Can Aid Spur Development? The Case of Microfinance

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Nov 2019
Global, November, 29 2019 - Preventive means are usually much more effective than reactive means of aid to less economically developed countries. This is true in epidemiology, which is why people are encouraged to get vaccines before flu season, and it is also true regarding natural disasters and instability. But is it true also in economic development?

There is a persistent divide between the average living standards of the relatively rich ‘global north’, broadly referencing mode economically developed countries (MEDCs), and those of the ‘global south’ broadly referencing less economically developed countries (LEDCs). This gap is a popular subject of discussion in social media, the news, and among celebrity advocates such as Leonardo DiCaprio and Angelina Jolie. All of this media attention incentivizes people to contribute to international causes, but how do people know where their money will be most effective and well-spent? Should people donate to popular foundations and NGOs for emergency aid, or should they contribute to foundations and causes that seek to promote  long-term development?

Charities dedicated to emergency rehabilitation and disaster relief are often helpful in short-term aid by providing funds that can go to food and healthcare services. For example, during the 2015 famine in Ethiopia caused by El Niño droughts, Ethiopia received substantial aid from the WFP and FAO to provide emergency food supplies. However, this may have dangerous long-term consequences. Local farmers may be particularly impacted, as they not only need to withstand low crop yields, but their prices may also decrease due to low demand as locals can rely on the free food provided by NGOs. This can lower incentives for local farmers to try to improve their methods and invest in new technology that can help increase yields.

Preventive means are usually much more effective than reactive means of aid to less economically developed countries. This is true in epidemiology, which is why people are encouraged to get vaccines before flu season, and it is also true regarding natural disasters and instability. But is it true also in economic development? An alternative which could prove to be effective in providing long-term solutions for poor communities not only in the global south but worldwide is microfinance. In some ways, microfinance seems to be an ideal option, as donors know exactly to which group of individuals their money is going and for what specific cause, whether for fertilizers in agriculture, or for sending a young woman to university. And of course, the extra bonus is that they will be eventually paid back. It is particularly helpful in countries where it is difficult to take loans from the banks due to high levels of corruption and gender imbalances. Microfinancing gives anyone the opportunity to gain economic power, whether they are male or female.

Unlike emergency aid, microfinance allows for individuals under financial stress to invest in materials needed for growth and the use of efficient, innovative technologies to help them reach their professional goals despite the odds being against them. However, this option seems like quite a small-scale solution for large-scale issues of poor education opportunities for women in the global south or agricultural recovery after a natural disaster.

Nobel Prize-winning economist Esther Duflo studied both the benefits and the limits of this appealing practice, and published her findings in her book Poor Economics. In the book, she acknowledges that microloans are one of the key elements that can help fight poverty, but it is certainly not an exclusive solution. In a small study in the Indian city of Hyderabad, Duflo found that the neighbourhoods that were offered micro loans showed evidence of improvement, where more people started businesses, invested in more durable items and equipment, and at the same time, total spending actually decreased. This is likely due to people wanting to take advantage of their opportunity, saving up to pay back the loans with interest, and no longer needing to spend money on ‘wasteful’ items, as they are replaced with the durable ones.

One of the main criticisms of microfinance is that it is a principle that assumes that people are rational and will make the right decisions that are smart for the long-term, when this is difficult to predict in real-time. People can be tempted to make reckless decisions and get into debt. One study claimed that microloans were responsible for the suicides of several Indian farmers that were unable to repay their loans and were under considerable stress which their loan officers exerted on them. However, it is unclear whether the loans had a direct causal effect, as farmer suicides have been steadily increasing in general in the study area. Additionally, in Duflo’s study there was no clear evidence of reckless spending; however there need to be more large-scale ethnographic studies that will be able to examine whether there are any significant long-term improvements for communities. Because microloans are a relatively new idea facilitated by easy access to the internet, most ongoing studies have not gone long enough to draw any definitive conclusions.

One of the main economic benefits of microfinance loans is how cost-effective they are. As loan takers are responsible for paying back loans with interest, this gives them the incentive to work hard and make smart investment decisions in order to produce more revenue. The very simple and direct transaction also reduces administrative costs, as loan officers do not need to be particularly well educated to do their job.

Duflo concludes that microfinance can be transformative for individual households and small businesses, but shows no revolutionary impact on the whole community. For major transformations to take place, and lift communities out of poverty, microfinance is likely not enough. This would more likely occur with larger developmental goals supported by more powerful institutions like the government, and would need to involve investments into infrastructure and healthcare services which can’t be achieved on such a small scale. Although it is unclear whether microfinance is the most effective and successful place to put money for closing the poverty gap, it has shown to be helpful and not have any negative impacts like donating clothes and money may have on the local economy.

Given all of these strengths and weaknesses of microfinance, it demonstrates it can be effective in helping give people in poverty unique opportunities to improve their quality of life and in some cases lift them out of poverty in the long-term. However, is this enough to make microfinance a better option providing aid to help close the poverty gap? The answer to this is unclear, as there are many specialized NGOs dedicated to specific causes like healthcare and education that also have long term development goals, and don’t solely provide emergency aid relief. These options may have the element that microfinance appears to be lacking: the ability to impact bigger obstacles of development. Microfinance is just one example of an alternative way for members of the so-called global north can invest their money for change in LEDCs. What is clear is that microfinance is a good place to start, particularly given the benefits of knowing exactly who the loans are going to.



 

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