Microfinance and Third World Poverty and Development--Posner

The award earlier this month of the Nobel Peace Prize to Muhammad Yunus and his Grameen Bank of Bangladesh has directed attention to the phenomenon of microfinance, which Yunus and his bank have pioneered. The term refers to the making of tiny loans to poor people in underdeveloped countries, like Bangladesh. The amounts are sometimes only tens of dollars, the borrowers are small farmers, shopkeepers, artisans, and other minute commercial enterprises--overwhelmingly female (97 percent)--and the interest rates, which are designed to compensate the lenders fully, are high—sometimes as high as 20 percent a day. Although Yunus's motivation is not primarily commercial, the high interest rates and a relatively low default rate (in part because groups of women related to or friends with the borrower often agree to guaranty repayment of the loan), said to be only 1 percent, enable the Grameen Bank and its imitators (collectively referred to as "MFIs"--microfinance institutions--to cover their costs. The MFIs provide other services to poor entrepreneurs as well, but the loans ("micrcredit") are the most interesting feature of this experiment in helping poor countries throw off their poverty. Microfinance began with the Grameen Bank in the 1980s, and to date the bank has disbursed almost $6 billion in loans to some 6 million people. The total number of borrowers from all microfinance institutions is expected to reach 100 million by next year. The aggregate value of these loans is a drop in the bucket so far as alleviating Third World poverty is concerned, but the award of the Nobel Prize is a vote of confidence that may encourage continued growth of the program. What exactly microfinance has to do with "peace" is obscure. The causes of war are complex, and it is by no means clear that poverty is a major one. In any event the actual contribution of microfinance to peace must be slight and speculative. So the award of a Nobel Peace Prize to Yunus was questionable, but that is not to criticize Yunus's project. The experiment is a worthy one, though its success has yet to be demonstrated despite glowing appraisals by Kofi Annan and others. It may simply be the latest development fad. It does however seem superior to philanthropy in the sense of handouts, which in this case would mean giving grants (or heavily subsidized loans) to small entrepreneurs on the basis of competitive applications. For that is a competition in rhetoric. Middlemen would spring up to assist the applicant in writing a persuasive application, and the fees charged by the middlemen would be a good example of how the prospect of obtaining economic rents (crudely, something for nothing) channels the expected rents into costs. And the grants would frequently be misallocated. The high interest rates that the microfinanciers charge induce self-selection by the borrowers: a borrower has to have confidence in the project for which he is seeking microcredit in order to be willing to assume the burden of servicing his debt. Of course such confidence is sometimes, and perhaps among the poor often, misplaced. An obvious question is why, if microfinance is remunerative, commercial banks and other commercial lenders did not enter the market long ago; for as I said, microfinance began in the 1980s. One possibility is that regulations designed to protect the solvency of banks limits their ability to make risky loans. Usury laws may be an obstacle too, if they are differentially applied to ordinary lenders as distinct from microfinanciers--yet the Grameen Bank seems to be an ordinary stock corporation, not a nonprofit. More important may be the existence of a close substitute for microfinance in the form of informal loans by relatives and clan members, a method of financing that is feasible (and extremely common) in societies in which the clan and the extended family can discipline members by threat of ostracism and other informal sanctions. The total capital possessed by the family or clan might be slight by usual commercial standards, yet if only one or a few members have any real entrepreneurial prospects, the limited capital may be sufficient to finance their tiny projects. So microfinance is perhaps best understood as a device for easing the transition from an economy based on trust to a normal commercial society. As a substitute for trust, microfinance has obvious drawbacks. Extremely high interest rates, though justified not only by the risk of default (and the opportunity cost of money, that is, the riskless interest rate) but also by the very high transaction costs of a tiny loan (since those costs are largely fixed, rather than varying with the size of the loan), burdens the borrower with very heavy fixed costs, since he must repay the loan regardless of the success of his enterprise. The higher a producer's fixed costs relative to his total costs, the riskier his enterprise, since if demand for his product falls or his marginal costs rise he will find it extremely difficult to adjust by cutting output; the cut will reduce the revenue out of which he has to pay principal and interest on the loan. Borrowing at astronomical interest rates seems an unlikely formula for commercial success--and the more unlikely the poorer the borrower. In the family or clan alternative, trust may provide an extremely low-cost substitute for the transaction costs involved in microfinance. Perhaps then microfinance will occupy a narrow niche in capital markets between family and clan resource pooling at one end and commercial lending at the other. Indeed, the fact that the overwhelming majority of microfinance borrowers are women suggests that the particular market failure that microfinance corrects is discrimination against women in the family and clan capital markets. An alternative form of microfinancing would be equity rather than debt financing, on the model of private equity firms like Blackstone and the Carlyle Group. Of course these multibillion dollars firms have no interest in making $100 loans in Bangladesh. But the Grameen Bank could presumably furnish equity in lieu of loans to its customers, thus sharing the risk with them and so reducing the risk to them; and it is a superior risk sharer because of size and diversification. But maybe the bank would find it too difficult to evaluate projects, or would fear being inundated by applications from the impecunious. I end on a skeptical note. The evidence for the efficacy of microfinance in stimulating production and alleviating poverty is so far anecdotal rather than systematic. The idea of borrowing one's way out of poverty is passing strange. And I am unaware of any historical examples of nations that climbed out of poverty on the backs of small entrepreneurs financed by credit. Also, recall that Grameen Bank has lent almost $6 billion to some 6 million persons. This implies an average loan of almost $1,000, which in a country like Bangladesh is not chicken feed and makes one wonder how much of the Grameen Bank's loan portfolio is actually microfinance. (Yet the bank's financial statement indicates that the average loan balance in 2005 was only $85--I don't understand how this squares with the aggregate figures that I gave above, which are also published by the bank!) Then too, the bank has been in operation since 1983, which is more than 20 years and indicates that the average number of borrowers is only 300,000 a year, with presumably many repeat borrowers. Bangladesh has a population of almost 150 million people. It is true that the microfinance movement is growing--and as it grows we may see default rates rising and the microfinanciers adjusting, as the Grameen Bank may already have done, by greatly increasing the minimum size of loans. Think back to that low default rate for the Grameen Bank. The bank does not have written loan agreements and does not sue defaulters or invoke other legal remedies against them. The natural inference to draw is that the bank is extremely selective in its choice of persons to whom it is willing to lend, and such selectivity, if imitated by other microfinanciers, must greatly limit the scope and impact of microfinance. I suggest, albeit tentatively, that there may be a good less to microfinance than its boosters claim.

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