I believe there’s a strong case for social investment in microcredit, but that the best case is built on new theories of change. Historically the standard microcredit theory of change has been that many (if not most) households are eager to start their own microenterprise but are stymied by a lack of access to credit, and if credit constraints are relaxed they will be able to make profitable investments and rapidly improve their standard of living. My read of the evidence is that rather than being frustrated entrepreneurs, most people are frustrated employees (and that’s true the world over, not just in developing countries); the number of people with the proper mix of aspirations, skills and opportunities to generate meaningful profits from microenterprise is limited.
For microcredit to show an impact in terms of revenues, profits or incomes, it likely has to do much more to both target loans to the limited set of people with the requisite attributes (check out this post from Bruce Wydick) and change the contract terms so that the loans are more conducive to business investment.
But there are also other theories of change worth considering; for instance, the value of microcredit for consumption smoothing given rampant volatility in incomes and expenses. To formulate a new theory of change for microcredit, it’s useful to consider an analogy to medicine: Is microcredit a vaccine or an antibiotic? Both vaccines and antibiotics are vital tools in the fight against disease but they operate very differently, and require different delivery models and processes to have maximum effect.
Start by thinking about the nature of credit constraints in the context that you care about. One perspective is that credit constraints are pervasive – many members of the community miss opportunities to invest, or suffer from a lack of ability to buffer downturns, because they do not have access to affordable credit when needed. If you believe credit constraints are pervasive, it’s also worth considering whether credit constraints are “contagious.”
As we know, most households are enmeshed in a complex social network where families borrow from and lend to each other (or make gifts) constantly (see, of course, “Portfolios of the Poor” and the classic mobile money remittances study by Jack and Suri, for instance). These financial relationships are a vital buffer against the worst of times. But they can also limit the ability of any household in the network to accumulate enough to make productive investments, and can provide a disincentive to such investments because of the increased claims that come from the social network when such investments are made (Google “Rotten Kin Theorem”). The lack of access can therefore spread through a community and perpetually limit the entire community’s ability to invest (check out this new paper that explores this possibility through the lens of informal loans for productive investment, or the lack thereof, within a network).
If the story of pervasive and contagious credit constraints makes sense to you, it would follow that making microcredit easily available to prevent “outbreaks” of credit constraints and limit the overall effect of credit constraints on the whole community is the right strategy. If so, it would be difficult or impossible to identify who would be “infected” with a credit constraint at what point, and wouldn’t make sense to try. Better would be “vaccinating” the whole community by making credit widely available. Note that in a vaccine frame it can be very difficult to identify the value of being vaccinated at the individual level – when herd immunity is achieved the value of vaccination to an individual will appear to be zero.
On the other hand, you may believe that credit constraints are not significant to large parts of a community, perhaps because few in the community have opportunities to invest at a rate of return above the cost of credit. Or you may believe that microcredit does not sufficiently relieve the constraint except when delivered at the right dose and at the right moment. If so, microcredit is more like an antibiotic than a vaccine. Making it easily available to an entire population without diagnosing the constraint and delivering the correct dosage might be worse than doing nothing.
Think of the village markets where every stall is selling essentially the same products – making it easier for more undifferentiated vendors to enter that market is close to a zero-sum game. In such instances, microcredit would operate like an antibiotic where drug resistance can develop. Not only will it will be difficult to identify the impact of microcredit if it is widely available, but wide availability may itself limit the gains even for those for whom it is most helpful. If you find this story plausible, the most important investment in microcredit would be better diagnostic and targeting tools, even at the expense of reducing availability.
Both the vaccine and the antibiotic stories are plausible and concordant with current evidence. It’s also possible that whether microcredit should be thought of as a vaccine or antibiotic varies from context to context. Thinking through the vaccine or antibiotic frame can help social investors clarify their theory of change and guide what areas of microcredit innovation to invest in.
The bottom line is that investment in microcredit innovation is both worthwhile and necessary (see the paper for more) – but rather than just supplying more funds to the industry, social investors need to go back to the drawing board, figure out their theory of change and invest appropriately in that theory of change.
By Timothy Ogden (Managing Director, Financial Access Initiative at NYU-Wagner)