In order to help get some kind of bearing on the impact of microfinance, we present here a short literature review on how microfinance affects the lives of the poor. The selected papers are organized into three categories: the broader context, the impact of microcredit, and the impact of microsavings (surprisingly, there seems to have been more work done on savings than credit).

The broader context

Effects of Financial Access on Savings by Low-Income People
Fernando Aportelo, Bank of Mexico
December 1999

This paper assesses the impact of increasing financial access on low-income people savings. Effects on households’ saving rates and on different informal savings instruments are considered. The paper uses an exogenous expansion of a Mexican savings institute, targeted to low-income people, as a natural experiment and the 1992 and 1994 National Surveys of Income and Expenditures. Results show that the expansion increased the average saving rate of affected households by more than 3 to almost 5 percentage points. The effect was even higher for the poorest households in the sample: their saving rate increased by more than 7 percentage points in some cases. Furthermore, the expansion, in general, had no effect on high income households. In the case of informal savings instruments, evidence of crowding out of these instruments caused by the expansion is limited. Results do not rule out the possibility that a considerable fraction of the increase in households’ savings could have come from new savings.

Do Rural Banks Matter? Evidence From The Indian Social Banking Experiment
Robin Burguess & Rohini Pande; LSE, Yale University
August 2003

Lack of access to finance is often cited as a key reason why poor people remain poor. This paper uses data on the Indian rural branch expansion program to provide empirial evidence on this issue. Between 1977 and 1990, the Indian Central Bank mandated that a commercial bank can open a branch in a location with one or more bank branches only if it opens four in locations with no bank branches. We show that between 1977 and 1990 this rule caused banks to open relatively more rural branches in Indian states with lower initial financial development. The reverse is true outside this period. We exploit this fact to identify the impact of opening a rural bank on poverty and output. Our estimates suggest that the Indian rural branch expansion program significantly lowered rural poverty, and increased non-agricultural output.

The Economic Lives of the Poor
Abhijit V. Banerjee and Esther Duflo; Abdul Latif Jameel Poverty Action Lab, MIT
October 2006

This paper uses survey data from 13 countries to document the economic lives of the poor (those living on less than $2 dollar per day per capita at purchasing power parity ) or the extremely poor (those living on less than $1 dollar per day). We describe their patterns of consumption and income generation as well as their access to markets and publicly provided infrastructure. The paper concludes with a discussion of some apparent anomalous choices.

The Impact of Microcredit

Expanding Microenterprise Credit Access: Using Randomized Supply Decisions to Estimate the Impacts in Manila
Dean Karlan, Jonathan Zinman;
Yale University, Darthmouth College, IPA, Financial Access Initiative, MIT Jameel Poverty Action Lab
July 2009

Microcredit seeks to promote business growth and improve well-being by expanding access to credit. We use a field experiment and follow-up survey to measure impacts of a credit expansion for microentrepreneurs in Manila. The effects are diffuse, heterogeneous, and surprising. Although there is some evidence that profits increase, the  mechanism seems to be that businesses shrink by shedding unproductive workers. Overall, borrowing households substitute away from labor (in both family and outside businesses), and into education. We also find substitution away from formal insurance, along with increases in access to informal risksharing mechanisms. Our treatment effects are stronger for groups that are not typically targeted by microlenders: male and higher-income entrepreneurs. In all, our results suggest that microcredit works broadly through risk management and investment at the household level, rather than directly through the targeted businesses.

