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Foreign Assistance, Investment, and Defense: A Methodological Study with an Application to Israel, 1960-1979

This paper develops a method for examination of the relations among outlays on capital formation and national defense and receipts of foreign assistance in developing and other aid-receiving countries. This model and its results should be of interest to any policy analyst concerned with the effects of aid on the indigenous allocation choices by recipients, since it allows one to trace out the effect of aid on these allocative decisions. The essence of the method, and its novelty, is to exploit the price-changing feature of foreign aid (as seen from the recipient's viewpoint) to obtain an estimate of the price responsiveness of the recipient country. With the response to prices so determined, ownand cross-price elasticities with respect to defense, investment, consumption, and so forth can be calculated, and the corresponding complementarities or substitutabilities among these categories of demand inferred. As will become clear, this question is closely related to the question of the extent to which there is a de facto diversion of military or nonmilitary foreign aid to other uses.1 This method is applied to Israel-chosen because of the urgency of its security and development objectives, the availability of data, and the magnitude of its foreignassistance receipts. However, the method is applicable to LDCs in general, many of which, in a struggle to improve living standards and simultaneously guard against perceived security threats, turn increasingly to developed states for assistance. The effect of aid on investment and growth has concerned economists for a generation. And the possibility that aid might be diverted into consumption has long been recognized as well.2 But trade-offs between development and defense, especially, have concerned economists in recent years. E. Benoit found strong positive relations be-