What role can finance play in ending poverty?
By Lindsay Stradley
With no time to dawdle, we dove headfirst last week into provocative ideas about poverty and the role finance could play in its reduction. Before addressing solutions, Lant Pritchett demanded that we first recognize poverty not as an identity or even a personal characteristic, but as a condition. Moreover, it’s a condition in which much of the world’s population – including a majority of people from the countries that Lant and Deepa Narayan studied in Moving Out of Poverty – currently find themselves.
What role can finance play in ending poverty?
Relatively small decreases in net poverty in these countries belie the huge amount of movement both in to and out of poverty. Given this churn, Lant posited two basic means of decreasing poverty:
- Augment people’s income or livelihood.
- Increase the availability of cost-effective social services.
Offering those two options are our starting place, he framed our course’s mission as an investigation into the role finance could play in those options. To save us time in this investigation, he assured us that microcredit’s role is tiny and venture capital’s role is fraught with complications possibly too great to overcome.
Microcredit isn’t the answer.
While acknowledging microcredit’s function as an extremely useful financial service, he discounted microcredit as a route out of poverty and provided several reasons. First, he argued that it’s based on a flawed conceptual model in which the combination of good ideas, skills, and assets enable people to build wealth. This model further assumes that poor people have the ideas and skills, so simply need financing for assets. Although people in poverty usually do lack financing, its absence is not the primary force pushing most people into poverty. (Quoting his former Nobel Prize-winning MIT economics professor Robert Solow, “Just because the tire is flat does not mean the hole is on the bottom.”)
Second, most people don’t want to be in business for themselves – and probably shouldn’t be. Cautioning us of an overreliance on mass microcredit, Lant warned, “The problem isn’t that people don’t have access to financing. It’s that they shouldn’t have access to financing.”
Third and finally, if most people will get out of poverty through employment rather than entrepreneurship, we should scale the impact of financing through larger businesses, not by financing large numbers of people. Instead of giving 1000 women financing to bake a dozen cookies, we should find a Mrs. Fields to employ 1000 women. Microcredit, he argues, can alleviate poverty en masse only insofar as it identifies the entrepreneurial rock stars who will employ others en masse. He concluded, “I’m interested in everybody getting a goat in the same way that the Russians wanted every girl to do gymnastics.”
VC probably isn’t the answer either.
If he dismissed the microcredit champions, Lant sympathized with the venture capital enthusiasts. The theory is on target, but the implementation is agonizingly difficult. In short, VC doesn’t work in countries where you can’t enforce contracts. If you give 1000 people $10 assuming that when one person achieves success, she’ll give you $10,000, you have to be able to identify that success; however, that identification can be a futile task without proper legal enforcement. Lant noted, “If you can keep two sets of books [for managerial and tax purposes], you can keep three sets.”
Even if the model works as it should, in these contexts VC still faces very high unit costs in its due diligence and transaction costs in its contractual arrangements. And when success comes, investors will likely struggle to find reasonable exit strategies.
So, what can finance do?
If microcredit and VC aren’t the easy answers, Lant challenged us to define the problem that we’re trying to solve in order to find the right solution. Focusing on our course title, “Financial Innovations in the Social Sector,” he asked if we believe that good innovations exist and could go to scale with access to better financing? Or, is there a lack of innovations? Or, finally, do the innovations exist but non-financial barriers are deterring their success?
All of the above. As we continue our investigation over the coming weeks, we will see situations in which each of the three applies. In all of these cases, Lant demanded that we remain critical, applying our commercial sense to test the market ideas that will be posed.
