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Abhijit Banerjee and Esther Duflo, co-founders of the Jameel Poverty Action Lab and co-authors of the recent book Poor Economics are at the heart of the movement to seek rigorous evidence about the lives of the poor and programs that aim to help them. As they write in Poor Economics, they believe that “we have to abandon the habit of reducing the poor to cartoon characters and take the time to really understand their lives, in all their complexity and richness.”

Recently I had the opportunity to sit down with Banerjee and Duflo for an extended conversation about the small and big pictures that emerge from their research, their critics and their plan to change the world. In fact, the conversation was so extended that I’ve had to break it up into pieces. We’ll be publishing it in four parts over the next few weeks—the full interview will be available soon via Amazon Kindle.

In Part 2, we discuss the state of microcredit, how we missed the obvious issues, and how to finance micro-entrepreneurs. You can find Part 1 here and Part 3 here.

Tim Ogden: At the [Microfinance Impact and Innovation] conference I really had my eyes opened by the Pande/Field paper on making microcredit loans more flexible [Ed. Note: Working paper is here]. They found that delaying when the first payment was due on a loan had a significant impact on borrowers willingness to invest in capital goods and invest in their business in general. In the US no one would think that the banks are a good source of entrepreneurial capital. Why did people buy into the idea that a banking model was a good source for entrepreneurial capital?

Abhijit Banerjee: Let me disagree with you. I think that banks have always been a decent source for paying salaries. Essentially the only funds you get from a bank are very short term loans which you use to deal with your cash flow, like a line of credit. If you think of what a developing country entrepreneur is, she often doesn’t have a lot of fixed capital.

For a lot of these micro-businesses cash flow really is the core issue, so in that sense it’s less implausible that banks are good sources of capital for microenterprises. Once you’ve bought the weights for your fruit stand, and you might already have that, all you have to do is replace one form of cash flow financing [a moneylender or savings] for the day with another form [microcredit]. In that sense microcredit is much more like paying salaries or wages than like setting up a business.

TO: But the capital that small businesses get from banks in the US isn’t growth capital. No one really expects it to finance growth. Lines of credit have always been conceived as cash management devices, not as a solution to launch growing businesses.

AB: Even in the US your credit line expands if you do well. And if you think that 90% of the capital needs of these businesses is cash flow, the fit isn’t that bad. There are lots of reasons why microcredit doesn’t work as well as it should, but I do feel that there’s some similarity—the bank model is not entirely wrong.

Esther Duflo: Two points. To some extent the fact that the businesses are like that is endogenous to the source of the money that is being offered. That is the point that the Field paper makes. That’s the point that you were making. I am going part of the way to what you said.

I think the Field/Pande experiment—giving people a little bit more time before repayment is such a small thing that allows people to consider something like buying a sewing machine—really shows that the reasons the businesses are like that is a product of the financing. Maybe something else would be better.

However the question you have to ask is: what’s the alternative?

Maybe some form of equity is better. This is what people believe to be the right way to give capital to entrepreneurs here. But how do you do equity easily in a system where very small enterprises makes it extremely costly. So my point is slightly different which is maybe it is not he best way to finance entrepreneurship in the best of all possible worlds, but we are not in the best of all worlds.

Maybe not. Maybe someone could still come up with a way of providing equity in an intelligent and cost effective way. Abhijit has been talking for a while about that the fact there are many chartered accountants in India. You could use them to provide a little bit of verification. Maybe it is possible to do equity to microenterprises but we are yet to find someone to bite, who would be willing to give their own equity.

AB: I think there is a lack of alternatives. Even in the US, most small businesses fixed capital is financed by second mortgages on your house, borrowing from relatives, something like that.

ED: In the US when you are big enough you start getting access to formal finance.

AB: That’s where in the US there is a huge difference. Once you’ve gotten to a certain size there are tons of people who give you tons of money, take equity in your business, but also even debt capital. But I think that at the beginning it is the case that essentially even in the US, people go to the bank to pay salaries and then they go to suppliers who give you some trade credit and then you use your second mortgage to buy your machine. So in some ways it’s not that different in developing countries. It’s just that the levels of income are so low, so that you can’t buy a machine with your second mortgage.

TO: But I think it is an example of something you talk about over and over: an overly simplistic understanding yields a solution addressing the wrong problem which yields inertia to keep doing the same thing. A huge part of overindebtedness crisis in microfinance is that people really believed that they were providing growth capital. If you really believe that you’re financing growing businesses, why would you stop? Why would you rein that in? 

AB: That’s totally right.

ED: It’s been obvious for a long time that these business are not growing. The Grameen Bank has been around for many many years and their loans are still very very small. Just forget about subtle impact evaluation or whatever; it’s been staring us in the face that these businesses are not growing, and the vast majority of people are not growing out of poverty or anything like that. If we had not been obsessed by the romantic idea of microcredit then maybe there would have been an earlier realizing of what microcredit does and what it doesn’t do. I think people are coming to that, to a small extent maybe because of our work stirring the pot. To be honest, it maybe would have happened anyway. But there’s been a lot of delay given that the facts were pretty obvious.

AB: I just gave a talk at the World Bank on exactly this topic. The crisis in microfinance is a result of the 3 C’s: credulity, cupidity and corruption. The politicians were corrupt, we were all credulous, and the microfinance people were greedy. Put them together and you get the crisis. Our credulity was significant. Somehow we believed that all repayment happens in microfinance due to some magic which made no economic sense. We knew it didn’t make economic sense. And then suddenly one day wake up to the fact that the actual loan officers would come to your house, maybe they don’t beat you up, but they do harass you.

You don’t need to do an evaluation to start asking questions. You just need to think about it for 10 minutes. These are desperate people with lots of financial demands. People in the family are sick, people lose jobs, the daughter needs to get married.

ED: But they repay anyway. Someone must be very convincing.

AB: But 90 percent repay. What is going on? How could we believe this was because of some tweaking of economic incentives? As economists I think we were basically inept in thinking about it or we would not have believed it. The core fact was staring us in the face. There was some amount of—I won’t say coercion, I think they are careful not to actually threaten—but there’s a lot of harassment. They come to your house, they call up your friends. I don’t think there’s anything wrong with it. It’s a moneylending business, it’s risky. But if the rest of the world thinks these are awful things to do, then you can’t expect better than a 90% repayment. And we didn’t look at this, we evaded the gaze of these facts that were looking back at us.

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