If I could ask all the deeply offended to hold back their outrage until the end of this post, that’d be great, thanks.

After months of being distracted by other reading material*, I have finally started reading “Poor Economics” by Abhijit Banerjee and Esther Duflo. And this week, happily, Businessweek.com published an article on microfinancing institutions:

“A Microlender backs startups to bring more than loans to the poor.“

Which gives me a chance to talk about microfinance and the poor.

What is Microfinance?

Muhammad Yunus, and his Grameen Bank, won the Nobel Prize in 2006 for founding microfinance, and for distributing small loans to the women of Bangladesh (which is actually known as “microcredit”). Or, to quote the citation, for “efforts though microcredit to create economic and social development from below“.

I think that we need to make the distinction between microfinance and microcredit… Microfinance is the provision of financial services (banking, loans, insurance, etc) on a small scale to the poor. Microcredit deals specifically with the extension of loans. And microcredit is where most of the media/academic attention is focused – as it’s the form of microfinance that is meant to release the poor from their poverty trap by providing them with the means to get out of it.

How Microcredit Works

The Grameen approach to microcredit (known as solidarity lending) works like this:

1. A poor person wishes to apply for credit;
2. The bank says to them “you need to be part of a lending group of five people before we’ll allow you to borrow any money from us”
3. “The lending group is there to help the bank monitor your progress”
4. “The group is under no obligation to guarantee your loan – that responsibility is yours alone”
5. “But if one of you defaults, then there will be no more loans for the other four until that loan is made good”
6. “Also, here is a list of 16 promises that you are going to make. We’re going to recite them together, out loud, before you get any money.”
7. Cool. Now here’s some money.

The above is a really clever mix of practical sense and human psychology. You make sure that the borrower is accountable to their friends rather than just the bank. You make sure that their default to the bank has a direct impact on their personal life. You heavily incentivise the group to make good on the debts on the individual without specifically requiring it. And some psychological studies have shown that there is a real difference between saying that you’ll do something and promising that you’ll do something**.

Also, Grameen Bank was talking about 98% of their microcredit loans being repaid. So only 2% of the loans made were going bad at the time. Just compare that to Spain today, with its recent bad debt number of around 10.78%. In summary: Yunus and Grameen Bank were saying that the poor are creditworthy.

It’s the type of statement that wins you a Nobel Prize.

The Problem

This news about the creditworthiness of the masses made a lot of investors very excited; and microcredit institutions began to pop up all over Asia, Africa and South America.

Awkwardly, these institutions weren’t nearly as successful… Critics began to say that there was not much evidence to suggest that any poverty alleviation was really happening. There was also some questioning of the Grameen stats***.

And rather unhelpfully, while all this was going on, Mr Yunus was fired from Grameen Bank for embezzlement (he maintains that the accusations were politically-motivated; which does seem to be the party-line of the recently (ironically) discredited).

So where did it all go wrong?

The Flaws in Microcredit

Some observations:

1. Solidarity lending only works if there is only one Microcredit Institution. If the threat is that the other members of your group won’t get loans if you default, and your mates can simply go to another institution if you default… Then the threat is not nearly as strong.
2. And actually, if you can go apply for loans at more than one microcredit institution, then why not get as many loans as you can? I mean, you’ve literally got nothing to lose.
3. Then, from an investor perspective, you’re giving money to people that are high risk (regardless of what that 98% story says) and not likely to be literate. So when you add a profit motive into this, what you get is “loan sharks” in well-meaning suits****.
4. Also, more importantly, these loans are meant to fund entrepreneurial enterprises. Is that what they’re really going to fund?

Enter: Poor Economics

When they sit back to logically assess microcredit, many economists make the following argument:

But that’s not what happens in most situations. And Poor Economics gives a great example of this. The authors were investigating whether the poor were stuck in a nutrition poverty trap. Here’s the basic summary of what they were investigating: because you’re poor, you don’t get enough to eat; and because you don’t get enough to eat, you’re too weak to work, so you stay poor.

They did their study in India, where they discovered that increases in income amongst the poor meant that they ate less as their income increased. And that’s not saying that they’re eating enough – because they weren’t eating enough in both situations. But all these poor people being interviewed who were claiming not to have enough money to buy food? They owned TVs.

Now isn’t that interesting?

It’s more than interesting: it’s fascinating. And here’s the explanation offered by one of the gentlemen they were interviewing:

Life as a poor person is boring – I’ve tried to find work, but I can’t – so I usually just spend my day here at home. And if I use my money to eat today, I’ll still be hungry tomorrow. But if I save to buy a TV, at least I won’t be so bored. Sure – I’ll be hungry. But I’m always hungry. So I’d rather have the TV.

That logic is flawless.

But that’s not really so good for the world of microcredit. Because it implies that at least some of those loans (if not most) are going to be used to alleviate boredom…

And maybe the reason we haven’t managed to make much headway against poverty is because the people who can help really don’t understand it at all.

PS: read the book. Even the Freakonomics guy was all over it with the praise.

*Example: the final book in Robert Jordan’s Wheel of Time. Like finally. @Gops_Sid – I hope you’ve also done it!

**Not kidding. But I guess we know it intuitively. It’s why we make marriage vows public, right?

***The 98% was almost definitely too high. According to the Wall Street Journal, over a fifth of the loans in question were overdue by almost a year. It’s a perennial problem with banks. Do you admit that the loans have gone bad? Or do you quickly give the borrowers a new loan to pay back the old loan – so now it looks like all your loans are new? Nothing like making it all look good on paper…

****Mr Yunus was shocked. He announced that he “never imagined that one day microcredit would give rise to its own breed of loan sharks”. Honestly. They should revoke the Nobel for that statement alone. On the one hand – the illiterate and the desperate. On the other hand – the very literate driven by a profit motive. That is a recipe for exploitation. And it’s just standard game theory.