Download Title: Why Foreign Aid may be More Effective at Promoting Economic

“Why Foreign Aid May be Less Effective at
Promoting Economic Growth in More Democratic Countries.”
David H. Bearce
Associate Professor of Political Science
University of Pittsburgh
[email protected]
1st draft:
Prepared for the IPES Conference in Philadelphia, November 2008, and previously presented at
the APSA Annual Meeting in Boston, August 2008. A second draft of this manuscript will be
prepared after IPES, based on the feedback from this conference. The empirical results
presented during my oral presentation will differ slightly from those in this draft of the paper.
These new results will added to the second draft of the paper.
Acknowledgements: I thank Desha Girod, Bill Keech, David Steinberg, and Joe Wright for the
helpful comments and suggestions
Abstract: This paper explores the relationship between economic growth and foreign aid
conditioned on the level of democracy in the potential recipient country. Arguing that aid
primarily improves growth by incentivizing economic reform, it explains why foreign aid should
be less effective in more democratic recipient countries. This proposition is then tested on a
sample of aid-eligible country/years, and the statistical results show that while foreign aid is
positively correlated with economic growth, this positive relationship between aid and growth
weakens in more democratic recipient countries. The statistical results also show that foreign aid
is correlated with capitalist economic reform, but only in more autocratic countries. These
conditional relationships are robust using a variety of “democracy” indicators, including the
Polity measure, Freedom House scores, and Vanhanen’s index of democracy.
1
“Why Foreign Aid May be Less Effective at
Promoting Economic Growth in More Democratic Countries.”
Existing evidence seems to show that foreign aid from Western governments has been, at
best, only conditionally effective at promoting economic growth in less-developed countries.1
Consequently, scholars and policymakers alike are interested in identifying the conditions which
make foreign aid more or less effective in this regard. Does aid effectiveness vary in terms of
the recipient country’s domestic regime type? Has Western aid been more or less effective at
promoting growth in more democratic recipient countries?
Answering these questions may shed some important light on the primary causal channel
through which foreign aid promotes economic growth, if it does so at all. When discussing the
potential effectiveness of Western foreign aid, most scholars seem to assume that foreign aid
should have its causal effect, if any, through recipient government spending. If recipient
governments consume their foreign aid, then it should have no (or even a negative) effect on
economic growth. But if these governments instead invest their aid dollars, then there may be a
positive impact in terms of economic growth and development. Thus, to the extent that
government investment spending is the primary causal channel through which foreign aid
promotes economic growth, one might expect aid to be more effective in more democratic
recipients because these governments arguably face greater political incentives to invest the aid
in public goods rather than to consume it for private goods (Bueno de Mesquita et al 2003; Baum
and Lake 2003).
However, this logic may be reversed if Western aid affects economic growth through a
different causal channel: by incentivizing economic reform. Some scholars have proposed that
1
The literature on foreign aid effectiveness is too large to cite each paper individually. But for a
good recent review of this literature, see McGillivray et al 2006.
2
foreign aid can act as financial incentive for recipient governments to engage in politically
costly, but growth enhancing, economic reform. Indeed, if reform is the primary causal
mechanism through which foreign aid promotes economic growth, then aid could be positively
related to growth even when recipient governments “consume” their aid, provided that they also
engage in meaningful economic reform. However, the political costs associated with economic
reform are potentially larger in more democratic national economies where the prospective
societal “losers” from economic reform have greater political freedom to organize their
opposition to the government’s reform efforts. Thus if economic reform is the primary causal
channel through which foreign aid promotes economic growth (rather than through government
investment spending), then foreign aid may be less effective at promoting economic growth in
more democratic countries because the same amount of foreign aid buys less economic reform in
this set of countries.
This paper explores the relationship between economic growth and foreign aid
conditioned on the level of democracy in the potential recipient country. Arguing first that
foreign aid primarily improves economic growth by incentivizing economic reform, it then
explains why foreign aid should be less (not more) effective in more democratic recipient
countries. This proposition is tested on a sample of aid-eligible country/years, and the statistical
results show that a larger amount of lagged foreign aid receipts is correlated with a higher annual
economic growth rate, but that this positive relationship between growth and aid declines (and
even disappears) in more democratic recipient countries. The statistical results also show that
foreign aid is correlated with capitalist economic reform, but only in more autocratic countries.
These conditional relationships are robust using a variety of “democracy” indicators, including
the Polity measure, Freedom House scores, and Vanhanen’s index of democracy.
3
The remainder of the paper is structured in five sections. The first develops the argument
outlined above in more detail. The second section is devoted to discussing certain econometric
problems that one encounters when trying to estimate the relationship between economic growth
and foreign aid. Using an econometric specification designed to overcome these problems, the
third section presents a series of statistical results exploring the conditional relationship between
economic growth and aid. The fourth provides some additional evidence by examining the
conditional relationship between economic reform and aid. Finally, the fifth section concludes
with a brief discussion of the policy implications associated with these results.
1. The Argument
Most arguments about the (in)effectiveness of Western aid assume that foreign aid would
operate on economic growth through a government spending channel. Recipient governments
receive a sum of money in the form of outright grants and/or highly concessional loans from
Western governments either directly (i.e. bilateral aid) or indirectly through international
financial institutions (i.e. multilateral aid). Recipient governments can either consume this aid,
spending it on unproductive pet projects, or they can invest their aid, spending it to promote
physical and human capital formation in their national economy. If recipient governments
consume their foreign aid, then it would not have a positive effect on economic growth and may
even have a negative effect (Lensink and White 2001). Conversely, if the money is productively
invested in the capital-poor national economy, then foreign aid could positively contribute to
growth and development.
To the extent that Western aid has its effect on economic growth by increasing public
investment spending, it becomes reasonable to think that Western aid should be more effective
4
(i.e. growth enhancing) when given to more democratic recipient governments. Inasmuch as it is
inefficient for democratic governments to rely on private goods for their political survival
(Bueno de Mesquita et al 2003), they have greater incentives to invest their foreign aid in order
to provide more public goods within the national economy. But autocratic governments, with a
relatively small selectorate and winning coalition, can better rely on private goods provision to
maintain their political power, allowing them to consume more of their aid dollars (Kono and
Montinola 2009). This logic effectively equates private goods provision with the potential
consumption of foreign aid and public goods provision with the possibility of foreign aid being
productively invested. To the extent that democracies do more of the latter (i.e. investment) and
less of the former (i.e. consumption), it is natural to think that foreign aid should be more
effective in more democratically-governed national economies.
