The Micromagic of Microcredit

The microcredit movement has garnered plenty of attention in recent years, and its founder -- Muhammed Yunus -- was awarded the Nobel Peace Prize in 2006. The concept is simple: small loans to third-worlders interested in beginning or expanding a small business may be the most effective way to foster economic development in poorer regions. The loans have a track record of repayment in 98% of cases and generally require a very small amount of investment (as low as $20). Some believe that microcredit loans do more for third-world development than charity or government aid since the money goes directly to those who can use it to increase growth. The legend of microcredit is so amazing that it sounds to good to be true.

Karol Boudreaux and Tyler Cowen examine the issue, and find that the commonly told story of microcredit is, in some ways, too good to be true. They find that the institution certainly has a net positive impact, but the results aren't quite so miraculous as proponents sometimes claim.

The achievements of microcredit, however, are not quite what they seem. There is, for example, a puzzling fact at the heart of the enterprise. Most microcredit banks charge interest rates of 50 to 100 percent on an annualized basis (loans, typically, must be paid off within weeks or months). That’s not as scandalous as it ­sounds—­local moneylenders demand much higher rates. The puzzle is a matter of basic economics: How can people in new businesses growing at perhaps 20 percent annually afford to pay interest at rates as high as 100 ­percent?

The answer is that, for the most part, they can’t. By and large, the loans serve more modest ­ends—­laudable, but not world changing.

Microcredit does not always lead to the creation of small businesses. Many micro­lenders refuse to lend money for start-ups; they insist that a business already be in place. This suggests that the business was sustainable to begin with, without a microloan. Sometimes lenders help businesses to grow, but often what they really finance is spending and consumption.

That is not to say that the poor are out shopping for jewelry and fancy clothes. In Hyderabad, India, as in many other places, we saw that loans are often used to pay for a child’s doctor visit. In the Tanzanian capital of Dar es Salaam, Joel Mwakitalu, who runs the Small Enterprise Foundation, a local microlender, told us that 60 percent of his loans are used to send kids to school; 40 percent are for investments. A study of microcredit in Indonesia found that 30 percent of the borrowed money was spent on some form of ­consumption.

Sometimes consumption and investment are one and the same, such as when parents send their children to school. Indian borrowers often buy mopeds and ­motorbikes—they are ­fun to ride but also a way of getting to work. Cell phones are used to call friends but also to run ­businesses.

For better or worse, microborrowing often entails a kind of ­bait ­and ­switch. The borrower claims that the money is for a business, but uses it for other purposes. In effect, the cash allows a poor entrepreneur to maintain her business without having to sacrifice the life or education of her child. In that sense, the money is for the business, but most of all it is for the child. Such ­life­saving uses for the funds are obviously desirable, but it is also a sad reality that many microcredit loans help borrowers to survive or tread water more than they help them get ahead. This sounds unglamorous and even disappointing, but the ­alternative—­such as no doctor’s visit for a child or no school for a ­year—­is much ­worse.

The whole article is not very long, and well worth reading.