Monday, January 10, 2011

The Shortcomings of Microcredit

Don’t get me wrong; I think that microcredit can be a wonderful tool to foster gainful employment and reduce poverty amongst the most financially-marginalized segments of the population. One of the primary financial barriers to poverty-reducing economic development in Second and Third World countries is that credit is only readily available to established business interests and entrenched elites; in countries like Bangladesh where Dr. Muhammad Yunus established the Grameen Bank, microcredit banks have indeed opened up entrepreneurial opportunities to rural peasants, the urban poor and women. And microcredit has not only served as a boon for the poor in Dhaka and Calcutta; microcredit programs have helped financially-marginalized groups to capitalize upon their innate entrepreneurial potential in places as varied as Harlem to rural Arkansas.

However, I’m glad to see that the New York Times is finally reporting that microcredit is something less than the miracle cure for poverty that it’s all too often cracked up to be. Critics of microcredit have long abounded on the ideological antipodes – diehard leftists oppose Dr. Yunus’ movement because it threatens the promise of State Socialism, and paradoxically enough free market purists object to the Grameen Bank’s dependency upon government subsidies. But when such a pillar of mainstream liberalism as The Grey Lady is reporting on the shortfalls of microcredit, now even the material objectivist must acknowledge that - like any other money manager – even some of the most well-meaning bankers to the poor have been been practicing reckless lending policies.

Nevertheless, especially since the popularization of the term microcredit from development circles to lay audiences, most lending institutions throughout the world are keen to at least rhetorically jump on the microcredit bandwagon – and the vast majority of self-described "microcreditors" have significantly less scrupulous lending and management practices than the Grameen Bank.

When most people hear the term microcredit they think of a financial scheme which extends loans to the poor at low, easily-repayable interest rates. However, all that a bank needs to do to call itself a “microcredit institution” in most developing countries is to conduct any banking activity under the broad premise of lending very small amounts of money with the stated intent of reducing poverty. What should separate microcredit from common loan-sharking is that the former species of loans to the poor should be issued at low interest rates. However, what constitutes "low interest rates" is relative. In countries where borrowers tend to pay grossly usurious rates along the lines of 60 percent annual interest, it is not so terribly dishonest for a bank to issue small loans to the poor at only mildly less usurious interest rates – say, 40 percent – and call themselves "microcreditors".

Microcredit can be empowering if a bank extends a loan of $20 to an unemployed Bolivian woman who wants to set up an empanada stand. But microcredit can just as easily refer to a situation in which a bank lends $20 to that same unemployed Bolivian woman to buy a pair of Jimmy Choo knock-offs. Predatory loans come in small sizes too. Particularly in economies where banks do not offer adequate financial products for individuals to save their money for regular consumption, it is fairly common practice for individuals to take out micro-loans for items that have little to no potential to be described as “business investments”.

In Mali, people often take out small loans from the local Kafo Jiginew franchise as Americans pay for our large expenditures on credit cards. One common big-ticket item that rural, property-less farmers will take out loans for is a motorcycle; one would argue that a new gasoline-powered motorbike is necessary to improve the efficiency of his business – he could travel to markets in nearby cities to sell their goats and chickens more quickly. Under such fairly valid-sounding proposals, the loan officer would lend them $600 to $700 for the cheapest bike on the market. But the economic reality is that the real value of a motorcycle in a proto-commercial agricultural economy is not derived from any profit that could be measured in dollars and cents. The total benefit of this microcredit-financed endeavor is more or less the sum of the value of time saved and the sheer prestige of driving around the village in a motorcycle – neither of which is going to help him sell any more chickens. Now, the farmer’s financial standing is even more precarious as he has to pay for gasoline for his bike and interest on his loan with more free time but no additional monetary income to show for it. From capital’s self-interested perspective this loan might have been a pretty shoddy investment decision – yet a bank like Kafo Jiginew has every right to classify such reckless lending as “microcredit”.

Compared to other endeavors for which banks issue micro-loans, a motorcycle is sadly a relatively sound investment. It’s somewhat less common for microfinance institutions to give small loans of a few hundred dollars to people who wish to buy cell phones and computers for their business operations which are used more often for listening to mp3s and downloading porn than they are for any profit-increasing business communications. Other times men would take out small loans of $10 or $20 to bet on the horses in France – consider it micro-leverage for investment on the commodities market. It is even more common for people in countries with underdeveloped financial institutions to take out exorbitant loans for things as frivolous as televisions, alcohol and cigarettes. If you think that subprime lending is a phenomenon exclusive to the U.S. real estate market, then you are sorely mistaken.

Economies predicated upon agriculture are particularly sensitive to predatory lending practices because the brief period after the harvest is typically the only time that peasant farmers ever stand to receive any monetary income. In the least-developed, poorest of the poor agricultural economies like parched Niger and Mauritania, the single millet harvests only come after the year’s brief, single rainy season; in significantly more prosperous and developed agricultural economies like Ghana and Tanzania, there might be enough rainfall for two long growing seasons so farmers’ revenues come in twice a year. When an economy based on rain-irrigated agriculture faces a drought, every single farmer might need to take out a loan in order to feed his family. However, loans taken out to finance pure consumption are not likely to ever be repaid – especially in a subsistence agricultural economy in which food is rarely sold on the market in exchange for currency. With so much demand for credit, interest rates rightfully go way up. The politically incorrect truth is that there is a rational reason why interest rates in these credit markets are generally so high: in developing, stagnant and regressing agrarian economies alike, the rural poor are not very creditworthy.

