What Is Microfinance Supposed to Do?

Everyone loves microfinance. The Wall Street Journal editorial page is super enthusiastic, but so is the World Bank, so are all those private equity kids who now want to do politically progressive ‘venture philanthropy’ with their gazillions, and so is Natalie Portman, peering winsomly from the cover of the NYT Magazine a couple of months ago. Muhammad Yunus set in motion a remarkable worldwide movement when he launched Grameen Bank in Bangladesh. But as it grows, as the resources available to it increase, and as people seek to scale it up worldwide to ever greater numbers, the questions about what it does, how it does it, and the limits are getting more important.

Indeed, as the movement toward microfinance as a tool of international development gets larger and richer and better resourced, there has been an outpouring of new literature on the subject. This literature falls into a couple of different genres – practical how-to books that range from best auditing practices to sample organization documents; academic writing seeking to put microfinance into perspective, often from a critical or semi-critical perspective; popular, popularizing books that, for example, tell the story of Yunus and Grameen Bank; and gradually, slowly, books by serious economists seeking to explain it in the formal terms of microeconomics. I’m in the middle of reading the current crop of books for a big review essay for the Times Literary Supplement in a couple of months; and it’s a lot of reading.

But my own background in this field goes to my weird joint interest in human rights and finance, nonprofits and money, mission and bottom lines. For the past fifteen years, I’ve chaired the board of a nonprofit private equity fund that invests in independent media in the developing world, the Media Development Loan Fund. It started with funding from Soros’ Open Society Institute, we have gradually built ourselves into a financial institution with some $60 million in media investments. What we do is not microfinance – our loans are typically to established media businesses and run in the range of hundreds of thousands to millions. But many of the basic principles are the same.

Noteworthy at this point is the decision by Grameen Bank to enter the US market. That move raises a lot of mission and financial questions. For example, the media fund I work with has so far declined (almost entirely) to work in developed world places such as the US or the EU, on the very simple rationale that even if there are media businesses such as newspapers in these places that could benefit from our assistance both financial and technical, there are lots of organizations in the developed world that can do that. We should do what pretty much only we do, which is work in places like Macedonia or Malaysia or (heaven help us and the political risk rating in our portfolio) Russia. So a question for Grameen Bank is why it makes sense for it to bring its work to the US, rather than extending itself in places in the world where its expertise is very, very special.

But a second category of questions involves the basic business of microfinance. When Grameen enters the US market, what does it think the unserved market niche is? Is it microloans to start new small businesses? This makes a lot of sense in places like Bangladesh or Peru – but, as James Surowiecki pointed out in an astute New Yorker article, one of the reasons why microfinance is successful is because it operates in places in which the informal economy is dominant, which is to say, places in which the rule of law and institutional arrangements that allow formal businesses to flourish are weak. It isn’t in fact such a great idea to have every person be an entrepreneur alone; advanced economies advance under conditions in which the businesses are formalized, most people are employees, businesses pay taxes and are regulated by things like OSHA and food and health authorities, etc. The generator of new jobs in the United States is not individual entrepreneurs selling tacos or flowers on the highway – that this can be successful in Peru or Mexico is, as Surowiecki says, a sign of institutional failure, not success – but small yet legal, formal businesses that grow:

Microloans make poor borrowers better off. But, on their own, they often don’t do much to make poor countries richer.This isn’t because microloans don’t work; it’s because of how they work. The idealized view of microfinance is that budding entrepreneurs use the loans to start and grow businesses—expanding operations, boosting inventory, and so on. The reality is more complicated … The vast majority have only one paid employee: the owner. As the economist Jonathan Morduch has put it, microfinance “rarely generates new jobs for others.”

This matters, because businesses that can generate jobs for others are the best hope of any country trying to put a serious dent in its poverty rate. Sustained economic growth requires companies that can make big investments—building a factory, say—and that can exploit the economies of scale that make workers more productive and, ultimately, richer. Microfinance evangelists sometimes make it sound as if, in an ideal world, everyone would own his own business. “All people are entrepreneurs,” Muhammad Yunus has said. But in any successful economy most people aren’t entrepreneurs—they make a living by working for someone else. Just fourteen per cent of Americans, for instance, are running (or trying to run) their own business. That percentage is much higher in developing countries—in Peru, it’s almost forty per cent. That’s not because Peruvians are more entrepreneurial. It’s because they don’t have other options.

