Who should receive a cash transfer?, or the paradox of micro-credit

Let’s say you send regular money to a poorer individual in another country.  You might wonder what are the possible rates of return on those funds, and furthermore does that analysis shape to whom you should give the money?

I don’t quite believe the argument I am about to write out, but I can’t yet find the flaw in it either.

Let’s say you find an individual borrowing micro-credit.  It is well-known that rates of interest on these loans often run between 50 to 100 percent, annualized, and furthermore many individuals/families dip into these markets frequently.  Furthermore, very high quality RCTs by Duflo et.al. and Dean Karlan show that micro-credit is not on average harming the families who borrow.

That implies these economies — at least in some their corners — have investments and/or liquidity deployments worth at least fifty percent per annum.  For simplicity, I will use an estimate of fifty percent.

Go to a borrowing individual and give him/her some money for free.  If micro-credit is no longer necessary, you have given that individual a high return.  If it was a cash-free loan, the return to that person would be fifty percent.  By simply giving the money away, it would seem the rate of return would be at least 2x that, or at least one hundred percent.  That is pretty good too.  Of course that individual might stay in the micro-credit market (post-gift), but that implies there are still worthwhile additional uses for the marginal liquidity.  And we’ve already seen that micro-credit does not usually harm those who use it.

So you’ve generated returns of one hundred percent or more with your cash transfer.  This does not require heroic acts of entrepreneurship, merely that the individual was previously a responsible user of micro-credit.

It also requires that these individuals be reasonably conscientious, and do not simply squander their new-found wealth.

But the core recipe is to give to conscientious current borrowers, for very high rates of return.

What is wrong with this argument?


Does it matter that your donation degrades the price signal you are exploiting to direct it?

I don't see how it would, especially if it's a one-off. Which signal would be degraded?

If cash transfers to users of microcredit become common, they effectively blend down the high rates the market based loans demand. Even if loans at high rates are on average fine for the borrower, in some cases they are not. The existence of donations to users of microcredit might create a perverse incentive to invest in projects that do not work under the high market rates to enter the donation lottery.

Think of it like this - if you had a 1% chance of getting your home mortgage forgiven you could rationally buy a (1% more expensive) house. That is a small effect but it scales with donation frequency.

The best response I can think of to this after a night of sleep is that at present margins the lottery effect is likely small. That said, it does probably exist.

One might see this as an effective counter-weight against the risk-aversion most humans are biases towards, a problem which is more accute the less money people have (the more there is to risk).
In other words if the relative ease of obtaining credit makes a person 1% more likely to take a risk and start a business it might be just cancelling out a 1% reduced likelihood of making a rational life decision caused by risk aversion.

Microcredit interest is outrageous because, for all the people who succeed and pay, there's another that doesn't, and doesn't pay. Your argument relies on being able to distinguish those that pay from those that do not better than the current microcredit lenders. If this was possible, wouldn't those people get cheaper credit? How often is a success a good predictor of future success? how often is failure predictor or future failure? If we ask investors on entrepreneurs, just having experience trying, whether successfully or not, makes an entrepreneur better. And yet, if you go look at returns from venture capitalists, for every Sequoia there's a dozen funds that only invest in losers.

So I guess that your argument is good if you can beat the market. What would Sumner do?

@Bob - you misread TC's argument, he's saying to GIVE AWAY the money, not lend it. See below for my answer to TC. I'm qualified to answer since I live in the Third World (the Philippines).

No, you misread bob's comment

"It also requires that these individuals be reasonably conscientious, and do not simply squander their new-found wealth."

TC's argument was instantly invalidated by the gigantic subjective hole he produced in the phrase above. "Reasonably conscientious" is large enough to fly a star destroyer through.


"What is wrong with this argument?"

Well TC, you answered your own question before you asked it.

"It also requires that these individuals be reasonably conscientious, and do not simply squander their new-found wealth."

I routinely lend via Kiva and have been doing so for years. I almost always get repaid in full. Finding reasonably conscientious borrowers is not that hard.

It's quite hard - and justifies the existence of Kiva as a third-party platform AND the existence of Kiva's on the ground partners that follow up w/ lenders, do pre-qualification, etc. If it wasn't hard, donors wouldn't "need" all that overhead.

@Bob Why do you say default rates are high in mico-credit? Typically, repayment rates (in India at least) are >95% when lending to an SHG. Interest rates are high because the low lending amounts make it difficult to cover admin and operational costs with low interest rates.

See this: https://economictimes.indiatimes.com/industry/banking/finance/mfis-say-all-is-well-in-loan-repayment/articleshow/55814567.cms
These numbers represent a month when repayments were extremely poor because of the recall of most cash in circulation in India.

It would depend on what country and which group.

"For example, in the manufacturing sector in Kenya, 67.9% of loans default, along with a 64% default rate in the service sector. "


1. You wrote, "By simply giving the money away, it would seem the rate of return would be at least 2x that, or at least one hundred percent."

This is the first flaw. Merely b/c x transfer generated returns of 50%+ under a 50% interest repayment schedule doesn't mean sales or revenue would magically double. Once cannot predict whether the returns applied to interest repayment could have been reinvested properly into the business.

