Must read: Poor Economics

Over the weekend, I finished reading Poor Economics: A Radical Re-Thinking of the Way to Fight Global Poverty.

If I had to boil it down to one sentence, here’s my take: things are usually not what they seem.

Yes, rather mundane conclusion, especially since we’re talking about the aggregation of years of painstaking economics research on what works – and doesn’t – in development work. But authors Banerjee and Duflo manage to make accessible their work – a tough task for most economists – so I figured my takeaway should be accessible also.

I particularly enjoyed chapter 9, which discusses micro credit. I am a big proponent of micro credit, the practice of giving small loans to poor people who otherwise have no access to formal financial tools. A classic example of why micro credit is needed is the vendor who borrows 100 rupees in the morning to purchase stock, only to repay the moneylender 101 at the end of the day. One rupee – about $0.02 USD – interest? Not bad, right?

If you do the math, the basic APR on that loan – if it goes unpaid – is 365% per year. Now what do you think?

That’s the reality of life for most low-income vendors – they can’t access bank finance so they have to borrow from friends and family and when that’s not possible, from the local moneylender. That is, until micro credit got started. Now, microfinance institutions will make small loans to those same vendors, except they’ll charge anywhere from 24% up to 90% APR. Expensive? Absolutely. Better than the moneylender? Absolutely.

OK, so microfinance makes sense. And there are more than 200 million microfinance clients around the world. But does it help bring people out of poverty? Banerjee and Duflo have run the numbers, and the short answer is: well, not always. Not even that often.

Huh? Here’s what the authors have to say:

Are there really a billion barefoot entrepreneurs, as the leaders of MFIs and the socially-minded business gurus seem to believe? Or is it just an optical illusion, stemming from a confusion about what we call an “entrepreneur”? There are more than a billion people who run their own farm or business, but most of them do this because they have no other options. Microcredit and other ways to help tiny businesses have an important role to play in the lives of the poor, 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 these businesses can pave the way for a mass exit from poverty.

Specifically:
– The businesses of the poor tend to have few if any employees and very limited assets.
– The businesses run by the poor are also generally unprofitable, which may well explain why giving them a loan to start a new business does not lead to a drastic improvement in their welfare.
– Many business suffer from the “empty shelf” problem: a space a created for a shop, but no inventory fills the shelves. Even a small investment in more inventory will have large marginal returns, but once the shelves are full, the business has no further scope to grow.
– Despite initial large returns to small investments, many small businesses hit at point at which a substantial capital investment is needed in order to continue growing. However, few people are willing to give such large loans to the poor.
– Because of this trap, the poor may not invest as much (both money but also emotions and intellectual energy) into their businesses because they know that their business will always remain too small to make real money.
– (In fact) Creating good jobs could go a long way in increasing the stability of the lives of the poor, which will, in turn give the poor the opportunity and the urge to invest in their children and save more.

This is just one chapter. Read the whole book…it challenges a lot of assumptions and is a really welcome addition to the discussion. I’m already reading Karlan and Appel’s More Than Good Intentions as well, and will report back when I finish…

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About Rob

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5 Responses to Must read: Poor Economics

  1. Minna Katz says:

    I enjoyed reading that,this AM!!
    Since I had read little about the world of micro-economics,I found today’s blog very interesting!!
    I will stay tuned.

  2. Bryan Farris says:

    Thank you sir. I can’t wait to read this book.

    I agree that creating good jobs would be ideal, but unfortunately its not likely to happen any time soon. I’m curious if we can find even cheaper ways to help the poor generate lump sums of cash for asset building purchases.

    • Rob says:

      Completely agreed, Bryan. Jobs…the elusive jobs. There aren’t enough to go around. In the meantime, entrepreneur identification – who is best qualified for a larger loan – vs. microfinance client acquisition is a tough line. No one does it particularly well (that I know of) and if they do, I can’t imagine them doing it within the constraints of the for-profit model. Good question on lump sums…the best I can come up with are institutionalized ROSCAs or cash transfer programs.

  3. Nabeel says:

    Thanks for the post, Robert. I think I’ll have to pick up the book. One false conclusion that I often see in critiques of microfinance is that the businesses are not profitable anyway. But that critique could apply equally well to any form of investing. I think it’s important for micro-lenders to demand proof-of-concept and SOME level of success BEFORE they make the investment. I don’t mean to sound elitist at all,but if I give someone with zero business sense some startup capital, I cannot reasonably expect to get it back. However, if I’m being selective with who or what I invest in (which seems to be perfectly reasonable), there’s no reason why a micro-loan should necessarily fail.

  4. Dad says:

    I think that the first loan is always the hardest to make, since the borrower has no track record. The first loan MUST be closely monitored and MUST be accompanied with mentoring, or else the borrower may have no idea how to make sure that there is a profit. The best success stories I’ve read include “business classes” so the borrower has some concept of how to run and manage their enterprise, no matter how small it seems.

    If the borrower succeeds, then they would be eligible for additional lending, and if they fail on their own, despite the mentoring, they either need additional mentoring or should be passed over should they make another request.

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