While this proposition sounds theoretically reasonable, it has simply not found much
empirical support. With aid, growth, and democracy measured largely in the cross-section,
Svensson (1999) did provide some statistical evidence showing that aid has a more positive
impact on growth in democracies.2 But this result stands in contrast to those presented by Boone
(1996, 322), showing that “democracies and liberal regimes do not allocate aid any differently
from other regimes” in that aid is used for consumption in democracies and autocracies alike,
increasing the size of government but not the rate of GDP per capita growth.3 Likewise, Kosack
(2003, 7) reported that “[c]onsistent with previous research, aid appears to be ineffective at
Svensson’s (1999) primary unit of analysis was the country/10-year period from 1970 to 1989,
giving each country a maximum of two observations. His positive aid*democracy interaction
term becomes about two-thirds weaker when using a more disaggregated unit of analysis, the
country/5-year period (see p. 289, Table 4).
3
For additional evidence on this point, see Remmer 2004 and Feyzioglu, Swaroop and Zhu
1998.
2
5
increasing economic growth, even when combined with democracy.”4 Indeed, the finding that
recipient governments, regardless of domestic regime type, tend to consume (rather than invest)
their foreign aid bolsters the case made by aid skeptics that Western financial assistance has had
little effect on economic growth in less developed countries because recipient governments
misspend the aid money received from donor governments (e.g. Easterly 2006).
But there is another causal channel through which foreign aid could positively influence
economic growth. As Morrissey (2004, 154) neatly summarized, “aid can contribute to growth
in two basic ways.” First, “by relaxing financing constraints… [aid] can finance investment in
physical and human capital that promotes growth.” Second, donors can also promote economic
growth by using their “aid as a lever to encourage policy reform, i.e. conditions are attached to
the aid.” In terms of this policy reform channel, it is important to understand aid could promote
economic growth even if recipient governments consume most or all of their foreign aid. As
Collier (1997, 56) wrote on this point: “Aid might be entirely spent on useless government
consumption and yet be remarkably effective if it induces governments to adopt growth-inducing
and poverty-reducing policies.”
It is also important to understand that these economic reform conditions need not be
formal. Whenever a Western government asks a recipient country to engage in capitalist
economic reform at the same time that it is providing aid to that country, the two issues (reform
and aid) become at least implicitly linked, even if they are not explicitly connected in the form of
an official lending contract as is often the case for multilateral aid. This understanding means
that bilateral aid without formal written reform conditions could also influence economic growth
by serving as a financial incentive for recipient governments to engage in capitalist economic
4
Kosack (2003) did, however, provide evidence showing that aid when combined with
democracy increased the quality of life, a somewhat different dependent variable.
6
reform. As Easterly (2003, 26) acknowledged, “aid could also buy time for reformers to
implement painful but necessary changes in economic policies. This conjecture seems plausible
but has not been systematically tested.”
As this last quotation helps illustrate, the causal logic connecting foreign aid to economic
reform needs more theoretical development and empirical testing. On the theoretical side, it is
useful to provide a definition of economic reform, along with some evidence that it can be
effective at promoting economic growth, if actually enacted. Broadly defined, economic reform
refers to policy change directed at creating and opening markets (i.e. capitalist economic
reform), including reduced barriers to international exchange, decreased government intervention
in and regulation of the national economy, more secure private property rights, and improved
“law and order.” Using this definition, economic reform would not include policy changes that
increase central planning or institute wage and price controls; likewise, it would not include
import-substitution industrialization since this development strategy led to both greater
restrictions on international trade and increased government intervention in the national
economy. Although it is certainly not uncontested, there is a large literature demonstrating that
such capitalist reform, when it is actually implemented, has been associated with increased
economic growth (e.g. Barro 1991, Knack and Keefer 1995, Leblang 1996, Goldsmith 1997,
Frankel and Romer 1999, and Claessens and Laeven 2003).5
Of course, developing country governments often find it hard to enact capitalist economic
reform. Such reform is difficult to implement because it inevitably creates a set of “losers” in the
national economy, at least in the short-term. If the economic reform is trade liberalization, then
the short-term losers are those working in the import-competing industries that stand to face
5
For some contrary evidence concerning this relationship, see Vreeland 2003, chapter 5.
7
greater competition from lower-cost foreign producers and risk losing domestic market share as a
result. If the economic reform is reduced government spending, then the societal losers are all
those who would benefit from fiscal policy expansion. And if the economic reform is more
secure private property rights, then the economic losers are the poor, including those without
much private property or the means to access it.
But as many political scientists would recognize, even if capitalist reform always creates
some set of societal losers within the national economy, the ability of these societal actors to
oppose the government’s efforts to engage in reform may depend, at least in part, on the
domestic political regime type. Indeed, there is a large political science literature (e.g. Haggard
and Kaufman 1992; Haggard and Webb 1994; Oatley 2004) arguing that autocratic governments
have an advantage in enacting economic reform and engaging in macroeconomic stabilization6
because they are more insulated than democratic governments from the societal actors that would
oppose such policies.7 Democratic institutions like political parties allow large societal groups
to organize and overcome the collective action problem. Democratic institutions like political
power-sharing give societal actors with at least some representation in the government the ability
to postpone, or delay, costly reform. And democratic institutions like regular competitive
elections create the possibility, even for societal actors without political representation in the
government, to vote out a government proposing unpopular economic policies.
This political science literature often uses the term “macroeconomic stabilization” instead of
economic reform. Using the definition offered earlier, macroeconomic stabilization can be
understood as one particular type of economic reform: policy change directed at reducing
inflation using some combination of fiscal and monetary contraction. Thus as discussed here,
economic reform includes, but is not limited to, macroeconomic stabilization.
7
There is also another literature (e.g. Maravall 1995, Geddes 1995) countering that autocracies
do not enjoy much of an advantage over democracies in terms of economic reform.
