The problem with microfinance

Muhammad Yunus and the Grameen Bank won the 2006 Nobel Peace Prize for making microfinance hip, not just improving the lives of the poor but also providing a concrete way for the wealthy to help in such a way as to empower the marginalized themselves. Win-win for everyone, right?

As a fan of microcredit, I was shocked by the provocative ideas in the book “Poor Economics,” by Abhijit Banerjee and Esther Duflo, who purported to reveal “the surprising truth about life on less than $1 a day.” The married couple who won the 2019 Economics Nobel (with Michael Kremer), extol inspiring individuals from India, Indonesia, China who lifted themselves out of poverty through creativity and effort, even though “they have less capital of their own, little access to formal insurance [or] banks. Moneylenders … charge interest rates of 4 percent a month or more … [making] the poor less able to make the investments needed to run a proper business and more vulnerable to any additional risk … from the business itself.”

Microfinance appears to be the answer, but Banerjee and Duflo disagree: even if many of the poor operate businesses, these are tiny and do not make much money.

The authors differentiate marginal return on a dollar versus overall return from a business.

The first is the “revenue net of all operating costs if you were to invest $1 less, or $1 more. If investing $1 less allows you to borrow $1 less and therefore repay 4 cents less in principal and interest, you would want to do so if the marginal return is less than 4 percent and not otherwise.” The second is “the total revenue net of operating expenses … what you take home at the end of the day … [which makes you] decide whether you should be in that business in the first place.”

Marginal returns can be high even if overall returns are low. The poor “are energetic and resourceful and manage to make a lot out of very little. But most of this energy is spent on businesses that are too small and utterly undifferentiated from the many others around them. [So] their operators have no chance to earn a reasonable living … You can start Microsoft in a garage … and keep scaling up, but to do so you need to be at the absolute cutting edge of some new product. For most people, that is not really an option … Although small loans may be available, no one (not even the microfinance institutions, which like playing it safe) will lend these small entrepreneurs enough money. Moreover, getting there might also need some management and other skills that they don’t have.”

How about training programs for the poor? Contrary to popular perception, sessions on accounting, inventory, interest rates, etc. in Peru and India resulted in increased business knowledge but not in more profits or sales.

The poor are entrepreneurs mainly because they have no choice, say the authors, but they actually prefer stable government jobs rather than business.

Even factory jobs looked down upon by the middle class are a lifeline for the poor, says Yale University’s David Atkin, who studied the heights of Mexican children whose mothers worked in maquiladoras (factories that make exports). Though wages are not high, the job is more stable than those in retail, transport or service.

Children whose mother’s town had a maquiladora were significantly taller than those born to mothers elsewhere. “The effect is so large that it can bridge the entire gap in height between a poor Mexican child and the ‘norm’ for a well-fed American child.”

Rather than glorifying entrepreneurship through microfinance, the authors urge government and society to create more stable jobs, not just in cities but in rural areas, which require improved infrastructure, regulatory environment, labor laws, credit from the private sector and the government.

“Microcredit and other ways to help tiny businesses still have an important role to play in the lives of the poor,” say Banerjee and Duflo, “because these tiny businesses will remain, perhaps for the foreseeable future, the only way many of the poor can manage to survive. But we are kidding ourselves if we think that they can pave the way for a mass exit from poverty.” INQQueena N. Lee-Chua is with the board of directors of Ateneo’s Family Business Center. Get her book “All in the Family Business” at Lazada or Shopee, or the ebook at Amazon, Google Play, Apple iBooks. Contact the author at [email protected].