2. I'm not sure about your goal. Are you trying to develop a P2P business? A charity that would eliminate the P2P model? More details would be helpful.

3. Your analysis doesn't account for sociological implications. Without a need to conform to a specific schedule, it's possible the community would not be as motivated to sell or expand their businesses. In short, the UN aid problem in African nations to date.

4. Forgive the simplicity of the example, but we both know it's easy to go from 1 dollar of sales to 2 dollars. Going from 2 to 4 dollars is the problem, as any economist knows who's studied wages in developing countries.

You are confused. The only substantive criticism you have to TC's question is to question whether the rate of return is indeed 50% to 100%. Aside from that, you've done nothing. See below for my answer. You're welcome.

Ray, FYI your answer below mimics my #3, i.e., you are saying Tyler's analysis doesn't account for sociological implications [of charitable giving vs. a market economy].

@Matthew Rafat - if so, we are in VIOLENT AGREEMENT as the cliche goes.

I would think that the rate of return is unlikely to double to 100%, because some people will use it to pay off debts. That has the exact same effective rate of return, saving the interesting, not higher or lower.

That said, https://www.givedirectly.org/research-at-give-directly has findings that are a lot more positive.

The answer to this paradox--where TC is GIVING AWAY money as opposed to the recipient having to BORROW IT (willingly) at 50-100% interest, is a "behavioral economics" SOLVED question. Fact: if you inherit your money in a lump sum (as I did recently from my going senile Greek uncle, RIP, and had to survive some Albanian mafia to get it, as he had it lying around the house, under mattresses among other places, I kid you not), you are more likely to spend this money recklessly, rather than wisely. Cite: something Thaler, Kahneman or Tversky wrote or could have wrote. By contrast...do I have to spell things out? Use your brain: give your money to the poor, they will use it to buy booze, but if they had to borrow the money and risk having their knees broken if they don't pay it back, likely they'll use the money to buy healthy food.

Bonus trivia: a lot of 'loan shark' lending here in the Philippines is done by Indians. I'm sure they use Filipino enforcers to collect, almost a given they do.

So... you are saying Tyler's analysis doesn't account for sociological implications [of charitable giving]?

Refuted by experimental evidence (see: GiveDirectly). You've done nothing, you're welcome.

Did Kahnemann et al look at this highly specific, very unusual subpopulation of the 50% profit/succesful microlender persuasion?
Getting those sweet 50% might mean the difference between life or death (or maybe the survival of a dependent). That's got to be at least as threatening as getting your knees broken? I'd say, the threat of wasting that money is implicit. And those people are used to the idea, that wasting money is scary. Call it a spillover effect.

I bet, those people would also spend their inheritance wisely (at least, as long as they're in that situation).

"...Use your brain: give your money to the poor, they will use it to buy booze, but if they had to borrow the money and risk having their knees broken if they don't pay it back, likely they'll use the money to buy healthy food."
I am sorry but this is more than wrong. There is no solid research that shows this, and it is exceptionally insulting to poor people.

Moreover, the 'behavioral economics' advocates you cite have never, to my knowledge, addressed the points raised in the OP directly but rather focused on ways people make decisions and ways this can used in dev work to reach more outcomes the dev planner desires.

Re measuring outcomes, in development work we look at thoughts such as those in the OP as incomplete. Money into a poor household or community or economy cannot really be measured in such simple ROI-like terms. If development worked like this-- $XX in = Y jobs out-- then poverty would have long ago been ended.

In dev work today, we look at CTs as having two targets: spending on what people need rather than what we think they need and supporting agency/self-efficacy efforts by trusting them to decide where program money goes (at least their direct share of it).

@jon- white man's burden / messiah savior complex noted. Here in the Philippines, I rescued a family from poverty by marrying their hot twenty-something girl half my age, and using my top 1% net worth (min. $10M+) to build her a dream house, furnish her anything her heart desires and so forth. You, and people like you, fly into Nairobi and throw a bit of cash around while being feted by black folk. Limousine Liberals, nuff said.

Interested in the details of your reckless spending spree.

@BD - sorry if I implied I'm wasting money, I'm not, though my burn rate in Manila is about $4k/mo., twice what I would like to have it, but finding fresh western style fruit (grapes! apples!) is expensive ($1 for grade B junk apple fruit and $2 for better quality, per piece) and other stuff in Manila is more expensive than commonly believed.

Not to question your (anec)data in anyway, but wouldn't real world data be a better starting point? Give Directly has been giving cash for, what, 9 years? 10? (founded a decade ago but doubt they gave cash that day).

Highlights from https://www.givedirectly.org/research-at-give-directly:

+$270 increase in earnings
+$430 increase in assets
+$330 increase in nutrition spend
0% effect on alcohol or tobacco spend
(Haushofer and Shapiro, 2016)

> What is wrong with this argument?

The flaw in the argument is that it discards the debt market that is doing the work of price discovery (of the debt -- i.e. setting interest rates and implicitly determining what enterprises should be funded) while assuming no loss of efficiency in capital allocation.

Equivalently: why not just abolish venture capital and have the U.S. government fund value-positive venture investments instead?

