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David Roodman's Microfinance Open Book Blog

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The first time I encountered Herman Daly’s work was part of a serendipitous chain of events of the sort that gives you pause years later with the thought of how different your life would be now if it had gone a tad differently then. Just out of college, I was spending a year at Cambridge University in England, supposedly studying mathematics. Instead, I found myself searching for distractions.

One short January day, I came across Small Is Beautiful, a 1973 work by the British economist E.F. Schumacher, on a friend’s bookshelf. It fused ecology and economics in a way I had never seen, and thrilled me with the results. A conversation with another friend led to Soft Energy Paths, written around the same time by Amory Lovins, a young American physicist turned Oxford don. When that appeared, it upended the conventional wisdom that the only antidote to energy shortages was ever-more-aggressive efforts to expand supply. (Instead, it argued, countries could and should use existing supplies much more efficiently.)

On the first page of his book, Lovins yielded the lectern to an economist at Louisiana State University. This economist backed Lovins in criticizing mainstream energy analysts for viewing energy demand purely and unthinkingly as something to be accommodated, not controlled.... "This approach is unworthy of any organism with a central nervous system, much less a cerebral cortex," Herman Daly wrote. "To those of us who also have souls it is almost incomprehensible in its inversion of ends and means."

It was a compelling quote. Daly spoke from both his mind and his heart---and thus, like Schumacher and Lovins, appealed to both my mind and my heart.

That's me reviewing Daly's Beyond Growth in World Watch magazine in 1997. (Funny, I spotted Lovins in the Brookings cafeteria last month. Took me a while to place him.)

My thoughts turned to Daly as I finished chapter 8 and digested two excellent new CGAP reports (here and here) and an Indian newspaper article on the growth and prospects of the microfinance industry.

The first CGAP report investigates recent microcredit crises in Bosnia, Morocco, Nicaragua, and Pakistan and their remarkably common causes:

1. Concentrated market competition and multiple borrowing.

2. Overstretched MFI systems and controls.

3. Erosion of MFI lending discipline.

I absolutely recommend the report, and I think this is a fine list, but it doesn't get to the root of matters as I am currently thinking about them.

I realized as I drafted chapter 8, which judges microfinance on how well it has done at building viable industries (conceptually distinct from demonstrably reducing poverty and empowering clients), that I had to distinguish growth from development. Microfinance is growing like so many sunflowers. When is that growth healthy, a true contribution to Schumpeterian economic transformation, analogous to the growth of a child? And when it is unhealthy, like mortgage lending in the U.S. not long ago, or cancer? Daly offers these definitions:

Thinking about how to apply this distinction to microfinance, I recalled the Galbraith quote from last summer: "All crises have involved debt that, in one fashion or another, has become dangerously out of scale in relation to the underlying means of payment." Growth in credit becomes unhealthy, what Daly calls uneconomic growth, when feedback about economic limits is unavailable or unheeded. Then credit overshoots and crashes. So I would say that where microcredit is growing fast and constraints are inadequate to prevent overshoot, that is not really economic development.

I elaborate in chapter 8:

A helpful framework for understanding credit crises is that of system dynamics. Consider a classic example from ecology, the introduction of reindeer onto the uninhabited St. Matthew Island in the Bering Sea in 1944. The herd started small, at 29 head. Naturally, the animals reproduced; and the more reindeer there were, the more fawns were born each year. This positive feedback loop generated accelerating growth. For a while, the deer thrived. In fact, they fattened off the land. In a research paper, U.S. government biologist David Klein captioned a 1957 photograph of four bulls: “Note the rounded body contours and enlarged antler size.” Then a negative feedback loop kicked in: the more animals, the less food per animal, and the less ability to survive and reproduce. If the population had responded quickly to the negative feedback—as hungry rabbits could by reabsorbing fetuses—then it might have coasted smoothly to the ecologically sustainable population level. The upper left quadrant of Figure 5 shows an abstract simulation of this situation, marking the sustainable level as 100. Notice that the rate of increase at any point along the curve is proportional to current population—so growth is very slow at the beginning—and to headroom—so growth peters out at the end too. Now, if we increase the number of fauns per litter, causing faster growth, the population still remains within the ecological limit, though it veritably slams into it (upper right).