6
8
Thus far, the political science literature on the autocratic reform advantage, or the
democratic reform disadvantage, has not been brought to bear on the economics literature
dealing with foreign aid effectiveness. Indeed, the former would be largely irrelevant to the
latter if foreign aid affected economic growth only through the government spending channel.
But to the extent that foreign aid operates primarily on economic growth by serving as a financial
incentive for recipient governments to engage in political costly reform, this political science
literature speaks, at least indirectly, to the question of foreign aid effectiveness. In doing so, it
answers with a proposition that runs contrary to the conventional wisdom that foreign aid should
be more effective in democratic countries, to the extent that aid can be effective at all. If the
recipient government either uses its foreign aid to buy off the societal losers or to selfcompensate for the political risk created by not buying off the societal actors opposed to its
reform proposals, then more foreign aid may be required to incentivize economic reform in more
democratic polities. In other words, the same amount of foreign aid buys less economic reform
in more democratic recipient countries.
Applying this logic to economic growth, which has been the primary dependent variable
in the foreign aid effectiveness literature, this paper advances the following testable hypothesis:
Western aid has been less effective at promoting economic growth in more democratic recipient
countries. This hypothesis will be tested by regressing per capita economic growth on foreign
aid receipts, a measure of democracy, and the interaction of these two variables using a sample
of aid-eligible country/years. Before presenting these results, however, it is important to discuss
some particular econometric problems that one encounters when trying to estimate the
relationship between economic growth and foreign aid. These potential problems inform the
statistical specification that will be used in the third and fourth sections of the paper. They will
9
also help explain why the empirical results presented in this paper may (and indeed should)
differ from certain results that have already reported in the aid effectiveness literature.
2. Econometric Issues
As mentioned in the introduction, existing empirical evidence tends to show that Western
aid has not been very effective at promoting economic growth in recipient national economies.
One reason for this general result could be our reliance on a theoretical model which assumes
that aid would have its primary effect on growth through government investment spending; this
subject was addressed in the previous section. But another reason for this result (i.e. ineffective
foreign aid) may be our reliance on an econometric specification that biases the results against
finding any positive relationship between aid and growth, even a conditional one. This section
will discuss three particular econometric problems in this regard, offering an alternative
specification better suited to estimating the relationship between aid and growth when the former
is expected to have its primary effect on the latter through the causal channel of economic
reform.
The first problem is known in the econometrics literature as temporal aggregation bias
(Geweke 1978, Freeman 1989). Models with economic growth as the dependent variable often
use a highly aggregated unit of analysis, including purely cross-sectional regressions where
growth is measured as the country average over a decade or more (e.g. Barro 1991). Economists
are understandably interested in long-term patterns of economic growth, but long-term growth is,
of course, composed of economic growth over shorter units of time. Furthermore, averaging a
country’s growth rates over multiple years eliminates all the information about its year-to-year
variation. This loss of information can produce some peculiar econometric results, including a
10
regression showing a high R2 but with relatively few statistically significant explanatory
variables. The lack of information in the dependent variable makes it relatively easy for just a
few independent variables to explain most of the variation (hence the high R2), leaving little
information for the other independent variables to explain (hence the many statistically
insignificant independent variables).
Indeed, in cross-sectional growth regressions with foreign aid as an independent variable,
modelers often report aid to be statistically insignificant. For example, Rajan and Subramanian
(2005a, 18) found “no robust positive relationship between aid and growth in the cross-section”.
But Karras (2006, 16) also showed how “the use of time-series data substantially clarifies the
issue, enabling us to arrive at sharper estimates of the growth effects of foreign aid [since]
ignoring the time dimension of the series and relying on cross-sectional data can mask the true
relationship and leave the researcher with weak and misleadingly insignificant results.”
On this point, econometricians recommend using the “natural time unit of the theory”
(Freeman 1989, 92) to deal with temporal aggregation bias and inefficiency. Since Western
governments appropriate their foreign aid on a yearly basis as part of their annual budgetary
cycle, and recipient governments formulate quasi-annual economic plans (which may or may not
include capitalist economic reform), the natural time unit of any theory about the causal effect of
Western aid through the economic reform channel would seem to be the country/year (not the
country/four- or five-year period and certainly not the country/decade or the country/twenty-year
period).8 The statistical models presented in this paper thus use the aid-eligible country/year as
their unit of analysis.
8
Pritchett (2000) outlined a number of potential problems facing scholars who model economic
growth using the country/year unit of analysis, so it is important to describe how to deal with
these potential problems. First, Pritchett showed that economic growth exhibits considerable
11
A second econometric problem comes from deflating a country’s foreign aid receipts by
its economic size, measured either by its gross national income or by its population. This
deflation presents a statistical problem because the foreign aid coefficient could then be the result
of either increases in the numerator (foreign aid receipts) or decreases in the denominator
(national income or population) or some combination of both. This problem is serious enough
when an increase in the numerator is expected to affect economic growth in the same direction as
a decrease in the denominator because it is hard to disentangle the former’s effect from the
latter’s. But the statistical problem becomes even more serious when an increase in the
numerator is expected to influence growth in the opposite direction as a decrease in the
denominator. In this situation, the modeler is likely to find an attenuated coefficient (i.e. β → 0)
or even one with a sign in the direction opposite to expectation if the variation in the
denominator dominates that of the numerator.
In fact, this is precisely the situation facing modelers when they deflate foreign aid with a
measure of national income, for example.9 Since national income at least weakly proxies the
amount of capital stock in the national economy, more income should be positively related to
variation over time and that this variation tends to increase for lesser developed national
economies. Thus, the statistical specification will control for the level of economic development.
Indeed, the fact that the economic growth of developing countries exhibits so much variation
over time should help assure readers that the country/year units represent independent
observations and should be modeled as such. Second, Pritchett noted that moving to higher
frequency units of analysis requires the modeler to pay more attention to the issue of temporal
dynamics. To this end, the statistical specification also controls for the lagged value of economic
growth. Third, Pritchett strongly cautioned against the inclusion of country fixed effects when
modeling higher frequency growth data due the possibility of attenuation bias for highpersistence independent variables. Foreign aid, which tends to be relatively sticky over time
especially when measured in terms of constant U.S. dollars, fits this criteria (i.e. highpersistence), as do other independent variables, including democracy. Thus, the statistical
specification does not include country fixed effects, although efforts are made to control for unit
heterogeneity through a series of other independent variables that will be discussed below.