The miracle of microfinance? Evidence from a randomized evaluation
Abhijit Banerjee, Esther Duflo, Rachel Glennerster, Cynthia Kinnan; MIT Jameel Poverty Action Lab, Indian Centre for Micro Finance, Spandana
October 2009
Hyderabad, India

The researchers from the Abdul Latif Jameel Poverty Action Lab (J-PAL) at MIT and the Indian Centre for Micro Finance worked with Spandana to randomize the roll-out of its microcredit operations in Hyderabad, India’s fifth-largest city. Spandana chose 104 areas of the city to expand into eventually, rejecting some districts as having too many construction workers, who come and go and might take Spandana’s money with them. In 2006–-07 Spandana started lending in a randomly chosen 52 of the 104. Researchers followed up by surveying more than 6,000 households between August 2007 and April 2008, restricting their visits to families that seemed more likely to borrow: ones that had lived in the area at least three years and had at least one working-age woman. The surveyors made sure not to visit an area until Spandana had been there at least a year. They surveyed in “treatment” areas (ones where Spandana worked) and control ones (where it did not yet).

The impact of microsavings

The Impacts of Savings
Dean Karlan
Financial Access Initiative
January 2008

A summary of literature on the impact of microinsurance up to January 2008.

Female Empowerment: Impact of a Commitment Savings Product in the Philippines
Nava Ashraf, Dean Karlan, Wesley Yin; HBS and Jameel Poverty Action Lab, Yale, University of Chicago
March 2008

Female “empowerment” has increasingly become a policy goal, both as an end to itself and as a means to achieving other development goals. Microfinance in particular has often been argued, but not without controversy, to be a tool for empowering women. Here, using a randomized controlled trial, we examine whether access to and marketing of an individually-held commitment savings product leads to an increase in female decision-making power within the household. We find positive impacts, particularly for women who have below median decision-making power in the baseline, and we find this leads to a shift towards female-oriented durables goods purchased in the household.

Savings Constraints and Microenterprise Development: Evidence from a Field Experiment in Kenya
Pascaline Dupas and Jonathan Robinson; UCLA, UCSC, NBER
March 2009

We conducted a field experiment to test whether savings constraints prevent the self-employed from increasing the size of their businesses. We opened interest-free savings accounts in a village bank in rural Kenya for a randomly selected sample of poor daily income earners. Despite the fact that the bank charged substantial withdrawal fees, take-up and usage was high among women and the savings accounts had substantial, positive impacts on their productive investment levels and expenditures. These results imply that a substantial fraction of daily income earners face important savings constraints and have a demand for formal saving devices (even for those that offer negative de facto interest rates).

Tying Odysseus to the Mast: Evidence from a Commitment Savings Product in the Philippines
Nava Ashraf, Dean Karlan, Wesley Yin
July 2005

We designed a commitment savings product for a Philippine bank and implemented it using a randomized control methodology. The savings product was intended for individuals who want to commit now to restrict access to their savings, and who were sophisticated enough to engage in such a mechanism. We conducted a baseline survey on 1777 existing or former clients of a bank. One month later, we offered the commitment product to a randomly chosen subset of 710 clients; 202 (28.4 percent) accepted the offer and opened the account. In the baseline survey, we asked hypothetical time discounting questions. Women who exhibited a lower discount rate for future relative to current tradeoffs, and hence potentially have a preference for commitment, were indeed significantly more likely to open the commitment savings account. After twelve months, average savings balances increased by 81 percentage points for those clients assigned to the treatment group relative to those assigned to the control group. We conclude that the savings response represents a lasting change in savings, and not merely a short-term response to a new product.

On the other hand, NYTimes microfinance evangelist Nicholas Kristof recently called for a “savings revolution”. To back up that call to arms, Rodman points to a great study on the impact of microsavings. That study, by Dupas and Robinson from rural Kenya, is an exciting read for it shows that despite negative rates of return on savings accounts, rural women both love savings accounts and seem to benefit from them:

We find that, about 6 months after having gained access to the account, the daily private expenditures of women sampled for the account were, on average, 37 to 44% higher than those of women in the comparison group. Their average daily food expenditures were 14-29% higher.

Why do savings accounts work so well? The study points out this may be because women without accounts “may be tempted to spend any cash that they hold” and because “it may be difficult to refuse requests for money.” In other words, savings accounts bring discipline to consumption patterns.

