Why Doesnt Capital Naturally Flow to the Poor

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From the viewpoint of basic economics, the need for microfinance is somewhat surprising. One of the first lessons in introductory economics is the principle of diminishing marginal returns to capital, which says that enterprises with relatively little capital should be able to earn higher returns on their investments than enterprises with a great deal of capital. Poorer enterprises should thus be able to pay banks higher interest rates than richer enterprises. Money should flow from rich depositors to poor entrepreneurs.

The "diminishing returns principle" is derived from the assumed concavity of production functions, as illustrated in figure 1.1. Concavity is a product of the very plausible assumption that when an enterprise invests more (i.e., uses more capital), it should expect to produce more output, but each additional unit of capital will bring smaller and smaller incremental ("marginal") gains. When a tailor buys his first $100 sewing machine, production can rise quickly relative to output

Figure 1.1

Marginal returns to capital with a concave production function. The poorer entrepreneur has a greater return on his next unit of capital and is willing to pay higher interest rates than the richer entrepreneur.

Output

Output

Worm Rig Walleye Rig

Figure 1.1

Marginal returns to capital with a concave production function. The poorer entrepreneur has a greater return on his next unit of capital and is willing to pay higher interest rates than the richer entrepreneur.

Capital

Capital possible when using only a needle and thread. The next $100 investment, say for a set of electric scissors, will also bring gains, but the incremental increase is not likely to be as great as that generated by the sewing machine. After all, if buying the scissors added more to output than the sewing machine, the wise tailor would have bought the scissors first. The size of the incremental gains matter since the marginal return to capital determines the borrowers' ability to pay.5 As figure 1.1 shows, concavity implies that the poor entrepreneur has a higher marginal return to capital (and thus a higher ability to repay lenders) than a richer entrepreneur.

On a larger scale, if this basic tool of introductory economics is correct, global investors have got it all wrong. Instead of investing more money in New York, London, and Tokyo, wise investors should direct their funds toward India, Kenya, Bolivia, and other low-income countries where capital is relatively scarce. Money should move from North to South, not out of altruism but in pursuit of profit. The Nobel-winning economist Robert Lucas Jr. has measured the extent of the expected difference in returns across countries (assuming that marginal returns to capital depend just on the amount of capital relative to other productive inputs). Based on his estimates of marginal returns to capital, Lucas (1990) finds that borrowers in India should be willing to pay fifty-eight times as much for capital as borrowers in the United States. Money should thus flow from New York to New Delhi.6

The logic can be pushed even further. Not only should funds move from the United States to India, but also, by the same argument, capital should naturally flow from rich to poor borrowers within any given country. Money should flow from Wall Street to Harlem and to the poor mountain communities of Appalachia, from New Delhi to villages throughout India. The principle of diminishing marginal returns says that a simple cobbler working on the streets or a woman selling flowers in a market stall should be able to offer investors higher returns than General Motors or IBM or the Tata Group can—and banks and investors should respond accordingly.

Lucas's ultimate aim is to point to a puzzle: Given that investors are basically prudent and self-interested, how has introductory economics got it wrong? Why are investments in fact far more likely to flow from poor to rich countries, and not in the other direction? Why do large corporations have a far easier time obtaining financing from banks than self-employed cobblers and flower sellers?

The first place to start in sorting out the puzzle is with risk. Investing in Kenya, India, or Bolivia is for many a far riskier prospect than investing in U.S. or European equities, especially for global investors without the time and resources to keep up-to-date on shifting local conditions. The same is true of lending to cobblers and flower sellers versus lending to large, regulated corporations. But why can't cobblers and flower sellers in the hinterlands offer such high returns to investors that their risk is well compensated for?

One school argues that poor borrowers can pay high interest rates in principle but that government-imposed interest rate restrictions prevent banks from charging the interest rates required to draw capital from North to South and from cities to villages.7 If this is so, the challenge for microfinance is wholly political. Advocates must only convince governments to remove usury laws and other restrictions on banks, then sit back and watch the banks flood into poor regions. That is easier said than done of course, especially since usury laws (i.e., laws that put upper limits on the interest rates that lenders can charge) have long histories and strong constituencies.

Reality is both more complicated and more interesting. Even if usury laws could be removed, providing banks with added freedom to serve the poor and cover costs is not the only answer. Indeed, as we show in chapter 2, raising interest rates can undermine institutions by weakening incentives for borrowers. Once (lack of) information is brought into the picture (together with the lack of collateral), we can more fully explain why lenders have such a hard time serving the poor, even households with seemingly high returns. The important factors are the bank's incomplete information about poor borrowers and the poor borrowers' lack of collateral to offer as security to banks.

The first problem—adverse selection—occurs when banks cannot easily determine which customers are likely to be more risky than others. Banks would like to charge riskier customers more than safer customers in order to compensate for the added probability of default. But the bank does not know who is who, and raising average interest rates for everyone often drives safer customers out of the credit market. The second problem, moral hazard, arises because banks are unable to ensure that customers are making the full effort required for their investment projects to be successful. Moral hazard also arises when customers try to abscond with the bank's money. Both problems are made worse by the difficulty of enforcing contracts in regions with weak judicial systems.

These problems could potentially be eliminated if banks had cheap ways to gather and evaluate information on their clients and to enforce contracts. But banks typically face relatively high transactions costs when working in poor communities since handling many small transactions is far more expensive than servicing one large transaction for a richer borrower. Another potential solution would be available if borrowers had marketable assets to offer as collateral. If that were so, banks could lend without risk, knowing that problem loans were covered by assets. But the starting point for microfinance is that new ways of delivering loans are needed precisely because borrowers are too poor to have much in the way of marketable assets. In this sense, for generations poverty has reproduced poverty—and microfinance is seen as a way to break the vicious circle by reducing transactions costs and overcoming information problems.8

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Responses

  • Carmen Douglas
    Why doesnt capital naturally flow to the poor. microfinance?
    2 years ago
  • Shay
    Why doesn.t capital naturally flow to the poor?
    2 years ago
  • melanie
    Why Does'nt Capital Naturaly Flow Of The Poor?
    2 years ago
  • Ernest
    Why does not capital naturally flow to the poor in micro finance?
    2 years ago
  • tommi
    Why doesnʾt capital today flow naturally from richer to poorer countries?
    1 year ago

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