JUNE 5, 2011, 8:57 AM IST Why Doesn’t Microcredit Create Entrepreneurs?

The authors of a new book that looks at ways to reduce poverty around the world (and whether they work) have suggested one possible reason why the microcredit model may not be creating more entrepreneurs: It rewards cautiousness.

Microfinance institutions have “rigid rules” that require small loans of a pretty fixed size, a weekly cycle of repayment often starting within one week of loan issuance, and lending to groups whose members keep an eye on each other, say the authors—economists Abhijit V. Banerjee and Esther Duflo.

“There is a clear tension between the spirit of microcredit and true entrepreneurship, which is usually associated with taking risks and, no doubt, occasionally failing,” they write. “It has been argued, for example, that the American model, where bankruptcy is (or at least was) relatively easy and does not carry much of a stigma (in contrast Sam Panthaky/Agence France-Presse/Getty Images with the European model, in particular), has a lot to do with the A microfinance loan recipient in Gujarat noted weekly repayments from fellow borrowers in January. vitality of its entrepreneurial culture. By contrast, the MFI rules are set up not to tolerate any failure.”

More In microfinance The book cites a study that allowed some clients to begin repaying their loans after two months, rather than after one week, and which The End May Be Nigh for Microfinance in India found that those given more time made larger (and riskier) South Asia's Microcredit Crisis Drags On investments, such as buying a sewing machine rather than a few SKS Shares Sink Ahead of Results saris to sell. India Journal: Linking Health and Microfinance This might appear to be more fodder for critics of the microfinance Sober Mood at National Microfinance Meet industry, which has faced a backlash in India in recent months. But Mr. Banerjee and Ms. Duflo don’t say microcredit firms are necessarily wrong to focus on inculcating strict repayment discipline or keeping loan sizes small. In fact, that may be exactly the right approach, they say, for lending in the circumstances in which they operate. Those small loans just won’t necessarily create businesses. And maybe that’s okay. The implication of this section seems to be that financing entrepreneurship and reducing lending costs for the poor are two different goals—and perhaps don’t need to be combined.

For those who see microcredit as a way to give poor households a little more flexibility in making financial decisions and to improve their lives, the industry is already accomplishing a fair bit. No one faults credit card holders, after all, for using their cards to take advantage of a great discount on a necessary purchase and save money, rather than to set up a business (as long as they pay back their debts on time).

In 2009, Mr. Banerjee and Ms. Duflo found distinct differences in neighborhoods around the city of Hyderabad where the microfinance firm Spandana expanded. They compared the 52 areas the company entered, chosen at random out of a total of 104, to the ones it didn’t, after a period of 15 to 18 months.

Although they didn’t see a “radical transformation” and the fraction of families that started businesses went up only from 5% to 7%, there were positive developments in the neighborhoods with access to the cheaper credit.

“People in the Spandana neighborhoods were more likely to have purchased large durable goods, such as bicycles, refrigerators or televisions,” they wrote. “Households that did not start a new business were consuming more in these neighborhoods, but those who had started a new business were actually consuming less, tightening their belts to make the most of the new opportunity.”

They suggested critics might regard the accomplishments of microcredit firms more kindly if these institutions would acknowledge their limits, particularly in fostering small businesses.

Mr. Banerjee, 40, and Ms. Duflo, 38, who are described by their Indian publisher as “the two hottest young economists today,” are at the forefront of shift to using randomized controlled trials to test poverty initiatives, most notably at MIT’s Abdul Latif Jameel Poverty Action Lab, which they founded along with Harvard economist Sendhil Mullainathan. Those trials, modeled on those used to test medicines, involve comparing groups where one set of people was randomly assigned to get the treatment or intervention in question, and the other (the control) wasn’t.

“Poor Economics,” which was published in the U.S. in April and is out this month in India from Random House, is one of several new books that talk up the importance of testing anti-poverty programs to see what they’re actually accomplishing. New York University economics professor William Easterly, who is known for his skepticism towards foreign aid, reviewed it for the Wall Street Journal, along with the very similar “More Than Good Intentions,” in April.

The book probably doesn’t contain surprises for readers familiar with development issues in India, but there are some nice anecdotes from their India research.

One of them describes how Nachiket Mor and Bindu Ananth, who were developing financial products for the poor at the ICICI Foundation at the time, unwittingly created a market for cow’s ears when they tried to set up a cattle insurance program a few years ago. Both are now with the IFMR Trust, an Indian group that aims to promote financial inclusion through market principles.

How? By instituting a requirement that policy holders making a claim for a dead cow must produce the said beast’s ear. Soon, enterprising sorts were cutting the ears off any cows that died, insured or not, and selling them to policy holders who wished to file a claim but whose cattle were still alive and kicking.

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