NextBillion - An Initiative of the William Davidson Institute at the University of Michigan

Wednesday, June 6, 2007

To understand why creating jobs, not offering microcredit, is the better solution to alleviating poverty, consider these two alternative scenarios: (1) A microfinancier lends $200 to each of 500 women so that each can buy a sewing machine and set up her own sewing microenterprise, or (2) a traditional financier lends $100,000 to one savvy entrepreneur and helps her set up a garment manufacturing business that employs 500 people. In the first case, the women must make enough money to pay off their usually high-interest loans while competing with each other in exactly the same market niche. Meanwhile the garment manufacturing business can exploit economies of scale and use modern manufacturing processes and organizational techniques to enrich not only its owners, but also its workers. Microcredit is the newest silver bullet for alleviating poverty. Wealthy philanthropists such as financier George Soros and eBay co-founder Pierre Omidyar are pledging hundreds of millions of dollars to the microcredit movement. Global commercial banks, such as Citigroup Inc. and Deutsche Bank AG, are establishing microfinance funds. Even people with just a few dollars to spare are going to microcredit Web sites and, with a click of the mouse, lending money to rice farmers in Ecuador and auto mechanics in Togo.

Wealthy philanthropists, banks, and online donors aren?t the only ones fascinated with microcredit. The United Nations designated 2005 as the International Year of Microcredit, explaining on its Web site that microentrepreneurs can use their small loans to ?grow thriving business and, in turn, provide for their families, leading to strong and flourishing local economies.? The Nobel Committee awarded the 2006 Nobel Peace Prize to Muhammad Yunus and Grameen Bank, declaring that microcredit is ?an ever more important instrument in the fight against poverty.?

All this enthusiasm for microcredit has attracted untold billions of dollars.1 Grameen Bank alone disbursed $4 billion in microloans over the last 10 years, and it now has 7 million borrowers in Bangladesh. In India, about 1,000 microcredit organizations and 300 commercial banks lent $1.3 billion to 17.5 million people in 2006, says Sanjay Sinha, managing director of Micro-Credit Ratings International in India.2 Worldwide, 3,133 microcredit institutions provided loans to 113.3 million clients, finds the State of the Microcredit Summit Campaign Report 2006.3

This fervor suggests that microcredit really must help the poor. And many have made grand claims to this effect, including Yunus, who said, ?We will make Bangladesh free from poverty by 2030.?4 Somewhat less ambitiously, the State of the Microcredit Summit Campaign Report 2006 states that ?microcredit is one of the most powerful tools to address global poverty.?

Yet my analysis of the macroeconomic data suggests that although microcredit yields some noneconomic benefits, it does not significantly alleviate poverty. Indeed, in some instances microcredit makes life at the bottom of the pyramid worse. Contrary to the hype about microcredit, the best way to eradicate poverty is to create jobs and to increase worker productivity.

To understand why creating jobs, not offering microcredit, is the better solution to alleviating poverty, consider these two alternative scenarios: (1) A microfinancier lends $200 to each of 500 women so that each can buy a sewing machine and set up her own sewing microenterprise, or (2) a traditional financier lends $100,000 to one savvy entrepreneur and helps her set up a garment manufacturing business that employs 500 people. In the first case, the women must make enough money to pay off their usually high-interest loans while competing with each other in exactly the same market niche. Meanwhile the garment manufacturing business can exploit economies of scale and use modern manufacturing processes and organizational techniques to enrich not only its owners, but also its workers.

As these scenarios illustrate, a surer way to ending poverty is to create jobs and to increase worker productivity, rather than investing in microfinance. But before going into detail about why it is better for an underdeveloped country to promote large enterprises, not microenterprises, let?s examine the theory behind microcredit.

Continue reading “Microfinance Misses Its Mark“