Is microfinance an effective tool for bringing people out of poverty? Many people with little first-hand experience of that sector assumed that it was after Muhammad Yunus, founder of the Bangladesh-based Grameen Bank, was awarded the Nobel Peace Prize in 2006. More recently, however, microfinance institutions have been criticized by many for not delivering on their earlier promise.
In recent years, David Roodman, keynote speaker at the 2013 Penn Microfinance Conference, has put that proposition through a series of rigorous mathematical tests, only to conclude that the yardsticks for measuring the success of the microfinance sector are more complex, subtle and elusive than people realize. Roodman, author of the book, Due Diligence: An Impertinent Inquiry into Microfinance, studied theoretical mathematics at Harvard before joining the Center for Global Development, where he is now a senior fellow.
“I dispute the original conclusion” of research that solidly linked microfinance to poverty alleviation, Roodman told his audience at Wharton. “I don’t believe you will be shocked by my conclusions, but I do feel that I put the emerging consensus about microfinance on a firmer foundation.” What kinds of useful roles can microfinance play, beyond the alleviation of poverty? Why is it so hard to measure the multiple impacts of microfinance? And what advice does Roodman offer microfinance institutions that are eager to provide social benefits to the poor?
Gaining Control over Their Lives
“I look at microfinance through more perspectives than, I think, has ever been done,” not just from the point of view of clients, but from the point of view of history and academic research, Roodman stated. The idea of helping clients by offering microfinance services is something “quite old,” he added, noting that the “family tree” of microfinance history goes back long before Yunus and Grameen Bank to such earlier innovators as Anglo-Irish satirist Jonathan Swift (around 1720), English educational writer Priscilla Wakefield (around 1800), German credit-union pioneer Friedrich Raiffeisen (1860s), Canadian credit-union pioneer Alphonse Desjardins (1900) and U.S. lawyer Arthur Morris (1910).
Roodman’s favorite figure in this long history is Wakefield, a Quaker living outside of London who devised the notion of creating a savings bank for indigent people in her area. Her goal was to help people develop the habit of thrift, “so they wouldn’t spend all of their money on gin.” The savings banks that exist on the planet today “descend from her original work,” he noted.
Much more recently, he said, the lengthy academic controversy about the impact of microfinance on poverty was sparked by a study by professors Mark Pitt and Shahidur Khandker in The Journal of Political Economy. The study concluded that micro-loans did, indeed, reduce poverty, especially when they were made to women. Although that conclusion supported the common consensus in the microfinance community at the time, NYU economist Jonathan Morduch applied the same data to his own study and concluded, on the contrary, that microfinance was not reducing poverty. While Morduch questioned some of the original foundations of the underlying analysis, he never submitted his study to a referred journal, according to Roodman. “There are as many academic points of view as there are academics. They come with a lot of questions about whether microfinance is good or bad — and they have a lot of influence on the global conversation about microfinance.”
Until recently, various academics were using “different statistical methods that were really complicated and hard to understand,” Roodman said. For outsiders, it was a lot like listening to atomic scientists talk about unfamiliar, highly complex issues. “You just didn’t know what was going on.” Rather than rely on the conclusions of others, however, Roodman studied the original data in the Pitt-Khandker study, replicated all of the original mathematical methods and wrote his own software code for analyzing the data. The turning point came when he digested his results. “Eventually, I got to the point where I did not believe the study.”
However, just as Roodman was “in the weeds” of grappling with the complex mathematics involved in drawing a firm conclusion, he visited some clients of microfinance programs to see what those initiatives looked and felt like on the ground. At that point, Roodman’s instincts — as much as his mathematical training — began to have an impact on his assessment of the situation.
In Cairo, Egypt, Roodman saw a crowd of women waiting to get their loans, their line overflowing beyond the lobby. With the aid of an interpreter, he asked those women what they were doing with their micro-loans. Although many of the women talked about how they planned to use their loan money to buy such necessities as bed sheets, clothing, make-up and scarves — rather than fund micro-enterprises — Roodman was impressed by what he saw. “It felt to me like something good was going on here. These women were using this service to gain a modicum of control over their highly constrained lives. Who was I, based on all of my number crunching, to tell them how to lead their lives?”