Wrong. The answer to YOUR question (last line) is Singapore, Japan (MITI), Korea and now China indeed have SOE or equivalents that do exactly that, i.e., abolish venture capital and replace it with government money. Source: Joe Studwell's book, and the cites therein.

My answer upstream--and only my answer--is the correct answer to TC's riddle.

No, none of those countries have abolished venture capital.

I came here to say this, pretty sure it's the right answer.

Indeed, how to find creditworthy people without a functional credit market?

Even if it's possible to find that easy creditworthy people, the morning after microcredit business is: (i) bankrupt, or (ii) interest rate even higher for the marginally less creditworthy people. WHere's the gain?

Which would be true of all charitable giving. If that is such an inferior solution why has it persisted so long? Where is the market-failure in that setting?

Charitable giving is grotesquely inefficient at generating returns. It is efficient at the sole axis over which it competes for donors: gratifying donors' ego.

Accepting your claim for the sake of argument you simply have not addressed the question I raise. It that is so inefficient why has it persisted? If you answer based on gratifying ego then you are implicitly conceding the return is there for the donor at the margin.

This is a more fully fleshed out version of my initial comment I think. The best response I can think of is that at the current mix of donations and loans, the loans dominate economics and no rational person relies on a random donation bailout.

That said, I think the reason you couldn’t scale the model (ie replace a high fraction of microcredit loans with cash transfers) is likely the problem that it destroys the market you’re using to direct donations.

Agreed on all counts, including that you said it first.

There is no flaw! Direct cash transfers are most likely more effective than microlending, in terms of poverty reduction per dollar spent. It takes a lot of overhead to collect loans, so no-strings-attached handouts can get a lot of bang for your buck.

GiveWell, the effective altruist charity evaluator, rates GiveDirectly, a cash transfer program, as one of its most effective charities. This holiday season, give the gift of cold hard cash, halfway around the world!

Read more: https://blog.givewell.org/2013/01/04/cash-transfers-vs-microloans/ ; https://www.givewell.org/charities/give-directly

Yep, TC seems to be outlining an argument for direct transfers over microlending, very similar to the ones made in the first link you posted.

The question is, how much more bang for the buck do you get, because a direct transfer is spent, but a micro-loan is reusable. The same dollar can be lent indefinitely. Even if we account for the reinvestment of returns from capital of the transfer recipient, those returns are accruing to a marginally wealthier person each time, whereas the loaned funds can be retargeted to the most impoverished each iteration, potentially having a greater impact on poverty reduction. As a side benefit, loaning across many individuals spreads the risk better than transferring to a single individual, even if the spead is serial rather than parallel.

Didn't Chris Blattman's recent research out of Uganda (?, one those small inland African countries) find that there were no longer-term benefits to direct cash transfers? The control and treatment groups converged to similar outcomes after 4 or 5 years. That's not nothing (being better off sooner is better than being better off later), but direct cash transfers are not some magic bullet and are probably overrated.

Yes I saw the Blattman analysis ('after four years people given cash end up in the same place as the control group' was the conclusion) but the analysis may be unique to Uganda. Notice upstream the link https://pennmfc.squarespace.com/thinktank/2016/3/26/default-rates-in-the-microfinance-industry that shows default rates in India are less than 5% while in Kenya the default rate is 64-68%. So Uganda, next door to Kenya, could be a "manana" style country where people don't care about their future, living for the moment.

Absolutely nothing wrong with the idea.

It's worth trying, to find out if it works. If it works, then micro-credit firms can serve as a pipeline to disbursing loans (since cost is the reason commercial banks do not service these micro businesses in the first place and MFBs already found a way to service them). I'm very familiar with the microcredit environment in Nigeria and working with an EA-aligned partner in the US to try something like this using data from the microcredit firms themselves.

Yes, micro-credit does not harm families with access to credit, yet these businesses don't scale due to the interest rates (which they seem happy to pay as long as there's access to credit) and perhaps other macro pressures which puts the businesses in some kind of debt cycle where they collect from one to pay another but still manage to be considered credit-worthy all round.

Being (considered) credit-worthy all round is the kind of trait you're looking for, right?

An incentive problem, possibly. If people know, that there'll be a cash transfer at having proven conscientiousness through paying back 10 loans on time, they might do that, to get the cash transfer and then default on their next loans.
Could be designed around, by making it a lottery. Every paid back loan gives you a ticket. Or by playing with the proportion of the transfer to the loans. It's likely anyway, that people who take microloans would get the same returns with larger sums. Also, the longer you wait for proof of responsibility, the less likely it'll be to have the same high returns. Low hanging fruit and all that.
A stronger argument against it, is that the solution just isn't as good as actually funding/buying stock in a microbank. You only have so much money to give. It's of course nice that a cash transfer creates a high return. However, if you decide to fund a microbank, you have created a (possibly self-replicating) welfare machine, which would give more return per donation in the long run (and for you less than -100%, if you buy stock, instead of a straight-up donation). Also, if you buy stock in various microbanks, you’ll understand the market better and through your mistakes will find and then preferably fund the best microbanks.
However, if the place you’re interested in helping already has lots of microbanks, then the interest rates won’t be super high anymore. Or at least they likely wouldn't be for repeat customers, who have proven their creditworthiness.
However, being credit worthy isn't as strong a signal for conscientiousness, as it was before. Because it's easier to pay back loans with lower interest rates. Also, we couldn't know anymore, that they still have projects, in need of funding, that would get those fabulously high return rates. We would have to strongly suspect, that they don’t anymore, since credit for that kind of thing is very cheap. So, they would have done them already.
If your cash transfer benefits families, that are loyal customers of a microbank, then aren’t you depriving the microbank the fuel it needs to grow? If it’s a for-profit bank, it might refuse to give you that data arguing quite rightly, that every cash transfer you make is a loan, that they don’t get to profit from.
I guess the argument against it would be, that cash transfers are just slaughtering the golden goose with extra steps.
Disclaimer: I did as you asked and found reasons, why it’s a bad idea. I haven’t looked for why it would be a good idea. Thus I’m highly biased.

