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Thirty years ago, the international development community was abuzz with excitement. The perfect solution to poverty in developing countries appeared to have been found: microcredit. According to prominent proponents like Grameen Bank founder Dr. Muhammad Yunus, microcredit would enable the global poor to escape their poverty by starting an income-generating activity. Encouraged by Yunus, the U.S. government and international development agencies, many developing countries began to establish their own microcredit institutions along Grameen Bank lines.

Thanks to a U.S.-led push to deregulate and commercialize the model in the 1990s, profit-motivated microfinance institutions (MFIs) were soon pumping out massive volumes of microcredit. By the early 2000s, in a growing number of countries, every poor person who wished to access a microloan could pretty easily do so. Many were certain that, thanks to Yunus’ bold idea, the world would soon witness an historically unparalleled episode of poverty reduction.

But Yunus was wrong.

While seemingly brilliant in its simplicity, scope and humanity – who could resist supporting the poor as they bravely attempt to make their own way out of poverty! – Yunus’ microcredit model was actually based on a fundamental misunderstanding of basic economic principles.

For a start, he failed to appreciate that the over-arching problem in poor communities is not a limited supply of necessary goods and services – even the poorest communities generally have enough grocery stores, personal transport suppliers and so on – but the spending power to access these items. Yunus had made a famous mistake in economics, believing that supply would create its own demand. So his microcredit model addresses the wrong side of the poverty problem: it helps to create more largely unnecessary local suppliers of the simple goods and services consumed by the poor, but provides no additional source of income with which to actually purchase this expanded supply.

This is why in developing countries, and lately in developed countries too, we find that new microcredit-supported microenterprises do not attract very many new unattached clients, but overwhelmingly end up taking away clients already attached to other informal microenterprises already operating in the same sector. And cramming more and more new microenterprises into poor communities leads to hyper-competition, which tends to soften prices. So already struggling microenterprises see a progressive reduction in their turnover, profits and wages – that is, they are made poorer. (However, middle class consumers often do very well from the availability of cheaper goods and services, thus typically exacerbating inequality).

Informal microenterprises also experience a very high rate of failure everywhere in the world. In order to repay a microloan taken out for a failed micro-business venture, many individuals are forced to deplete family savings, divert remittance flows, and finally sell off family land and other household assets. A failed microenterprise thus often leaves a very large number of individuals in deeper poverty and insecurity than before.

Benefiting the wealthy at the expense of the poor

This combination of factors helps to explain why microcredit programs generally create no net additional employment or income, and so do not make any net positive impact on poverty. In fact, such market-driven dynamics actually help to undermine the gradual development and growth of the local economy. Moreover, with so few local market opportunities, it’s not surprising that the poor increasingly choose to access microcredit simply to underpin needed consumption spending. This may avert a household crisis in the short term, but the long-term consequences of this strategy are quite frightening.

Consider South Africa’s experience after 1994, when the poor black majority was greatly encouraged to get into microcredit-supported informal microenterprise activity to finally resolve their apartheid-era poverty and unemployment. This encouragement came in spite of the abundant evidence that most poor black townships and rural communities were already pretty well supplied with the simple goods and services linked to informal microenterprises. There was thus little, if any, real market space for many more informal microenterprises, resulting in a reduction in self-employment incomes overall, which actually fell by a staggering 11 percent per year in real terms from 1997-2003. Poverty was thus intensified in the poorest black townships and communities in South Africa, with the pain simply redistributed among the now larger population of informal black micro-entrepreneurs.

Meanwhile, rather embarrassingly, the rich white community actually benefitted from the increased availability of cheaper goods and services. Moreover, when the black community began to realize that microcredit was not the solution to their employment and income needs, they started using it simply as a way of quickly raising their living standards. Massive quantities of microcredit were soon being accessed in order to secure the things immediately needed for survival which couldn’t be covered out of current income. The end result has been an unimaginable individual indebtedness problem that now seriously threatens the stability of the country.

Longer-run sustainable development is decisively stymied

An even more important issue that Yunus and his followers failed to grasp relates to the longer-run development of the local economy. Formal, “minimum efficient scale” and potentially innovative businesses are widely recognized as the most powerful forces behind productivity growth, poverty reduction and sustainable development – far more important than informal microenterprises and self-employment ventures. Notwithstanding, developing countries are increasingly channeling their scarce domestic financial resources, as well as international aid and investment, into unproductive informal microenterprises – diverting it from other, more productive and sustainable enterprise development activities. For instance, Africa has more micro-entrepreneurs, informal microenterprises and self-employment ventures per capita than anywhere else in the world. This massive proliferation of petty individual entrepreneurship (and the associated diversion of scarce financial resources, technical expertise and state/collective effort), is a huge part of what’s holding the region back. Similar situations have arisen from Latin America to Asia, wherever microcredit has inflated the already hyper-competitive informal sector at the expense of more efficient enterprise structures. This is undermining the far more productive formal business sector, which finds itself consistently undersold by informal competitors that pay subsistence wages, routinely evade taxes, and are willing to operate with woefully sub-standard health and safety conditions.

Consider also the iconic village in Bangladesh where Yunus actually pioneered his microcredit model – Jobra – and which today is just as poor and under-developed as it was in the 1970s. Individual success stories notwithstanding, microcredit has had no cumulative positive development impact there. Worse, the arrival of massive volumes of microcredit over the years has led to a very serious problem of individual over-indebtedness, fraying the bonds of local trust and cohesion and inflicting new forms of suffering on the poor. For example, an increasing number of the men in Jobra are now forced to undertake sporadic day-laboring jobs in nearby Dhaka and Chittagong simply to repay the installments on microloans that, in almost all cases, have not led to successful income-generating activities.

Commercialization has opened the door to massive abuse of the poor

Unfortunately, rather than leading to a higher phase of development as promised by its leading advocates, the commercialization and deregulation of the microcredit industry in the 1990s precipitated an even greater calamity for the world’s poor. In countries from Bosnia to India, senior MFI managers and shareholders have become spectacularly rich, leaving over-indebted (and already poor) customers to pick up the tab. And in countries from Nicaragua to Morocco, the unstable market-driven dynamics given birth by microcredit have led to destructive ‘boom-to-bust’ episodes that have damaged their economies and frayed their social fabric. At times, they’ve exacted an even harsher toll, as in the notorious tragedy in the Indian state of Andhra Pradesh, where hundreds of suicides in late 2010 were linked to extreme over-indebtedness and the high-pressure collection techniques of MFIs like SKS Microfinance. Crucially, once again, in none of these countries is there any solid evidence that poverty has been reduced as a result of the massive expansion in the supply of microcredit.

Yunus promised the world — and especially the poor — that microcredit would usher in an historic episode of poverty reduction and sustainable bottom-up development. What transpired instead was a poverty trap. The sooner we begin to accept this sour reality, the sooner we can begin to think about alternative financial models and institutions that actually help the poor.

Milford Bateman is a freelance consultant on local economic development and, since 2005, Visiting Professor of Economics at Juraj Dobrila Pula University in Croatia.

Editor’s Note: This working paper from Milford Bateman lays out a more comprehensive version of his case against microfinance, including supporting materials.