There is an interesting parallel with microcredit here. Recent studies of microfinance show that microcredit tends to smooth out consumption – allowing people to purchase consumer goods (TVs, refrigerators) that they would not be able to pay for up front. No doubt, microsavings can help individuals do the same – consumer more. However, there is a huge difference in the dynamics of how that consumption happens. In the case of microsavings, individuals are spending past income. In the case of microcredit, individuals are spending future income – money they neither have nor can risk loosing.

This also leads us to another benefit of microsavings – it acts as insurance in times of illnes. This is another “suggestive finding” of the Dupas and Robinson study:

We find that individuals are not fully protected from income risk. In particular, our logbooks show that, over the period of study, women in the control group were forced to draw down their working capital in response to health shocks. Women sampled for the savings account, however, were less likely to reduce their business investment levels when dealing with a health shock and were better able to smooth their labor supply over illness. In particular, women in the treatment group were more likely to be able to afford medical expenses for more serious illness episodes.

Finally, there is reason to believe that microsavings might be better business as well. For one, it requires no startup capital – which is provided by the clients themselves. Second, the cost of providing credit should actually be higher that for provision of savings – because accepting savings does not require doing a credit check. And finally, operational costs should also be similar or lower.

That logic brings us full circle. Microsavings do much the same for the poor as microcredit (i.e. smooth consumption and investment). And they do so at a lower cost. So why not replace microcredit with microsavings – which seems to be microcredit at a lower cost and with insurance built in.

For more, read Financial Inclusion in India and Do Rural Banks Matter.

The studies are not new but their coverage on the NYT is certainly refreshing. And looking at them together reveals a few interesting points.

First, it is clear that the accepted usage of the term “microfinance” has expanded substantially. First Macro Bank should not even be compared to Spandana for its target clientele is extremely different – existing entrepreneurs with above average national income. That FMB qualifies as a “microlender” seems to suggest merely that microfinance is now behaving as any business – going after the most profitable clients.

Second, it is clear that the impact of microfinance is a lot more fuzzy than development enthusiasts had us believe:

The effect on businesses is not dramatic but some clearly benefit. In the Philippines, male-owned businesses increase profits, although female-owned businesses do not. In India, borrowers who already own a business buy assets for their business. One borrower out of eight starts a business they would not have started otherwise. Others buy durables for their homes

However, there is no evidence that microcredit has any effect on health, education, or women’s empowerment, at least right now, eighteen months after they got the loans. On the other hand, there is also no evidence that people are behaving irresponsibly. Indeed in India we have evidence of people giving up some of the little daily pleasures of life (like tea, snacks, betel leaves and tobacco), to pay for bigger things that they could not previously afford (carts for their business, televisions for their homes).

So, microfinance has no clear impact on socio-economic indicators. And that is ok according to the authors.

Many seem to think that this is not enough. However, as we see it, microcredit seems to have delivered exactly what a successful new financial product is supposed deliver—allowing people to make large purchases that they would not have been able to otherwise. The fact that some people expected much more from it (and perhaps they are right, may be it will just take longer), is perhaps inevitable given how eager the world is to find that one magic bullet that would finally “solve” poverty. But to actually blame microcredit for not promoting the immunization of children is no different from blaming immunization campaigns for not generating new businesses.

In other words, the failure of microfinance to deliver a miraculous cure for poverty is a failure of its early proponents, not of the method itself. As a report pointed out in 2006, microfinance should be viewed as just another business. That perspective is very necessary if we are to get some realism into the debate on what works in microfinance and what does not.

Microfinance has succeeded in developing a relatively low-cost delivery model that can reach millions of underserved clients. That is its success. Its failure is that it has for too long believed in its own rhetoric of poverty alleviation. Now that we know that is not true, it is time to move beyond an obsession with providing credit, to other financial products such as savings and insurance that are likely to be much more effective at insulating the poor from life’s volatility.

Mull over that one for a moment. Mr. Blumenthal isn’t suing to right a wrong. He admits that he’s suing to coerce a change in policy no matter what the public’s elected representatives choose.