I think we basically agree about the perverse incentives though you perhaps explained it better.

The self replication point I’m not sure I as find compelling - the gifts become personal property of the recipient and contribute to capital formation through that channel. To the extent the microcredit banks are better capital allocators than the individuals receiving donations in aggregate it is more efficient to give capital to the banks in general. However, if the gifts are replacing loans for serial borrowers, which is I think TC’s construction, the only difference is that borrower no longer has to pay fees to keep borrowing.

If the borrower no longer needs the capital they can try to find a vehicle to turn their new stock of savings into a loan (day putting it into a bank). I am not sure why this outcome is worse than putting the money into the bank initially and it is clearly better for the lucky borrower.


This post ought to be retitled "In Which TC Forgets How To Reason Like An Economist."

The interest feeds the microbank, which has an information advantage over the borrower, regarding investment opportunities. The borrower will likely still have his share of 50%+ projects and is unlikely to deposit the money in the bank (or a microbank).
However, the microbank has access to people with 100%+ projects.

And from what I understand, microlending is a magical place, where risk doesn't scale with profits, as harshly as it does in the formal, overexploited world.

I’m trying to imagine, what these projects look like. Maybe buying a cow or a goat is always profitable. The first few cows alone bring you out of poverty, because they’re more profitable. But if you have so many cows already, you would want to buy a goat as a hedge against mad cow disease.
Or the fifth cow isn’t as profitable as the first couple, because you’re running out of space or time to care for them to maximize each single-cow utility score. If the borrower is thinking about buying space or labour, he’s likely ready for the formal credit market.

Cash transfer to reliable people vs letting the bank provide the money with interest might be like choosing between giving a person saved from drowning some hot tea and hope he’ll help later with the work of saving people (cash transfer to stabilized borrower) vs spending all your effort on getting more people out and letting the rescued pay for their own damn tea (not undercutting the bank).

@Jeff R
No, he thinks more like an economist than you. (or rather like one, who has taken Hanson's et al work to heart).
He probably already likes the idea and he knows it’s inefficient to fight your own confirmation bias, so he crowdsources it, instead. [or he knows, that if the big bad economist naively ever says yes to something, he’ll get people wanting to prove him wrong]

Likewise, I’m not really interested to agree or be persuaded by Analyst’s counterpoint here (I wanna win god dammnit!), because being biased firmly against being proven wrong, I’ll have an easier time finding something clever defending myself. This is collaborative adversarial truth seeking. Pick a side (or invent one, if you feel adventurous) and defend it with all the bs you come up with. Humans decide what the truth is first, then come up with reasons defending it later.

The issue doesn’t have to be something important for us personally. I mean, look at Ray Lopez getting all worked up, because he’s decided, that it couldn’t possibly work, because it’s what those dastardly limousine liberals would do [it’s really cute man, never change!]. And through his general attitude, that free money will be wasted, because it’s disconnected from values, thus immoral [or whatever he thinks, my model of him probably isn’t all that great] he’s the only one bringing up the research about wasted windfalls by Kahnemann. I don’t think it applies here, but that’s because I think he’s a little over the top and disagreeing with him is more fun anyway. I wouldn’t have considered how the cash transfer situation differed from a normal windfall situation without him.

This is not a human flaw per se, but rather a clever hack for humans to be able to think at all, because of […predictive processing model, mumble, mumble, Surfing Uncertainty-something, Elephant in the brain….]. Whatever the sensible arguments are, some of them are bound to have been brought up by somebody. If he’d laid out more of his thinking, he’d have biased us. If he even thought about it more, instead of laying the minimum idea out, he’d have biased himself even more into thinking his original thoughts are the most important. Never do your own thinking, if you can help it. You can't trust yourself, after all :)

"it’s what those dastardly limousine liberals would do "

I'm pretty sure the organized religious are way ahead of the "limousine liberals " when it comes to charitable giving.

You asked what the projects are. I think they are in general some combination of physical farming equipment and spatial arbitrage or classical trading (move stuff around and sell at markups). At least these are the two examples I recall from some time ago...