9
Much the same problem could arise using a foreign aid measure deflated by population (i.e. aid
per capita) since population proxies the amount of labor stock available in the national economy.
12
economic growth. Thus, its inverse (1/national income) should be negatively related to
economic growth, and multiplying foreign aid by this inverse works against finding any positive
effect for the information in the numerator. As Rajan and Subramanian (2005a, 12)
acknowledged on this point: “There could be a possible downward bias in the aid coefficient
because aid-to-GDP ratios are dominated by movements in GDP, the denominator.”
Firebaugh (1992, 118) explored this denominator problem in the context of the
relationship between inward foreign direct investment (also often deflated by country size) and
economic growth, recommending that modelers “separate the numerator and denominator” and
then “enter them as individual regressors in growth models.” The econometric specification used
here follows this strategy with foreign aid receipts, national income, and population as separate
independent variables. Given this specification, the foreign aid coefficients will measure the
effect of a one-unit increase in foreign aid receipts (measured in millions of constant U.S.
dollars), holding constant recipient income and population.
Furthermore, this statistical specification makes theoretical sense given a causal argument
about aid’s effect on growth through economic reform. While economic reform would create a
greater number of losers in a larger national economy, it should also create a greater number of
winners in a larger national economy. To the extent that the number of reform losers is roughly
proportional to the number of reform winners, the effect of foreign aid through the economic
reform channel would not be conditional on country size (although it may be conditional on
other factors such as domestic regime type), thus making the foreign aid variable theoretically
mis-specified if deflated by either national income or by population.10
10
It is also worth noting that deflating the foreign aid variable is same as including an interaction
term without the necessary constitutive terms because foreign aid deflated by national income,
for example, is foreign aid multiplied by 1/national income.
13
Yet a third econometric problem is introduced when modelers instrument their foreign
aid variable in an economic growth regression using political, military and strategic variables.
Modelers understandably use these variables because they are more plausibly exogenous to
growth than would be any economic, social or demographic variable. But when the causal
theory concerns aid’s effect on growth through the economic reform channel, this
instrumentation strategy becomes problematic. It is problematic because the strategic, political,
and/or military benefits associated with foreign aid are precisely that factors that reduce the
incentives for donor governments to enforce any economic conditions associated with their aid
(Dunning 2004, Bearce and Tirone 2008). In other words, when a Western government obtains
important strategic benefits (e.g. military base rights) from providing financial assistance to a
less-developed country, it becomes much less likely to insist that the recipient government
engage in capitalist economic reform and curtail its foreign aid when such reform is not
forthcoming. This logic suggests that political, military and strategic variables should only
weakly correlated (if at all) with the foreign aid receipts that could be effective in promoting
economic reform. The statistical problems associated with using weak instruments are well
understood in the econometrics literature (e.g. Bound, Jaeger, and Baker 1995), and they help
explain why scholars using strategic, military, and political variables as aid instruments often
report insignificant aid effects in their statistical models of economic growth (e.g. Boone 1996;
Rajan and Subramanian 2005a).
But if political, military and strategic variables are problematic as foreign aid
instruments, then how might scholars deal with a potential endogeneity problem? An alternative
strategy is to use a lagged value of foreign aid receipts. It is worth noting that this would not
even be possible in a cross-sectional growth regression (forcing modelers to rely on implausible
14
and weak foreign aid instruments), but it becomes a feasible strategy when using the
country/year unit of analysis. The statistical specification offered here lags the foreign aid
variable by four years (i.e. t-4). Given this long time lag, the foreign aid variable becomes
plausibly exogenous to economic growth in the current year (i.e. t-0).11 Furthermore, it
reasonably satisfies the exclusion restriction since it is hard to identify how lagged aid could
influence economic growth through any causal channel other than those directly associated with
foreign aid itself.12
A four year lag on the foreign aid variable also makes theoretical sense in the context of
the argument advanced in this paper. Indeed, it should take several years before economic
reform, once implemented, produces any measurable effect on the country/year growth rate.
While there has been little research to identify precisely the causal time lag between reform and
growth, four years would seem to be a reasonable approximation. For the record, the statistical
results presented below are very similar when using either a three or five year lag, so they are not
simply an artifact of choosing a four year lag for the foreign aid independent variable.
11
For readers who remain skeptical about the exogeneity of a foreign aid variable lagged four
years, it is important to mention that any remaining endogeneity works against finding support
for any hypothesis about foreign aid effectiveness. This is true because more economic growth
tends to result in lower foreign aid levels (Hudson and Mosley 2001, 1035) as the recipient
government becomes less needy and thus less eligible for aid following the Development
Assistance Community’s criteria. Consequently, any reverse causality in this negative direction
makes it harder, not easier, to find statistical support for a positive relationship running from
lagged foreign aid to economic growth (Rajan and Subramanian 2005a, 8).
12
Indeed, it is this exclusion restriction that makes just about any variable potentially
problematic as an instrument for foreign aid in an economic growth regression. As Rodrik
(2005, 11) wrote on this point: “it is genuinely hard to find credible instruments which satisfy
both the exogeneity and exclusion requirements” in growth regressions because “it is always
possible to find a story about why an exogenous variable belongs as a regressor in the secondstage of the estimation (therefore making it invalid as an instrument).”
15
3. The Evidence, Part I
Having discussed some important econometric issues in specifying a statistical model to
estimate the relationship between growth and aid through the economic reform channel, this
model can now be laid out in greater detail, leading to a presentation of the first set of statistical
results. The argument offered in the first section of the paper hypothesized that Western aid has
been less effective at promoting economic growth in more democratic recipient countries. This
hypothesis will be tested using equation (1), estimated for a sample of aid-eligible country/years
1964-2003 (N ≈ 4000).
