Perceptions Matter: The Effect of Foreign Aid on Democracy Depends on Incentives
Countries that are not strategically important or that receive more aid from unconditional donors make significantly more progress toward democracy than countries that are strategically important and receive more aid from conditional donors.
Does foreign aid promote democracy around the world? While major donors like the US support democracy both in principle and with material resources, foreign aid is used to further a variety of competing objectives from disaster relief to export promotion to bolstering important allies. Since those allies are not always democracies, the actual impact of aid on democracy is not obvious. Add to this the potential negative effects of "free resources" that make a government less dependent on its people or foster corruption and the ability of aid to promote democracy is indeed uncertain. In this post, we give a preview of our forthcoming paper in the April 2014 edition of the European Economics Review, which takes a closer look at the impact of foreign aid on democracy.
Previous academic research has mixed findings regarding the relationship between aid and democracy. World Bank economist Stephen Knack examined aid and changes in Freedom House democracy ratings from the 1970s to 2000 in a frequently cited article. Looking at the data in a number of different ways, Knack found no evidence that aid promotes democracy. Those countries in Knack's sample that received more aid did not experience greater democratization than countries receiving less aid.
Economists and political scientists working on this topic since Knack's publication have often turned their focus to the short run impact of aid in the hopes of uncovering incentive effects. If donors make their promises of aid conditional on improvements in political rights and civil liberties, aid might provide leverage to push a democratic agenda. Conversely, the incentive effects of aid might be more like those of oil, inducing an "(un)natural resource curse" that hinders democratic development. Using these approaches, some researchers find negative results (i.e., aid promotes autocracy) and some find positive results (i.e., aid promotes democracy).
The majority of these studies, however, suffer from some basic problems. Past research designs have largely ignored the procedures Freedom House experts use to construct democracy scores. The result is an inefficient use of the available information and attenuation bias – a bias toward finding no impact.
Repeating Knack's approach with an improved estimation method and a more comprehensive dataset we find a very different result — a robust positive link between aid and democracy. In other words, over the course of several decades, foreign aid has promoted democracy. The magnitude of this effect, however, is fairly small.
Using this improved estimation method, we can also address the question of short run incentive effects. Can the promise of future aid work if that aid is conditional on steps toward democracy? Will governments — either of their own volition or due to societal pressures — respond to these monetary incentives? Answering this question is tricky because we observe aid flows, not the conditions and negotiations between donors and recipients. A country might receive more aid after moving toward democracy exactly because a donor offered such a deal. Alternatively, the transition toward democracy may have occurred for different reasons altogether, but donors may simply like democracies and provide more funds. In short, the direction of causation is not clear and we must heed the adage that correlation is not causation.
Our solution is to look at the situation from a different vantage point. We ask: When are donor decisions based on democracy? We find that some donors ("unconditional donors") always consider democracy when allocating aid, while other donors ("conditional donors") disregard democracy when the recipient country is strategically important. That is, for these conditional donors strategic considerations can override governance issues. For unconditional donors and for countries that are not considered to be strategically important, donor threats to withhold aid if democratization does not occur are credible and should have an impact. However, for conditional donors interacting with strategically important countries, such threats are hollow and should have no impact.
Our short run findings strongly support this mechanism. Countries that are not strategically important or that receive more aid from unconditional donors make significantly more progress toward democracy than countries that are strategically important and receive more aid from conditional donors. The effects of facing the right incentives are large.
Aid does promote democracy, and the impact of that aid on democracy can be large when people in the recipient country believe the donor is committed to promoting democracy. The full paper, entitled "Aid and Democracy Redux," and our detailed findings are available here.