More than Good Intentions

Chapter 4 - To Borrow: Why the Taxi Driver Didn't Take a Loan

People don't borrow money even when they say they'd like to. Muhammad Yunus, a Bangladeshi professor, found that lending small amounts to the poor (microcredit) really helped them establish enterprises and improve their lives. His Grameen Bank received the 2006 Nobel Peace Prize for starting this trend, but what does the evidence say about the benefits of microcredit? Microcredit institutions, as opposed to local moneylenders, typically offer general products that do not necessarily match the needs of microentrepreneurs who don't want to have money lying around. So despite the availability of microcredit, money lenders demanding high interest rates are still in demand.

A study shows in fact that payday loans in the United States helped low-income (yet employed and hence relatively safe) debtors by providing them with a cushion to maintain their jobs and by extension their incomes in face of unexpected adversity such as necessary spending on vehicle maintenance or family care. This finding challenges the popular framing of moneylending as a more exploitative form of microcredit. Note however that this study hinged on borrowers having an income. There are indeed risky borrowers who will not be able to repay their loans so the question revolves around the money-generating power of the borrower. Microcredit as opposed to moneylending typically targets microentrepreneurs, people pursuing profits, so lending to them depends on the viability of their businesses.

Another study shows that indeed when these microentrepreneurs receive extra capital, their monthly profits increase by 6% of the grant amount on average. This is a fantastic return that might justify the high interest rates on microloans. But of course, the 6% returns were an average, meaning some entrepreneurs lost and others gained as is the nature of life. More educated entrepreneurs ran more profitable businesses but the study sample was too small so the evidence is rather weak. Also, women surprisingly ran less profitable businesses than men. Another study in the Philippines showed the same gender disparity but it also revealed differences between wealthier and poorer borrowers (wealthier borrowers fared better) and, most strikingly, it showed that the most profitable businesses in the study sample did not increase their revenues but instead reduced their costs by shrinking their operations and laying people off. It wasn't great news but it was telling.[1]

Enter another study that tested the usefulness of microcredit started from scratch in communities without such institutions. This took place in Hyderabad, India, and very few people took on loans. Among those who did, microenterprise spending was only part of the story, again, as many people also used one loan to pay off another. The researchers looked more carefully at how these loans worked for different types of people, what economists call heterogeneous treatment effects. They found that people with a stronger entrepreneurial bent (that is, literate people of working-age with some security like land or a paying job, "actual entrepreneurs"), funneled the money into their businesses. But on average the study showed no results because "unlikely entrepreneurs" splurged on temptation goods. It's also worth noting that a middle category of "likely entrepreneurs" used the money to purchase durable goods that could be used in an enterprise. So they were setting up.

All in all, microcredit works for some people and not for others. It's a tool for poverty reduction, but it's not the only one.

Chapter 5 - To Pursue Happiness: Having Better Things to Do

The microlenders discussed so far require that borrowers spend the money they borrow only on business expenses, but is this requirement helpful? What do people normally do with the money they borrow? Would they rather spend it on leisure, or would they neither borrow nor pursue entrepreneurial endeavors?

Muhammad Yunus suggests that the poor are capable and not lacking in entrepreneurial skill as evidenced by their very survival. But evidence from the study on "bents" above suggests that not all borrowers stand to make good money from the loans they take. Several more recent randomized control trials tested this very idea: whether business training helps microentrepreneurs. If poor entrepreneurs have nothing to learn, then the training programs should not yield any results. But indeed studies conducted in Mexico, Peru, and the Dominican Republic did yield results, highlighting that training does improve business practices among participants and hence profits.

The question of what a poor person does with the money they borrow still looms large, however. Necessities often prevent indebted people from closing their credit balances. One interest-bearing loan might well be used to pay down a prior loan bearing a higher interest rate, but it might also be split up to cover other necessary expenses. The poor have to weigh their opportunity costs and, lacking many essentials, closing prior loans will not always top their lists.

Some lenders restrict spending categories, but asking people where they spend their money will probably not yield truthful results. One creative survey method allows researchers to probe the proportion of survey respondents who spend on categories prohibited by the lender. It involves comparing the ratio of positive to total responses in two lists that are identical except that one list has a few additional items that people are expected to lie about. Such lists protect respondents and, when delivered randomly to different respondents, yield the true response rate on the group of sensitive questions. Studies that employ this method reveal that many microenterprise borrowers pay lip service to lenders while not necessarily spending money on business expenses.

Money is slippery. Just as water trickles first into the deepest holes, money is used first where it is needed or wanted the most. Restricting borrowers' spending is thus most likely to end in vain.

Chapter 6 - To Cooperate in Groups: What About the Weakness of the Crowd

The thousands of microlenders that set up shop following Mohamad Yunus's Grameen Bank model largely operated on a group lending model. Money would be lent out to groups, leveraging the borrowers' knowledge in the absence of formal legal mechanisms and information networks. This meant bad borrowers in a group would harm good borrowers. Was this efficient? It certainly made the lenders' work more viable, simplifying the debt collection process and passing the burden of screening onto borrowers who had social networks brimming with information and social currency to maintain. Social programs could also be delivered to these borrower groups who were gathered to borrow anyway. But was there a better approach?

Small-time borrowers would be incentivized to take larger loans if their loan is relatively small compared to others in their group. And although the lender saves time by meeting with many borrowers simultaneously, the borrowers' time is wasted since they could have paid more quickly if it were just them and the lender. Most importantly, however, good borrowers have to cover for bad ones so they leave the group as soon as they can. The Grameen Bank realized this and revamped its operation, naming it Grameen II, while ensuring that individuals still enjoyed the social support of other borrowers and lenders still enjoyed the operational benefits of group lending. It worked in Bangladesh but would it work elsewhere?

