Business | Microfinance

Microfinance Misses its Mark

In a comprehensive article on the reputed Stanford Social Innovation Review (SSIR), Aneel Karnani debunks all the hoopla surrounding microfinance. His conclusion is clear - “microfinance doesn’t cure poverty.”

The Reality of Microfinance 

The problems Karnani cites are well known, and were pointed out years ago by Thomas Dichter, among others. People take microfinance’s poverty alleviating characteristics as fact - so much so that nobody has really studied the phenomenon. Those that have, says Karnani, find the impact on poverty is not as unambiguous - and he quotes several studies:

One of the most comprehensive studies reaches a surprising conclusion: Microloans are more beneficial to borrowers living above the poverty line than to borrowers living below the poverty line. This is because clients with more income are willing to take the risks, such as investing in new technologies, that will most likely increase income flows. Poor borrowers, on the other hand, tend to take out conservative loans that protect their subsistence, and rarely invest in new technology, fixed capital, or the hiring of labor.

Microloans sometimes even reduce cash flow to the poorest of the poor, observes Vijay Mahajan, the chief executive of Basix, an Indian rural finance institution. He concludes that microcredit “seems to do more harm than good to the poorest.”

The failure of microfinance to bring people out of poverty should not be surprising, except to those deafened by its hoopla. People below the poverty line simply “do not have the skills, vision, creativity, and persistence to be entrepreneurial. Even in developed countries with high levels of education and access to financial services, about 90 percent of the labor force is employees, not entrepreneurs.” Indeed, Thomas Dichter made a similar point, pointing out:

The microcredit paradox is that the poorest people can do little productive with the credit, and the ones who can do the most with it are those who don’t really need microcredit, but larger amounts with different (often longer) credit terms.

Karnani’s Solution: Jobs, not Microcredit

Karnani - as you may remember - previously challenged C.K.Prahalad and his “Bottom of the Pyramid” theory (see also NextBillion). He, of couse, has his own solution - creating jobs through encouraging labor intensive industrial production. The PDF of his article is worth reading, for it shows how poverty declined rapidly in China, but not India and Africa - largely due to such growth.

Yet my analysis of the macroeconomic data suggests that although microcredit yields some noneconomic benefits, it does not significantly alleviate poverty. Indeed, in some instances microcredit makes life at the bottom of the pyramid worse. Contrary to the hype about microcredit, the best way to eradicate poverty is to create jobs and to increase worker productivity.

To understand why creating jobs, not offering microcredit, is the better solution to alleviating poverty, consider these two alternative scenarios: (1) A microfinancier lends $200 to each of 500 women so that each can buy a sewing machine and set up her own sewing microenterprise, or (2) a traditional financier lends $100,000 to one savvy entrepreneur and helps her set up a garment manufacturing business that employs 500 people. In the first case, the women must make enough money to pay off their usually high-interest loans while competing with each other in exactly the same market niche. Meanwhile the garment manufacturing business can exploit economies of scale and use modern manufacturing processes and organizational techniques to enrich not only its owners, but also its workers.

A Good Idea Gone Worse: Markets Trump the State

Karnani makes a lot of sense. Microfinance may have some non-economic benefits but it has been hijacked by “development experts” and “grassroots NGOs” to expand their legitimacy, and become something it never was intended to be. He is equally critical of Prahalad, who in his opinion “glosses over the real issue” - the failure of government and public service - by urging companies to provide consumer goods when what they need are the fundamentals:

Why do poor people accept that they cannot expect running water? Even if they do accept this bleak view, why should we? Instead, we should emphasize the failure of government and attempt to correct it. Giving a voice to the poor is a central aspect of the development process.

That is the key here - the development process. In that sense, the hoopla around microfinance and markets is doubly egregious - for it encourages a blind belief that markets will solve the world’s poverty issues by themselves. They will not. Indeed, by promoting microfinance, and micro entrepreneurs, the hoopla might make things worse, by encouraging economic activity well below economies of scale.

For too long, the world has naively believed that microfinance alleviates poverty. A nobel peace prize and several hundres of millions in private capital have been dedicated to the cause. Yet, the cause is ephemereal. The reality of microcredit is less attractive than the promise, and “even The Economist is beginning to realize it”. Time the well informed development expert, philanthropist, and policy maker focused on something real.

© 2007 The Discomfort Zone.