George Stigler posited that economic regulation is best understood as a product created via a market process. In the market for regulation, different participants—such as politicians, firms, and voters—buy and sell the rules of the game to serve their individual interests. In new research, Jac Heckelman and Bonnie Wilson use Stigler’s theory of economic regulation and special interest capture to study why foreign aid to developing countries that is tied to market reform has not successfully accomplished its goals.
Liberalism made much of the world rich and remains the best path to prosperity for billions of people around the world who are mired in poverty. What’s not clear, however, is how to move nations that have not yet embraced rule of law, widely distributed property rights, and market exchange towards greater economic freedom. In recent decades, Western governments and international organizations have tried to use foreign aid to “buy” pro-market reforms in poor countries. These efforts have not clearly been successful, as existing evidence on the impact of aid on reform is mixed. In recent work, we ask “Why?” We find an answer in George Stigler’s theory of economic regulation: special interest capture.
Here’s the puzzle: If the path to prosperity evidently runs through economic freedom, why are all nations not clearly traveling down it? What prevents naturally occurring or spontaneous (as opposed to aid-induced) market-oriented reform? On some accounts, reform does not take place in poor countries because it is costly, literally. The building and maintenance of the state capacity necessary to support market-oriented institutions requires real resources, resources that poor nations simply do not have. Independent judiciaries must be built and judges trained in order to establish and protect property rights. Inefficient fiscal and monetary systems must be dismantled and new administrative and enforcement mechanisms put in place. Regulatory frameworks that support rather than stymie market exchange must be developed. From this perspective, grants of aid relax a state’s budget constraint and jump-start reform. As long as aid grantors can distinguish reform-minded politicians from kleptocrats (and grant or withhold funding accordingly), aid should work. The trouble is, a large body of evidence suggests aid does not lead to reform. There is some evidence of positive effects. Many, though, find no meaningful causal impact of aid on reform. Some work even indicates that aid has had perverse effects and led to less, not more, market-orientation in institutions.
The lessons Stigler taught us offer an alternative explanation for the puzzle that is the lack of spontaneous market-oriented reform in many nations. Stigler’s insight into economic regulation is both simple and ingenious. He postulated that we get regulation the same way we get goods and services: there’s a market for it. The trick is to recognize who’s buying and who’s selling. On Stigler’s account, firms and industries are buying. They lobby for regulation that benefits them (rather than the public), typically by making entry difficult for competitors. Politicians are selling in exchange for votes and resources arranged by firms and industries. As these buyers and sellers engage in exchange in the market for regulation, an equilibrium emerges. Unless and until some outside force “shocks” the market, inefficient regulation (that benefits firms, industries, and politicians, and that harms the general public) persists.
What does a market for regulation have to do with foreign aid and institutional reform? À la Stigler, we suppose that there is a market for regulation and the other political rules of the game that constrain human interactions. Grants of aid shock this market and upset the status quo equilibrium. How should we expect an aid shock to play out? Suppose that politicians are reform-willing but face opposition by special interests that wish to maintain the rules and regulation they influenced and from which they benefit. In this context, aid may help a reform-willing government survive opposition and advance reform. Notably though, the effectiveness of aid will be conditional on the extent of opposition. If special interests are weak, aid may be sufficient to overcome (or buy-off) opposition and generate reform. If special interests are strong, they may successfully block reform and aid will be ineffective. Potentially, aid could serve as a catalyst for increased special interest activity and even lead to backsliding on reform.
In the market for economic freedom, while politicians may be reform-minded and interest groups reform-opposed, it’s possible that preferences could be reversed. Politicians may be reform-reluctant and groups reform-supporting. Reform-reluctant politicians who benefit from the status quo are no puzzle, but why would interest groups actually favor reform? Richard Doner and Ben Ross Schneider have argued that in some nations, the political and economic environment is so anti-market (featuring rule-of-men rather than rule-of-law, insecure if any property rights, and virtually no opportunity for a robust network of exchange relationships to develop) that groups are pro-market (rather than merely pro-business). In such contexts, commercial interests favor the economic freedom that has the potential to unleash their creative energies to the betterment of themselves and consumers. The stronger these interest groups are, the more likely a grant of aid is to generate reform.
Overall, a Stiglerian perspective suggests that the impact of aid on reform will be conditional on the extent of special interest influence as well as on the extent to which existing rules and regulations are pro-market or anti-market. In relatively pro-market countries, more special interest influence is expected to decrease the likelihood that aid will successfully induce market-oriented reform. Special interest capture may even be so thorough that aid backfires and leads to more illiberalism. In relatively anti-market countries, more special interest influence is expected to increase the likelihood that aid works and induces market-oriented reform.
To test this idea, we assembled measures of market-orientation in reform, aid, economic freedom, and interest group activity for 92 aid-receiving countries over four periods of time, 1975-1985, 1985-1995, 1995-2005, and 2005-2015. We then estimated the impact of aid on reform, conditional on interest group activity and economic freedom, controlling for potentially confounding effects from other determinants of reform.
We originally anticipated (and hoped) that we would find some meaningful range of interest group activity and economic freedom levels for which aid had a positive impact on reform even while we expected to find a range over which the impact was negative. These different effects for different combinations of interest group activity and economic freedom would not only confirm the existence of a Stiglerian market for institutions and reform, but would also explain why much of the prior literature has failed to identify a clear impact of aid. Compared to our work, the prior literature effectively reveals an average of the potentially positive and negative effects, and therefore finds little impact.
Our findings reveal clear evidence of a market for institutions and reform. Contrary to our expectations though, there is virtually no range of conditions under which the estimated impact of aid on reform is positive. There is, however, a substantial range of conditions under which the estimated impact of aid on reform is negative. Overall, the findings suggest that aid intended to encourage market-oriented reform has in fact been largely associated with a perverse decline in the market-orientation of institutions. The exceptions to this rule have only occurred in countries in which institutions are the very least market-oriented and in which there are relatively large numbers of interest groups. For the most part, the evidence suggests that groups oppose reform, and that they are not only successful at blocking change, but that when they are relatively large in number and when institutions are most market-oriented, they are associated with substantive institutional backsliding. Unfortunately, the market for markets appears to be captured by special interests.
While our work suggests that aid has largely failed to produce market-oriented reform due to market capture, it should not be interpreted as a blanket failure of aid to advance development and the well-being of those living in poor nations. It is also vital that the failure of aid to produce market-oriented reform should not discourage us from the general project of market-oriented reform. As Kevin Grier and Robin Grier show, the potential for market-oriented reform to enhance economic development and welfare is substantial.
Paradoxically, economic freedom, like love, may be one of the things that money (and aid) just can’t buy. A conversion of hearts and minds to the project of economic freedom may be what’s needed (possibly along with a hefty dose of shame for political and business elites who have rigged the rules in their favor and refused others the opportunity to compete and contribute). Economic historian Deirdre McCloskey has argued that the great enrichment that began for many in the world roughly 200 years ago came about due to a shift in beliefs and moral norms that lent dignity and esteem to the merchant class. Today, there are people leading the charge for such a shift in the remaining parts of the world where it is needed. For example, Senegalese entrepreneur Magatte Wade is a fierce advocate for economic freedom and entrepreneurship as an engine of prosperity in Africa. Where top-down efforts to buy reform have failed, it may be that ground-up efforts like hers will be the catalyst that finally creates change.
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