Benjamin Powell and Matt Ryan.
For more than 50 years individual countries and international agencies have given aid to third world countries to promote economic development, yet poverty still persists in many recipient nations. In recent years development economists and agencies have increasingly recognized the importance of institutions that support property rights and economic freedom in promoting development. Nevertheless, nations continue to provide aid to less developed countries. This raises two important questions. Does the receipt of aid lead to increases or decreases in economic freedom, and are increases in economic freedom rewarded with more aid or punished with reduced aid?
The failure of aid to directly promote development in impoverished countries is well documented. Boone (1996), Vasquez (1998), Easterly and Levine (2001), and Ovaska (2003) all find that development aid fails to systematically improve growth rates. Easterly (2001) summarizes World Bank aid policies that have failed to promote development. Although aid has generally failed to promote development, Burnside and Dollar (2000) argue that aid can be effective if the correct policy environment is in place. This leads us to examine the characteristics of the correct policy environment and whether aid has been directed to countries with it.
Since the development of the indexes of economic freedom in 1995, a substantial body of literature has related economic freedom to growth rates and standards of living. The Economic Freedom of the World annual report is the most comprehensive index measuring economic freedom. It looks at 37 distinct pieces of data in five major categories: government size; legal structure and security of property rights; sound money; free international trade; and regulation of credit, labor and business. The index ranks countries back to 1970 over five-year intervals, allowing time series analyses to be conducted. Research by Dawson, Gwartney, Lawson and Holcombe (1999), de Haan and Sturm (2000, 2001), Adkins, Moomaw and Savvides (2002), Pitlik (2002), and Weede and Kampf (2002) all find that increases in economic freedom are positively correlated with increases in economic growth rates. Other research indicates that higher levels of economic freedom in a country also increase growth rates, though some research debates whether this is statistically significant. Berggren (2003) provides a comprehensive summary of the literature on economic freedom.
While much has been written on the relationship of economic freedom to growth rates and standards of living, little has been written on the relationship between aid and economic freedom. Vasquez (1998), Ovaska (2003) and Heckelman and Knack (2005) are exceptions; they examine both economic freedom and aid. Ovaska looks at whether the quality of governance (economic freedom) affects the results of aid, while we look at whether aid affects governance and if governance affects aid flows. Heckleman and Knack (2005) examine whether aid impacts freedom and the effect it had on growth over 10 and 20 year periods (1980-2000). They find aid negatively impacts overall economic freedom. Our study expands on their results by looking at a total time span of 30 years (1970-2000) and by analyzing the impact of aid flows on freedom scores in smaller five and ten year time periods. Our study also differs by examining changes in freedom scores and changes in flows aid from period to period instead of just levels of aid flows. Vasquez (1998) examines what happens to the flow of aid when economic freedom changes. He observed a limited number of both countries and years; section three of this paper expands on his work by looking at a larger set of countries over a 30 year period.
- Has Foreign Aid Influenced Economic Freedom?
P.T. Bauer long contended that intergovernmental aid increases the size and scope of recipient governments, contributes to the politicization of life, negatively impacts economic performance, and is, on balance, an anti-market force (1971, 1978, 1984, 1990). His long list of anti-market policies to which aid contributes includes expulsion of productive groups, suppression of private trade, restriction of the inflow of foreign capital, confiscation of property, forced collectivization, takeover of foreign enterprises, discouragement of agriculture, support of unviable projects, and import substitution (1990: 46).
In measuring the impact of aid flows on changes in freedom it is difficult to say that aid has much of a positive or negative effect on freedom. This could be because prior aid flows were similar to those in the period observed. If aid does adversely impact economic freedom, we may be observing countries where previous aid has already decreased freedom such that the current, near-constant aid levels cause freedom scores to remain poor but not change significantly. To address this, we next looked at how changes in aid flows impact changes in freedom. Any one pair of aid and economic freedom figures spans ten years. As an example, the change in the average amount of aid from the span 1970-1975 to the span 1975-1980 was paired with the change in freedom from 1975 to 1980. This model allows previous aid to be incorporated into the initial freedom score so that we can see how the change in aid flow affects economic freedom over the next five-year period.
In this study, aid had a negative sign, indicating that increases in aid flows from one period to the next decreased freedom scores over that time. However, aid failed to be statistically significant in any of the regressions. Our highest level of confidence attained in any of these regressions was 83.8 percent. The coefficient on communist countries was again positive and significant, indicating that their freedom improved more rapidly than other countries. Income per capita again failed to be significant.
