Prizes for Development: The Political Economy of Subsidizing Good Institutional Outcomes

Abstract

This dissertation sets out to understand how the effectiveness of foreign aid in promoting economic growth in low-and middle-income countries could be improved. It does this by merging the political economy/public choice literature, the industrial organization literature, and the literature on development aid effectiveness and then developing a theory based on this previous work. The dissertation is in eight chapters. Chapter I introduces and outlines the arguments of the paper and demonstrates that institutions, more than any other factor, are the fundamental cause of long-run economic growth. Chapter II reviews the literature on barriers to institutional reform, exploring the political economy/public choice problems in-depth and demonstrating that countries can get caught in a trap of non-development and therefore a case for intervention exists. Chapter III reviews the literature on Official Development Assistance (ODA) effectiveness, demonstrating that it largely finds that ODA in the form of subsidized inputs such as capital has failed to achieve its stated objective of facilitating economic growth in low-and middle-income countries and outlining possible theoretical reasons for this failure. Chapter IV reviews the history of ODA designed to influence policy outputs, such as conditional loans and selective disbursements, finding that such efforts also failed to make ODA directly cause growth, yet arguing that such innovations were a very positive step in the right direction. Chapter V demonstrates empirically that foreign aid has been moving in the right direction by rewarding improved institutions as it is found that changes in ODA are increasingly positively correlated with changes in indicators of institutional quality over time, thus supporting the notion that even though ODA may not support economic growth directly, the future of foreign aid is to function as a mechanism to produce political incentives compatible with the creation of institutions that lead to good economic outcomes. Chapter VI analyzes advantages realized by moving away from the practice of subsidizing inputs and outputs and toward a system where cash-transfer type “prizes” are awarded on a rule-based system. Grants or prizes that are conditioned on pre-defined improvements in institutional and/or economic outcomes solve most of the informational, principal-agent, and political economy problems outlined in the previous chapters. Chapter VII provides further applications by suggesting ways that poor governments can support infrastructure development and spur industrialization at home using the model developed here. Finally, Chapter VIII is a short conclusion that reviews the arguments of the dissertation.