But the world’s poor still need to be able to obtain capital without resorting to debt slavery if they are ever to improve their lot. The advent of Grameen-style microcredit is without a doubt a step in the right direction as it popularizes and democratizes lending, but it is also no panacea to the ills of the various financial sectors of the developing world. So what then should the doe-eyed idealists of Davos, Wall Street and Cambridge do if they sincerely wish to rid the world of poverty?

The harsh reality is that aside from conducting checkbook activism on Kiva, there are not a whole lot of options available for private good-doers to extend affordable credit to small entrepreneurs in the Hindu Kush. The opportunities to improve the lending practices of the Global South lie for the most part at the feet of the banking and government elite who reside in the gated communities of these countries’ capitols – in so many words, the very individuals who have the most vested interest in the status quo and not a whole lot of desire to expand credit to the masses who live in shantytowns and mud huts. Western development agents and business consultants might have a role to play in reforming the financial sectors of foreign nation, but only insomuch as we can educate and persuade these elites to implement change in their respective institutions.

Bankers in countries like Guinea and the Ivory Coast tend to practice such egregious usury partly because they make a disproportionate amount of loans to their friends and family-members. In many African cultures it is considered the social obligation of anyone with money to share it with anyone and everyone who might ask for a handout; not only for the haves to lend money to the have-nots, but for the haves to simply give it away – people who keep all of their money to themselves are often shunned and isolated from the rest of the village. Judging by the rate at which credit applicants actually get denied, it would be fair to say that such communitarian social mores are expressed in the decisions of loan officers who simply can’t say no to their blood relatives no matter what sort of lavish status symbols they plan on buying on credit. Not surprisingly, a sizeable portion of these terrible loans never get amortized, so banks do have to charge high interest rates on all of their loans – large and small – simply in order to stay in business. In order to stem the worst of the worst lending decisions and make credit more accessible, banks need to crack down on crony capitalism by introducing stricter standards of professional ethics, increasing transparency in their lending practices and holding loan officers accountable when they issue such egregious loans.

Another one of the reasons why interest rates remain so daunting to would-be entrepreneurs in the Global South is that so many of the microloans issued by banks go to finance not just business investments but also consumption goods that cannot lead to direct financial returns. According to free market ideals people should be able to spend and consume as they want to without having to go into debt, but banks have to start offering modern financial products in order for that ideal to become a reality. Microcredit is only part of the equation; what the world’s poor need even more desperately is some form of microsavings. In many of the countries where microcredit is needed there simply are no financial products which reward small account holders for saving; in these markets, people have to pay the bank exorbitant fees simply in order to keep an account open and thus saving money in a bank account is a losing endeavor for all but the super-rich. If the yeoman farmers and proletarians of the world could stow their money away in bank accounts which reward savers with interest instead of vice versa, they would be able to pay for things like emergency health care without having to resort to the crushing debt which crowds out the market and stifles entrepreneurship. Microsavings is even more necessary for the rural peasants and urban poor of the world to accumulate their own capital to start a small business independent of the whims of any bank – a phenomenon which could foster the strengthening of bourgeoisies and middle classes in societies dangerously stratified between the tiny financial elites and the sprawling, starving masses.

In order to obviate the absolute most predatory sort of micro-lending, quasi-modern banks also need to take a step backward in order to go forward by creating new financial services which cater to those borrowers whose means of production remains defined by pre-capitalist subsistence agriculture. In particular, banks which issue microcredit and microsavings accounts to the poor need to establish cereal banking divisions which allow small farmers to deposit their surplus in years of good harvests and to withdraw a few sacks of millet, rice or corn to feed their families in years of drought and blight. Chauvinists of Western capitalism might be inclined to pooh-pooh cereal banking as a philanthropic sideshow, but those who think that the archaic proto-commercial economy has nothing to do with the shortage of affordable credit in the relatively modern money market are profoundly mistaken. When there is a drought which threatens the subsistence farming population with starvation, everybody wants to take out loans from the bank to pay for basic foodstuffs – loans which most likely will never be repaid by people who have no source of monetary income – and so interest rates skyrocket for everyone. The expansion and development of cereal banking can serve to reduce the risk of all participants in the money market and should drive down interest rates for all borrowers – including those who wish to take out a loan to start a new cash business.

The impoverished masses of the underdeveloped world are also shut out from affordable credit largely because in most of these countries where they live the law does not recognize any titles or deeds to the one thing they have: the land they live on. As a result, peasant farmers and urban slum-dwellers have no de jure property they can use as collateral to help them receive a favorable loan. Developing countries should heed the advice of Peruvian economist Hernando de Soto and overhaul their property laws to codify the de facto land property of the credit-needy poor so that they can collateralize what little they do have. Champions of traditionalism and leftists opposed to private property in general howl at what they perceive as the injustice of such unabashed Neoliberalism and Western imperialism – but I dare de Soto’s detractors to come up with a better way of addressing the basic causality between land that cannot be collateralized and the paucity of affordable credit. If the humanitarians of the world are so genuinely concerned about predatory lending, they should applaud the efforts of the World Bank, USAID and the like when they push such property-livening legal reforms which could serve to reduce the incentive for banks to charge such usurious interest rates in the first place.

Microcredit has warts just like any other financial product, but the shortcomings of this strategy to foster economic growth and poverty reduction do not mean that it must be discarded to the ash heap of history. Indeed, much of the Global South’s economic ills could be abated if their respective banks were to simply begin genuine microfinance programs which emulate the Grameen Bank’s commitment to issuing loans at low, affordable interest rates strictly for the purpose of business development. Yet the expansion of real microcredit is only a partial reform of economic systems which fail the bottom billion of the world's poor; if these countries are ever going to fix their credit markets in a way that systematically reduces let alone eliminates poverty, their bankers, borrowers and legislators are going to have to comprehensively reform their financial practices.

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