No doubt, there is truth to each of these criticisms of climate litigation. But they are all also irrelevant.

Bad for Business? So What?

Yes, climate litigation might be bad for some businesses – particularly the more polluting ones. But it would also be good for others, such as businesses involved in improving energy efficiency, renewable energy generation and the like. But regardless, what if such litigation was bad for business – should we then disallow it? The US Clean Air act, when it was enacted in 1970, was also no doubt seen as bad for business. But hardly anyone would argue that it should not have been enacted on those grounds. So, “bad for business” does not qualify as a potential shield against such litigation.

What is a Nuisance Law?

What about the suggestion that such litigation is a “nuisance”? But who gave the WSJ the right to label certain laws as a nuiscance? Certainly not the citizens of America. In fact, the very term “nuisance laws” is an oxymoron. Laws are not a nuisance – they exist to provide citizens protection of their rights. And due process exists to ensure objectivity in the deliverance of justice, as far as possible.

Take the case of the Tobacco industry, which was sued by hundreds of individuals from the 1950s to the 1990s. No doubt such litigation was both “bad for business” and a “nuisance” for some. But it led to the Tobacco Master Settlement, a USD 206 billion settlement, and dramatically changed views on smoking across the US and the world. Interestingly, no individual “nuisance” lawsuits ever won in court, a validation of the checks and balances of the American legal system and the high burden of proof required of plaintiffs.

Given this history climate skeptics and the WSJ – “if that’s not redundant” – should actually welcome such lawsuits. They would allow both sides of the story to be heard in open court and an objective assessment can then be made of the link between CO2 emissions, global warming, and its effects on cities or ecosystems. Indeed, the burden of proof would be on the plaintiffs from the “green lobby” – so if the skeptics really believe there is no global warming they should hardly worry about such lawsuits. Just as in the case of the tobacco industry, no definitive link may be found for some time – but it may still lead to a better understanding of the issue.

Regulation through Litigation?

Finally, what of the criticism that such litigation arrogates power from Congress to the courts? This is indeed correct. Theoretically, the legislature legislates, the executive “executes” and the judiciary serves as the last word on the matter.

However, this broad principle cannot be taken as absolute because there has always been an overlap of power across these arms of government. And that overlap exists because the legislature is not a perfect representation of the people’s will – insofar as it is not direct democracy and is often biased by private lobby groups. Thus, the potential arrogation of some power to the judiciary is understandable.

Furthermore, there is a long tradition of regulation through litigation including by the US government itself (United States vs. Microsoft Anti-trust lawsuit, or lead paint litigation). At issue here are not the outcomes of these  efforts but the principle of whether individuals and private groups can sue. If the government can, then why not individuals?

Finally, regulation through litigation, while having its own set of problems, also provides benefits. These are summarized well by Tim Lytton in the Texas Law Review:

(1) framing issues in terms of institutional failure and the need for institutional reform; (2) generating policy-relevant information; (3) placing issues on the agendas of policy-making institutions; (4) filling gaps in statutory or administrative regulatory schemes; (5) encouraging selfregulation; and (6) allowing for diverse regulatory approaches in different jurisdictions.

Conclusion

The WSJ editorial argues that litigation against high emitters of CO2 is both frivolous and sets and a dangerous precedent for an anarchic world where everyone can sue everyone. Yet, a long history of similar litigation suggests that both governments and individuals have used litigation in the past to raise issues that the legislature failed to do so. Society is no worse, and some may argue, is better for such litigation. Despite the costs involved, the principle should simply be to let the truth prevail – rather than avoid facing it because it is “bad for business.”

Forbes is all praise for this new design: “Take a look at the designs for what could someday be the world’s cheapest PC, and you may start to wish you were a third-grade child in Burundi.” This magical device is thinner than an iPhone, all-plastic, touchscreen, durable, and backlit. And all that for an amazing USD 75.

