Cecil Bohanon and John Horowitz: Microlending has fallen out of favor as a cure for poverty

Muhammed Yunis, an economics professor from Bangladesh, won the 2006 Nobel Peace Prize for developing the idea of microfinance. His vision was to empower poor individuals, particularly women, by providing them with small loans to start businesses.

His view challenged the prevailing belief that the poor could not afford loans and would only fall deeper into debt. Yunis argued that these individuals could, indeed, afford the loans if they used them to start small businesses, thereby lifting themselves and their families out of poverty.

Unfortunately, lenders’ costs for a $100,000 loan are not much different than for a $100 loan, so the effective interest rates on microloans are generally 20% to 70%. While some people have overcome poverty via microloans, economic research finds that microloans don’t improve the finances or health of most low-income individuals.

A recent book by Mara Kardas Nelson exposes the coercion many microloan borrowers in poor and developing countries face. The Dickensian horrors of debtors’ prisons, which were outlawed in the United States in 1833, are alive and well in many poorer nations. Prison conditions are predictably horrific, and some debtors take their own lives rather than go there.

Development economist William Easterly noted in a review of Nelson’s book: “The consensus among most economists is that microfinance institutions have failed to realize their grandiose promises of ending poverty.”

Microlending has fallen out of favor as a poverty cure. Many development economists are looking at alternatives such as basic income guarantees or educational subsidies.

Low-income people in the United States can access credit through payday loans, installment loans, borrowing money on their credit cards, and overdraft fees when they have negative bank balances. Interest rates on these products are typically over 20%, so some call for laws to cap interest rates.

Unfortunately, price ceilings that impose artificially low rates generate a shortage of credit. Though there are probably ways to reduce interest rates for the poor, some reform proposals, such as banning payday loans, may worsen matters. One study found that though Chapter 13 bankruptcy rates decreased after prohibiting payday loans, complaints against lenders and bill collectors increased, as did overdraft fees at banks.

Though low-income people in the United States are typically much more affluent than those in developing countries, lending to those with few financial assets is a problem all economies face. Since the war on poverty in the 1960s, economists have found that neither microloans nor transfer payments are magic bullets that eliminate poverty.•

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Bohanon and Horowitz are professors of economics at Ball State University. Send comments to ibjedit@ibj.com.