Growthit = β0 + β1*Aidit-4 + β2*Democracyit + β3*(Aid*Democracy) + βX*Controlsit (1)
The dependent variable, Growth, measures the growth rate of real GDP per capita for
country i in year t in constant terms using the chain index from Penn World Table 6.2 (Heston,
Summers and Aten 2006). The first independent variable, Aid, measures the net amount of
bilateral and multilateral aid received by the aid-eligible country from the Organization for
Economic Cooperation and Development’s (OECD) Development Assistance Community
(DAC) in millions of 2005 U.S. dollars (OECD 2006) lagged four years. Given the argument
about recipient governments potentially keeping their foreign aid as financial compensation for
engaging in politically costly economic reform, Aid includes financial assistance in all sectors
and categories since just about any aid dollar could be conceivably used in this manner given the
evidence about foreign aid fungibility (e.g. Feyzioglu, Swaroop, and Zhu 1998). For theoretical
reasons, Aid does not include any financial assistance from non-Western governments (e.g. the
16
USSR, China, and Middle Eastern oil producers) since these are not donors who would be
expected to push recipient governments to engage in capitalist economic reform.
The second independent variable is Democracy, which will be coded using three different
operational indicators with broad country and temporal coverage - 1) the Polity measure, 2)
Freedom House scores, and 3) Vanhanen’s index - given all the controversies associated with
how to best measure this key theoretical concept (Munck and Verkuilen 2002). For each of these
three measures, the Democracy variable has been recoded so that 0 corresponds to the most
autocratic government with larger values indicating more democratic country/years. The
democracy variable is then interacted with the Aid to form the multiplicative Aid*Democracy
term.
With this multiplicative term, β1, the coefficient on the Aid component term, measures the
effect of a one-unit (millions of 2005 U.S. dollars) increase in Western aid when Democracy = 0,
or when the recipient country has the most autocratic domestic regime type. The hypothesis
advanced above thus predicts that β1 should be positively signed, indicating that more aid has
been associated with increased economic growth in the most autocratic set of recipient countries.
The hypothesis also predicts that β3, the coefficient on the Aid*Democracy interaction term,
should be negatively signed, indicating that Western aid has been less effective in promoting
economic growth as the recipient countries become more democratic. Finally, it should be
clearly stated that the hypothesis makes no direct prediction concerning the sign of β2, which
measures the effect of having a more democratic domestic regime type when the country
receives no aid, or Aid = 0.
As indicated in equation (1), the statistical model also includes a set of control variables.
To deal with the temporal dynamics associated with economic growth measured annually, the
17
independent variables include the lagged value of Economic Growth. To control for recipient
country size as discussed earlier, the statistical specification includes logged (to reduce
skewness) measures of both Population and National Income using data from the Penn World
Table. These control variables are also important in a model of economic growth because they
proxy, respectively, the level of labor and capital stock in the national economy. The concepts of
labor and capital stock are central to most economic production functions, serving as the
“barebones” basis for certain statistical models of economic growth (e.g. Vreeland 2003, 118).
Since Pritchett (2000) showed that economic growth exhibits considerable variation over
time with this variation increasing for lesser developed national economies, the specification also
includes a measure of GDP per capita in constant terms to proxy the level of Economic
Development (Heston, Summers and Aten 2006). This variable is also standard in economic
growth models in order to capture the so-called “convergence” effect whereby poorer countries
take advantage of technological advances made by richer countries to grow at a higher rate.
In their study of growth regressions, Levine and Renelt (1992) reported the investment
share of GDP to be one of the most robust predictors of economic growth, so Investment is
included in the statistical specification, along with Private Consumption and Government
Consumption following a Keynesian model of production/growth.13 Given a theoretical
argument about aid influencing growth through the economic reform channel, it is also important
to control for the other channels through which foreign aid might influence growth, either
positively (e.g. Investment) or negatively (e.g. Government Consumption). Since Rajan and
Subramanian (2005b) have also argued that aid may influence growth through exchange rate
13
The denominator problem discussed earlier may also be present in the coefficients for these
deflated control variables (Investment, Private Consumption, and Government Consumption), but
since the argument advanced in this paper has no theoretical stake in the signs of these variables,
it simply follows the traditional specification used in the growth literature.
18
values, the specification also includes Exchange Rate, which measures the value of the national
currency unit relative to the US dollar. The data for these four independent variable come from
Penn World Table 6.2 (Heston, Summers and Aten 2006).
Pritchett’s (2000) concern about using country fixed effects in a country/year model of
economic growth was mentioned in an earlier footnote, so to capture some of the remaining unit
heterogeneity, the specification offered here opts instead for a series of regional dummy
variables. The omitted category is the Asian Tigers (Taiwan, South Korea, Malaysia, and
Singapore), so the seven other regional dummies (Sub-Saharan Africa, Central America, South
America, Eastern Europe, Asia-Former Soviet Union, Other Asia-Non Tiger, and Middle
East/North Africa) should generally take on negative coefficients given their comparison to the
relatively fast-growing Tigers. Finally, to account more fully for exogenous economic shocks
and unmeasured globalization pressures that may affect economic growth, year fixed effects are
included in the specification (although their coefficients are not reported in the statistical tables
for space considerations).
The estimates of equation (1) begin with Democracy measured using the Polity indicator.
Polity (Marshall and Jaggers 2002) scores the country/year domestic regime type on a 20-point
scale based on political participation and competition, the openness and competitiveness of
executive recruitment, as well as constraints on the chief executive. Since all of these features
could make it harder for democracies to implement economic reform, Polity offers some face
validity as a Democracy indicator, at least for the purposes of this paper. As mentioned earlier,
the Polity indicator has been rescaled so that the least democratic country/year is coded as 0 and
the most as 20.
19
Recognizing that not all readers will accept Polity as the most valid Democracy indicator,
equation (1) is also estimated using two other indicators, which both capture a variety of relevant
factors and offer wide temporal and cross-national coverage. The second Democracy measure is
the Freedom House (2008) score, coding the country/year unit in terms of both political rights
and civil liberties. Since both factors are potentially relevant to the argument advanced in this
paper, they are inverted and added together (much like the democracy and autocracy components
in Polity) to form a 12-point scale with 0 indicating the least democratic country/year and 12 the
most democratic. The third Democracy indicator is Vanhanen’s (2000) index, which codes the
country/year domestic regime type based on its political competition and participation. For the
sample used in this paper, Vanhanen’s index codes the least democratic country/year as 0 and the
most as 44.14
Table 1 here
The three estimates of equation (1) are presented together in Table 1. As hypothesized,
the Aid constitutive term (β1) is positively signed and the Aid*Democracy interaction term (β3) is
negatively signed in all three models. However, as carefully explained by Friedrich (1982) and
Brambor, Clark, and Golder (2006), we are not particularly interested in the individual statistical
significance of either of these terms. Instead, we want to know their joint significance or, more
correctly, the marginal effect of Aid on Growth, which comes from the linear combination of
14
The simple correlation between these Democracy indicators is at least 0.76, which strongly
suggests that they all measure the same underlying theoretical concept and are not capturing
something fundamentally different from each other.