Forbes may be fooled, but the somewhat more tech-savvy folks at CNET remind us to take everything coming out of the OLPC Foundation with several grains of salt:

Remember, this is the organization that didn’t just scrap the XO-2, but couldn’t even tack a touch screen onto the current XO-1 laptop, which isn’t anywhere near the $100 that Negroponte once dreamed of.

Wired calls it “vaporvare”, pointing out that “CG mockups and philanthropic promises aren’t the same as real, shipping hardware.” Then again, perhaps it doesn’t have to be. As Mr. Negroponte himself says, “We don’t necessarily need to build it. We just need to threaten to build it.”

That must be code for, “You should know I cannot do this, and if you don’t then the joke is on you.” Or perhaps Mr. Negroponte believes he is the design center for the developing world’s computers. But at a sticker price of several billion dollars, that is a very expensive center indeed. He could get away with it once, but the real question is will media continue to pander to Mr. Negroponte’s self-gratifying dreams?

Finally, if there is any doubt left in your mind that the OLPC is a good idea, here’s another hint. Mr. Negroponte concludes by saying, “Sure, if I were a commercial entity coming to you for investment, and I’d made the projections I had in the past, you wouldn’t invest again, but we’re not a commercial operation. If we only achieve half of what we’re setting out to do, it could have very big consequences.”

To paraphrase: “I cannot do what I promise and at the price I promise. But that doesn’t matter, because we are not a commercial operation. And you being a government could not possibly be bothered by such things as expenses, forecasting, and budgets. Just throw your money my way.”

Any OLPC believers still out there, please cling to your faith.

Wayan Vota started an Educational Technology Debate on what the OLPC has achieved thus far with the assertion that the OLPC is “changing education, technology, even culture in ways beyond any one person’s understanding.”

Going by some of the comments that follow one could be excused for thinking that the OLPC is the best thing to happen to the world since sliced bread. The XO laptop will magically transform students into self-learners (”peers working collaboratively in teams”). A more balanced followup by Scott Kipp still proposes that thanks to the OLPC, “evaluations, discussions and policy assessments about whether or not to have computers in the classroom will very soon be entirely obsolete, if not already.”

Such overwhelming enthusiasm is surely out of place, and perhaps a bit of perspective is important.

For one lets be realistic that the OLPC is not “revolutionalizing” education. Yes, OLPC will soon have 1 million XO laptops in circulation. But compare that with 121 million children not in school, 668 million children that started primary school in 2007, or the 774 million illiterate adults and the OLPC does not seem that revolutionary. No doubt, computers will be important in the future to deliver education, but a lot of schools still struggle with having a blackboard or even a building. So lets not overstate either the scale or the impact of the OLPC.

Second, it is a stretch to say, as Wayan does, that the XO spawned the netbook. What the XO did do was spawn the Classmate PC. But the next step is a bit of a stretch.

Even if the XO did spawn the netbook, the lesson from this is two-fold. First, that non-profit initiatives such as the OLPC are particularly well-suited to creating new innovations, particularly for under-served populations.

Conversely, and this is the second lesson, the dissemination of commercially viable innovations is best left to the private sector. The XO laptop still costs upward of the original USD 100 target price. Meanwhile, the Amazon Kindle costs USD 259, the cheapest netbook now costs USD 98, and in developed countries netbooks are available for free with Internet/data plans. So the second lesson is that if you want cheap computers, don’t let a single institution – particularly a non-profit – build it as a monopoly.

A third lesson, to paraphrase Scott, is that teachers are part of the solution – not the problem. This is not wording that OLPC proponents would like because constructionsm sees teachers as a corrupting influence. Too much of the broader debate around the quality of education in developing countries also lays blame on teachers – without exploring the context in which they operate. Yet, is there an OLPC project that has substituted teachers with laptops? So, the second lesson is that if you want to achieve education for all, spend more on teachers and on computers. And if you must choose between the two, spend on the former.

