Thursday, March 13, 2008

In defense of micro-credit (and job creation, and health, and ...)

A recent article by James Suroweicki in the New Yorker argues that micro-finance has become over-hyped. Suroweicki concludes that micro-finance is not the binding constraint because it does not create new jobs. Instead, developing countries need more small and medium-scale enterprises (SMEs), which are the source of most job creation in the developed economy. So we should focus on SMEs instead.

After working in the international development field for over twenty years, I can tell you I have heard this argument many, many times before. Not the specific content of the argument, mind you, but the structure of the argument.

When I began my first job at USAID in Manila in 1984, SMEs were a big part of the aid program, and John, the head of the SME department, wanted even more resources. "SMEs create jobs, and jobs create wealth - can't you guys understand that?" I remember him yelling during a strategy meeting.

The only problem was that his program was not particularly effective. He was spending tens of millions of dollars, but it turned out that creating small enterprises was a lot harder than people thought.

All of 23 years old, I thought I was more enlightened. After studying the experience of other countries, I concluded that new small enterprises arose only when agriculture production was great enough to generate the incomes needed to create demand for non-food products. When I finished that analysis, I began arguing vociferously that we should put of all USAID's resources into agriculture. I was sure that this was the way to go. Regrettably, I had to leave Manila to return to grad school before the final decisions were made...

My experience at USAID was a harbinger of things to come in my subsequent fourteen years at the World Bank, working in countries such as Niger, Indonesia, and even Russia. A small group of people would do an analysis that showed that "X" was the key to growth and development, and that without major investment in "X" the country would stagnate. ["X" might be health, education, transportation, integrated rural development, water, or financial sector development, including micro-credit.] Then, voila, the aid program would be adjusted to spend far more money and expertise on "X".

After a few years (usually about three) it became clear that programs focusing on "X" were not a panacea. Most often, the aid programs did not produce a whole lot of "X." Sometimes the programs succeeded, but alas, more X did not seem to have the expected effect. In any case, there would then be more studies and a big strategy session, and we would conclude that now the country desperately needed "Y" to develop. The cycle started again.

After many cycles of this, two things became clear to me.

First, there is no single "X" that will lead to economic development. Countries instead need some combination of A,B,C and X, Y, Z. And the needed combination of those things is not static- it changes over time.

Second, individual experts, and even organizations staffed by experts are unable to guess (much less promote) the right combination of A,B, C, X, Y, and Z that a country needs at any given time.
Expert-driven mechanisms lack the information and feedback loops needed - and they also lack the bandwidth. I had really smart colleagues in the World Bank, and I can tell you we worked very, very hard. But in the end there were only 24 hours in the day and our heads often felt like they would explode if we try to absorb more information or do more analysis.

Here is the conclusion I drew from my experience: only well functioning markets can make the right decisions about the allocation of resources that will lead to growth. And by markets, I don't mean only financial markets, though they are important, or markets in physical goods. I also mean political markets, where regular citizens' voices are heard (democracy is a political market). And well functioning educational markets allow students to pursue their interests and gain the knowledge and skills needed to get productive jobs. The list of markets goes on.

Markets serve the critical function of allowing people to express the many different things they need and want. And then they allow other people, companies, organizations, and even government agencies to hear those needs and try to satisfy them.

Markets are not a panacea. They often don't function well and sometimes they misallocate resources and have booms and busts. But we simply have not discovered any other system that works better.

Sometimes people ask me what I think the highest impact projects on GlobalGiving are. Health projects? Education projects? Micro-credit? Small business and job creation? I tell them that there is no answer to that question. Whether a project is good depends on whether individual people or their community representatives say they need it, and whether they can raise the sources needed to implement it. Find a project that resonates with you, I tell my friends, and just jump in.

See two earlier posts related to aid markets and microfinance here and here.