20
both β1 and β3 given some value of Democracy. This marginal effect can be calculated using
equation (2).15
∂Growth/ ∂Aid = β1 + β3*Democracy (2)
To help the reader see more precisely how the marginal effect of Aid on Growth varies by
the domestic regime type of the recipient country, this marginal effect (along with its 95 percent
confidence intervals) can be plotted across the range of possible Democracy values. Since
Democracy has a different range for each of the three indicators used in Table 1, each estimate
requires its own figure: Figure 1 corresponds to model 1.1, Figure 2 to model 1.2, and Figure 3 to
model 1.3.
Figures 1-3 here
Starting with the Polity measure for Democracy, Figure 1 shows that the marginal effect
of Aid is about 0.001 for the most autocratic country/year observation (Polity = 0). While this
effect may appear to be small (note that the average annual growth rate of per capita GDP is less
than 2.0), this marginal effect is statistically different from zero with greater than 99 percent
confidence and is substantively large. With regards to the latter, this marginal effect implies that
a one standard deviation increase in Aid (about 500 million 2005 US dollars) would yield a 0.5
increase in the real per capita economic growth rate four years later for the most autocratic
country, representing the difference between a growth rate of 2.0 and 2.5, for example. But
Figure 1 also shows that when Polity = 10 (halfway through the 20-point Polity scale), this
substantive effect has been reduced by about 40 percent (from 0.0010 to 0.0006). Furthermore,
The standard error of the marginal effect is given by the formula: √ var(β1) + Democracy2
var(β3) + 2 Democracy cov(β1, β3).
15
21
the marginal effect of Aid becomes indistinguishable from zero (i.e. statistically insignificant)
when Polity ≈ 14.
The differences in the marginal effect of Aid are even more pronounced when using the
Freedom House score for Democracy, as shown in Figure 2. For the most autocratic
country/year (Freedom House = 0), the marginal effect of Aid is about 0.0016, implying an even
greater substantive effect than when using the Polity measure. Furthermore, the decrease in aid
effectiveness is also greater when using the Freedom House scale. Note that when Freedom
House = 6 (halfway through the 12-point scale), the marginal effect of Aid has been reduced by
about 45 percent (from 0.0016 to 0.0009), with the marginal effect becoming statistically
insignificant when Freedom House ≈ 8. Finally, the starkest variation in the marginal effect of
Aid comes when using Vanhanen’s index for Democracy, as shown in Figure 3. For the most
autocratic country/year (Vanhanen = 0), the marginal effect of Aid is 0.0009, which is
statistically different from zero with greater than 99 percent confidence. But halfway through
this Democracy scale (Vanhanen = 22), the marginal effect of Aid has been reduced by about 60
percent (to 0.0003), making it statistically indistinguishable from zero.
To summarize, all three estimates of Growth presented in Table 1 tell the same basic
story. More Western aid has been associated with significantly more economic growth, at least
for the most autocratic observations in the dataset. But Western aid has been less effective, even
statistically ineffective, for more democratic country/years.
4. The Evidence, Part II
Having shown that foreign aid is less effective at promoting economic growth in more
democratic recipient countries, how can we be certain that this relationship operates through the
22
causal channel of economic reform? One quick answer is that the statistical specification used
for the results in Table 1 controlled for the other causal channels through which foreign aid
might impact economic growth, either positively (Investment) or negatively (Government
Consumption and Exchange Rate). Thus, the marginal effect of Aid in these estimates measured
the impact of Western aid on economic growth when investment, governments spending and the
exchange rate were all held constant. But recognizing that some readers may desire some
additional evidence on this point, it is useful to present a second set of empirical results with
economic reform (replacing economic growth) as the dependent variable.
This exercise is also important given a recent paper by Montinola (2008), which argues
that aid conditions should be more effective at inducing economic reform in more democratic
regimes because new aid disbursements are more valuable to democracies because they are
unable to stockpile aid given the need to spend it immediately on public goods for their political
survival. This argument suggests, in contradiction to the one advanced here, that foreign aid
should be more (not less) effective at promoting economic reform in more democratic recipients.
Given this apparent theoretical disagreement about how foreign aid should influence economic
reform in more democratic countries,16 it is useful to regress a measure of reform on aid,
democracy, and the interaction between these two independent variables to provide some
empirical evidence concerning this relationship:
16
Although they may appear to be contradictory, these two arguments can, in fact, be
theoretically reconciled. If we think of a recipient government trading economic reform for aid
dollars, then it would be expected to engage in economic reform when a > r, where a indicates
the monetary value of foreign aid and r indicates the political costs associated with economic
reform. The argument advanced in this paper deals with r, assuming a to be constant.
Conversely, Montinola’s (2008) argument deals with a, assuming r to be constant. Thus, it is
certainly possible that while r is larger in democracies as argued here, a could also be larger in
democracies (i.e. the same amount of aid money is worth more to a democratic government) as
proposed by Montinola.
23
Reformit = β0 + β1*Aidit-5 + β2*Democracyit + β3*(Aid*Democracy) + βX*Controlsit (3)
In equation (3), the dependent variable Reform is measured using the Fraser Institute’s
Index of Economic Freedom. This index is a widely-used indicator in the economic growth
literature for capturing a government’s broad market-oriented policy stance (Heckelman and
Knack 2005, 1), scoring countries on a 0-10 continuous scale (with larger values indicating more
economic freedom) based on five factors: 1) size of government, 2) security of property rights, 3)
sound money, 4) freedom to trade internationally, and 5) regulation of credit, labor, and business
(Gwartney and Lawson 2007, 9-12). These five factors accord nicely with the definition of
economic reform that was offered earlier in the paper: reduced barriers to international exchange,
decreased government intervention in and regulation of the national economy, more secure
property rights, and improved law and order.17 However, the one drawback in using this
measure of economic freedom is that it is coded only in five-year intervals from 1975 to 2000.