Finally, it has also taught us that policymakers don’t always make the most judicious use of taxpayer money. The approximately USD 150 million spent on XO laptops, for instance, is the same annual amount needed to achieve 100% literacy in Brazil. Yes, the OLPC has certain other benefits, such as evaluating the impact, benefits and drawbacks of computers in the classroom. But at a potential price-tag of USD 66.8 billion for all the world’s primary school children, it would be a very expensive experiment indeed.

Such reasoning is far too simplistic for these individuals, and surprisingly echoes the words of Lord Griffiths, Vice Chairman of Goldman Sachs, who said that “we have to tolerate the inequality as a way to achieve greater prosperity and opportunity for all”.

Becker and Posner’s posts skirt around two key issues.

First, Becker says that pay had nothing to do with the crisis:

I have not seen convincing evidence that either the level or structure of the pay of top financial executives were important causes of this worldwide financial crash.

On this he is most certainly right. Yet, while pay may not have been a direct cause of the crisis, it was in hindsight a predictive symptom of it. Fundamentally, the crisis was caused by a breakdown in ownership of responsibility. Financial executives, traders, and bankers bought and sold instruments on which they did not own the risk and thus did not feel compelled to view the transaction and the hefty profits that came with it with a healthy dose of skepticism.

No doubt other factors contributed to that tunnel vision – including a blind belief in the correctness of financial wizardry. But an incentive structure that rewarded short-term gain and encouraged overlooking fundamentals certainly did not help.

Posner, for his part, at least agrees to the principle of reforming compensation structures. Yet, he also concludes that “regulating financial compensation is a mistake”  because it cannot be done within the bounds of reason. Even if escrow and clawback clauses were added to executive compensation structures “that would be too small an expected penalty to dissuade him from making the deal. The penalty could not be made sufficiently heavy to disuade him without depriving him of most of his current income.”

Unfortunately for Posner the rebuttal to his “it cannot be done” argument is right there. Why not deprive the executive of most of his current income? The case for doing that is a natural extension of the principle of risk and benefit sharing.

Bonuses were designed to reward employees and allow them to participate in the potential of their work and the performance of their company. But over the years executives have come to view bonuses as part of their normal salary with poor performance to be penalized simply by a lower bonus. This gain-only structure is incomplete and not how it was meant to be. The logical thing would be to have a bonus for good years and a penalty for bad years. The possibility of loosing money from ones base salary should be part and parcel of every compensation structure.

There are two good reasons for such a structure.

First, it helps avoid risk where it is not necessary. As Posner mentioned, financial executives are overpaid given that their pay is based on “speculative profits that are not net additions to economic welfare, because they are offset by the losses of the speculators on the other side of successful speculators’ trades.” Raising the specter of loosing money will minimize speculation and force individuals to consider the potential consequences – positive and negative – of their actions.

Second, it is fair. If executives can gain from better performance they should also loose from poor performance. That is the principle that investors accept on the stock market and entrepreneurs accept when they setup companies. Why should executives and employees be treated any different when things go sour on their watch?

How different is this philanthropist? And what does it say about philanthropy and society?

The first question is answered by Kramer himself, who sees this as a new approach that brings together four elements – taking responsibility for the change they seek, engaging others to build coalitions, using structures and partners from outside the non-profit sector, and creating knowledge to influence the behavior of others.

It would appear from this that what venture philanthropy did at the level of the institution, catalytic philanthropy does at the level of society. Venture philanthropy focuses on addressing the fundamental challenges facing institutions – lack of long-term funding, organizational limitations in expertise, etc. Similarly, the common thread amongst catalytic philanthropists seems to be that they are addressing a single societal challenge (such as meth addiction in the example used by Kramer).

Seen in this light the catalytic philanthropist is not new, but is still rare. Carnegie’s initiatives to address education, the Rockefeller Foundation’s support of research into high-yielding varieties of seeds, and the Gates Foundation’s efforts to address fundamental shortcomings in public healthcare in the developing world all follow that same trend to varying degrees. If that is the case the catalytic philanthropist is not that different from the subject of the book Philanthrocapitalism: How the Rich can Save the World.

