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David Roodman's Microfinance Open Book Blog

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Schumpeter is a sort of patron saint in this field. I may be alone in thinking that he should be treated like a patron saint: paraded around one day each year and more or less ignored the rest of the time.---Robert Solow, 1994

I explained Tuesday that I am looking now at microfinance through the development-as-institution-building lens (or filter). "Development" in English signifies both an outcome, as implied by the Amartya Sen--inspired Human Development Index, and a process, as encoded in the Latin root volvere, "to roll." And it is really the process of development that is hardest and most important to understand. It seems that most countries that have become rich did so by enduring decades of economic churning, in which new ways of making things displaced old. Typically the spread of these innovations was associated with the rise of new corporations---makers of steel, software, etc. "It is not the owner of stage-coaches who builds railways." To use another word from the same root, development is a series of revolutions. An economy that ceases to generate such institutional revolutions ceases to develop. For the development process to avoid becoming cancerous, institutions' drive for growth must be checked by external factors such as competition, regulation, and consumer preferences. One can generalize the conception beyond corporations to organizations generally: non-profits such as the Red Cross as well as democratic governments also arise to put their stamp on society by producing things that people have reason to value.

The leading proponent of this view of development in the history of economics was the Austrian economist Joseph Alois Schumpeter. In Capitalism, Socialism and Democracy (1942), He popularized, but did not coin, "creative destruction":

...the history of the productive apparatus of a typical farm, from the beginnings of the rationalization of crop rotation, plowing and fattening to the mechanized thing of today---linking up with elevators and railroads---is a history of revolutions. So is the history of the productive apparatus of the iron and steel industry from the charcoal furnace to our own type of furnace, or the history of the apparatus of power production from the overshot water wheel to the modern power plant, or the history of transportation from the mailcoach to the airplane. The opening up of new markets, foreign or domestic, and the organizational development from the craft shop and factory to such concerns as U.S. Steel illustrate the same process of industrial mutation---if I may use that biological term---that incessantly revolutionizes the economic structure from within, incessantly destroying the old one, incessantly creating a new one. This process of Creative Destruction is the essential fact about capitalism.

I just read half of a translation of his 1911 Theory of Economic Development. I doubt I'll read the other half: it's pretty tough going. Seems like the guy could have said what he wanted to say in a lot fewer pages. I realized that he was one of the last in the tradition of literary economists reaching back to Adam Smith and the French physiocrats, who thought in prose, not equations. (As it happens, the just-departed Paul Samuelson led the generation that mathematized---revolutionized---economics starting in the 1940s.)

At any rate, Schumpeter makes himself clear. His starting point is a theoretical economy called the circular flow, which I imagine as a pre-modern seaside market town in northern Italy with winding, stone-paved streets. In the circular flow, little changes, ever. The farmer sells to the butcher, who sells to the shoemaker, who sells to the candlemaker, who sells to the farmer. Income and expenditure circulate in predictable ways, day to day, year to year. Credit is useful but inessential. Schumpeter knows that the circular flow is an artifice, but it lines up with a paradigm he wanted to revolt against. A few decades before, Alfred Marshall had popularized, but did not coin, the iconic graphs of supply and demand that showed prices balancing economic forces.

The important question, Schumpeter says, is not what makes this equilibrium, but what breaks it. "Carrying out a new plan and acting according to a customary one are things as different as making a road and walking along it." How do economies change? Where do railways and Model T's come from? His answer: the hero of development is not the scientist nor the inventor but the entrepreneur, the one who strikes out to make "new combinations" of materials and labor---new products, or old products made new ways---and so disrupts the circular flow. "Development in our sense is then defined as the carrying out of new combinations." And profits exist only to reward such entrepreneurship.

Thanks to Robert Heilbroner, this is about what I expected to read. I came to Schumpeter to understand how in his conception, the process of development flows through the business of financial services, to help me see Muhammad Yunus and John Hatch and other microfinance innovators as heroes of development.

But a surprise awaited me: for Schumpeter, the process of development can course through the business of financial services, yes, but far more importantly, the business of financial services flows into the process of development. Credit is the oxygen of the body economic. In order to carry out new combinations, entrepreneurs need purchasing power with which to hire workers and obtain materials---in particular, to draw these factors of production from the established circular flow. One of the more mind-boggling, everyday facts in economics is that banks create money (but not wealth) out of thin air. You put your money in a savings account and it is still yours. Yet the bank lends most of it to someone else, who can spend it: one dollar becomes two. If the borrower successfully invests the money in new economic activities, then the growth in money will eventually be matched (or surpassed) by growth in wealth produced. In fact, without the money created through credit, Schumpeter submits, the entrepreneur could not obtain the purchasing power to disrupt existing economic patterns. At least in capitalist societies, the hero behind the hero is the banker:

The banker...is not so much primarily a middleman in the commodity "purchasing power" as a producer of this commodity....[H]e has himself become the capitalist par excellence. He stands between those who wish to form new combinations and the possessors of productive means. He is essentially a phenomenon of development, though only when no central authority directs the social process. He makes possible the carrying out of new combinations, authorises people, in the name of society as it were, to form them. He is the ephor of the exchange economy.

Few today doubt the essential role of finance in development. Though the recent financial crisis may lead you to smirk at the suggestion that credit is good for the economy, last year's credit market freeze-up was aptly compared to a heart attack, the damage from which has still not healed. The financial system is essential economic infrastructure, as I discuss at the end of chapter 2 (but I think I'll move that content to the new chapter 8). Less clear is under what circumstances availability of finance limits economic development, i.e., when limits on its availability constrain economic growth and when boosting banking would thus spur growth. As it happens, I've shown that some of the most important statistical evidence on this question is indecisive.

Accepting the important role of finance in development does put microfinance in an interesting light. Read Portfolios for the Poor and I think you'll see that financial services for the poor do not disrupt the circular flow so much as smooth it. To the (significant) extent that takers of tiny loans invest in businesses, they largely do so in low-tech subsistence activities such as retail. Yunus may be a Schumpeterian hero, but microborrowers as a rule are not, even though he may see himself in them. So while we should not make the perfect the enemy of the good, it is worth reflecting that even as Schumpeter might have admired Yunus as he must have Henry Ford, the Austrian economist would probably not have viewed microcredit per se as an engine of economic development. The arrival of microcredit is development in itself, but does not radiate ripple effects the way that a similar revolution in banking for larger businesses, the kinds that can hire and scale up, might do. In Schumpeter's sense, microfinance rarely causes development among the clients who are its public face.

The worry is that banking for the not-so-poor is neglected in development efforts because it is less photogenic. Also underemphasized may be the scope for microfinance to take savings of the poor and on-lend to people and businesses already a step up the economic ladder.

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CGD blog posts reflect the views of the authors drawing on prior research and experience in their areas of expertise. CGD does not take institutional positions.