Some enthusiasts for microfinance have sold it as an important component of the solution to poverty in developing countries. It often does help lower poverty, especially of poor women, but it cannot ever make more than a small contribution to overcoming poverty. As I said on October 29th 2006 when we posted on microfinance, “Economic growth requires secure property rights, encouragement of private enterprise, openness to international trade, stimulation of education, limited and sensible regulations, and reasonably honest government. Microfinance makes only a small direct contribution to any of those variables”. Others may subtract some of the variables I mention, and add different ones, but no serious development economist would suggest that microfinance would have a major role in the economic development of poor economies.
Nor did microfinance invent small-scale loans to poor farmers and others. Local moneylenders in India and elsewhere have been doing that for centuries. However, the Grameen Bank founded in 1983 by Muhammad Yunus discovered several rather new ways to lend to the poor. This bank loaned primarily to poor women, usually Moslem women. Local moneylenders generally ignored Moslem women, either out of prejudice against women managing their own (small) businesses, or for other reasons.
The Grameen Bank also encouraged the formation of credit groups of a few women, about five members typically, that guaranteed repayment of the loans made to each woman in the group. Members of a group pressured other members to repay since they all might suffer if any member defaulted. With these guarantees, a group did not have to put up any collateral for the loans made to its members, a big advantage to poor women.
Although microfinance has had only a small impact on overall poverty in any country or region, studies suggest it has helped the Moslem women who received small loans. Families in which Moslem women have received microfinance improved the education of their children, especially the education of daughters, spent more on medicines, and accumulated more gold, which is usually the primary asset of Moslem women in Asia.
Yunus and many others have criticized the participation of for-profit lenders in microfinance. Yet in fact, for-profit lenders have always participated, although on much smaller individual scales than the companies Posner mentions (Compartamos and SKS Microfinance) that have hundreds of millions of dollars of capital. For-profit lenders have charged ”high” interest rates, but they have usually been flexible in allowing borrowers to take longer to repay if they were experiencing temporary financial difficulties. One would expect these lenders to adapt some of the lending innovations pioneered by the Grameen Bank and other microfinance lenders if the innovations improved repayments or helped in other ways to raise profits.
Although examples have been given of excessively high interest rates and other questionable terms changed by some for-profit micro lenders, it is not apparent that such behavior has been common. Poor farmers are accustomed to the borrowing process because they need to borrow in order to finance their outlays on seed and other farm inputs that occur months before they harvest rice or other crops to sell. Unscrupulous lenders could not easily fool these borrowers.
Even with well-informed borrowers, commercial interest rates will be high to borrowers with poor collateral, and to borrowers whose incomes fluctuate greatly due to the weather and other factors. Government-imposed ceilings on interest rates and other lending restrictions are likely to prevent such borrowers from gaining access to funds, unless governments or NGOs provide subsidized lending. This is why ceilings on interest rates and most other lending restrictions recently introduced or proposed will end up doing more harm than good.
After the financial crisis began, similar claims about exploitation of ignorant consumers were levied against providers of credit cards and mortgages. These claims motivated the consumer “protection” and other parts of The Dodd-Frank Wall Street Reform and Consumer Protection Act passed in July 2010. Yet little evidence suggests that borrowers were widely fooled by small print on borrowing contracts, by how interest rates were calculated, or by other claims about consumer exploitation (see my post on July 11, 2010). The consumer protection provisions of this Act will do little good, and will raise borrowing costs to the consumers who can least afford it.
Governments in countries with substantial microfinance should be mainly concerned about increasing the degree of competition among micro lenders in more remote rural areas. For monopolies do charge excessively high interest rates, and require borrowers to satisfy other onerous terms. Non-profits and other lenders should be encouraged to operate in localities where risk-adjusted interest rates are high, and anti-monopoly agencies should investigate possible collusion among lenders in these localities. Such policies would be more effective than trying to discourage for-profit lenders from making microloans.