The rise of such a philanthropist may be heralded as a good thing. But is it?

As Kramer says, traditional donors “delegate to nonprofits all responsibility for devising and implementing solutions to social problems.” But by putting faith in catalytic philanthropists, society also delegates responsibility for improving its lot to wealthy individuals, rather than to the elected representatives in government that are usually mandated that task of ensuring societal progress. That, certainly, cannot be a good thing for it implies that either governments have been unsuccessful in meeting society’s demands or that the ambitions of wealthy individuals exceed the capabilities of government.

The real reason for the rise of the catalytic philanthrocapitalist (to combine terms) is probably a mix of those two. But the correct response to a failure in governance is not to delegate the responsibility to another unaccountable individual. And the ambitions of individuals can just as easily do harm as good.

This is not to say that such philanthropy is bad. The basic premise that meaningful, long-term social change cannot happen via check-book philanthropy is correct. But when philanthropists engage in transforming society to match their visions, they must critically ask themselves if changing society is indeed their responsibility? And if they conclude that it is they must still be careful and understand there is a fine dividing line between visions and mirages.

Referring to the two Bretton Woods financial institutions, Keynes once wittily observed that the “Bank’s a fund and the Fund’s a bank.” Whether the IMF should continue to be a bank is being hotly debated. But it is in India’s interest to push the Bank to be less of a financial fund and more engaged in generating and financing ideas and technology for development.

It is refreshing to see this idea put forth so elegantly because the timing is right. As India and China rise in the world they have sought more influence over the world’s financial institutions. During the financial crises much attention focused on a potential future role for the IMF. But in an environment where the efficacy of aid has often been questioned, the World Bank is no stranger to questions about its future either.

Back in 2007 the WSJ had suggested that the bank be disbanded altogether given that it did little more than fund corruption. The same year Prof. Bhagwati suggested that the Bank be a think tank of 300, in contrast to the 8000+ it employed at the time. That is not far from what Subramaniam suggests today.

The premise is simple – that the World Bank suffers from an identity crises as a development aid fund. Its “core” business of financing development projects is irrelevant in fast-growing Asian countries that can access market capital. And in poorer countries where private capital is unavailable the Bank is only one of many players. And anyway, according to their research (see PDF papers here and here), development aid has no impact on growth. So, what is the World Bank good for?

Despite this evidence, the World Bank’s current lending practices overwhelmingly favor traditional lending to governments over global public goods. The numbers are difficult to pin down but global public goods financing is unlikely to exceed 20 percent of total World Bank lending. In other words, current practice is inversely correlated with the evidence. What makes this inverse correlation particularly egregious is that there are many suppliers of traditional aid (bilateral donors, NGOs, private philanthropy) but few suppliers of global public goods. The World Bank should be filling the latter empty space instead of further crowding the lending business.

Global public goods remain dangerously underfinanced, notwithstanding the massive amounts raised by the Global Fund and the Gates Foundation for public health. Research into public health, education, access to water, and climate change has been neglected or has often focused on the interests of the developed world. This explains, for instance, why the climate change agenda has focused so overwhelmingly on mitigation issues, rather than on adaptation or insurance against unavoidable changes.

Clearly, we need an “inventor of last resort” to finance research, development, and scaling of technologies that are necessary but for which there is no viable market return. Subramanian puts forward his suggestion as primarily of interest to India and other fast-growing economies. But his proposed realingment would be useful for most developing countries, given the substantial transformative power of such public good investments.

On the other hand, some of the biggest contributions to development have come from global public goods such as the green revolution and the medical breakthroughs, especially related to the development of antibiotics and vaccines. The technical discoveries leading up to the green revolution were financed by official aid and private philanthropy. And the adaptation of the green revolution technologies to varying climactic conditions across the developing world was actually undertaken in the internationally-funded CGIAR network of research institutions (including ICRISAT which is located in Hyderabad) that are now sadly in decline, in part due to international financial neglect.

