The idea has a wonderfully simple and powerful appeal: Give a tiny loan to a poor person in a poor nation. Watch her start a small business — whether hawking tomatoes or fattening goats — that puts her and her family on the first rung of a ladder that will elevate them out of poverty and into the middle class. Repeat across the planet.

Few proposals for economic development have been so durable and so celebrated as microcredit — the provision of business loans as small as $100 to the poor. Its appeal has spanned the political spectrum, drawing in the left with its subversive promise to empower women in sexist societies and enticing the right with its emphasis on entrepreneurship and individual responsibility. The World Bank and other lending agencies have bought into it, as have foundations and countless individual donors. In 2006, microcredit became the only economic development idea to win a Nobel Peace Prize, when the laurel went to Muhammad Yunus and Grameen Bank, the financial institution for the poor that he founded in Bangladesh.

There has been enough time and evidence now to explore the full impact of microcredit in depth, and, set against its vaunted reputation, my verdict is dour: Microcredit rarely transforms lives. Some people do better after getting a small business loan, while some do worse — but very few climb into the middle class. It’s a constructive endeavor, but it has been vastly overhyped. And the hype has undermined the good that the movement can achieve.

One reason microcredit has soared so high in public esteem is the power of the stories its promoters tell. In his memoir, Yunus tells of Murshida, a Bangladeshi woman whose husband regularly beat her. One day after he sold the roof of their hut to pay gambling debts, a storm soaked Murshida and her three children. When her husband came home, Murshida confronted him. He divorced her on the spot and threw her and the children out of the house. Murshida moved in with her brother and in time took her first microloan — $30 to buy a goat and sell the milk. With larger credits, she started a business sewing and selling scarves. Eventually she employed 25 women.

Such anecdotes are powerful. But that does not make them representative. Poor people who take loans use them in different ways and with different outcomes. By luck or by pluck, some do well, and it is their stories, of course, that microcredit promoters have most often recounted.

To be fair, microcredit has had more than selective storytelling on its side. Dozens of academic studies in the 1980s and 1990s seemed to validate the anecdotal evidence. Researchers typically surveyed hundreds of families and looked for patterns in the data. Perhaps families that had used microcredit also reported higher earnings, for example. The premier analysis was funded by the World Bank and appeared in the prestigious Journal of Political Economy in 1998; through complex statistical methods, it found that microcredit cut poverty in Bangladesh, especially when women received the loans. One of the researchers later estimated that 5 percent of Grameen Bank borrowers climbed out of poverty each year.

But most such studies had a significant problem: If some households with higher borrowing also display higher earnings, can we really know which is causing which? Does credit make households less poor, or does being less poor make them more apt to borrow money in the first place?

In recent years, a new generation of development economists has addressed this problem by experimenting with microcredit programs, randomly offering loans to some people and not others. Just as in the best drug trials, this has allowed researchers to measure cause and effect more precisely. If, one year later, those who received loans earned more or enrolled more of their girls in school, what factor other than the loans could explain those happy outcomes?

The first randomized studies of microcredit appeared in 2009. MIT economists found that in the slums of the megalopolis of Hyderabad, India, small loans caused more families to start micro-
businesses such as sewing saris. Existing businesses saw higher profits. But over the 12 to 18 months the researchers tracked, the data revealed no change in bottom-line indicators of poverty, such as household spending and whether children were attending school. Perhaps those who made more from their own businesses earned less in wages outside the home. A study in Manila by American economists Dean Karlan and Jonathan Zinman also found no effect on poverty for families one to two years after they received a loan.

On the heels of such studies came more bad news. Microcredit bubbles began to reveal themselves as financial bubbles do — by popping, in places such as Nicaragua, Bosnia, Morocco and Pakistan. In Bosnia, for instance, the microloans outstanding shot from $275 million in 2005 to $1 billion in 2008, before slumping to $830 million in 2009 on defaults and write-offs.

In 2010, amid reports of suicide among overindebted borrowers, the government of the Indian state of Andhra Pradesh ambushed the microcredit industry there with a harsh law that all but shut it down. Microlenders must now register with the governments of the districts in which they operate and must seek approval for each loan. This puts much power in the hands of local officials, who in some cases are known for their aptitude in converting such leverage into delays and graft.

I believe that Andhra Pradesh overreacted in quashing rather than reforming the industry. But in talking to borrowers there in late 2010, it became clear to me that, even if the state was overreacting, it was doing so in response to a real problem. The proliferation of fast-
growing microlenders had made it easy for poor men and women to get in over their heads in hundreds of dollars of debt. Not all were wise enough to avoid the trap.

These bubbles may be the first in history fed more by charity than by greed. Almost all the large-scale financing for microcredit has come from private donors, socially minded investors, public aid agencies and, in India, private banks complying with legal quotas for lending to the poor and minorities. Ironically, almost all were motivated by the idea that microcredit was a sure-fire aid to the poor.

The zeal for microcredit may have undermined the power of the larger microfinance movement, which involves the creation of financial services, beyond just loans, that are available to the poor. Financial services are like clean water and electricity — they are essential to leading a better life. Imagine if you didn’t have access to bank accounts, insurance or mortgages. Poor people need such services more than anyone, because in developing countries, poverty does not just mean low income, it means volatile income. The poor need to set aside money in times of plenty and draw it out in lean times. Financial services allow you to save for wedding expenses, borrow for funeral costs or insure for health care.

The industry should move away from its long-standing focus on credit, and experience shows that it can. Mature microfinance institutions in Indonesia, Bangladesh and Bolivia are doing at least as much deposit-taking as loan-making — good news for the poor, since it is much harder to get in trouble by saving too much than by borrowing too much. In Mexico, Compartamos Banco offers life insurance along with its loans and ranks among the country’s largest life insurers. And in Kenya, the mobile-phone-based money-transfer system M-Pesa now does more transactions then Western Union.

But the funding flows into microfinance are, if anything, impeding such initiatives by heavily favoring credit. According to the Consultative Group to Assist the Poor, public and private investors — including social investors seeking to do good while doing well — committed a record $3.6 billion to the microfinance industry in 2010, with 86 percentdevoted to financing microloans. One wonders when the next bubble will pop.

The best approach is not to pour more money into microlending. It is to put less in — and target it for start-up investments and training that can build durable financial institutions that deliver a variety of services to the poor. This approach would cut the costs of microfinance for donors while increasing the benefits. It might not transform the lives of the poor, but it would improve them.

David Roodman is a senior fellow at the Center for Global Development and the author of “Due Diligence: An Impertinent Inquiry into Microfinance.” Follow him on Twitter: @davidroodman.

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