Questioning the Conventional Wisdom about the Benefits of Microfinance and Encouraging Entrepreneurship

In 2006, Muhammad Yunus and the bank he founded, Grameen Bank, were jointly awarded the Nobel Peace Prize for their work in essentially creating the business of micro-finance, extending small loans to poor Bangladeshis so they could start their own businesses. Micro-finance, due to the typically high interest rates charged and the communal pressure against defaulting (villagers understand that their credit would be put at risk collectively if one of them defaults) has proved quite profitable and has been implemented in various poor countries. Saturday's Financial Times featured a letter to the editor from a visiting professor of economics at the University of Juraj Dobrila Pula in Croatia, Milford Bateman, that contested the conventional wisdom about the benefits of micro-finance, "Microfinance’s ‘iron law’ – local economies reduced to poverty". Below is an excerpt from Professor Bateman's letter:

[I]n nearly 25 years of academic and consulting work in local economic development, my experience is that microfinance programmes most often spell the death of the local economy. Put simply, to the extent that local savings are intermediated through microfinance institutions, the more that country or region or locality will be left behind in a state of poverty and under-development. This is an “iron law of microfinance”. Focusing on isolated cases of microenterprise success simply does not add up to economic development. The reason microfinance is supported is overwhelmingly political/ideological – the economic rationale is simply not there.

I have recently been working as a consultant in Serbia. Here the foreign-owned commercial banks since 2001 have massively discovered microfinance. From almost zero in 2001, the commercial banks now channel 22 per cent of their total loan portfolio through highly profitable microfinance (household microloans) programmes amounting to almost 12 per cent of gross domestic product.

This has had two important results: first, a serious shortage of funds for small and medium-sized enterprises, which is deeply damaging because SMEs have by far the most sustainable growth and development potential. Second, thanks to microfinance there has been an accelerated proliferation of informal-sector microenterprises in Serbia over 2004-08, so the country is now chock-full of traders, kiosks, shops, street-traders and subsistence farms. The base of the economy is quite simply being destroyed.

[...]

The East Asian countries managed to develop brilliantly through channelling much, if not most, of their savings into serious growth-oriented sustainable business projects. This is why many east Asian countries may have started at similar GDP levels as Bangladesh in the 1970s but have since then massively outpaced Bangladesh in terms of growth and development. 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.

Professor Bateman's letter to the Financial Times brought to mind an article by Scott Shane titled "The Non-Starters" in the current issue of The American. Unfortunately, that article doesn't appear to be available online [Update: it's available now], but Shane's point was somewhat similar to Bateman's, although Shane focused on business in the U.S. Shane wrote that most start-up businesses in America were economically unproductive, created relatively few jobs, and what jobs they did create tended to be lower paying and have fewer benefits than those at larger companies. The reason for this, according to Shane, was that there simply are fewer talented entrepreneurs with high levels of human capital than there are Americans who start small businesses, and that many small businesses are started by unemployed or underemployed individuals who are motivated to do so partly by government incentives (e.g., government small business loans, grants, training and other encouragement) and by the relatively low opportunity costs for them of starting a small business, due to their current employment status.

These unskilled entrepreneurs tend to have high failure rates partly because they have low levels of human capital and partly because they tend to enter over-crowded niches. Scott Shane thought that an appropriate policy response by the U.S. and state governments would be to stop encouraging everyone to become an entrepreneur, and to instead think like a venture capitalist and provide support for those entrepreneurs with more obvious potential. Professor Bateman's point about micro-finance -- that it is supported for political/ideological reasons -- would seem to apply to American policies toward entrepreneurship and small business start-ups.


The photo above, of Dr. Yunus displaying his Nobel Peace Prize, is from the Nobel Foundation's website.