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A Second Look at Microfinance: The Sequence of Growth and Credit in Economic History, Cato Development Briefing Paper No. 1

A Second Look at Microfinance: The Sequence of Growth and Credit in Economic History, Cato Development Briefing Paper No. 1

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icrofinance—the provision of financial servicessuch as small loans to the world’s poor—hasgrown in the past decade, extending billions of dollars in credit to tens of millions of people. A major aimof the microfinance movement is to provide funds forinvestment in microbusinesses, thus lifting people out of poverty and promoting economic growth.Recent experience and the economic history of richcountries, however, suggest that those expectations areunrealistic. Most people, poor or otherwise, are not entre-preneurs, so there is little reason to think that mass creditwould in general lead to viable business start-ups. Today asin the past, business start-ups in the advanced countriesdepend predominantly on savings and informal sources of credit; past forms of microcredit never played a role in smallbusiness development, and much microcredit is actually used for consumption rather than investment. In the histo-ry of today’s rich countries, moreover, economic growthoccurred first, then came credit for the masses. That creditwas and is predominantly for consumption rather thaninvestment.There is no reason to believe that the nature andsequence of growth and mass credit are fundamentally dif-ferent for poor countries today than they were in the past.We should not expect microfinance to noticeably affectgrowth or successful business development.
the cato institute1000 Massachusetts Avenue, N.W., Washington D.C. 20001-5403 www.cato.orgPhone (202) 842-0200 Fax (202) 842-3490February 15, 2007
no. 1
A Second Look at Microfinance
The Sequence of Growth and Credit in Economic History
by Thomas Dichter
Thomas Dichter is the author of 
Despite Good Intentions: Why Development Assistance to the Third World Has Failed
(Amherst: University of  Massachusetts Press, 2003). He has worked in international development since 1964 in a variety of institutions including the World Bank, the United Nations Development Programme, the Peace Corps, and numerous nongovernmental organizations.
 Executive Summary
Microcredit—the extension of small loansto very poor people—has grown rapidly in thepast decade, reaching tens of millions of indi- viduals around the world and providing bil-lions of dollars in loans.
From the very beginning of the microcredit movement, thepresumption has been that the poor lackaccess to formal financial services, particular-ly to nonusurious credit. In some of therhetoric of the movement, it has even beenpresumed that the poor are deliberately “excluded” from access to credit.The response has been to democratizecredit, providing access to all. Such access, itis thought, will enable the poor to workthemselves out of poverty by investing inmicrobusinesses or asset acquisition, whichin turn will feed into economic growth. Pickup almost any article on microfinance in thelast 15 years (or more recently any microfi-nance website) and you will find assertionsthat reinforce this notion:The women I’ve met in Uganda andGuatemala are so resourceful, and it’s just amazing to see how, with theircourage and diligence, they create smallbusinesses with such tiny amounts of money.
[T]he bank gave her a loan of . . . US$25.Such a small sum to start a businessseems laughable, but this was no joke—this was “microcredit,” designed forwould-be entrepreneurs in poor areas.
Microcredit programs have successful-ly contributed to lifting people out of poverty in many countries around theworld.
The mission of the Microcredit SummitCampaign:Working to ensure that 175 million of the world’s poorest families, especially the women of those families, are receiv-ing credit for self-employment andother financial and business services by the end of 2015.
We have seen how access to loans anddeposit services has empowered mil-lions of people to work their way out of poverty. . . . Microfinance is a powerfultool to fight poverty. Poor householdsuse financial services to raise income,build their assets, and cushion them-selves against external shocks.
Moreover, the 2006 Nobel Peace Prize winnerand founder of the Grameen Bank, Muhammad Yunus, has famously called credit a humanright.
