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Technology
Department of Economics
Working Paper Series
Massachusetts
Institute of
The Uses of Economic Theory: Against a Purely Positive
Interpretation of Theoretical Results
Abhijit Banerjee,
MIT
Working Paper 02-24
May 30, 2002
Room
E52-251
50 Memorial Drive
Cambridge, MA 02142
downloaded without charge from the
Social Science Research Network Paper Collection at
This paper can be
http:/ /papers. ssrn.com/paper.taf?abstract id=xxxxx
MASSACHUSETTS INSTITUTE
OFTECHMOLOGY
AUG
1 2 2002
LIBRARIES
Technology
Department of Economics
Working Paper Series
Massachusetts
Institute of
The Uses of Economic Theory; Against a Purely
Positive
Interpretation of Theoretical Results
Abhijit Banerjee,
MIT
Working Paper 02-24
May 30, 2002
RoomE52-251
50 Memorial Drive
Cambridge, MA 02142
downloaded without charge from the
Social Science Research Network Paper Collection at
http: / /papers.ssrn. com/paper. taf?abstract_ id=xxxxx
This paper can be
The Uses. of Economic Theory: Against
a Purely Positive
Interpretation of Theoretical Results
Abhijit V. Banerjee'
February 1,2001
This Version
May
30,
2002
JEL Codes: B4, D8, 02
Economists are excessively influenced by the so-called positive economics view, which
says that economists should only describe and not prescribe. Here I argue that this view
is flawed because it makes unreasonably strong assumptions about what players (the
agents taking economic decisions) know and understand. I then use the example of
micro-credit to show how this bias towards positive economics has distorted the policy
debate.
I
am
grateful to
Kaushik Basu, Esther Duflo and Dean Karlan for helpful comments.
1
1.
Introduction:
The
question.
"The philosophers have only interpreted the world
the point is to change it.
in
various ways;
This oft-abused quote from Karl Marx" captures well the dilemma of economic theory:
theorist sees
when
economic reasoning everywhere
to sell, to the
how
figuring out
to
—from
the trader deciding
What should
she
make of what
better off if they took her advice.
choices are the best response, or
or less understands the
To put
This
is
try to
it
that is
It is
knows
which
better
and they
the observed
influence the choices, presuming that she
being played? Should she merely interpret the
it?
is
a positive or normative
question that every practicing economist has had to
level, but for the
to deal with his
differently, as an analyst, should she
of course the old question of whether economics
discipline.
some
change
is it to try to
game
how
most part
the
discipline within
economics makes
positive political
economy and
interpreting the world;^
way
its
it
own
has worked
is
that
come
to
terms with
choice. For example, the related sub-fields of
institutional analysis are explicidy
focused towards
on the other hand, the sub-fields of market design and social
and better governance
structures.
Other sub-fields, such as development economics, are less clear-cut. While there
long tradition of institutional analysis (why do
^
Marx
^
Canonical examples of
we
is
a
observe sharecropping or bonded
(1888).
this style
at
each individual sub-
choice, are, by the nature of their project, focused toward developing better trading
institutions
to
would have chosen them? Or should
see her problem as being to find the economic environment in
world or
how
she sees? Should her presumption be that the
she try to influence their choices, on the presumption that she
more
buy and
lend most effectively, to the government department deciding
players have chosen their strategies as economists
would be
to
farmer setting the terms for his tenant, to the village money-lender
auction off logging concessions, to the businessman figuring out
regulators.
when
A
of research include Stigler (1986), Olson (1965), and North (1981).
2
labor?) there
is
also a disquiet with this methodology, as reflected, for example, in the
work of Robert Townsend. Townsend has done important work
economics
tradition,'*
but
in his
in the positive
1995 paper on "Financial Institutions
Northern Thai
in
Villages", after observing that institutional performance varies widely across villages, he
deliberately stops short of explaining the difference in performance.
perhaps no one has taken the
village.
initiative to
While he does not say
develop the institutions
so, this clearly
He
in the
suggests that
worst-performing
opens up a space for an economist
interested in promoting better institutions.
However, even within development economics, methodological discussions, or even
explicit statements of methodological stances, are rare. This has the advantage of
avoiding the endless methodological disputes that
I
will argue in the
coming pages,
it
afflict the
also contributes toward
other social sciences, but, as
muddying
a
number of
important policy issues.
My strategy in this paper is as follows:
begin with an extended discussion of pure
I
positive economics, as the one clear methodological stance that one finds
economists.
will argue that, at best
I
economics. The problem then
prescription.
to
I
is
it
applies only to a quite limited
where
to
—what
go through a case-study of the current debate on micro-credit, which,
one particular instance of how an ill-drawn boundary can
2. Positive
The
is,
domain within
draw the boundary between description and
have, regrettably, no formula to offer on this point
with some admittedly loose thoughts on
classic
among
how
better to
muddy
I
I
do instead
is
will argue, is
the waters.