The problem is adverse selection. People who agree to pay high rates of interest are self-selected for having investments with high rates of return. If you give away money the self-selection is gone. You will go from getting the average social return on the 1% of investments where borrowers have enough confidence in the investment to risk bankruptcy to the average social return on everybody which is probably negative.
Of course Tyler's example is to take someone who has already borrowed. In that case the answer is not flawed at the current margin but it scales very badly.
Many credit firms use a version of this method. They find someone who obtained a high-interest loan from a lender with asymmetric information and use the fact of the loan to infer that the borrower is more credit-worthy than s/he seems and offer a loan at lower interest.

Are you testing the quality of your commenters? It's the marginalrevolution year-end quiz!

I can't tell if he wants this to be true or if he's just letting y'all school him in order to seed doubt that giving even the microcreditworthy poor a cash transfer today is better than buying urban-dwellers a Coke seventy generations hence. Entertaining, in any case.

Yep, the more that I think about it the more bizarre Tyler's post is. A gift and a loan are different in so many ways; why is Tyler even asking us (or himself) to compare them on the basis of rate of return? The answers offered by Jeju and peri are as good as any.

Tyler your mistake is to compute expected returns conditional on success.

Consider the borrowing. The interest rate is r=50%, so by taking a loan of $1 the borrower reveals the project is expected to return at least that much. A successful project is worth g-r; a failed project is worth -b, which is paid to the lender, and the investment is destroyed.

Consider the lender. Does the lender expect to make a 50% return on his investment? I find this hard to believe; otherwise we should see profit-maximizing companies picking up these free dollar bills. It seems more reasonable to assume the lender expects to earn a market rate, say 0%.

[Good state--Success], probability p,
borrower's payoff: g-r,
lender's payoff: r-1.

[Bad state--Failure], probability 1-p,
borrower's payoff: -b,
lender's payoff: b-1.

Then we should have,
p(g-r) + (1-p)(-b) >= 0,
pr + (1-p)(b-1) = 0.

Put r = 0.5. Then we find that b = (1-1.5p)/(1-p) and g >= (1-p)/p. So if someone looks up the success rate p, we have parameters that work.

Agreed. 50% is risk adjusted rate- lender receives the portfolio return, not just the winners.

Also agree with prior comment that the aggregate return (lender/borrower) has just been transferred.

Finally agree with Ray, though his language is inflammatory: borrowers will take on less renumerative projects if the money is free. Suppose you could have loan criteria to ameliorate, but that is lending by committee - taking the market out of the decision.

Separately, the costs to administer micro loans probably has a great deal to do with the high interest rates, though technology should be able to greatly reduce.

What is the (or whose) social value function being maximized here? Tyler seems to care only about the borrower, who clearly benefits from his plan. But what about the erstwhile lender?

IOW, if grants instead of loans are such a great idea, then payday loan companies (that also do small loans with interest rates that can reach 50%-100%) should give the money away instead of lending it.

So is Tyler aiming his advice at altruistic organizations? Don't most of them do grants and donations already, rather than lending money to beneficiaries?

Stallholder ag-finance guy based in Africa the last 7 years speaking here… After working in this area for many years (Africa and Central Asia mostly) here is my quick analysis.
Microcredit rates are high mostly due to the costs of origination and servicing, not credit loss or local interest rate level. Example, a USD100 loan for a month at 70% annual earns about USD 5.83 in interest income. If local cost of funds is 25%, that’s USD 2.08 for a net interest margin of USD 3.75. From this you have to pay staff and overhead plus there is credit risk (although this is quite low in many instances). Thus, the interest rates look usuriously high but when translated to cash it’s not so “juicy”. Assuming a micro lender that is not subsidized by some NGO/government program, this is at least sustainable.

The issues I have with TC’s analysis (behavioral ones aside) are:
1. Apples to oranges: gift versus loan. Is this a sustainable solution to provide financing that is widely available when needed?
2. TC focuses on rates. From a pure finance perspective the “investor” has a return of -100%. The recipient has an infinite return.
3. By the way, what’s the cost of identifying and then sending the small amount from donor/investor to the recipient? You might end up with an expensive ad-hoc gift program instead of an expensive but available loan program.

This is the best answer so far.

Good comment. Also, over time, won't people spend resources to put themselves into a position to receive such a gift, which seems wasteful?

I guess it's a question of scaling. If you already know someone who would make good use of the gift, do it- like with Tyler's Ethiopian buddy.

"1. Apples to oranges: gift versus loan. Is this a sustainable solution to provide financing that is widely available when needed?"

+1, this seems to be the best point

Micro-credit just needs seed money to maintain a certain amount of lending per year, charitable giving requires the entire pool of money to be replaced every year.

Also what group is going to significantly increase their foreign aid budget without any implicit demands?

I do think as a higher percentage of countries lift themselves out of poverty, the world will have more foreign aid and a tighter area to target it on. But at the end of the day, the crux of the manner is where is the money coming from and how much will be given on an ongoing basis.

"Microcredit rates are high mostly due to the costs of origination and servicing, not credit loss or local interest rate level."

So what you are saying is that we need a new cryptocurrency for micro-credit?

The issue is assuming that the borrower is using the funds for long term investment as opposed to meeting a short term liquidity crunch. If they can't preserve capital long term then your gifts are only effective if the timing is right, and otherwise doesn't reduce future borrowing.