Figure 5. How fast growth and delayed feedback about limits cause overshoot

Microcredit growth curve 1Microcredit growth curve 2

Microcredit growth curve 3Microcredit growth curve 4

For insight into herd behavior in finance, watch what happens when information about headroom is muffled or ignored. This is simulated by making growth proportional to headroom in the past rather than to headroom now; conceptually, this allows a doe to mate in a time of plenty and give birth into famine. It turns out that when litters are small, the feedback delay does no harm, because headroom in the recent past nearly matches headroom now. Information is accurate and the herd still coasts to equilibrium (lower left). But if the drive for growth is high and information about limits is delayed, the population repeatedly overshoots and collapses (lower right). In the abstract example in the figure, the population plunges 79 percent, from 188 to 39. On St. Matthew in the winter of 1963–64, the herd crashed from 6,000 animals to 42. After, Klein visited the island and found it scattered with bleached horns and skeletons.

These graphs teach an important lesson: a system overshoots when information about its “scale in relation to the underlying means of payment” is unavailable or unheeded and when its drive for growth is aggressive. Neither ingredient alone is necessarily harmful. But both are present in microcredit today. As for the first, the enthusiastic investment flowing into microcredit fuels fast growth. The social motivation behind this capital may add to the danger by dulling business sensibilities. And once aggressive lending starts at one MFI, it is contagious within a country. Initially conservative managers abandon caution in order to keep up with their peers. Yet sustainable lending calls for a delicate balance of risk-taking and conservatism. To maintain control, MFI managers need training programs for new workers, pay formulas that do not overly reward disbursement, and internal data systems for tracking portfolio health. All need tweaking over time. Growth that outpaces this internal development is the growth of a weed tree. Bank branches will be big but not strong.

(Here is the spreadsheet I used to make these graphs. All four are based on the same equation. You can vary the growth drive and the feedback delay and watch the results.)

For me, the three CGAP points are really one: the industry's inability to manage its own growth. That's equivalent to delay in feedback about how much headroom there is beneath Galbraith's limit. But the report's conclusions are largely silent on the other half of the problem, on whether microfinance investors, such as the ones who placed a newspaper ad in Nicaragua, need to take a careful look in the mirror. (CGAP's Xavier Reille just hints at it in his blog post.) If there were not so much finance for microfinance, the industry's weaknesses would not be so dangerous. Yes, the industry should reform, for example by setting up credit bureaus. But these things are easier said than done and take time. Hypergrowth robs the industry of time.

To fully understand the causes of the recent microcredit crises, this question must be confronted: Are donors and investors putting too much money into microfinance, or at least into some microfinance institutions? Is microfinance the overfunded underdog?

(We in the west usually focus on international investment in microfinance. Keep in mind that most of the fuel for the blistering growth in India, which is a substantial share of global growth, is from domestic banks complying with priority sector lending rules (analogous to the U.S. Community Reinvestment Act). Perhaps the Reserve Bank of India is right to rumble about revoking microfinance's priority sector status.)

Recently a subcommittee of the U.S. House of Representatives held a hearing on this question, among others. Experts testifying answered far better than I could.

Damian von Stauffenberg provoked, with his usual flair:

"Overall," Damian told the committee (at 1:03:00 in the video), "there's too much money chasing too few microfinance institutions today." "It doesn't mean that every microfinance institution is swimming in money. Far from it. But on the whole there's too much money there. And that, as you as members of the finance committee know better than anybody else, is a dangerous situation" (1:04:20).

Elisabeth Rhyne stated a sensible strategy for targeting finance:

Hard to argue with. But who is listening? In 2007, Damian coauthored Role Reversal; it detailed examples of major donor agencies ignoring such advice. Here's the European Bank for Reconstruction and Development inflating the Bosnian bubble:

Role Reversal's thesis was that public money was crowding out private money. I'm not persuaded of that yet, because private socially motivated investors can exhibit the same foibles as public socially motivated investors. For me the issue is more "over-crowding" than "crowding out." In practice, however, the two are nearly the same. According to the latest data I have, more than 90% of the money going into microfinance is public money---more than most people realize. Thinning the crowd requires reducing public flows, at least to mature institutions. Since an 80-20 rule probably governs the allocation of funding---80% of the money goes to the strongest 20% of institutions, which need it least---this probably means that for the sake of economic development, total funding for microfinance should go down. Not up.

Although we can rely on finance for microfinance to generate growth, that does not guarantee development. Socially minded microfinance investors, public and private, should formulate strategies that recognize this distinction and prove that they are executing.

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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.