Can Microcredit bring development?

Micro credits are one of the most popular tools for development aid now.  The idea is, to put it simply, that the poor are in a “poverty trap” that keeps them poor and that micro loans can empower them to overcome the difficulties connected with the poverty trap and become successful “Micro entrepreneurs”. Micro credit is also a comfortable solution for rich countries because microcredit pays mainly for itself so it doesn’t require huge amounts of aid payments. But while it seems clear, that there is some positive impact on the individual level, there are justified doubts that it will help to promote development. The reason for that is, that we can’t just translate a micro effect on the macro level because there might be adverse effects on third parties.

The Poverty Trap

An important argument for micro credit is the poverty trap. The poverty trap is a concept that explains poverty by poverty. That means, a poor individual or even a poor society is not able to overcome its poverty easily by own effort. The poverty trap can consist of malnutrition, lack of education or lack of health services. In all these cases, the poverty causes additional costs or lowers productivity and income. So instead of the accumulation of capital the poor see a net depreciation for their household, making it impossible for them to climb up the ladder of wealth. Many argue that these poverty traps are not inevitable but instead could be overcome if the households just had a financial push in the beginning to enable investments. With these investments, the productivity and hence the income should increase and lift the household out of the poverty trap. In a neoclassical model of perfect markets, the household could of course borrow the money for the needed investments, but in reality, poor households often lack access to financial institutions. Partly it’s because they don’t have collaterals. Partly because, due to high administrative costs, no bank offers the small loans they would need. In many cases there isn’t even a bank in geographical proximity, and the local credit shark takes ruinous interest rates. So the non-existing access to financial services can itself be considered a poverty trap.

Escape the trap by micro loans?

And here, microfinance comes into play. Muhammad Yunus, one pioneer of micro finance developed the most common concept of microcredit in the 70s and spread it with his Grameen Bank since 1983. Micro credit institutions like the Grameen Bank target especially the poor: They don’t demand collaterals. For ensuring the repayment, the Grameen Bank instead gives loans only to groups of people so they can not only help each other out in case of temporal inability to pay, but also the group pressure leads to more responsible behaviour. Additionally, the Grameen Bank targets women specifically because it has been shown by several studies that they are more responsible than men, so this measure does not only empower women but also allows for even lower risk premiums. Furthermore, there are trainings for the loan recipients to increase their productivity further. In some cases these measures have been very successful, so the hope of many microcredit advocates is, that if enough poor get access to microcredit, poverty can be eradicated. However, this is not as simple for the economy as it is for the individual, and we have to consider some “external” effects of microcredit.

The downsides of micro credit

Ahlin and Jiang (2008) argue that there is a productivity hierarchy with subsistence labour at the bottom, self-employment (or micro-entrepreneurship) in the middle and entrepreneurship at the top. They define entrepreneurship as following: “Entrepreneurial activities are assumed to require a relatively large scale of capital and employment of wage laborers, while engaging in self-employment requires capital and only one’s own labor.” Micro credit can clearly help subsistence workers to reach the level of self-employment. However, the effects on entrepreneurship can be ambiguous: Micro entrepreneurs or self-employed pose competition to traditional entrepreneurs on labour, credit and sales-markets. The problem here is, that entrepreneurship is assumed to lead to long run development because it uses larger scale, accumulates capital and is innovative. However, competition itself shouldn’t be harmful but is widely considered as a source of wealth and progress. Therefore, to tell whether micro entrepreneurship can hurt development through the channel of hurting the “normal” entrepreneurship, we have to clarify two questions:

  1. Do micro firms have an unfair advantage over “normal” firms?
  2. Does self-employment or “micro-entrepreneurship” has same positive effects on development as traditional entrepreneurship?

Regarding the first question, we can say that on the sales-market the unfair advantage is informality. Although micro enterprises lack economies of scale and are normally much less productive than small or medium enterprises, they are, due to their informal character, more able to avoid taxes and regulations, driving down their costs and making them competitive. The formal enterprises don’t have this option and lose market shares.

The second question has to do with the structure and conditions of micro loans. Micro loans are characterized by high interest rates and short maturities. These conditions are obviously not favourable towards sophisticated, long-term and risky projects and enterprises. Instead micro credit promotes unsophisticated short-term projects, mostly in the retail and services sectors as well as subsistence farms. However, these kind of enterprises are inherently non-innovative and not able to grow much. The next problem is, that they are mainly operating on local markets that are already saturated. So another reason they can’t grow, is just that there is no additional demand for their products. A meta study of Duvendack et. Al.  (2011) evaluates a broad range of empirical studies and comes to the conclusion that there is no significant positive impact of micro credit on development.

Conclusion

So the hope that microcredit is some sort of a universal remedy and will “eradicate poverty” seems wrong. But there is also hope for the idea of microcredit: It’s overall effect on development is not significantly negative and only in the mean it’s zero. The meta study found positive as well as negative results, so it could be dependent on culture, geography, economic structure etc. whether microcredit is helpful for development or not. If we cut back the expectations towards microcredit a little bit and tread it as only one of several tools for development, it could be possible to apply microcredit successfully on a case by case level.

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