This could occur If they say a social obligation to give hard cash to the destitute. it might be preferably to be in debt, you've purchased some of the goods you wanted and don't have extra resources that you're then compelled to share. But ignoring that the value derives from short term liquid seems to be the main error.

Yeah. If people are getting one-month long loans like Bill says they are, then the loans likely just get them out of rare emergencies.

Lets say a village of 100 people has 33 loans a year. This would look like frequent dipping. However, what if they are paid off after a month on average? This means they only are only willing to accrue high interest on average 10 days a year ((30 days x 33 loans)/100 people). If all the benefit is only available day one, like in a small emergency, then each individual only has one third of a day at some random time each year with the 50% return. The individual who already has a loan, who Tyler is considering giving money to, has already utilized their 50% return opportunity, and they are no more likely to get another such opportunity in the near future than anybody else.

It seems possible to me that a donor who lives in the village, who could quickly spot these moments of need, could indeed produce that kind of return. These moments would be hard to spot though. For example I can imagine parents who have provided food consistently for months, but run out of food and money one day, and they feel a very large marginal benefit from providing food 100% of days rather than 99.5%. A charity that could find trustworthy local people to dole out cash to individuals during small emergencies could be very powerful.

"It seems possible to me that a donor who lives in the village, who could quickly spot these moments of need, could indeed produce that kind of return."

This would resemble the role of a church father or pastor, who uses church money for lending/local charity.

Why isn't there local competition springing up bringing down cost of origination? Why is servicing so high relative to the loan? Naively, I'd expect that overhead (labor mostly) would be cheap proportionally.

this was meant to be a question to Bill.
Post didn't nest correctly, somehow.

And with 'proportionally' I mean, why aren't the proportions the same as we have with bigger loans with higher risks, that make those profitable, if the size of the loan is just a matter of region (which is also an assumption).

Labor costs are cheaper, but you still face the fact that larger sized and longer maturity loans make more interest income than small and short ones. However, the time and effort to originate and service are not that much different. Plus the micro credit entity still has rent, IT, regulations and other staff/overhead. This is one reason why commercial banks avoid this market. The effect is similar in developed markets... for example where you saw the commercial paper market dis-intermediate commercial banks in the US. I hope that I addressed your question!

Or are criminal organizations running some debt slavery scheme instead, pushing out any less ruthless competition?

half the comment got eaten, sorry.
What I meant to ask was:
Why isn't there an informal sector, that doesn't care about the regulations and minimizes overhead (working on a cheap laptop, hiring muscle/enforcer types only as needed, setting up shop in your own home or renting out a corrugated sheet metal from some slum lord)?

My idea was, that there might be competing criminal organizations (Mafia-like, but with a penchant for machetes and their use) in the microlending business, that are fundamentally more exploitative, that would murder competitors and thus the underclass starves itself of capital access.

I have to ask. I really don't know how places like Lagos or Khartoum actually function in the micro (or macro for that matter).

'You might wonder what are the possible rates of return on those funds'


'have investments and/or liquidity deployments worth at least fifty percent per annum'

Amazing what buying a couple of goats or cows can do for the investment portfolio, isn't it?

'Go to a borrowing individual and give him/her some money for free.'

In which that money yields precisely the same - a couple of goats or cows, in this example.

'What is wrong with this argument?'

Nothing - it gloriously illustrates how an economist thinks. Particularly, to stay specific, how an economist publicly interested in raising his status is attempting to use virtue signalling to influence a public policy debate in the country he lives in.

To solve adverse selection, could you use the same underwriting methods that lenders with high interest rates and low NPLs use? One potential problem I see is that underwriting adds costs. However, my understanding is that most micro-finance institutions use very simple underwriting that doesn't cost much.

To solve the problem of cash transfers not incentivizing the same sort of good behavior as loans, could you first require full repayment and then give the principal and/or interest back to the lender? They get the cash transfer, but they have to "earn" it first. If they don't default, then there's no "prize." And no, you don't need a stick to create incentives. Micro-finance lenders with high repayment rates don't send goons with baseball bats after delinquent borrowers. They usually don't send anyone. They just write it off. And collateral is usually symbolic. However, the same problem might apply here: loan servicing adds costs.

By introducing such costs, the mechanisms that mitigate the limitations of the cash transfer idea might also make the idea unable to self-sustain. Maybe interest is the simply cost we have to pay to pick (underwrite) and make (incentivize) winners.

From what I've seen, though, underwriting and servicing are not the main costs of micro-loans. Rather, the big cost categories are:
(a) The cost of funding, because lenders have to pay back their own long-term lenders. You're looking at an immediate 15% APR in a lot of developing countries, if not worse.
(b) Marketing, because the market is competitive and clients can be hard to reach, and
(c) Branch and branch staff costs, because you need an army of loan officers spread around the country.

Cost of funding could be reduced through preferential lending. Marketing and branch/staff costs could probably be greatly reduced nowadays thanks to technology.

A difference could be the timing. People borrow money when they really need it. They might receive the 'free' money while not really needing it, which could lead to squandering. But is that enough to undo the entire rate of return?

If you give them the money for free, how exactly do you get a return on your investment?

