Distrusting the Debtor

A central question in judging microcredit: When can we as creditors trust the judgment of the poor as borrowers? These days we can all reel off examples of unwise borrowing in rich countries (though I daresay unwise lending is more to blame for the current crisis). Do the world's poorest people, with less margin for financial folly, borrow more prudently? Two things I've read recently tend toward opposite answers to this question.A rough concept paper by Bindu Ananth, Dean Karlan, and Sendhil Mullainathan asks us to

Consider the case of a vegetable vendor in Chennai: Nearly every morning, she takes out loans to buy vegetables from a wholesaler, and in the afternoon she pays the loan off with her daily sales. She does this every day, paying an interest rate of 10% per day. Fruit vendors, flower vendors, and other vendors of perishable products take out similar high interest, short-term loans to finance their working capital.

Thanks to the power of compounding interest, 10%/day works out to 128,330,558,031,335,170%/year. 128 quadrillion percent per year. That stratospheric number does not mean much in the real world. But Ananth, Karlan, and Mullainathan bring it down to earth in a nice way. They imagine a vegetable seller who perpetually borrows 1,000 rupees (about $20) at 10%/day. If she cut her daily spending by just 5 rupees, the price of a cup of tea, and put that money in savings, she would eventually accumulate enough that she would not need to borrow anymore. And that would take not the 200 days you might expect (200 days @ 5 rupees/day = 1,000) but 33 days. Why? As her savings built up, she could borrow less and less, using her savings too to buy potatoes and eggplant each morning and recouping the money with sales over the day. And as her borrowing went down, so would the interest she paid. She could add the savings on interest to her kitty, helping it grow much faster---that's where the compounding comes in.Ananth, Karlan, and Mullainathan run the numbers in a spreadsheet and find that after 33 days, the seller would have freed herself of a 100 rupee/day interest bill, which would raise her net income by $2/day. A month of modest abstinence would pry out of her debt trap and lift her above India's poverty line.So why don't the real vegetable vendors do it? The authors consider a few possible answers. One is "liquidity preference": borrowing your capital rather than digging into your savings for it puts more resources at your disposal in emergencies. But:

The most likely explanations seem to be that vendors do not fully appreciate compounding, or do not have access to a cheap commitment savings device that facilitates this exact process of unraveling their debt. We are currently testing these hypotheses in the field and running interventions that will facilitate a switch from debt-cycle to savings-cycle. We will look at whether mental accounting and financial planning training or access to a savings lock box help vendors save in increments (e.g., one less cup of tea per day), and then reduce their borrowing in increments.

(The idea behind the lock box is that vendors might prefer saving to borrowing if only they could do so safely.)I gather that the research has been done but is not yet written up.The authors of Portfolios of the Poor: How the World's Poor Live on $2 a Day don't confront that puzzle directly, but they tend to take a more sanguine, trusting view of high rates for short-term loans. They point out that informal loans are often paid back late, yet without any extra interest charges, which dramatically reduces the effective interest rate. (Are the vegetable sellers' loans flexible in this way?) And whatever interest the poor do pay may be a reasonable and ultimately minor fee for the valuable service of helping them manage their spending over time:

Seeing interest rates as a fee rather than an interest rate goes some way to helping us understand why households are sometimes happy to pay what we might consider to be astronomically high interest rates....[A] poor person may sensibly pay 50 cents to borrow $10 for a day or so to tide her over a problem, even if the annualized rate calculates to more than 500 percent. The absolute outlay is just not that great, even if the percentage rate is astronomical.

The point that the total cost of interest is small compared to the borrower's income seems to clash with the idea that the vegetable seller could save her way out of poverty in a month. I'd welcome thoughts on this tension.