"The Microfinance Promise" by Jonathan Morduch, in Journal of Economic Literature (Dec. 1999), American Economic Assn., 2014 Broadway, Ste. 305, Nashville, Tenn. 37203.

Around the world, particularly in Bangladesh, Indonesia, and Bolivia, "microfinance" institutions have sprung up in recent decades to make small, usually collateral-free loans to the poor, enabling them to go into business for themselves. They become textile distributors, street vendors, and furniture makers. Some eight to 10 million households have taken such loans, and there is hopeful talk by the World Bank and others of expanding the total to 100 million by 2005. Advocates tout microfinance as a way of alleviating poverty without permanent subsidies or massive government programs. They claim it is a "win-win" solution, in which both the lending institutions and the poor clients benefit. Morduch, a lecturer at Princeton University’s Woodrow Wilson School of Public and International Affairs, urges a more cautious view.

"Alleviating poverty through banking is an old idea with a checkered past," he notes. From the early 1950s through the 1980s, many countries put reducing poverty through the provision of subsidized credit at the center of their development strategies. In nearly all cases, Morduch observes, the result was disastrous. "Loan repayment rates often dropped well below 50 percent; costs of subsidies ballooned; and much credit was diverted to the politically powerful away from the intended recipients."

Mindful of this past, microfinance advocates claim there is a new determination that the programs become financially viable without ongoing subsidies. "Programs typically begin by lending just small amounts and then increasing loan size upon satisfactory repayment," Morduch says, and repayment must start almost immediately. Microfinance advocates also stress the significance of innovations such as "group-lending" contracts. Pioneered by Bangladesh’s Grameen Bank, these contracts effectively make a borrower’s neighbors cosigners for the loan, thus creating pressures for repayment, even without collateral.

But "the boldest claims [for microfinance] do not withstand close scrutiny," writes Morduch. "High repayment rates have seldom translated into profits as advertised. Most programs continue to be subsidized directly through grants and indirectly through soft terms on loans from donors. Moreover, the programs that are breaking even financially are not those celebrated for serving the poorest clients."

Even the Grameen Bank--which now has more than two million poor borrowers, 95 percent of them women, getting loans that total $30–40 million per month--"would have trouble making ends meet without ongoing subsidies," Morduch says. Though the Bangladesh bank reported "repayment rates above 98 percent and steady profits," it used some nonstandard accounting definitions, was slow to write off loan losses, and treated grants from donors as income. Had it not done that, he calculates, the bank’s reported $1.5 million in profits between 1985 and 1996 would have been $34 million in losses. But so what? he says. "Even if the bank is not the economic miracle that many have claimed, it is not obvious that its failure to reach financial self-sufficiency is in itself a problem," so long as the donors remain committed and the social benefits outweigh the costs.

Microfinance may well have a role to play in alleviating poverty, Morduch concludes, but, even in the best of circumstances, that role will be limited: helping to "fund self-employment activities that most often supplement income for borrowers." Making "a real dent in poverty rates," he suggests, will require increased economic growth and more new jobs.