What poor countries need most, then, is not more microbusinesses. They need more small-to-medium-sized enterprises, the kind that are bigger than a fruit stand but smaller than a Fortune 1000 corporation. In high-income countries, these companies create more than sixty per cent of all jobs, but in the developing world they’re relatively rare, thanks to a lack of institutions able to provide them with the capital they need. It’s easy for really big companies in poor countries to tap the markets for funding, and now, because of microfinance, it’s possible for really small enterprises to get money, too. But the companies in between find it hard. It’s a phenomenon that has been dubbed the “missing middle.”

At the same time, many observers, including Surowiecki, have noted that in the developing world, much of microfinance is not really about entrepreneuership, but is instead about loans that help people who do have some form of income to smooth out some of life’s big events and expenses – weddings, funerals, education fees, things like that. That is a very different kind of economic model for making microfinance loans than use of loans to purchase inventory for sale on the street, as in a street food vendor.

And in the United States, it has been suggested that a role for microfinance lies in providing banking and financial services to the poor as an unserved niche. Indeed, Grameen Bank USA’s website motto is “banking for the unbanked:; it then follows that up with the possibly disparate missions of entrepreneurship, banking services for the poor, and credit building for poor women. It might turn out to be the case that there is an underserved niche in the US which can be filled by nonprofit organizations such as Grameen. It might turn out to be the case in servicing remittance payments, or payday loans at lower interest rates, or various other financial services of particular interest to poor people. It remains to be seen whether such niches genuinely exist, at rates of return (i.e. negative rates of return, i.e., financial subsidy) that nonprofits can provide over the long term. I don’t know the answer to that question, and I’m not sure anyone does. Still, one of the most compelling publications in the microfinance field came out fifteen years ago from Accion International, and is still telling reading – “What Microcredit Can Learn From the Moneylenders.”

Put another way, it is not self-evident that the problems of the poor in the US over the last ten years have been lack of access to credit, at least not in the way that the poor often lack access to credit – capital of any kind – in the developing world. It might be so for the US, but that would not have been my first guess. What the efficiencies of a nonprofit organization are over a for-profit firm in establishing even a niche financial product such as cost-effective world wide remittance transfer is also far from evident to me. Maybe it is the case that consumer financial services such as remittance payments don’t create competition and lowered transaction costs and lower fees over the long term, but why this would be, I don’t know. Are the barriers to entry really so great that only Western Union is able to do it? And that a nonprofit can do it better and cheaper? Maybe, but it would not have been my first guess. After all, services like remittance payments are really just transfer services, not credit.

My own guess is that the issue of the poor and credit in the United States is not lack of access as such, but instead regulatory issues such as the ability of credit issuers to jump all of one’s interest rates across the board for late payments on one card – deep regulatory inequities of the kind that Elizabeth Warren has tirelessly pointed out, but which are most efficiently addressed by stronger regulation and consumer protection laws and enforcement. In third world countries, it makes sense to establish an alternative credit market by nonprofits, in part because government regulation is weak, inefficient, corrupt, etc. But in the United States, I would have guessed – more than guessed, I would bet – that the more efficient and fairer mechanism is stronger government regulation of the market and all its participants as a whole. There is not a general equivalence between the behavior of firms and consumers in developed and developing economies, and one big reason is the efficiency and effectiveness and fairness of government regulation of the market. There are many, many inequities and fairness gaps in US consumer protection in matters of credit, but solutions worked out for places like Peru in which regulatory reform is unlikely at best – solutions that seek to create market alternatives – are really counsels of despair. I say try regulating the heck out of them first because in a developed market economy, it is likely to be both more efficient and more fair.

I am second to none in my admiration for Grameen Bank. Still, and finally, beyond questions about financial services, I have questions about whether any of these things are services that an organization with unmatched skills in dealing with the developing world should be seeking to deploy in the US, or whether that is better left to US domestic institutions, whether for profit or non profit. In the organization in which I serve, we have strongly differing views on this question; I am clearly on one side and others, with great expertise and persuasiveness, are on the other. But we are all agreed it is a crucial nonprofit resource question.