Finally, this proposal makes sense because it is likely to do the least damage. If aid has no impact on growth at best and can seriously distort a nation’s economy at worst, is it not better to spend the money outside the country? Jagdish Bhagwati suggested as much in an Oped piece for the WSJ in 2005 (better formatted PDF here). Subramanian’s suggestion shows how that can happen in practice.

The need to finance public goods has never been greater. The technology gap between the rich and poor countries is expanding and that trend is only likely to accelerate as we move into a low-carbon economy. Countries with access to technology will reap the rewards of higher productivity, more adaptability, and a higher standard of living. Yet, those at the bottom of the scale will never form a viable market, and their needs will continue to be ignored. There is a strong case for the intervention of a relatively impartial international institution to both invest in the needs of developing countries and to coordinate their replication.

In the end, the success of this proposal will depend less on its actual value and more on the politics of aid. India wants to double the size of the World Bank, but it also wants a much bigger voice in its running. That can only happen at the expense of the Bank’s current masters. So the question is whether the world’s major donors will allow the World Bank to take on a new role, or by obstructing it will make the institution irrelevant?

The result: Today in India, some poor neighborhoods are being “carpet-bombed” with loans, says Rajalaxmi Kamath, a researcher at the Indian Institute of Management Bangalore who studies the issue. In India, microloans outstanding grew 72% in the year ended March 31, 2008, totaling $1.24 billion, according to Sa-Dhan, an industry association in New Delhi.

This development should hardly be surprising as commentators have long warned of the perils of too much credit chasing too few good candidates. That, and poor governance, were identified last by the MF Banana Skins 2008 report as key challenges for the future of the industry.

There is a parallel here with the sub-prime crises which had its origins in these same twin problems – too much credit and moral hazard on the part of those doing the lending (see this post for more). Yet, despite these problems, microfinance continues to grow.

According to the Monitor Institute microloan volume grew from USD 4 billion in 2001 to USD 25 billion in 2006. And new microfinance investment vehicles (MIVs) are going beyond debt financing to take equity stakes as well (e.g. the DWM Microfinance Equity Fund I closed this summer with USD 82 million from four institutional investors), illustrating a growing confidence in this sector.

An interesting observation is that loan volume growth seems to be outpacing actual investment growth by a large margin. While loan volumes were USD 25 billion in 2006, a CGAP brief estimates assets in MIVs in Europe and the US at only USD 6.5 billion. The remaining money must be coming from savings, public equity (e.g. Compartamos), philanthropic grants, IOs, and other public institutions. Nevertheless, MFIs must still be heavily leveraged to have such large loan books.

A second observation is that while private MIVs have the most incentive to ensure quality of microloans they also have the most incentive to charge higher interest rates. This is particularly so now that microfinance advocates have advertised themselves as a new and uncorrelated asset class resilient to the economic recession.

This makes microfinance doubly vulnerable compared to housing finance before the sub-prime crises. While the latter was only vulnerable to defaults from below, microfinance is also vulnerable to ethical pressures. Having sold itself as a “social investment,” microfinance cannot be seen to create indebtedness. Should that happen the flood of money in this sector will likely dry up quickly, putting pressure on the MFIs and in turn on the borrowers.

It is time that social investors and microfinance proponents scaled back their optimism – both on the impact of microfinance and on its investment potential. Microfinance cannot be immune to the basic rule of finance that risk and return are correlated. Moreover, such high expectations provide incentives to actually undermine both the social impact and potential returns of microfinance. An expectation of growth incentivizes providing loans even to those that cannot use them for anything other than consumption. And an expectation of higher or more consistent returns provides incentives for higher rates, which in turn can lead to indebtedness.

Microfinance investors may be doing damage to their own investments in this manner, by compromising the sustainability of the model. It is time for some realism, because regardless of whether microfinance is good or not endless growth cannot be without consequences – as the subprime crises showed.