There was an Econtalk Episode about this.
These communities have negative interest on savings, because there is pressure from neighbors and Family to spend this Money on them for trivialities. Being able to say you Need that Money because you owe it back is a defense against those Claims People have against you.

For those interested, check out:

Giving the money (instead of lending) makes more dificult to filter the people who will invest wiselly the money (adn then are able to repay the loan + interest) from the people who will simply spend it

Not sure if this is a flaw in the argument or in one of the premises so....

I find the arguments based on averages increasingly questionable and in the most simple terms think they are all subject to the fallacy of composition type errors.

I suppose the other aspect for assessing the analysis might be to remove the assessment or rates of returns as presented here and look into just how such rates of returns might be estimated for charitable giving -- as we're shifting from a loan to a pure transfer. Here then we have two separate rates of return to consider I suspect. That of the recipient and that of the donor

Here I don't think the argument fails but the analysis needs to be slightly different.

It's been pointed out but was not clearly stated in the argument -- costs of identifying the appropriate recipient. The micro lenders will have local knowledge that might not be available to the giver. Moreover, the micro lenders will have both incentives not to share that information and will face some harm with such "poaching" of their clients.

Could this be a case of private virtues and public vices?

What happens when microfinance is crowded out and cash transfers can no longer piggybank on their client identification, screening and capacity building work of MFIs? The interest rates reflect costs of administering loans, which, other than repayment compliance, would be no different for cash transfers if one followed TCs suggestion.

“the core recipe is to give to conscientious current borrowers”

This might be difficult... even in the developing world, it seems most conscientious borrowers would have better options that taking out loans at 50% interest.

Neither a borrower nor a lender be. That's implicit in Cowen's lesson. It's true the overall economy (i.e., output) is better off - even the half that would have defaulted on a "loan" produce something. Of course, it's a short leap from Cowen's lesson to Keynesian economics. In a recession, send everybody "free" money; or in the case of Republicans, in a robust economy send the wealthy "free" money to buy more yachts and houses - Keynesian economics turned on its head.

"or in the case of Republicans, in a robust economy send the wealthy "free" money"

It's delightful how you conflate not taking earned money with getting "free" money.

I tell you what you need to send me $100 for reading your post.
Ok, nevermind. Look at how nice I am, I just gave you $100 in "free" money!

Transaction costs. There’s a cost to knowing your customers and offering/arranging the loan and collecting repayment, and it’s significant compared to the size of the loan.

This used to happen in the U.S. People would sell household goods on credit and come by weekly to collect 25 cent payments.

Seems like you are reinventing the wheel here. I would assume theres already volumes of research on the payback for philanthropy

"the core recipe is to give to conscientious current borrowers, for very high rates of return."

Shouldn't the cost of the loans be equal to their marginal cost? The high cost of the loans suggests that finding "conscientious current borrowers" is somewhat difficult and costly. If you are suggesting piggybacking off the information provided by micro-lenders, then I'm not sure this is a welfare maximizing use of your donation. If they have an investment plan that is capable of creating >50% annual returns are they really the ones that most need your help? I assume pretty steep diminishing welfare returns to consumption, so giving to those with the highest expected lifetime income of an extremely poor community will not be a welfare maximizing act. If you aren't looking for monetary returns, mustn't you be trying to maximize welfare?

From a less theoretical way of looking at things, my understanding of microloans is that the borrowers often use their borrowed funds to make their own loans within their community. There is a risk that you won't actually end up increasing investment in valuable projects as much as you'd like if the person you give the money to has a monopoly on loanable funds within that community. Though of course monopoly pricing would likely be less of a problem in a small community.

Assume you have a can opener........

If you could duplicate all the circumstances, the return to the borrower should be the same for the gift as for the loan. An example could be that the borrower goes to take out a loan and is completely surprised by receiving a gift instead. The use of the funds would then be fully independent of the source, at least until prospective borrowers start to figure out that there's a significant chance of a gift the next time they ask.

Maybe a better question is why the return is so high, or appears to be. I wonder whether in some instances (at least) it might conflate the return on the investment along with creating an employment opportunity for the borrower. Much of the "return" could really be a wage. It's like a sole proprietor (say an accountant) who has a little firm that employs a few staff, and is very profitable. Now she decides to bring in a junior partner, who must buy into the business. When this occurs, it becomes important for the sole proprietor to distinguish the returns the firm earns, versus the salary compensation she is paid for his hours working for it. The junior partner would be entitled only to a share of the former.

In the microcredit example, the difference would be between the borrower using the money to, say, buy a machine she uses to employ herself, versus buying a second machine she then uses to hire a salaried employee. The actual return on the investment would be better represented by the latter. However, the decision to take the loan for the first machine would be influenced by the wage differential the borrower could then earn as compared to her next-best employment opportunity. If other comments are correct that the seemingly-high microcredit interest cost is mostly fixed transaction costs, then expanding the loan's size might also be possible at a lower incremental interest rate that then permits the second machine to be financed successfully -- although these are empirical issues, of course.

But in any event, I suspect there is something to this wage question in understanding the apparent productivity of the micro-investment and its scalability (or not).

I imagine that most of these borrowers are interest rate insensitive and are instead "payment" For example, many people in America (especially poor people) will buy a car based on the monthly payment. They don't care if the interest rate is 20 or 40%. What they care about is can they meet the monthly payment.

