Cynicism and the Science of Poverty Reduction

I love microfinance because it helps people by assuming the worst in them.

Elizabeth Schroeder came by Oregon State yesterday to give a lecture on the efficacy of microfinance. For those who don't know, microfinance is a lending system used in developing countries where normal credit markets don't exist. Lending is a pretty hard thing to do in the long run. Imagine people came up to you and asked to borrow some money with interest. Would you do it? You might if they appeared wealthy, gave collateral, and had good references. Those don't necessarily exist in the developing world. Banks understand the same thing.

This can be damning for poor communities. Starting even a simple business can have substantial start-up costs, which become problematic barriers without lending. Wealthy nations also suffer. Our simplest economic models tell us that you can get a lot of bang from your first bucks invested than from your billionth, and yet capital is not flowing into these economies of great potential. The uncertainty is just too great for traditional financial systems, even though there is money to be made in the developing world.

Enter microfinance. In this system, you, the lender, still don't know much about your clients in the developing world, but those potential borrowers probably know a bit about each other. They have friends just like everyone else, and they gossip and pry and quietly judge one another just like you. It's simple, then. Offer individual loans, but only to people who have formed a group of five other interested borrowers. If anyone in the group defaults, you cut credit off to everyone in the group. What happens is that people will only invite into a group friends who they trust not to default. As an added bonus, you might even get a little social pressure on deadbeat debtors to make their payments, and you don't spend a dime on collection agencies.

There's money to be made in these lending groups. The average interest rate is around 20%, while the repayment rate is an impressive 90%. It doesn't take a finance major to see the profit in microfinance. Oh yeah, you're also helping the poor of the world (as Ms. Schroeder demonstrated in her paper), but it's an example of cold economics turning the gears and not high-minded idealism. Bankers want to make money, struggling entrepreneurs will self-select, the incentives are there, and everyone is made better off.