Mountains of Debt
Despite numerous success stories, Roodman acknowledges that there are many true tales about poor people who have used micro-loans to build up mountains of debt they could not repay. Even worse, they face the challenge of interest rates that are shockingly high by conventional standards. Why are those rates so high? “It is not easy to make loans to lots and lots of poor people without going bankrupt. You can easily spend more than $100 collecting on a $100 loan. That basic business reality strongly shapes how business is done,” Roodman said.
What defines success in the world of microfinance? Even that question has multiple, complex answers. Digging deep into the phenomenon of microfinance, Roodman identified three definitions of success, each of which matches up with a different definition of “development.” First, there is the proposition that microfinance gets people out of poverty, which correlates with the concept of economic development as an escape from poverty. While everyone acknowledges that this happens, the thornier question is: How frequently does this happen? How common is this process?
A second definition of success is that microfinance leads to greater fulfillment or “greater agency,” including civil rights and more control over borrowers’ lives. A third definition is the notion that microfinance leads to the development of industry. Roodman noted that this theory is connected with Austrian economist Joseph Schumpeter’s famous model of “‘creative destruction,” the concept that successful economic development is a process of constant “churning” that, while very destructive, does reduce poverty. But does microfinance really do that? How often? This impact is also hard to measure.
At its best, “microfinance contributes to development when it is linked to the host economy in many ways,” said Roodman, thus providing the economy with “not just capital from abroad, or not just loans to locals,” but loans to a wide variety of borrowers. Microfinance then provides not just credit, but also savings.
To properly assess the impact of microfinance, Roodman suggests that researchers need to understand “reality as it is” as well as “reality as it would be without microfinance,” and then “distill the complex variety of differences” between the two. All kinds of outcomes happen when people borrow from microfinance institutions, but the promotional brochures of these institutions tend to focus on a limited range of positive outcomes. If, for example, you are told about one woman who took a loan and is doing well — and then about another woman who did not take a loan and is not doing well — the inference is that the loan is the key variable that increased the first woman’s wealth. In actuality, however, “There are a lot of stories that can explain why that [result] happened,” Roodman said.
He identified several hidden sources of bias that make it “very hard to tell what caused what” when evaluating the impacts of microfinance. One hidden bias may be a significant difference in the financial status of the borrowers. The woman who achieved more success may actually be better off to begin with, Roodman suggested. Or perhaps the more successful woman might have succeeded without a micro-loan because she had more “gumption,” he said. That unquantifiable variable is omitted from mathematical formulas used for assessing the impact of micro-loans on financial success.
A third source of bias is that more microfinance offices tend to be opened in those geographical areas that are better off economically. In some regions, success rates are higher because borrowers have more resources — or possibly more education or financial knowledge. Finally, a fourth source of bias is that struggling people often drop out of their micro-loan programs, raising success rates among the survivors in those programs, but actually proving nothing about the effectiveness of those programs in reducing poverty, Roodman noted.
Recommendations for Microfinance Institutions
In conclusion, Roodman recommended that microfinance institutions:
- Play to their broad array of strengths by “building dynamic institutions to mass-produce useful services for the poor,” rather than simply focus on trying to alleviate poverty. In that regard, he cited such success stories as Bolivia’s BancoSol, which has split into two different institutions; one that focuses on microcredits — which has 169,000 borrowers – and another institution that focuses on savings, which had 485,000 customers as of 2012.
- Discourage efforts to lend to the very poorest people in the community, since they may be unable to repay their loans.
- Deemphasize credit and move toward savings deposits, insurance and money transfer services for the poor.
- Look to new technologies, such as the mobile web, to reduce inefficiencies and to expand access to a wider range of services in a wider range of communities.
Roodman cautioned that “credit markets are inherently unstable, particularly when your clients are poor. It is easy to overestimate how many people want loans.” Indeed, he estimates that “only 10% of people want microcredit loans, while more want savings accounts.”
Finally, he concluded, even if MFIs and their stakeholders ultimately judge microfinance to be a success, “It is not going to reach every [poor] person. But we should try to build resilient institutions, reliable institutions that will be there tomorrow.”