Microfinance is a Band-Aid Solution to Poverty

A while ago, Stephen Daley and I co-authored a Mercatus Policy Series based on Daley’s field work research on microfinance in the Philippines (see also here and here). While microfinance may have some impact for some people in the slums of Manila, Daley’s field work research led us to think that most microfinance beneficiaries don’t graduate (i.e., don’t enter the formal world) and remain poor. Our conclusion was that at best microfinance is a band-aid solution to poverty. The real problem is elsewhere: it is located in the institutional context that influences how individuals exercise their alertness to discover gains from trade.

This is exactly what Amar Bhidé and Carl Schramm argue in today’s Wall Street Journal. They contrast Edmund Phelps’s understanding of entrepreneurship to that of Mohammad Yunus. They rightly say that “turning more beggars into basket weavers” (as Yunus’ view may imply) may not make Bangladesh less of a “basket case.” Instead, they contend that the poverty of countries such as Bangladesh results from their “comprehensive backwardness”—perhaps a harsh way of explaining that Bangladesh lacks institutions conducive to entrepreneurial activity. In contrast, Phelps makes the right points, echoing the views of Mises, Hayek, and Kirzner (Bhidé and Schramm actually mention Hayek and Knight in their article!).

Daley and I concluded that governments in developing countries could pursue a different course of action to help the poor. Fostering microfinance may not be a desirable solution in the long run. In the Philippines alone, the government could, for instance, remove legal discrimination based upon ethnicity that impedes the development of financial markets from the bottom up (informal lenders are very entrepreneurial).

Microfinance has become a “viable option” only because of a poorly functioning institutional environment. It’s good that Phelps, Bhidé (who is a friend of mine), and Schramm (whose book is, ironically, not very high on institutions) say the same thing.

Comments

[Matt C.]

It would be interesting to combine the work of microfinance with that of the work of Hernando De Soto's work. Would it be possible for microfinance to work in what DeSoto calls the "extra-legal" environment? Would it really matter how much microfinance is available if the ability to use property as you see fit is unavailable?