Those calling for Western aid to hasten macroeconomic stabilization and structural reform in Eastern Europe and the former Soviet Union argue that it will support living standards during the painful transition, allay distributional conflicts and thus reduce political resistance. Others maintain that foreign transfers can only endow vested interests with additional resources with which to resist reform and delay the adoption of the policies required to contain inflation, balance budgets and introduce market forces. In Discussion Paper No. 961, Research Fellows Alessandra Casella and Barry Eichengreen study the impact of foreign aid by adopting the AlesinaDrazen model, in which the need to collect higher taxes delays stabilization and competing distributional interests engage in a war of attrition to impose the tax burden on each other.

Foreign aid transfers typically take effect only after a period of high inflation, an extended debate in the donor country and a further delay after the decision has been taken. Casella and Eichengreen investigate the effects of these stages' timing on the transfer's effects. Foreign resources may be used to underwrite government spending, so the announcement of aid hastens stabilization by reducing future public debt and hence the fiscal burden borne by the faction that will eventually surrender, but any delay between the announcement and disbursal of aid creates incentives to postpone concessions until it arrives.

If the transfer is announced at an early stage, any distributional faction that faces high inflation costs concedes at once; failing that, all groups deduce that none suffers severely from inflation, and optimal individual decisions interact with the game's structure to hasten the release of information and the stabilization. If the announcement takes place at a late stage, however, all groups know that all will prefer to wait for the disbursal, so the announcement can only delay the flow of information and the ensuing stabilization. Casella and Eichengreen conclude that the donor country's timing of an aid transfer plays a critical role in determining its outcome.

Can Foreign Aid Accelerate Stabilization?
Alessandra Casella and Barry Eichengreen

Discussion Paper No. 961, May 1994 (IM)