A study with Green Bank in the Philippines tested this very difference between individual and group lending. It found that individual-liability loans did not feature significantly higher default rates, although they required more careful tracking by the bank. Individual-liability loans also increased as people invited close friends and family, no longer fearful that a shared debt burden would get in the way of relationships.

Borrowers in developed countries have countless ways to borrow and for good reason. It makes sense therefore to broaden the range of loan products when testing what might help reduce poverty, but it would also be good to better understand group dynamics.

A study with Peru's FINCA microlender showed that trustworthy players (as identified in a game that reveals trustworthiness) were more likely to do good on their loans than profit maximizers. An earlier study also showed that the more culturally coherent a group is, the more likely its members are to make timely payments and to remain in the borrowing group even if they had missed some payments. Yet another study tests whether the routine meetings that borrowers attend--in part to make payments, but also to just chat and develop a relationship to promote healthy borrowing habits--are at the right frequency. Can groups operate better on different payment timelines? A study in Kolkata, India, proves yes. Borrowing groups that met weekly were more likely to have fostered trustworthiness (measured using another creative game) and to have met payments on their loans than groups that met monthly.

Microcredit is just one cog in the wheel of microfinance. Besides savings which we'll look at next, the simple yet crucial development that is yet to happen is the speeding up of everyday transactions.

Chapter 7 - To Save: The Unfun Option

Chapter 7 casts Vijaya, a flower merchant in Chennai, India, as the entrepreneurial protagonist who faces a savings dilemma. She works her business and generates a profit healthy enough to maintain the subsequent profits of a microfinance institution. Vijaya needs the loans not only to operate her business but also to pay household bills and send her kids to school. She could save a dollar a month and rid herself of her lender in twenty weeks. But why do Vijaya and countless others in India and elsewhere find themselves shackled by these rotating payments when they could potentially pay them off? The answer is in the premise. Saving is procrastination's first target. It's boring and it requires discipline[2]. Communities have long recognized the difficulty of saving and so savings groups like ROSCAs and fee-based deposit accounts are popular around the world. There is thus space for formal savings institutions to support entrepreneurs who lack access to alternative savings mechanisms.

Pascaline Dupas and Jonathan Robinson and UCLA and UCSC carried out an experiment to study these dynamics and found that, when providing people in rural Kenya with deposit accounts that demand fees upon withdrawal, people who already had informal savings were eager to sign up, and those who did sign up fared better when faced with illness by resorting to their savings rather than eating into their business capital, working fewer hours, or selling their goods. But was this generalizable?

Studies were ongoing [at the time of publication] in efforts to replicate similar experiments in different contexts. One study asks whether poor individuals have enough disposable income to save anyway. Perhaps the issue is not in overcoming behavioral challenges to savings. Dean and coauthors ran an experiment with Green Bank clients in the Philippines to test this idea. They found that people opted into "commitment savings" contracts (which ban withdrawal altogether, like imposing infinite fees, until a preset goal is reached) and saw their savings deposits soar despite their low incomes. So poverty did not hinder savings. It was all behavioral. In fact, even in relatively wealthy communities, behavioral barriers to positive actions like saving hold people back.

Richard Thaler and Shlomo Benartzi tested this behavioral hypothesis in the retirement savings industry in the United States and found results so convincing that US retirement fund managers now provide behavioral nudges to encourage positive behavior by reducing the costs of beneficial actions. People today can opt into such nudges in the pursuit of just about anything using a website called StickK.com (developed by a team under Dean Karlan's leadership) which allows users to tie money to their goals whether they are trying to cut bad habits or start good ones.

And, finally, perhaps commitment nudges such as these were too strong. Perhaps one need not lose money to start engaging in healthy behavior. Experiments conducted in Bolivia, Peru, the Philippines, and the United States proved that simply reminding people to save or rephrasing retirement terminology using less jargon increases people's likelihood to save. Such lazy and irrational creatures we are.

Poor Economics (a separate book)

Regarding business and the futility of microfinance, Abhijit Banerjee and Esther Duflo argue in Poor Economics that the size of the loans and the nature of businesses run by poor people make it so that in absolute terms, profits are meager. The businesses they operate and by extension their profits are too small. What is appealing is that their marginal profits are high which is why microfinance works for many of them. They generate enough profits not only to survive but to pay off interest as well. With high profit margins, any capital injections should be helpful, but managers don't find it worthwhile because finance is not the main barrier to business expansion. Growth potentials are dire for their typically undifferentiated products or services that also generally do not require high-skilled labor. Entrepreneurship is difficult and they are stuck staying small. Even business training has proven fruitless in general.

For many of these people, starting a business is usually the only option available and stable jobs in government or elsewhere are more attractive. A stable job implies a stable income and more comfortably supports long-term planning and goal-setting. Employed people with stable incomes can also more easily secure loans and school admissions for kids. But good jobs generally require moving to the city, so the question is also related to migration policies and urbanization which unfolds a whole host of questions regarding social security and traditional rural social structure. More socialist governments such as those of China and Korea have such policies involving government subsidies built into their institutions. Good jobs rather than microenterprise might be the more reasonable large-scale solution to poverty around the world.

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[1] Is there an institutional story here regarding the ease of filing bankruptcy and the oiling of Schumpeter's process of creative destruction? How do poor entrepreneurs handle bankruptcy in other countries?

[2] See Freaks of Fortune by Jonathan Levy (my summary here) for related debates on whether newly emancipated slaves in Postbellum America would utilize savings accounts.