Back to the drawing board? — A harsh look at microfinance

To start, I want to say that my mind has been racing despite sleep deprivation and jet lag since I touched down in Mumbai at 0135 IST this morning. This is the first I have set foot in India since 2005 and thus my first visit since the inception of TC-I, which makes the experience all the more exhilarating. But on to the post …

In the past, I have criticized microfinance’s shortcomings, particularly with regard to its inability to actually stimulate significant job creation. However, I also have recognized that despite its downfalls, microfinance still serves as a useful tool in the arsenal of a poverty alleviation strategy.

Now, microfinance has come under more scrutiny, as opponents argue that this financial product actually hurts the interests of the poor and that it can lead to the romanticization of the bottom of the pyramid, creating dangerous consequences. These new arguments further support my point that microfinance is relative to other approaches not an effective tool in combating poverty.

In an article in the Financial Times, Milford Bateman criticized microfinance as damaging because it:

• [creates a] shortage of funds for small and medium-sized enterprises (SMEs), which can be damaging because SMEs are a proven route to sustained growth and development

• accelerates proliferation of informal-sector microenterprises (e.g., kiosks, shops, subsistence farms) instead of industrial ventures

[Source: India Development Blog]

These points mirror those I have brought up before. Nextbillion.net features another article criticising microfinance. In “Romanticizing the Poor,” published by the Stanford Social Innovation Review, author Aneel Karnani argues:

Rather than viewing the poor primarily as consumers, people interested in economic development should approach the poor as producers. The best way to alleviate poverty is to raise the real income of the poor by creating opportunities for steady employment at reasonable wages.

Karnani’s argument reinforced my point that most people are not entrepreneurs and would prefer a job with a stable salary than one in which they acted as their own boss.

I empathize with these arguments. We have seen that research into the actual effects of microfinance is unclear at best, and in a world of limited financial resources, allocating capital to financial products with little tangible return seems wasteful.

Another study conducted by the Brookings Institute leads us to believe that in reality, larger firms are both more productive and pay higher wages to employees than smaller firms. The study also indicates that larger firms are overwhemingly formal in nature, in that they fully are integrated into the legal and tax structures of their environment. But most importantly, this study tells us that the presumed jump from a small, informal firm to a large, formal one does NOT actually occur.

Put simply, the study espouses the idea that providing microcapital to individuals operating in the informal secor will not lead to them growing into real, substantial businesses that will create jobs for others. Instead other entrepreneurs, with higher talent levels, will come in to displace these microentrepreneurs altogether!

By this logic, it appears that investing in microfinance enterprises will likely NOT lead to the creation of companies that will serve as engines of growth and livelihood creation. So why is this finding so critical to our approach to accelerating poverty alleviation? In understanding this shortcoming of microfinance, we also understand that the private sector alone will never be able to successfully provide the tools needed for poverty alleviation.

SMEs require the support and coddling of their governments to succeed. For example, cultural and legal views on things like bankruptcy must be fashioned in a way that favors true entrepreneurship. Both the Brookings study and SSIR papers recognize and embrace the need for government action in the endeavor to stimulate job growth. The Financial Times’ Bateman sums up this point well, abeit harshly, in his article:

“Economics 101 shows conclusively how critical savings are to development, but only if intermediated into growth- and productivity-enhancing projects. If it all goes into rickshaws, kiosks, 30 chicken farms, traders, and so on, then that country simply will not develop and sustainably reduce poverty.” [emphasis added]