Overall, our regression results are mixed but on balance tend to support Bauer’s claim that aid promotes statism. We find that countries receiving aid are less economically free than those that do not. This could be a confirmation of Bauer’s claim that aid harms economic freedom, or it could simply be an indication that countries with less freedom are more likely to get aid. Our strongest regression results find that countries that receive larger amounts of aid over a five year period, even after controlling for their level of income, have a lower freedom score at the conclusion of that period. When we compare the level of aid a country receives to how its freedom changes over five years, we find a very slight positive relationship in some cases. But this could be because the country already had a low level of economic freedom since it was receiving large amounts of aid, and that a constant, high aid flow does not cause economic freedom to continue to worsen. Examining changes in aid flows and freedom scores eliminates some of the above problem. We find that increases in aid negatively impact changes in economic freedom, but the results are not statistically significant.
This section is neither a resounding confirmation nor rejection of Bauer’s claims. The one clear result that emerges is that aid is unlikely to increase economic freedom. There is some indication that aid actively harms freedom but the result is not perfectly clear.
Is Good Policy Rewarded with Aid?
The economics literature and aid agencies have recognized that an environment of economic freedom and property rights is necessary for economic development. Research by Burnside and Dollar (2000) claims that although aid in general cannot promote growth, if given to countries with the right policy environment the aid can be effective. Their research is disputed, however. Easterly, Levine and Roodman (2003) and Brumm (2003) find that aid has a negative impact even with good policy, while other research—Hansen and Tarp (2000), Dalgaard and Hansen (2001), and Guillaumont and Chauvet (2001)—also casts doubts on the Burnside and Dollar results.
Despite debate, many in the policy world believe aid can work if the right policies are in place. The World Bank has written, “There is no value in providing large amounts of money to a country with poor policies” (1998: 13). Similarly, the millennium challenge account has been set up to direct U.S. foreign aid to countries with better policies in the hope that aid will be more effective. Thus, since good policy is necessary for economic growth, and at least some researchers believe aid can be effective if a country has good policies in place, the question that we address in this section is “Have increases in economic freedom been rewarded with increased aid?” Vasquez (1998) found the opposite, that the greater the reductions in economic freedom, the greater the increases in aid. Vasquez only looked at 20 countries from 1985 to 1990, however, and 24 countries from 1990 to 1995. Our study expands on his by including data for 96 countries over thirty years to see if his result can be generalized.
We used a regression model to determine if improvements in freedom were rewarded with increases in aid. In this case, since freedom is the independent variable and aid flows are dependent, we simply used aid flows instead of adjusting the figure to reflect aid as a percent of income or expenditure. We are only concerned with whether policy changes that increase freedom are rewarded with more aid. Since freedom scores are available at five-year intervals, aid flows were again averaged over the same five-year period. Thus, we now compare the change in freedom over a five-year period with the change in aid from that period to the subsequent five-year period. For example, the difference in freedom scores from 1980 to 1985 becomes the independent variable (Freedom), and the difference in aid from 1981-1985 to 1986-1990 becomes the dependent variable (Aid).
We found that the coefficient of freedom was negative and statistically significant. A one point rise in freedom will lower subsequent aid flows by $240 million. Increases in economic freedom—the addition of proper policies and implementation of sound institutions—were not rewarded with more foreign aid. In fact, steps in the right direction were punished by decreases in foreign aid. This occurred even though discussion of property rights and economic freedom in development agencies increased over the time period considered. When we examined the last period with complete data available in isolation, the 1990s, improvements in economic freedom continued to be punished with lower levels of aid; the results were not statistically significant, however.
The debate that has ensued since the publication of Burnside and Dollar (2000) has led to doubts that foreign aid can promote development even if it goes to countries with good policies. However, even if Burnside and Dollar are right, we find that aid agencies have not rewarded good policy with increased aid. They punish improvements in economic freedom by decreasing aid.
Conclusion
Although many articles examine whether aid promotes development and whether economic freedom promotes development, little empirical research has been written on the relationship between foreign aid and economic freedom. We examined both how aid influences economic freedom and if increasing economic freedom has been rewarded with aid. No clear cut theoretical case proves that aid either increases or decreases freedom. It could be that governments in impoverished countries receiving more aid will not need to tax their own citizens as much to obtain a given level of spending. If governments held spending constant, then aid could conceivably increase economic freedom. Alternatively, as P.T. Bauer has argued, aid could lead to the expansion of the public sector relative to the private sector and thus decrease economic freedom. Our paper examined this question, with mixed results. Our regressions give some indication that aid decreases economic freedom. Our findings clearly can cast serious doubt on the proposition that aid increases freedom in poor countries. Given the World Bank’s mission of promoting economic growth in poor countries and the strong empirical literature on the importance of economic freedom for growth, our paper indicates that since aid cannot be shown to have a positive influence on freedom, aid is unlikely to lead to development in poor countries.
The second question we addressed is whether improvements in economic freedom were rewarded with increased aid. While there has been debate as to aid’s effectiveness if a country has good policy, we find that good policy has not been rewarded. Increases in economic freedom have been punished by decreases in the amount of aid a country receives.
