It may be one of the most tragic stories in economics: the rise and fall of microcredit.
The concept — reducing poverty in impoverished countries by giving very small loans to people without collateral — was once the most promising innovation in development economics. But after its inception in the early 1980s and its subsequent explosion in the following decades, one thing was missing: results.
Today, microcredit is an intellectually deflated balloon. Years after the concept was introduced to poor communities in more than 75 countries, the data is mixed at best on whether it actually worked. Many of the people in Bangladesh, where the concept originated in the mid-1970s under the hands of Nobel laureate Muhammad Yunus, still face extreme poverty. The death knell might have been the Indian state of Andhra Pradesh, where a booming microfinance market turned to crisis in 2011 as borrowers began to stop paying off their loans in protest of high interest rates.
But that doesn’t mean microcredit is dead — or even discredited. The problem is that microcredit was saddled with unreasonably high expectations, and we lost a sense of its more modest potential.
Timothy Ogden, managing director of the Financial Access Initiative at New York University, makes this point clear in a compelling and nuanced paper published this month that reviews a group of impact studies on microcredit released in the spring of 2015. For Ogden, the lesson of the past few decades in microlending is that we’ve become swept up in a fantasy about what it could accomplish.
“It’s such a compelling story that we want to believe,” Ogden said in a phone interview. “‘All that’s holding these people back is opportunity, and if we do just this little thing, the world gets better.’”
Any notion that microcredit has potential to fuel sustained economic growth is misplaced. Credit and investment alone don’t drive economic growth in the long run — these are just tools in a broader development toolbox. Just about any economist would agree that the true driver of growth is innovation, which is difficult to capture simply through financial means.
Microcredit institutions are able to survive because they charge high interest rates on their loans — as high as 25 or even 100 percent a year — to cover the high costs of administering many of tiny loans. But they’re also able to protect themselves from the risk of default through group lending — where a group of people take out loans together and use peer pressure to keep payments up — and other financial techniques, like guaranteed loans or even subsidies.
For an average microcredit borrower, this means quick money that can be used to purchase essential resources such as a chicken or a cow, but it doesn’t necessarily mean investing in businesses that could lead to sustained income growth. The impact studies Ogden reviewed do show, however, that borrowers benefiting the most from small loans were people who had already started a business prior to receiving access to more credit. This makes sense: Borrowers who have already invested in starting their own enterprise have goals in place for how they want to expand their business.
This is an important lesson for microcredit: Not everyone is an entrepreneur. Just because someone is likely to pay back a loan doesn’t necessarily mean that he or she is a good target for credit. Instead, as Ogden argues, microlenders need to revamp their work for better impact, changing who they target and experimenting with different loan designs. In fact, this is high time for social investors to put more resources into microlenders to make those experiments possible.
The optimism is encouraging, but the question still lingers: Why were we misled by microcredit in the first place? How did turn it into a false silver bullet?
It’s possible that microcredit became so popular simply because it offered a free-market approach to solving problems that avoided government intervention.
“There was something about the political zeitgeist of the ’80s,” Ogden said. “ ‘Just free people up. The free market will work. The problem is that these people have been shut out of these markets.’ That message appealed to the free-market ideologues and also appealed to the dignity-for-the-poor advocates on the left.”
Microcredit became a grand solution that was destined to disappoint. Political ideology got in the way of true political science — an unfortunately common phenomenon.
Still, nuance in the data points to hope that microcredit has a place yet in development economics. Paired with other development tools that economists are raving about — such as giving grants directly to impoverished communities — microlending can offer a sustainable investment option for small entrepreneurs, leading to a renewal in its mission to fight extreme poverty.