The book you edited with Howard Rosenthal came out of a conference on credit markets for the poor in developed countries. How do the credit problems of poor people in the United States differ from those in developing countries?
A lot of the work in developing countries that’s attracted attention recently has to do with microcredit and group lending, which has been pretty successful in some countries. There have been some attempts at replicating similar experiments in the United States and other developed countries, and they don’t seem to work in developed countries. So that’s one important difference.
One finding that has really been a big eye-opener for me is a chapter by Timothy Bates on equal-opportunity lending programs. Most of the time these programs don’t work well in two respects. First, they often don’t reach the people they’re intended to target. And second, when they do reach the people they’re intended to target, often these people start businesses that end up being unsuccessful. Often people who are approached to set up a business on very favorable lending terms may not have the skills to run a business. They may not have investment opportunities that are worth investing in. A better policy might be to direct them to training programs and encourage them to take on more qualified jobs rather than become entrepreneurs.
The presumption is that poor people are not able to become entrepreneurs because they are credit rationed, and we’re going to lend to them on more reasonable terms and then magically that should set them up as successful entrepreneurs. I view Bates’s chapter as having very broad lessons even for developing countries, because we’re now being told that microcredit could be a model for lifting millions out of poverty. But it’s a very specific model. It’s a model where we make them become entrepreneurs of some kind. And the reality is not everybody is really able to be an entrepreneur.
The other point Bates makes is that these programs often aren’t able to target truly poor people who are willing to take on a business. So they lend to people who could actually borrow from a bank but obviously prefer to borrow on subsidized terms. Money is channeled to these entrepreneurs, who are more likely to be successful. They are then pooled with the unsuccessful entrepreneurs and help justify the program because they raise the success rate. But in fact the funds are misdirected.
Can you talk a little bit about the credit options that are currently available to low-income households in the United States?
A big development that John Caskey discusses is the growth of payday lending. It’s now overtaken pawnshop lending, and one of the companies operating payday lending is a large, publicly traded firm. The interest rates can be astronomical. The amounts borrowed at any one time are relatively small: $200 or $250. The mechanism is you sign a postdated check that you deposit against the loan.
There’s been phenomenal growth in this market. You might think that the people who make use of this facility are just people who happen to have an unexpected, temporary cash shortfall. But this chapter highlights that often people are coming back on a regular basis. As with credit cards, most of the money gets made on so-called revolvers — people who roll over their debts. Eventually they may default, but in the meantime the lender has really made a lot of money.
You have to have a bank account to get a payday loan because you have to be able to write a check that you put as a deposit. And we know this is a highly profitable business to be in. Maybe we could lower the cost of borrowing for some households if we increased entry into this market — particularly entry by banks themselves. Why aren’t the banks offering this facility at lower rates to their own customers? I think there are banking regulations that probably make this impossible or unappealing. That would be an area that I would single out for possible regulatory reform.
Community lending organizations have proven to be very successful in Bangladesh and other developing countries. Why do those lending models seem to be less effective in the United States?
In a chapter called “Networks and Finance in Ethnic Neighborhoods,” Robert Townsend compares access to credit in three ethnic communities: a predominantly African-American community in Chatham, a suburb of Chicago; a community of Hmong immigrants from Laos that emigrated to Minneapolis–St. Paul after the Vietnam War; and an ethnic Mexican community on the south side of Chicago. What he finds is that there are large variations across these three communities in how much informal community lending goes on. His chapter reveals just how important a role credit markets organized around community networks can play.
Social and cultural background plays an important role in fostering these community lending arrangements. One family member wants to start a business and is able to raise small amounts from a whole network of friends and relatives. So one very important variable is how close these family ties are. And in some of these communities there are very close-knit ties.
The reason more formal community lending programs don’t work well in developed countries seems to be that they have only been tried in communities that were not that well integrated. The other factor may have to do with the costs of running these programs. In the United States, the geographical dispersion is so large that the costs of reaching people, handing out the money in small quantities and monitoring the loans swamps the returns that you might get. And unlike in developing countries, you have to compete with all sorts of other forms of lending, so the selection effect may be worse.
Is microentrepreneurship a silver bullet for reducing poverty?
That’s a question I think nobody has an answer to. Some of these programs have been very successful, but the early programs in developing countries were subsidized in one form or another, and they were small-scale. I have no doubt that in most countries if you look for a community with the right ethnic and cultural background, you will be able to make it work. But the question is how can you scale this up? Can you scale this up to reach millions of households, millions of borrowers? That’s a much harder goal, and I’m not sure that’s ever going to be achievable.
The other thing that people haven’t really paid enough attention to is what Bates’s chapter focuses on for the United States. Is this really the right way of addressing poverty? We’re seeking to make small-scale entrepreneurs out of households that may not have the skills, the preferences or the appetite for risk taking. If we used those subsidies for other types of interventions, we might be more successful. Another important issue is what’s the psychological impact if you give someone a loan and tell them that you are doing them a special favor and then they fail in spite of getting preferential treatment? Haven’t you made them even worse off than they were before?
Can you talk briefly about your own research on credit markets?
What prompted our conference and the book is some earlier work I did with Howard Rosenthal on political intervention in debt contracts — interventions like debt moratoria or bailouts in an economic crisis. We study how these interventions come about. What kinds of political coalitions get formed to pass such legislation in the midst of a crisis? To what extent should you try and tie politicians’ hands to prevent such political interventions? And what kind of intervention should you allow? What’s better, a moratorium or a bailout? Who gets hurt? Who benefits?
People have often decried bailouts, saying that they encourage lenders to lend recklessly, which is true. But if your starting point is that you have credit rationing to begin with, then at the margin at least, that’s a policy that goes in the right direction. For moratoria, it’s the other way around. If you make it too easy to cancel debts ex post, then you undermine credit markets ex ante. And then the question is how do you want to organize the political process to limit those moratoria? What kind of majority rule should you have, and what kind of limits on the extent to which you can cancel debts?
When you look at the political process, you find that the big innovations in credit markets always come after a crisis. The crisis creates a political constituency for intervention. So, for example, in the 19th century the United States passed a bankruptcy law following a crisis. When things improved people realized, well, we’ve overreacted, and the pendulum swung back in the other direction.
Does this mean that all forms of political intervention in credit markets are bad? Our study shows that, to the contrary, such political intervention can bring about improvements by helping complete debt contracts that often do not anticipate or contain adjustments for exceptionally hard economic slumps. For example, debt contracts in Louisiana did not contain any special provisions for a major catastrophe like Hurricane Katrina. We argue in our article that in such cases it is desirable both ex post and ex ante to allow for political intervention in the form of either bailouts or debt moratoria.
Patrick Bolton is the Barbara and David Zalaznick Professor of Business at Columbia Business School.
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"Credit Markets for the Poor"