Due Diligence

Due Diligence: An Impertinent Inquiry into Microfinance is a detailed analysis of the effects, philosophy, approaches, and merits of microfinance as an institution and as, increasingly, a charitable focus of the developed world. The author, David Roodman, was a senior fellow at the Center for Global Development at the time of writing this book, and is an expert in microfinance and economic development. This book starts as an overview and a history of the spectrum of microfinance institutions (something I found very valuable, since I knew very little about microfinance prior to Kiva's popularity), and then attempts a critical, data-driven analysis of whether, to what extent, and by which measures microfinance is successful.

The most common aspect of microfinance, made popular and prominent by Kiva among others, is microcredit: small loans to people in developing countries. The underlying theory of microcredit is that lack of financial services handicaps prospective entrepreneurs and business owners in the third world, preventing them from growing businesses, funding expansion, and moving out of poverty. By extending relatively small amounts of credit to these people, or so the theory goes, they can better smooth out the uncertainties of day-to-day life and get the necessary capital to expand small local business.

Microcredit is not the only type of microfinance, though, and Roodman's careful discussion of that point was one of the most informative parts of this book for me. It can also come in the form of microsavings — tiny bank accounts or small-scale savings plans — or microinsurance. Roodman makes a very interesting argument that these three forms of microfinance form two opposing continuums. Microcredit is the easiest to provide and microinsurance is the hardest, for many reasons he discusses including some that were surprising to me, but microinsurance is arguably the most helpful and beneficial to the individual poor and microcredit is the least.

The opening history and survey does an excellent job showing the range of techniques and approaches used in microfinance, and showing the challenges of providing it. I had some vague understanding of the logistical challenges in serving areas far away from traditional infrastructure. I had much less understanding of the fascinating array of techniques in use, both inside and outside what's become the microfinance industry. Some of these techniques are brilliant examples of human economic creativity and skill at balancing incentives with risk protection. There are a much wider variety of approaches and instruments available than the individual or group loans that one typically sees on a site like Kiva, all with different trade-offs in group size, flexibility, rigidity, risk, and complexity. This book is well worth reading just to get a feel for the huge array of financial arrangements possible outside of the traditional banking structures that most readers of this review are used to.

Another question Roodman answers thoroughly is why microfinance is so focused on microcredit. My vague unease with that was strengthened by reading David Graeber's Debt, which among many other things makes clear some of the social perils and power imbalances in lending. Due Diligence both crystallized that discomfort and explained why alternatives are difficult. Both microsavings and microinsurance necessarily involve considerably more regulation (which has both advantages and complexity), since they involve taking and safeguarding people's money and promising service in the future. Lenders require less trust; lenders instead extend trust and assume that risk themselves, and are in a position to do so. Microinsurance is also harder to explain and harder to target, although it is potentially the most helpful financial instrument when well-targeted. And microcredit can absorb huge influxes of capital from the outside, lending it out in a region, while both microsavings and microinsurance are necessarily built on the money already in the local economy and are inherently more resistant to external involvement. (I'm of the opinion this is a significant feature, but it makes it far harder for them to catch on as a charitable trend.)

The heart of the book is a hard look at whether microfinance, and particularly microcredit, works. Roodman attempts this analysis for three different definitions of working: lifting people out of poverty (the most commonly claimed success), giving people more freedom and control over their lives even if their poverty level does not change in absolute terms, and developing the local economy. Sadly for charities like Kiva, microcredit does surprisingly poorly on the first two metrics.

There is still little clear data, and the degree to which data from one region is applicable to a different region is highly debatable, but what evidence we have does not support the theory that microcredit lifts people out of poverty. In fact, the more intense the microcredit, the more likely it appears to be that credit pathologies common in the developed world, such as taking out loans from one organization to pay off loans from another, spirals of debt that is unlikely to ever be repaid, and aggressive debt collection methods, turn up in microcredit as well. The vision of the entrepreneur who succeeds through new-found access to capital is largely a myth. Indeed, the current packaging and presentation of loans to distant charities in developed countries means that even the supposed purpose of the loans is dubious. Loans are almost always presented as being for some sort of business activity, since that's what external charities want to fund, but money is fungible and the funds are more often used for all the things people normally need to use funds for: weddings, funerals, food for the family in hard times, paying off other loans to relatives, and other daily expenses.