The data coverage is also limited by the fact that Reform is defined here as the change in
economic freedom (ΔEconomic Freedom) over a five-year period; hence, the first observation is
lost in each country time-series.
17
I would argue that the reform indicator used here offers a better measure of capitalist economic
reform than the dependent variable used by Montinola (2008): the government’s budget balance
(revenues – expenditures) deflated by national income. First, as discussed in an earlier footnote,
fiscal stability is but one narrow dimension of capitalist economic reform, and the measure used
here captures economic reform across a wider variety of dimensions. Second, the government’s
budget can be balanced in two different ways: by raising tax revenues or by cutting expenditures.
To the extent that governments do the former (i.e. raise taxes), then they arguably increase their
intervention in the national economy, which would not be consistent with capitalist economic
reform as defined in this paper.
24
To be consistent with the five-year intervals in the dependent variable, Aid will now
measured with a five-year lag, although the results reported below are very similar when using a
four-year lag. Next to Democracy and the Aid*Democracy interaction term, the same basic set
of control variables are included. The one new independent variable is the prior level of
Economic Freedom, replacing the lagged value of economic growth. This new control variable
helps to account for the fact that it should become harder to enact additional economic reform as
more reforms have already taken place (i.e. the lower hanging fruit is picked first).
To the extent that it has been harder for Western donors to incentivize economic reform
using foreign aid in more democratic recipient countries, the marginal effect of Aid on Reform
should decrease with larger values of Democracy. In equation (4), this argument implies that β1
should be positively signed and β3 should be negatively signed.18 As before, we are not so much
interested in the individual significance of either β1 or β3; instead we are interested in the joint
significance of β1 and β3 given some value of Democracy.
∂Reform/ ∂Aid = β1 + β3*Democracy (4)
The presentation of these results follows the structure used in the last section of the paper.
The estimates of equation (3), using the three different Democracy indicators, are presented
together in Table 2. Given the relatively small sample size (N ≈ 400), this set of results is less
econometrically efficient than the earlier set, and it should be noted that this inefficiency works
against finding empirical support in favor of the proposition advanced in this paper.
Nonetheless, the estimates do accord with expectations: lagged Aid has a statistically significant
Conversely, Montinola’s (2008) argument would predict a negative sign on β1 and a positive
sign on β3.
18
25
effect in promoting economic reform, at least in the most autocratic set of recipient countries
(hence, β1 > 0). However, aid effectiveness in terms of promoting economic reform declines as
the recipient country becomes more democratic (hence, β3 < 0).
Table 2 here
To assess the marginal effect of Aid on Reform, the linear combination of β1 and β3 is
plotted across the range of Democracy values in Figures 4-6 along with its 95 percent confidence
intervals: Figure 4 uses the results from model 2.1, Figure 5 from model 2.2, and Figure 6 from
model 2.3. All three figures show the same basic relationship: Western aid has promoted
economic reform, but only in more autocratic countries. While statistically significant for the
most autocratic set of countries, the marginal effect of Aid becomes statistically insignificant
when Polity ≈ 8 (Figure 4), Freedom House ≈ 4 (Figure 5) and when Vanhanen ≈ 8 (Figure 6).
In other words, it has proven harder for Western donors to incentivize capitalist economic reform
when the recipient government is more democratic, consistent with the earlier set of results
showing that Western aid has been less effective at promoting economic growth in more
democratic countries.
Figures 4-6 here
5. Conclusion
This paper argued that Western aid has been less effective at promoting economic growth
in more democratic recipients because it is harder to incentivize economic reform using foreign
aid in this set of countries. The statistical results support both the “cause” and the “effect” of his
26
argument. In terms of the cause (economic reform), Western aid has been associated with
capitalist reform only in the most autocratic set of aid-eligible countries. In terms of the effect
(economic growth), Western aid has also been associated with real per capita GDP growth only
in more autocratic recipients. Both of these statistical results are robust using a variety of
democracy measures, including Polity, Freedom House, and Vanhanen’s index.
This paper will now conclude with a brief discussion focused on two policy implications
that emerge from these results. First, one might argue that if Western aid has purchased less
economic reform and growth in more democratic recipients, then less foreign aid should be
gifted to these governments. Stated somewhat differently, given the domestic opportunity costs
associated with sending money to foreign governments, development aid should not be provided
to countries, even more democratic ones, where and when it is not expected to have a positive
economic effect.
However, there is another way to interpret the evidence presented in this paper. To the
extent that Western donors value democratic norms and institutions, developing countries that
have already taken steps towards democracy are arguably more “deserving” of Western aid. But
the evidence presented here suggests that these developing democratic governments may also be
more “needy” since they require more foreign aid to leverage the same amount of growth
enhancing economic reform than do less deserving autocratic governments. This logic suggests
that rather than cutting Western aid to more democratic recipients, aid disbursements to this set
of countries should be increased. To this end, policymakers could make use of the argument that
developing democratic governments need more outside financial assistance to facilitate capitalist
economic reform. Conversely, if Western aid was more effective at promoting growth through
economic reform in democracies, then policymakers could only argue that such countries were
27
more deserving, but not that they were more needy than autocracies. Thus perhaps counterintuitively, the evidence in this paper could strengthen the case for providing more foreign aid to
developing democracies.
Second, these results also suggest that Western aid for democratic promotion and aid for
economic development may work at cross-purposes, at least in the short-term. Finkel, PerezLinan, and Seligson (2007) have shown that U.S. aid to promote democracy has been at least
modestly effective with regards to elections, civil society and a free press. Unfortunately, these
are all institutions which could make it harder for a new democratic government to enact and
then implement capitalist economic reform. This understanding raises the old question about
reform sequencing: democratic before economic reform or economic before democratic reform.
The results in this paper do not provide an answer to this question, but they do suggest that if
Western policymakers value democratic promotion and use their aid to achieve this foreign
policy goal, then they will need to accept that their economic development aid may become less
effective as a result. In this sense, foreign aid (like any other policy instrument) can be
effectively targeted towards only one policy goal at any one time: either democratic promotion or
economic development, but not both simultaneously.
28
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32
Table 1: Estimates of Growth.
