prosperity throughout the world.

Each year, the World Bank publishes a report called Doing Business, which includes a ranking of countries based on the relative difficulty for local citizens to launch and maintain businesses. The report clearly illustrates that countries that receive the most foreign aid have the highest cost of entry for entrepreneurs. The bottom end of the list is composed primarily of nations in Africa.

In the 1960s, by which time almost all African nations had gained independence, billions of dollars of aid began flowing to Africa. But despite 40 years of aid, the state of African institutions remains tenuous and African nations overwhelmingly poor. Clearly the aid system has not been effective.

Not only has Africa remained poor, but the aid system has impeded the growth of existing business sectors and helped strangle entrepreneurial efforts. How? The majority of people employed outside of the agricultural sector are employed by governments and NGOs rather than, as in most societies, businesses. The amount of funding that goes to governments and NGOS dwarfs investment in the business sector.

Africa’s governments are largely content with the current system. Accepting the flow of aid is easy; the large number of people employed in the aid sector depend on it for their livelihoods and aren’t eager to change.

Under these conditions, the market can’t operate normally to create wealth, the business sector is marginalized and much of Africa remains poor.

What is your plan for ending poverty in poor nations?
The plan that Bill Duggan and I propose is inspired by the one shining success story of official development aid: the Marshall Plan.

The original Marshall Plan, proposed in the aftermath of World War II, made loans to European businesses in the form of production inputs: seeds to farmers and machines for factories, for example. The businesses repaid the loans, in cash, to local governments, which in turn invested the repaid funds in rebuilding public and commercial infrastructure, such as ports and roads. At the same time, pro-business policy reforms were implemented.

This is a wonderful model in that it creates automatic discipline: investment in infrastructure was dependent on businesses repaying loans. That’s the kind of mechanism we’re advocating.

Will the terms of loans to African countries be different? Yes. Will the infrastructure that the repayment of these loans generates be different? Yes. A great many other details will be different. But the basic mechanism is really quite simple, quite brilliant and hasn’t been tried since the Marshall Plan.

But Africa is very different from post-war Europe. Europe had a well-developed business sector prior to the war, and the Marshall Plan helped to rebuild it. But many African nations don’t have well-established business sectors to begin with. How does this plan account for such different circumstances?
When Greece participated in the Marshall Plan, it was strikingly similar to many African countries today. It was small, very poor, war-torn, and there was civil war at the outset. England, though devastated by the war, was comparatively rich with its institutions and economy intact. Despite these differences, Greece and England both benefited from the business and economic development facilitated by the Marshall Plan. Local business is highly adaptable to local circumstance.

Microfinance, which has made entrepreneurs out of millions of individuals in the world’s poorest countries, is an example of this. Muhammad Yunus, who developed the concept of microfinance while a professor of economics at Chittagong University in Bangladesh and who won the Nobel Peace Prize in 2006, understood the inherent adaptability of local business sectors. When the Grameen Bank lends money, it doesn’t dictate how borrowers should run their businesses, or how or with whom they must trade. The bank requires only that loans be repaid. Like the Grameen Bank, our plan would not dictate the terms of business.

Why isn’t something like microfinance enough?
Microfinance can be a catalyst for entrepreneurship up to a certain stage of business development, but the businesses launched through microfinance need to develop into full-fledged small businesses if they are to promote greater economic growth. Small and medium-sized businesses are the source of growth in all countries. Eighty percent of China’s employment, for example, is in small business — not in microfinance.

The barriers to growing past micro-entrepreneurship are formidable. Starting a formally-recognized business can require months of waiting, and paying enormous fees — including bribes — as the Doing Business rankings show. An example we use in the book is Mozambique, where starting a business requires forms 12 government agencies; you also have to pay bribes to each of the 12 government employees who stamp your documents. When you have 12 stamps, you can — at last — run your business without fear of being shut down. Similar hurdles in other countries mean that micro-entrepreneurs have a very difficult time becoming a political or economic force strong enough to challenge the status quo.

The bright spot is that micro-lenders are increasingly expanding their loan programs to serve not only individuals, but also established small and medium-sized businesses. Our proposal includes provisions for supporting existing small and medium-sized businesses through microfinance institutions.

How do you define success for this plan?
Success for each country will vary, but the key indicator will be to see a substantial percentage of the population move out of poverty. For the smallest poor countries, that might require 50 years of sustained investment in the development of their business sectors. Remember that it took Europe about a century to move from feudalism to private business. India and China, with so many natural resources, have moved relatively quickly over the last few decades. To move from poverty to prosperity in 50 years would be quite good.


William R. Duggan is Senior Lecturer in the Management Division at Columbia Business School.

R. Glenn Hubbard is dean of Columbia Business School and Russell L. Carson Professor of Finance and Economics.

Read the Research

R. Glenn Hubbard, William Duggan

"The Aid Trap: Hard Truths About Ending Poverty"

View abstract/citation 


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