Microfinance through rational eyes: reflections on David Roodman’s Due Diligence

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/picture: Caritas SACCO, Nkokonjeru, Uganda/

Microfinance has been under the spotlight ever since it gained currency in the 1990s. David Roodman, senior associate at Center of Global Development, evaluates the impact of microfinance in his 2011 book Due Diligence: An Impertinent Inquiry into Microfinance.

Roodman builds his argument incrementally throughout his book. In the first two chapters, he points out important differences between how the poor and the rich use financial services. While the rich can navigate their way through complicated banking products and increase wealth, the poor, with low financial literacy, often view the bank merely as a safe place (relative to their mattresses) to store their money. Moreover, there are explicit and implicit barriers preventing the poor from fully utilizing financial services. Managing a fixed savings account requires a steady income to put aside, which is challenging for agricultural households with fluctuating seasonal incomes; getting a loan requires collaterals, guarantors and a lengthy process which many feel reluctant to go through.

Recent years have seen a growing literature on evaluating microfinance, but Due Diligence stands out by evaluating microfinance according to three definitions of development. This treatment reconciles conflicting evidence of microfinance’s ability to foster development.

The first definition, development as escape from poverty, is widely adopted in academic evaluations. Roodman points out problems with most microfinance evaluation studies ranging from naive econometric regressions, implausible instruments and assumptions, to the lack of wide applicability of Randomized Controlled Trials (RCTs). After reviewing several classic economic studies about microfinance, Roodman concludes:

First, poor people are diverse, and so are the impacts of microcredit upon them.
Second, there is no convincing evidence that microcredit raises incomes on average.
The ambiguity about average impact arises from four intertwining factors:
– Different people use microfinance in different ways.
– Even people who use it in the same way can experience different outcomes.
– Families, villages, and neighborhoods are complex webs of causal relationships, which are hard to disentangle.
– Average effects depend as much on the ability of microfinance institutions to select those most likely to use finance well as it does on the potential effects on each user.

I echo the first reason in particular. Savvy businessmen are more likely to get loans of appropriate amount and make wise investments than illiterate, uninformed farmers. Self control also determines how much one gains from microfinance, as many poor people borrow not to invest in productive activities but to consume.

The second definition, development as freedom, is more subtle. High repayment rates are usually built upon tight repayment schedules and credible threats against default. Yes, the poor might be getting the loan they want. But they have to pay a significant portion of their incomes back to the lender every week. This is not only a burden but also limits them from reinvesting business incomes into other productive use. Upon sickness of a household member, weekly repayments can force a household into a debt cycle which is hard to get rid of.

The third definition, development as industry building, places development into a macro picture instead of micro-level households. Challenges exist on the way to “creative destruction”.

Roodman writes with rigor and maintains a logical flow of his arguments. An outstanding feature is the wide citation of research from other disciplines, especially anthropology. I have found the quotes from Helen Todd intriguing and thought provoking.

Microfinance, like all other initiatives to reduce poverty, will not reach its goal unless it is combined with government efforts to improve people’s ability to use it. Economists and policy makers are often tempted to design one-time interventions and expect these to change lives, but often ignores the complex social mechanism operating in the background. Affordable quality education, reliable energy supply, water and sanitation, transportation networks, healthcare facilities, and many others remain to be established before we can trully talk about development.

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One thought on “Microfinance through rational eyes: reflections on David Roodman’s Due Diligence

  1. Pingback: Banerjee’s Review on Micro-finance Research | Maryandmusic's Blog

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