[homeles_ot-l] The Poverty Business: How Low-Income Credit is Dangerous Or The Myth of Enterprise & the End of Poverty via Cheap Credit as a Way Out of Poverty?

Fri Feb 29 12:55:50 EST 2008

The Business of Poverty: How Low-Income Credit is Dangerous.
By Dweep Chanana June 6, 2007. 

BusinessWeek recently ran a cover story on The Poverty Business<http://www.businessweek.com/magazine/toc/07_21/B4035magazine.htm>: Inside U.S. companies audacious drive to extract more profit from the nation's working poor. This is not a publication that has said much against microfinance, yet if a case had to be made against our unbridled enthusiasm for it, the lead story<http://www.businessweek.com/magazine/content/07_21/b4035001.htm> would serve very well.
There are two similarities between the poor in the US and the poor in the rest of the world. First, they don't make much money. Second, everyone wants to lend to them. This article gives plenty of food for thought, for why that may not be such a good thing - not as a business, but as a way out of poverty.

A Question of Choice

Some support credit based on the faith that the market knows best. Credit - even expensive credit - allows the market to function, and is better than no credit at all simply because it increases choice. Much the same argument is made by C.K.Prahalad, in support of the Base of the Pyramid theory - which extols corporations to see the billions of poor as consumers:

  Nobody, poor or rich, is compelled to pay a high price for a used car, a credit card, or anything else."The only feasible way to run a capitalist society is to allow companies to maximize their profits," says Tyler Cowen, an economist at George Mason University in Fairfax, Va. "That will sometimes include allowing them to sell things to people that will sometimes make them worse off."

Even if one were to accept the superiority of free-markets (not a given), this argument has a flaw. The theory fails because low-income consumers - and the poor in developing countries - do not live in perfect markets. Rather, they live in markets that are imperfect and subject to asymmetric information. The result is exploitation, and a choice that can be often illusory, and sometimes dangerous:

  A public housing administrator who reviews tenants' tax returns pointed out to Thomas that Jackson Hewitt had pared $453, or 10.4%, in tax-prep fees and interest from Thomas' anticipated refund. Only then did she discover that various services for low-income consumers prepare taxes for free and promise returns in as little as a week. "Why should I pay somebody else, some big company, when I could go to the free service?" she asks. The lack of sophistication of borrowers like Thomas helps ensure that the Money Now loan and similar offerings remain big sellers.

Cheap Credit
Another argument for microcredit is that it is cheaper than the alternative - a moneylender. In America, there is no equivalent, so low-income credit is indeed the only alternative. But is it really cheap?

Not quite. If anything, credit has become more expensive:

  Federal Reserve data show that in relative terms, that debt is getting more expensive. In 1989 households earning $30,000 or less a year paid an average annual interest rate on auto loans that was 16.8% higher than what households earning more than $90,000 a year paid. By 2004 the discrepancy had soared to 56.1%. Roughly the same thing happened with mortgage loans: a leap from a 6.4% gap to one of 25.5%. "It's not only that the poor are paying more; the poor are paying a lot more," says Sheila C. Bair, chairman of the Federal Deposit Insurance Corp

The microcredit market is still new, but one sees a similar trend there. As access to credit has expanded, institutions have grown and tapped commercial capital. That capital seeks market and risk-adjusted returns. Those returns can only come at the cost of more expensive credit - and poorly informed consumers.

The Myth of Enterprise & the End of Poverty

Finally, the diehard also believe that microcredit helps start new sustainable businesses. By some miracle, the developing world's poor are an army of entrepreneurs, seeking capital to start sustainable and profitable businesses, that will pull millions of microcredit customers out of poverty. Yet, evidence suggests microcredit does not go to start enteprises, but to smooth consumption. And that is a road that is just as likely to lead to indebtedness, as to riches:

  She graduated in 1992, owing $45,000 on student loans. That debt became her main financial burden, she says. The 9.5% interest rate isn't particularly steep, but she tended to view the payments as less pressing than putting food on the table or paying rent. Late fees piled up. Today she owes $159,991, up from $117,000 only 18 months ago. When dunning notices arrive, she tosses them in the stove.

There is no reason to believe that the poor in America are any less entrepreneurial than their developing world bretheren. So if credit - cheap or not - has not saved the former from poverty, is there reason to believe it will save the latter, who have substantially fewer skills and opportunities?

Calling a Spade a Spade: A Good Business 

Low-income consumers in the U.S. are an interesting case study for microfinance proponents worldwide. Because credit by itself doesn't seem to be helping them. "Instead of becoming an opportunity for upward social and economic mobility, it becomes a debt trap for many trying to move up," according to Nouriel Roubini, an economics professor at New York University's Stern School of Business.

There is a lot of money involved here. According to Stephens Inc, such "alternative financial services" totals more than $250 billion a year. Still, let stop pretending that credit will save the world and its poor. It hasn't yet in a country where it has been plentiful for a long time. This is a business, and microcredit an industry. Like all businesses, it will help some and make others worse off. Let us figure out what to do with the latter.

Discussion
3 comments for "The Business of Poverty: How Low-Income Credit is Dangerous"
  1.. Well written and I completely agree with you. For the past 9 or 10 years I have been thinking that enough of microfinancing. In some projects I visited, the same goat was being shown around to different donors. Most banks are now in the microfinance business anyway. Finally, the interest rates for most microfinance schemes (donor financed) I have heard of are much higher than commercial rates. There is not much difference from traditional moneylenders. The only way microfinance can really work for the poor is if it is linked to a traditional self-help savings group. The idea would be to encourge small regular savings for a group.

  btw. have been reading your blog for some months and think that you have some excellent stuff. Who are you?

  Posted by Mukul | June 20, 2007, 3:13 pm<http://www.planetd.org/2007/06/06/the-business-of-poverty-how-low-income-credit-is-dangerous/#comment-77935> 
  2.. Mukul,
  Thanks for your note - your first hand experience would probably help dispel some of the myths around microfinance. As for me, I work in emerging market finance and socio-economic development. Will be happy to exchange more information offline.

  Posted by Dweep Chanana<http://www.planetd.org/> | June 20, 2007, 7:04 pm<http://www.planetd.org/2007/06/06/the-business-of-poverty-how-low-income-credit-is-dangerous/#comment-77966> 
  3.. [.] was overzealous and highly competitive lenders that "actively sold subprime loans" (see also). The corollary for microfinance is that if the aim is development (as opposed to building a new [.]

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