 As many practitioners of microcredit(including this author) have learned, however,money is fungible—it can be used for anything. Although we knew that in the abstract, itbecame real as we began to see poor borrowersuse their loans for what the industry has cometo call “consumption smoothing,” ironing outthe highs and lows in cash flow so that crisescan be met or large purchases made. But that very term suggests that the microcredit move-ment is not all that comfortable with the idea of “consumption” plain and simple, since it isimplicitly recognized that making it possiblefor poor people to use credit for goods and ser- vices (even if some, such as medicine or educa-tion, are necessary) is not really what micro-credit started out to do.Those of us who work or have worked inmicrofinance in fact step gingerly around a number of things that underpin our work.We tend to skirt the question of consump-tion and spin euphemisms around the ques-tion of whether the poor invest their loans inbusiness with terms like “microenterprise,”“entrepreneurial agents,” and “income-gener-ating activities.”History—the history in the “north” of for-mal and informal credit use for businessinvestment, and the history of formal andinformal credit use for consumption—has a lot to teach us about the credit-for-everybody notions of microfinance. Its lessons might
History has a lotto teach us aboutthe credit-for-everybody notions of microfinance.
bring our expectations of microfinance moreinto line with reality. For the economic histo-ry of the rich nations strongly suggests that
earlier forms of microcredit never playeda significant role in business start-up orsmall business development,
the first efforts at democratizing finan-cial services were almost entirely savingsand “thrift” based,
economic development in fact came before(or at best alongside) the movements todemocratize financial services, and
when credit for the poor did come along,it
the savings movement anddeveloped almost entirely in relation toconsumption.If those lessons are valid, microcredit, still thedominant service in microfinance, seems tohave long been on a path that does not leadto the kinds of results that a great many prac-titioners and advocates have hoped it would.I will not deal here with the assumptionthat the poor are entrepreneurial. The distri-bution of entrepreneurial character is pretty much the same everywhere in the world.Some people have it, others do not. It is notsurprising that many people think the poorin developing countries are nascent business-people; after all, most of them must take tothe informal marketplace to generate smallamounts of cash, and that is what makesthem seem like they are engaged in busi-ness—but that is subsistence activity, a sort of default mode, and not what I call “real” busi-ness. If all other things were equal, one wouldsee quickly and clearly that, as in the West,only a minority will make their careers asentrepreneurs.Instead, this study is meant as a survey of the history of access to credit and its use inthe advanced industrial countries during themain period of their development, beginningin the late 18th century and continuing intothe mid-20th. The emphasis will be on North America and Great Britain, with some refer-ence to Germany. But the subject and the lit-erature are extensive, and a more thoroughreview could add much by looking at the restof Europe and Japan as they became “devel-oped.”
Do the Poor Have Assetsand, If So, How Do They Husband Them?
Since the credit-for-everybody notion isbased partly on the belief that the poor needcredit so they can build assets, we need firstto look at the clients—the poor themselves.Did the poor in the past lack assets, and dothey today? The problem is complex.First, many of the assets of the poor, espe-cially the rural poor, have been in the past, andare still today,
from view, often deliber-ately so, to avoid exploitation or expropria-tion. Read any novel about or description of peasant life from the 19th century onwardand you will read of the peasant’s capacity tohide what he has or what he has made fromthe tax collector, the landlord, or his neighbor.When houses were taxed on the number of windows, people built houses with no visiblewindows on the road side. When 16th-century farmers in the Alps paid their rent on pasture-land with milk, they didn’t milk their cowscompletely during the first milking of the day and used the excess milk taken during the sec-ond, nighttime, milking to make
cheese. Likewise in rural India, China, Russia,or the United States, relatively poor peoplefound (and find) ways to hide or underesti-mate their assets.That understandable tradition fits ratherwell with the altruistic side of the microfi-nance agenda—it reinforces the belief that thepoor are without assets, and much of ourresearch on poverty does little to change thatbelief. When we do survey the poor prior tosetting up a microfinance project, the research(because of time and funding constraints, andperhaps our ideology) is more often than notdone too quickly and superficially to unearthanything more profound than the answers thepoor want to give to the researchers. Only long-term field work (of the ethnographic sort
Many of theassets of the poorare
from view.

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