Mind the Gap: The World Bank and the Financing Gap theory of Development

Since the establishment of the concept of aid for development after the Second World War, there have been roughly six failed methods that have been used to foster growth in the developing world. The first method was the financing gap theory which postulated that a recipient country needed project financing in order to develop.

Based on the Harrod-Domar economic model of 1946, the financing gap theory was used throughout the 1960s and 1970s as the method to calculate and deliver aid throughout Africa and Latin America. The main focus of this aid was the construction of large infrastructure projects.

The financing gap theory postulates that economic growth is proportional to investment. One could estimate the amount of growth one wants to achieve, and thus derive the amount of investment necessary in the country by comparing the difference between savings and investment. Since the target country for development was too poor to finance its own investment, and private capital flows to developing countries were at the time negligible, Western donors would step in to fill the gap.

This theory was lent further credence in 1960 by Walter Rostow in his influential work The Stages of Economic Growth. Rostow projected that increasing investment by five to ten percent of national income would launch a developing economy into “self-sustained growth.” The major drawback of Rostow’s projections are that they were heavily influenced by the apparent success of the Soviet Union’s attempts to industrialize at the time.

Using this theory the World Bank and others calculated the amount of aid necessary for a country’s economic growth and then financed large infrastructure projects in the developing world. Hydroelectric dams, new highways and industrial projects were funded across Africa and Latin America. The problem with this method is twofold.

First, the financing gap theory states that aid will encourage a government to increase its savings rate which will then be re-invested in the economy. This, however, has not been the case. The historical evidence demonstrates that the recipients of aid instead increase their government spending in light of the new found inflows of capital.

Secondly, aid for investment creates inverse incentives for growth. The greater the gap between savings and investment, the greater the financing gap and thus the greater amounts of foreign aid that will be received.

Despite the historical failure of the financing gap model, it is still in widespread use in many of the international financial institutions, namely the World Bank, to project the amounts of foreign aid necessary to create growth. A 2001 UN Report on development used the financing gap model to call for more aid for developing countries.

The World Bank is back at it again – only this time in Chad. In 2000 the World Bank financed the construction of a 1000 kilometer pipeline from landlocked Chad, across Cameroon to the Atlantic ocean. The idea was that the World Bank would finance the pipeline in exchange for an agreement with the Chadian government that 70% of of its revenue would be spent on poverty reduction.

In 2006, shortly after the pipeline became active, the government of Chad reneged on its agreement with the World Bank. Unusual for the World Bank, it froze the earmarked funds in what became a media sensation.

This being the World Bank, of course, it blinked first. Now Chad is only required to develop a new “poverty reduction strategy” in cooperation with the World Bank.

One has to wonder, what exactly is a “poverty reduction strategy?” Does it include the concept of “good governance and free and fair markets?” Nevermind – after the World Banks’ $4.1 billion investment, the World Bank now has over $300 million of additional projects in Chad.