The microlenders are similar. They borrow the money based on an ability to repay at some monthly number. When borrowing this way the borrowing costs are perceived as low and affordable.

The affordable monthly number allows for easier computation of the potential value of the loan. The loan will cost me x per month, and I can generate y in income per month. The numbers are easy to calculate and the decision is made.

If you are given a windfall the calculation changes. Previously any potential investment, or monthly return, had to be greater than the potential cost, or monthly expense. Now you are free of the "burden of debt" and can take on investments that have lower rates of return. You might even buy things that have a negative return (in terms of cash flows) because you don't need to worry about future debt payments.

Think of saddling a corporation or government with debt because the officials lack the discipline to avoid wasteful spending. You tie their hands with debt payments, limit their access to fresh funds, to avoid frivolous expenditures. (Assuming that will limit at least some officials.)

Every time I see a loan pitched to me quoting only the monthly payment, I get a little bit offended, and a little sad.

This is of course how interest only loans, variable rate ARMs, and balloon payment deals helped to blow the economy up.

Interest-only loans, they're basically free money bro!

aside from many great comments above, I want to stress that something seems to be "learned" through the practice of lending and borrowing. I worked at a community microfinance project about a decade ago in Nairobi for about a month or two where I digitized the ledgers of all of the different groups. the groups with the highest fines, highest interest, etc were the groups that had been participating in microfinance groups the longest. Each year when they would come back together to write the rules for the next year, they would seem to get a little more stringent. As they made loans to each other it seemed to me that they got better at learning about rates of return themselves and thinking strategically about when to take out money or not (admitedly highly anecdotal). I feel like there is some sort of learning by doing that goes on with these high interest microloans that cannot really exist with gifts.

How about lending as much as you can at 10% interest and assuming you will lose 40% per year?

Thanks for the info on GiveDirectly. It was very compelling; after research I just gave them $50.

How are we calculating "return" here? It seems to me the donor's return is -100% and the recipients' return is + infinity.

I'm late to the party, I know. I don't have as much exposure to the micro-lending world as other commentators, but I do have some.

My experience suggests that "the best" recipients of micro-loans do exactly what prior_approval said they do: They buy a cow. Then, they move to the city and get a textile job while renting the cow to some villager. Now they make a higher income, because they're textile workers, and a rental income from the cow. They save their money and buy their own sewing machine to do freelance work, or buy another cow and keep renting.

Biggest problem I can see about this is that eventually there will be 1,000 cows available to rent, and only one poor, unconscientious sucker stuck renting all of them. The market collapses when textile mills are operating at max capacity and everyone else is already renting someone else's cow.

To say that 'micro-credit is not on average harming the families that borrow' is unfair. The only way some of these low income families manage to repay their loans is by borrowing from a different source and thus, getting trapped in an unending loop of debt. Additionally, stating 'But the core recipe is to give to conscientious current borrowers, for very high rates of return' as the defining point of the argument is to eliminate and exclude a large part of the population in low-middle income countries, where the lack of awareness/information of financial programs and existing policies itself, is what hinders individuals' growth.

The main use of developing country micro-credit is to effectively allow wives to hide cash from their husbands for needed family expenditures.

Without micro-credit, the husbands would spend any cash saved by the wife on drinks & other fun. By taking out a loan, the family honor is on the line to eventually pay it back, so the husband plays along. Besides, the big pile of cash is gone out of the sight of the husband quickly because the wife takes out the loan and then uses it for a large purchase rapidly.

If women's rights were better and bank regulations were liberalized, there would be no need for it.

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The biggest flaw in this I can find is that 80% of commenters failed to understand that the idea was to come AFTER micro-credit, not as a replacement of it. So, you might want to be more careful in explaining.

That said, I love it. if a micro-credit user has managed to repay a loan then the user is making effective use of the funds, and the cash transfer will be more productive than other unqualified transfers. In addition, if the user is coming back, it indicates that they haven't managed to escape a lack of capital, probably because of the high interest rates. A direct cash transfer would take an already identified good quality candidate, with a qualified need and solve their capital problem directly.

One counter-argument I can think of is that it will raise the default rate in micro-credit since this repeat user will leave the pool. But I'd expect this would only practically effect part of the user pool, and that rates might rise a little as a result, but not dramatically.

The best counter argument I see in the comments is the idea that a user might be repaying these loans via cyclical loan taking, possibly involving illicit sources. I don't know if that's a true pattern, but there is a risk for it to rise as a method to get the eventual payout. But there's already an incentive to try and prevent this, and those illicit sources are illegal, so there's hope that it could be policed. But it's a pretty big risk to watch out for.

I've also seen the lottery argument, that this might encourage additional risk in micro-credit, on the hope that the user pays off the loans effectively there will be a bigger reward at the end. That said, that effect seems likely to be small, and there's additional benefits tied to it as well (more entrepreneurism, one of the original objectives of micro-credit)

Also, when looked at from a full economy perspective, the productive value will probably strengthen it overall making stability better and credit more accessible. Plus it's just a good thing to help that one individual who you now have a fairly high level of confidence in your efforts being effective.

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