AID, ECONOMIC FREEDOM, AND GROWTH

1. INTRODUCTION Donors have multiple objectives in providing foreign assistance to poor countries. Aid is motivated in part by donors' foreign policy objectives; for example, much U.S. aid goes to Egypt and Israel to maintain peace in the region. Aid is also motivated by commercial concerns and is often granted conditional on the funds being used to purchase goods or services from firms in the donor country. Whether or not aid is successful in achieving these objectives can be assessed relatively easily. It is more difficult to determine aid's effectiveness in attaining other objectives, however, such as democracy promotion, building institutional capacity, market liberalization, and economic growth. One must control for numerous other determinants and correct for the possibility that aid is endogenously determined. The bulk of the evidence suggests skepticism concerning donors' ability to influence these processes to a substantial degree in most developing countries through aid programs. Evidence is mixed on links between aid and growth, and there is certainly no robust positive relationship, even for countries with better institutional and policy environments (Easterly, Levine, and Roodman, 2004; Ovaska, 2003). Boone (1996) found that aid did not increase investment or benefit the poor as measured by human development indicators but that it did increase the size of the government. Using the Freedom House and Polity democracy indexes measured over long periods of time, Knack (2004) finds that aid has no impact on democratization in developing countries. Even worse, higher aid levels are associated with significantly larger declines in institutional capacity over time, using measures of corruption, bureaucratic quality, and rule of law from the International Country Risk Guide (Knack, 2001). Both these studies correct for the possibility of reverse causation, as aid spuriously could appear ineffective if donors tend to direct it toward countries with deteriorating conditions. In fact, that is not how most donors allocate aid, and two-stage least squares tests confirm that the exogenous component of aid--aid predicted by country size, initial levels of infant mortality, literacy, and so forth--is associated with declining quality of governance and is unrelated to democratization (Knack, 2001, 2004). More recently, foreign aid has often been intended by donors to entice recipient nations into policy and institutional reforms favorable to private sector economic development. Several studies have recently shown that increases in "economic freedom" contribute positively to national growth (Adkins, Moomaw, and Savvides, 2002; Dawson, 1998; Gwartney, Lawson, and Holcombe, 1999). Aid, therefore, can be used as a means to further the end of growth, if donors are successful in using it as a carrot to induce market-oriented reforms. Aid could sometimes have unintended and less favorable effects on economic freedom, however. Friedman (1958) long ago argued that because most foreign aid goes to governments, it tends "to strengthen the role of the government sector in general economic activity relative to the private sector." The availability of aid funds can further rent-seeking activity (Bauer, 1984) or serve to bail out governments from crises that might otherwise be forced to adopt liberalizing reforms (Rodrik, 1996). In this study, we investigate the relationship between aid and changes to economic freedom in recipient nations over the 1990-2000 decade. The evidence is mixed. We find that aid does not significantly increase economic freedom overall. A similar conclusion is reached by Boockmann and Dreher (2003) in the case of International Monetary Fund (IMF) and World Bank loans. However, when we disaggregate economic freedom into five separate categories, we find that they have differing effects on growth. Arguably, if growth is the ultimate objective of aid, analyses of aid's impact on economic freedom should differentiate among the five categories by the strength of their links to growth. …