On the empowerment front, microcredit fairs little better, and here I particularly appreciated Roodman's clear-eyed and honest portrayal of common microcredit practices and their benefits for the creditors. For example, microcredit makes much of loaning to women, and presents this as a story of female empowerment. Roodman argues that there is some reality behind that, but it's also clear that microcredit organizations loan to women because women are more likely to repay — not due to any inherent gender trait, but because women are easier to intimidate and shame into repaying. Similarly, the much-vaunted group loans, usually presented as a way for the community to support each other and teach each other financial skills, are most common in the poorest regions because they represent an outsourcing of costs. The main risk to the lender is that poor people have no such thing as credit histories, and detailed investigations of someone's trustworthiness is expensive. Groups are jointly liable and therefore will police themselves and check each other's reliability at no cost to the lender. Groups will also use intimidation tactics and even violence against members who don't or can't repay their share, without the lender having to get involved or have any responsibility for those tactics. Roodman takes a philosophical tone on this topic, noting several times that services for the very poor are generally of low quality and finance is no exception. I'm less inclined to be philosophical; after reading this book, I find it very hard to support group loans.

This leaves economic development as the most compelling argument left for microcredit. This is weak tea for people like myself who wanted to believe in the transformative power of microcredit, but Roodman does a solid job explaining why it's still important. There is a great deal to be said for the perspective that only industrialization actually lifts people out of poverty on any substantial scale, and therefore the most useful type of aid is aid that somehow contributes towards industrialization. Building a native financial industry could arguably be such a step. And there seems to be some real merit and lasting effect to having a richer and more capable set of local financial institutions.

However, here, it's not at all clear that external money helps. In fact, there's quite a bit of evidence that external money hurts, since it pushes microfinance institutions to find ways of using that money and pleasing external donors instead of building their infrastructure and capabilities as financial institutions. The earlier institutions, such as the Grameen Bank, seem to have done a better job at being local institutions woven into the local economy than have the later organizations that are largely supported by western donors. Roodman makes a good case for the usefulness of microfinance as a part of economic development, but it comes with a strong argument against too much external funding, and particularly against the practice of developed world donors funding specific loans.

I came away from this book feeling like I had a much better understanding of the core problems and techniques of financial services for the poor, and with a strong desire to see more microsavings than microcredit. The two are closer in nature than I had expected, and Roodman's analysis of the similarities was fascinating, but microsavings seems less vulnerable to some of the credit pathologies. There is also some statistical evidence that microsavings does provide some modest reductions in poverty, while the evidence for microcredit is much less compelling.

Sadly, from the perspective of a resident of the developed world such as myself who would very much like to help, neither microsavings nor effective microcredit seems likely to benefit from my contributions, and particularly not in the form of a site like Kiva. The end of this book is a long appendix that reprints multiple blog posts on related topics, including additional discussion of the problems with the Kiva model. Effectively, Kiva is a way for people like myself to subsidize microcredit organizations. It's not at all clear that subsidies are needed, and there's some reason to believe that they encourage negative and destructive behavior. The way they are marketed involves a certain amount of lying, or at least distortion, on the part of multiple actors in the microcredit picture. And they're a distraction from microsavings, and from microcredit based on loaning out savings from within the same local economy, both of which seem to have considerably more positive properties.

Due Diligence is a book with a somewhat narrow target audience. It will appeal primarily to people with an interest in economics, particularly development economics, or who are evaluating microfinance charities or analyzing their support of groups like Kiva. But within that context, this is an excellent book, and I recommend it to your attention. Roodman is clear, thorough, and fair within my ability to measure that, and while no one book can be the final word on a topic, he adds considerable data and thoughtful analysis.

If you are a supporter of Kiva, like I was, I fear you'll find this book rather discouraging. But it's better to have the information than not, and I found it a good reminder of the inherent drawbacks of loans and debt. There is, sadly, nothing magical about microcredit that removes those problems.

Rating: 9 out of 10

Reviewed: 2014-06-26