Foreign Aid, Time Horizons, and Trade Policy

Abstract

Although there are theoretical reasons to expect foreign aid to promote trade liberalization, empirical research has found no relationship. Without disputing this general nonresult, we argue that foreign aid can incentivize liberalization under certain conditions. In the absence of aid, the incentive to liberalize trade depends on government time horizons: Far-sighted governments have incentives to do so, whereas short-sighted governments do not. It follows that foreign aid should not encourage far-sighted governments to liberalize, as they do so in any case. Foreign aid can, however, induce short-sighted governments to liberalize by ameliorating short-term adjustment costs. We thus hypothesize that aid is more likely to promote trade liberalization when given to governments with short time horizons. We support this hypothesis with an analysis of aid, time horizons, and two measures of trade policy. Our results contribute to the growing debate about the conditions under which foreign aid encourages growth-enhancing policies.