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Understanding the Aid to GDP Relation: Not a Piece of Cake

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Not the most domestically-inclined man, my father once went to the grocery store to buy a cake only to find flour when he opened the box. He blamed it on the box cover which featured a temptingly baked and frosted cake. Such mix-ups are endearing unless the stakes are much higher.

Case in point: the myth that international assistance to Afghanistan accounts for over 90 percent (or sometimes 97 percent) of the country's gross domestic product (GDP). This error confuses the flour for the cake by conflating assistance with a country's GDP. While aid can have a positive impact on GDP, the error overstates the relationship and stokes already heightened anxieties about the impact of future aid levels on Afghanistan's economy.

The mix-up appears to revolve around the phrase "accounts for." In 2009/10 Afghanistan's GDP was $12.2 billion and international assistance (civilian and military) was $10.7 billion; in 2010/11 aid was $15.7 billion and GDP was $15.9 billion. In comparing sizes, it's accurate to say aid was almost 90 or 97 percent the size of GDP (depending on the year). But saying aid "accounts for" 90 or 97 percent of GDP, changes the relationship from one of ratio (size comparison) to one of function (input and output).

Even if we accepted the function relationship at face value, saying aid "accounts for" GDP doesn't make sense when aid happens to be larger than GDP. In fact, in 2007/08, international assistance to Afghanistan totaled almost $10.3 billion while GDP was only $8.7 billion. So how could aid "account for" more than (118 percent of) the value of GDP?

"Gross domestic product" is a very specific economic term. It measure the market value of final goods and services produced within a country's borders in a given time period. GDP is commonly expressed as a sum (Y) of private consumption (C ), investment (I), government spending (G), and net exports (X - M), or Y = C + I + G + (X - M).

Financial inflows like international assistance generally do not impact GDP directly. But it can have important indirect and knock-on or "multiplier" effects, especially if used to finance productive investments. Assistance to Afghanistan has enabled public investments ("G") in new roads, power, irrigation, etc., increasing the country's productive capacity and prospects for future growth. For example, an aid-financed road reduces the cost of transporting inputs to farmers and getting their goods to market, encouraging increased agricultural production and sales. The assistance dollars don't count directly as GDP, but the increased farm production and sales do -- for years to come.

Similarly, international spending on construction, real estate, and local services like telecommunications and transport has helped add to consumption ("C"). The spending generates income for local businesses and employees who then spend on their own business and household needs and so on. Aid has also helped close the current account deficit as exports are routinely dwarfed by imports (the "X-M").

Yet, the majority of international assistance has not actually entered the Afghan economy. After three decades of conflict that devastated the country's productive capacities, international aid agencies have been forced to look outside of Afghanistan for most goods, services, and expertise to rebuild the country. The World Bank estimates that over the last decade not more than 25 percent of international assistance has been spent "in" Afghanistan as opposed to "on" Afghanistan. Ironically, this is good news as one contemplates the likely decrease in international assistance over the next decade -- the multiplier effect of aid spent in-country is less than one might have thought on hearing a statistic like "aid accounts for 97 percent of GDP."

What matters now is what happens to Afghanistan's economy given future aid levels. Impacts on economic growth are likely to be muted because of the limited assistance that's entered the economy, although insecurity and governance are real threats. Assistance is important, however, for continued development, promoting economic diversification, and managing the country's huge financing gap. This is why at the recent Senior Officials Meeting (SOM) the international community reaffirmed the 2012 Tokyo commitment to continued assistance and putting at least 50 percent of their total development aid "on-budget."

Anxieties over future aid levels in Afghanistan and the possible effects on the economy make it important to understand the relationship between international assistance and GDP. The "90/97 percent" accounting mixes up the flour for the cake. International assistance has a vital role to play in enabling Afghanistan's development but there's more to the making of GDP than this ingredient alone. So even if the simplicity of equating international assistance with GDP looks tempting -- don't buy it.