"Micromortgages": A Better Approach to Economic Development Through Entrepreneurship?

Guest post by Charles Johnson

Our foundation president, Carl J. Schramm, has criticized Yunus's approach to microfinance, most recently in his essay for the Claremont Review of Books. In comparing the Nobel Prizes awarded for economics and peace in 2007, Dr. Schramm argued in the Wall Street Journal that microfinance might not be the panacea for world poverty that aid development agencies, like the State Department, have suggested that it is. With co-author, Dr. Amar Bhidé, Schramm writes,

Mr. Yunus's ameliorative entrepreneurship however is very different from the transformative entrepreneurship that Mr. Phelps argues has been central to modern capitalism. Indeed, most of the ventures funded by microloans in Bangladesh are activities that were marginalized by modern entrepreneurs: They don't involve any economies of scale or scope or the use of new technologies capable of producing significant advances in overall productivity and incomes. 

 Economic development does wonders for peace, but what does microfinanced entrepreneurship really do for economic development? Can turning more beggars into basket weavers make Bangladesh less of a, well, basket case? A few small port cities or petro-states aside, there is no historical precedent for sustained improvements in living standards without broad-based modernization and widespread improvements in productivity brought about by the dynamic entrepreneurship that Mr. Phelps celebrates.

It seems, though, that microfinance, far from being the panacea, may simply encourage consumption at the expense of long term economic growth. As a welfare program, microfinance isn't necessarily bad, as it most likely going to keep people from starving, but it lacks the kind of true impetus to drive true growth. True, Yunus’s model may be preferable to the massive government to government loans and spending of the Bengladeshi government, but that isn’t really saying much, even if the money is put directly into the hands of individuals.

A most recent article, titled,”A $9 Trillion Question: Did the World Get Muhammad Yunus Wrong?,” in Foreign Policy makes a similar point: how can the estimated $17 billion in loans actually help elevate the living standards of the $4 billion in poverty and why has it been so lackluster at generating real results?

Peter Schaefer writes,

Moreover, most of the existing microfinance credit is subsidized. Very little comes from private, profit-seeking capital markets (as of 2004, just $2.7 billion, or about 60 cents per poor person per year). This is because development banks do not really require collateral for their microloans. They often use subsidized credit, as they generally aren't profit-seeking. But banks backed by private capital markets require collateral. This means that their loans are too expensive for most of the long-term needs of the poor.

For instance, the private Mexican microbank Compartamos charges 100 percent annualized interest -- which, to be fair, reflects the real risk of providing an unsecured loan. But such long-term interest rates cannot encourage capital investment in projects that need time to gestate. And though shorter-term loans with 25 or 50 percent annualized rates beat the street rate, such debt cannot be carried for any length of time. As a result, the pool of global capital is largely inaccessible to poor people. And the solutions proposed by Yunus and de Soto for formalizing the economy of the poor and thus lifting them from poverty prove only marginal.

In short, too much debt tends to sink individuals faster than it takes for them to make long-term financial decisions. The author suggests that “micromortgages” could actually help promote real long-term growth. He writes,

How would it work? Let's consider a poor individual living in a house without a title or even an address in Mexico. He hopes to formalize his house. So, he visits a local bank to apply to register his property. To the bank, he represents potential demand for credit -- the bank has incentive to research his claim, help him map his land, assess any improvements, and submit his information to the registry. The bank would do this in return for his loan business and a fee to cover costs. 

The bank would then submit the individual's information to the government, ready for entry into an official national digital registry. Were the application accepted for processing, he could take out a form of title insurance from the bank, which could then safely extend credit to the applicant. The modest application fee would be added to his loan principal, allowing him to immediately use the balance for, say, a long-term micromortgage to finance a business.

 Intuitively, tapping into the equity in your home makes sense. Many entrepreneurs in the U.S. have used home equity lines of credit to finance their businesses, why should the developing world be any different?  

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