Why Microcredit Works

Karol Boudreaux and Tyler Cowen look at microcredit in the Wilson Quarterly. This is my favorite insight:

Sometimes microcredit leads to more savings rather than more debt. That sounds paradoxical, but borrowing in one asset can be a path toward (more efficient) saving in other assets…

In poor communities, money is often an ineffective medium for savings; if you want to know how much net saving is going on, don’t look at money. Banks may be a dayßøßølong bus ride away or may be plagued, as in Ghana, by fraud. A cash hoard kept at home can be lost, stolen, taken by the taxman, damaged by floods, or even eaten by rats. It creates other kinds of problems as well. Needy friends and relatives knock on the door and ask for aid. In small communities it is often very hard, even impossible, to say no, especially if you have the cash on hand…

A dollar saved translates into perhaps a quarter of that wealth kept. It is as if cash savings faces an implicit “tax rate” of 75 percent.

Under these kinds of conditions, a cow (or a goat or pig) is a much better medium for saving. It is sturdier than paper money. Friends and relatives can’t ask for small pieces of it. If you own a cow, it yields milk, it can plow the fields, it produces dung that can be used as fuel or fertilizer, and in a pinch it can be slaughtered and turned into saleable meat or simply eaten. With a small loan, people in rural areas can buy that cow and use cash that might otherwise be diverted to less useful purposes to pay back the microcredit institution. So even when microcredit looks like indebtedness, savings are going up rather than down.

I think this view of microcredit, as helping to foster non-monetary savings, is a very good way of looking at one of the things that microcredit can achieve.

I’m less impressed by the rest of the paper, especially the generalization from the way that Grameen Bank was originally set up (but hasn’t been for over five years):

Often there is no explicit collateral. Instead, the banks lend to small groups of about five people, relying on peer pressure for repayment. At mandatory weekly meetings, if one borrower cannot make her payment, the rest of the group must come up with the cash…

Though its users avoid the kind of intimidation employed by moneylenders, microcredit could not work without similar incentives. The lender does not demand collateral, but if you can’t pay your share of the group loan, your fellow borrowers will come and take your TV.

This might still be true of some microcredit organizations; I’m pretty sure that it’s not true of the biggest or the most successful ones.

Boudreaux and Cowen say that generally microcredit is not used to found businesses, so much as to extend credit to people who already have businesses; they also imply that a lot of microcredit repayments ultimately come from reparations. I’m not convinced: while some microcredit loans are surely used for consumption, as they say, a huge number are also used for classical uses like buying a goat or a sewing machine.

Shahe Emran, Mahbub Morshed and Joseph Stiglitz, in one of my favorite economics papers ever, found that microcredit plays a hugely important role in allowing women to enter the workforce – something which you’d never guess from reading the Wilson Quarterly piece. Boudreaux and Cowen also fail to mention the transformative effect that putting household finances in the hands of women rather than men can have.

Overall, however, I agree with them. Microcredit is useful, but it’s not a panacea: it can’t solve the problem of poverty. So long as you’re realistic in your expectations, however, it can be a fanastic tool in the development arsenal.

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