Does Foreign Aid Promote Democracy?

This study provides a multivariate analysis of a conventional wisdom about relationship between foreign aid and promotion of democracy. Although using data from different sources and employing different statistical methods Knack does not find strong empirical evidence to support the contention that foreign aid promotes democratization. 
Knack uses two different democracy measures (freedom house data and polity score) to test the hypothesis. In the final analysis, he argues that "the evidence presented  here does suggest that either the favorable impacts of aid on democratization are minor, or they are roughly balanced by other democracy-undermining effects of aid dependence."
Many aid donors include the promotion of democratic government as a major goal of their aid programs. The U.S. Agency for International Development (USAID) alone spends more than $700 million annually on democracy-related programs, including elections support, the strengthening of parliaments, judiciaries and political parties, and fostering the growth and power of ‘‘civil society organizations" such as labor unions. In 1975, section 116 was added to the Foreign Assistance Act, conditioning U.S. aid on respect for human rights and civil liberties.
The author starts with an important warning by noting "the fact that many aid recipients have become more democratic does not by itself imply cause and effect." He lists some studies found that  conditioning aid on reform in recipient nations is largely ineffective. With high levels of aid, recipient governments are accountable primarily to foreign donors rather than to taxpayers: ‘‘those with the loudest single voice on revenue and expenditure decisions are international lending agencies’’ (Brautigam, 1992:11)."
Knack also argues that aid may also encourage coup attempts and political instability, by making control of the government and aid receipts a more valuable prize, reducing the prospects for democratic governance. It is widely acknowledged that violent competition for control over large-scale food aid contributed to the breakdown of government in Somalia (e.g., Maren, 1997).
Article also quotes findings of Svensson (2000) suggesting that aid is associated with greater corruption in ethnically heterogeneous countries but not in more homogeneous countries.
In this study annual data on aid are taken from the World Bank’s World Development Indicators, based on data collected by the OECD’s Development Assistance Committee, dating from 1975. Aid is measured net rather than gross, that is, current loan repayments are subtracted. Military assistance is excluded.
In the data analysis part of the article ‘‘third wave’’ regional dummies are positive, and significant in the majority of cases. Of these, the coefficient for the Latin America dummy is the largest and most significant. Economic growth is positively related to democratization as expected, Initial income and illiteracy levels are never significant.
In a different model the author tests foreign aid's impact in the post-Cold War period but results show that aid is unrelated to democratization in the post–Cold War period either.
The findings of the study are so robust that the author runs harder tests but never finds strong correlation between foreign aid and democratization. For example, USAID currently has an explicit policy of directing more aid toward countries that appear to be making greater progress on democratiza- tion. Targeting aid toward countries that appear to be making progress in democratizing would bias aid coefficients in a positive direction in OLS regressions. Even with this potential upward bias, equations 1–6 fail to link aid with democratization.
An alternative, informal approach to exploring the direction of causality is to compare the strength of democratization’s relationships with aid early in the period and late in the period. If aid averaged over 1975–1989, for example, turned out to be strongly related to democratization (measured over the full period 1975–2000), that would suggest aid encourages democratization. On the other hand, if aid disbursed later in the period, for example 1990–1999, were more strongly related to democratization (again, measured over the full period), that would suggest aid is allocated as a reward for prior or ongoing democratization. In fact, aid over each of these sub-periods has equally small and insignificant relationships with democratization.
In order to test the contentious link between religious composition of a country and democratization he adds percent Muslim, percent Protestant and percent Catholic variables. Only percent Muslim variable is significant (at the .06 level). An increase of nearly 40 percentage points in percent Muslim is associated with a decline of about 1 point on the Freedom House index.
In short, the evidence presented in this study “does suggest that either the favorable impacts of aid on democratization are minor, or they are roughly balanced by other democracy-undermining effects of aid dependence.