Microcredit does not help eradicate poverty; it might have some beneficial effects, but the reality is much less attractive than the promise. Creating opportunities for steady employment at reasonable wages is the best way to take people out of poverty.
Microcredit has a simple and powerful, even seductive appeal. The United Nations, having designated 2005 as the International Year of Microcredit, declares on its website that “currently microentrepreneurs use loans as small as $100 to grow thriving business and, in turn, provide their families, leading to strong and flourishing local economies.” Enthusiasm for microcredit has attracted untold billions of dollars from governments, commercial banks, wealthy philanthropists, and other donors.
In spite of the resources devoted to microcredit, it does not significantly reduce poverty. A large-scale empirical study conducted by the World Bank, Moving out of Poverty, concluded “microcredit schemes do not seem to lift large numbers of people out of poverty.” Furthermore, the Poverty Action Lab at MIT has conducted a few randomized control trial studies on microcredit, and concluded that while microcredit “does not produce sweeping, dramatic transformations, it does appear to have some important— though modest—outcomes for certain people.” Microcredit helps provide the poor liquidity over periods of cyclical or unexpected crisis. It might yield non-economic benefits such as increasing self-esteem, improving social cohesion, and empowering women, though some studies dispute even these benefits. In fact, microcredit often has a negative impact on poverty; poor households simply become poorer through the additional burden of debt.
Yet, the bigger problem lies not with microcredit but rather with micro-enterprises. Some clients of microcredit are certainly true entrepreneurs, and are able to create thriving businesses. But the vast majority of microcredit clients are caught in subsistence activities with no prospect of success. With low skills, little capital, and no scale economies, these businesses operate in arenas with low entry barriers and fierce competition, which lead to meager earnings that cannot lift their owners out of poverty. This should not be too surprising. Most people do not have the skills, vision, creativity, and persistence to be true entrepreneurs. Even in developed countries with high levels of education and infrastructure, about 90 percent of the labor force is employees rather than entrepreneurs. Although developed countries have greater availability of financial services, only a small fraction has used credit for entrepreneurial purposes. Most clients of microcredit are not micro-entrepreneurs by choice and would gladly take a factory job at reasonable wages if possible. We should thus not romanticize the idea of the ‘poor as entrepreneurs.’
Creating opportunities for steady employment at reasonable wages is the best way to lift people out of poverty. The International Labor Organization states, “Nothing is more fundamental to poverty reduction than employment.” In development economics, there is wide theoretical and empirical support for the increasing preponderance of wage labor in a developing economy. It is instructive to look at the pattern of poverty and employment over time in China, India, and Africa (which, all together, account for about three-quarters of the poor in the world). In China, where the incidence of poverty has declined significantly, a large and growing fraction of the population is employed. In Africa, where the incidence of poverty has remained unchanged, a small and shrinking fraction of the population is employed. India’s performance lies somewhere in between. India’s efforts at poverty reduction have been hampered by its poor performance in job creation.
Increasing employment opportunities is, of course, a complex challenge and there is no magic solution. It is too ambitious and perhaps futile to try to develop a holistic framework or a comprehensive action program to increase employment for the poor. It is better to make well-targeted, pragmatic and focused interventions. Contemporary history clearly shows that it is the private sector that is the best engine of economic growth and job creation. For example, the private sector has created three quarters of all jobs created in China since 1992, according to the International Finance Corporation. Even though the private sector is primarily responsible for job creation, governments, international organizations, and NGOs can and should facilitate this process. Generating employment requires regulatory policies that facilitate the creation and growth of private businesses. Other factors that influence business growth and job creation might include access to capital, financial system, pool of entrepreneurial talent, macroeconomic stability, infrastructure, and public services.
More specifically, governments can focus on promoting SMEs. Small and medium enterprises (SMEs) are the major creators of employment opportunities and therefore hold an important key to employment and poverty reduction. SME expansion boosts employment more than large firms because SMEs are more labor intensive, less skill intensive, and less capital intensive—creating jobs better suited to the poor. This is also appropriate for developing countries with an abundance of labor and a relative shortage of capital. But, unfortunately, the economic structure in low-income countries is polarized with the informal and large enterprises playing a large role, and the SMEs playing a smaller one—the so-called ‘missing middle.’ The path to economic development is clearly associated with a growing role of the SME sector.
Microcredit has received much attention and has grown rapidly in recent years. Nevertheless, microcredit has not had a significant impact on alleviating poverty. The women who have received these loans run businesses while possessing low skills, little capital and no scale economies, and as a result do not earn enough to rise out of poverty. Therefore, creating employment and increasing productivity is the best solution to poverty. We should emphasize the role of the government in providing basic public services, which have a direct and significant impact on productivity. Overall, governments, businesses, and civil society would be well advised to reallocate their resources and energies away from microfinance and into supporting SMEs in labor-intensive industries.
Aneel Karnani is Associate Professor of Strategy with the Ross School of Business at the University of Michigan . Karnani’s research focuses on competitive advantage, strategies for growth, global competition, and emerging economies.