Aid (lagged 4 years)
Democracy
Aid*Democracy
Growth (lagged 1 year)
Population (logged)
National Income (logged)
Economic Development
Private Consumption
Investment
Government Consumption
Exchange Rate
Sub-Saharan Africa
Central America
South America
Eastern Europe
Asia – Former Soviet
Union
Other Asia - Non-Tiger
Middle East/North Africa
Constant
R2
N
1.1
Polity
0.00097***
(0.00034)
0.002
(0.027)
-0.000038
(0.000024)
0.12*
(0.06)
-0.84*
(0.45)
0.63
(0.44)
-0.00013**
(0.00006)
-0.030**
(0.013)
0.082***
(0.028)
-0.029
(0.020)
-1.29e-06***
(4.92e-07)
-1.28
(1.13)
-1.76*
(1.02)
-2.44**
(0.97)
-0.82
(0.91)
0.37
(1.23)
-0.76
(0.96)
-1.39
(0.93)
0.51
(7.04)
0.07
3957
1.2
Freedom House
0.00170***
(0.00047)
0.049
(0.072)
-0.00014*
(0.00007)
0.16***
(0.05)
-1.30***
(0.44)
1.04**
(0.42)
-0.00014**
(0.00006)
-0.021
(0.016)
0.072*
(0.038)
-0.020
(0.019)
-6.24e-08
(4.39e-07)
-0.50
(1.09)
-1.23
(0.92)
-1.33
(0.89)
-0.41
(0.70)
1.79
(1.19)
0.079
(0.89)
-0.75
(0.84)
-8.74
(6.98)
0.08
3685
1.3
Vanhanen
0.00088***
(0.00030)
-0.005
(0.018)
-0.000024
(0.000015)
0.14**
(0.06)
-1.31***
(0.38)
1.10***
(0.37)
-0.00016***
(0.00005)
-0.016
(0.012)
0.079***
(0.027)
-0.016
(0.017)
-1.70e-06
(1.67e-06)
-1.68*
(0.92)
-2.02**
(0.81)
-2.73***
(0.77)
-1.60*
(0.88)
0.37
(1.43)
-1.18
(0.79)
-1.73**
(0.79)
-7.43
(5.97)
0.08
4218
33
Table 2: Estimates of Reform.
Aid (lagged 5 years)
Democracy
Aid*Democracy
Economic Freedom
(prior level)
Population (logged)
National Income (logged)
Economic Development
Private Consumption
Investment
Government Consumption
Exchange Rate
Sub-Saharan Africa
Central America
South America
Eastern Europe
Asia – Former Soviet
Union
Other Asia - Non-Tiger
Middle East/North Africa
Constant
R2
N
2.1
Polity
0.00018**
(0.00007)
0.018***
(0.006)
-9.13e-06*
(4.92e-06)
-0.32***
(0.04)
-0.09
(0.07)
0.05
(0.07)
0.000034***
(0.000010)
0.001
(0.003)
-0.0008
(0.0048)
0.004
(0.005)
2.72e-07
(2.25e-07)
-0.27**
(0.13)
-0.14
(0.12)
-0.37**
(0.15)
-0.13
(0.17)
0.88***
(0.16)
-0.19
(0.12)
-0.37***
(0.13)
1.26
(1.17)
0.22
395
2.2
Freedom House
0.00017**
(0.00008)
0.021*
(0.012)
-0.000015
(0.000011)
-0.31***
(0.04)
-0.11
(0.09)
0.09
(0.09)
0.000021*
(0.000012)
0.0004
(0.0034)
-0.0016
(0.0060)
0.001
(0.005)
4.51e-07**
(1.89e-07)
-0.21
(0.18)
-0.16
(0.18)
-0.25
(0.19)
-0.26
(0.22)
1.04***
(0.19)
-0.17
(0.16)
-0.33*
(0.18)
0.60
(1.38)
0.17
403
2.3
Vanhanen
0.00015**
(0.00007)
0.006
(0.004)
-5.76e-06
(3.68e-06)
-0.31***
(0.04)
-0.14
(0.09)
0.11
(0.08)
0.000020
(0.000012)
0.001
(0.003)
-0.0010
(0.0052)
0.002
(0.005)
2.66e-07
(2.60e-07)
-0.17
(0.16)
-0.10
(0.16)
-0.21
(0.16)
0.01
(0.19)
1.05***
(0.17)
-0.12
(0.14)
-0.32**
(0.15)
0.38
(1.37)
0.19
425
Cell entries are OLS coefficients with robust standard errors clustered on country in parentheses.
Statistical significance is indicated as following using two-tailed tests: *** p ≤ .01, ** p ≤.05, and * p ≤.10.
34
Figure 1: Marginal Effect of Aid using Polity for Democracy (model 1.1).
Marginal effect of Aid
0.0014
0.001
0.0006
0.0002
-0.0002 0
2
4
6
8
10
12
14
16
18
20
Polity
-0.0006
Figure 2: Marginal Effect of Aid using Freedom House for Democracy (model 1.2).
Marginal effect of Aid
0.0024
0.0018
0.0012
0.0006
0
-0.0006
0
2
4
6
8
10
12
Freedom House
-0.0012
Figure 3: Marginal Effect of Aid using Vanhanen for Democracy (model 1.3).
Marginal effect of Aid
0.0013
0.0008
0.0003
-0.0002
-0.0007
-0.0012
0
4
8
12
16
20
24
Vanhanen
28
32
36
40
44
35
Marginal effect of Aid
Figure 4: Marginal Effect of Aid using Polity for Democracy (model 2.1).
0.00027
0.0002
0.00013
0.00006
-0.00001
-0.00008
0
2
4
6
8
10
12
14
16
18
20
Polity
-0.00015
Marginal effect of Aid
Figure 5: Marginal Effect of Aid using Freedom House for Democracy (model 2.2).
0.00028
0.0002
0.00012
0.00004
-0.00004
0
2
4
-0.00012
6
8
10
12
Freedom House
-0.0002
Figure 6: Marginal Effect of Aid using Vanhanen for Democracy (model 2.3).
Marginal effect of Aid
0.00025
0.00015
0.00005
-0.00005 0
5
10
15
20
-0.00015
Vanhanen
-0.00025
-0.00035
25
30
35
40