I
conclude
draw the boundary.
Economics?
answer
to the question
posed
at the
end of the opening paragraph of
the paper
of course, Milton Friedman's plea for a positivist economics: Stick to interpreting the
world— the world does
not need your help. His argument relied on his famous analogy
between economic actors and an expert
billiard player.
See Townsend (1993) on the medieval economy.
The
billiard player
does not need
or even want to study physics in order to be able to clear the table
from
his experience
his fingertips,
on the
though he
table, serves.
may
find
There are a number of reasons
First,
where he
tries
why 1 do
many
out
out different
ways of organizing
need other people to participate
to
make
thinking of
costly and
know
it
ways of making
it
game by many hours of
activity for a
and he would have
to
is
that
to try
he would
pay them for
in these trials
their
have to be large
to play seriously (in this case, this involves
hard for the lender to collect). Running
it
finally
moneylender would be
The problem
his lending operations.
in these trials
same shot and
the
trials is
therefore
not obvious that the moneylender can afford to run enough of them to
is
ball has to
it
lot
billiards, like all other sports, affords a
go into the pocket and not merely
very small margin of error.
in the vicinity
of the pocket. This
To
achieve
this
kind of precision the model would need to take account
of very particular facts about the player and the setting, and at least
facts are nearly impossible to
quantify— the
moves, his posture, his stance,
miss the pocket. This
hours and this
is
hard to base one's strategy in billiards on an analytical model based on the
laws of physics:
will
the
exactly what he needs to do.
what makes
of a
agent, likewise, has strategy at
ways of making
worthwhile for them want
Second, championship
The
different
at
Moreover, the stakes for the people participating
enough
up
not find this analogy particularly persuasive.
The analogous
discovers the one he wants.
his intuition, built
hard to articulate the theory behind his choices.
because a billiard player acquires his expertise
practice,
time.
it
The economic
—
is
why most
is
etc.
If
feel
of the surface, the
billiards players
of us will never be good
to
of those
the player's
arm
one misses or misjudges any one of them, the ball
why good
judgments, by contrast, do not need
way
some
have to pracdce for endless
at billiards.
be exacdy right
—one
just
Most economic
needs to get close
enough. Therefore even analytical methods that offer only qualitative answers ("make
sure that the collateral has value in those states of the world
to default"; "first price auctions tend to
where the borrower
want
dominate second price auctions when the buyers
are risk-averse") or loose quantitative answers ("the inflation rate will
may be good enough.
will
go up by 5
to
6%")
Finally,
even
if it
were possible
some narrow domain by long
economic agent's
do
interest
improve one's economic judgment over
to significantly
practice,
it is
not at
While a great
so.
all
clear that
it
would be
billiard player has
no desire
in the
to help others
play like him, the moneylender, auction designer or compensation consultant has a stake
in
knowledge
that is easily taught.
He wants
a single formula that can be used in a range
of situations, so he can delegate part of his job to others and extend the scope of his
business: General principles are
more
him than
useful to
the exact solution in
one specific
case.
A more useful
analogy, to
my mind, is
to think of
economic decision-making
as a craft,
not unlike fishing or small-scale garment manufacturing. Like fishing and garment
making,
it
is
his potential
make
customers
fruitful use
—
of the credit he
There
is
like fishing
who
are they people
is
offering
market signals, and a businessman has
Moreover,
A money-lender has to learn how to judge
a craft that needs to be learned.
know how
can be trusted, will they
them?
A trader has to learn how
to figure out
how
to negotiate
to
to interpret
with the regulators.
and garment making, most people learn these things informally:
no school for learning
extreme example, for learning
to
be a money lender or a
how
to
pay bribes) just
street
vendor (or to take a more
as there is
no school
for would-be
fishermen or petty garment producers. Finally, the craftsmen and the economic agent
(read petty businessman) are often one and the
countries: farmers lend
same person,
money, fishermen also trade
in fish,
at least in
developing
and the garment maker also
runs a garment shop and deals with the regulators and the tax-men.
The statement
that
economists should not
try to
change the way people do business,
translated to the case of any of these other crafts,
would amount
craftsman has nothing to learn from a technical specialist. Or
expert has no autonomous role
—
if
there
to saying that the
at least that the technical
were some know-how
that the
have wanted from the technical expert, he would have already bought
I
think
it is
This
true
is
reasonable to say that this
is
it
craftsman would
from him.
an excessively optimistic view of the market's
even when the regulators are honest. There is usually a judgment call involved somewhere
and the businessman who does not know how to present his case effectively is
the regulation process,
always more
if
likely to get into trouble.
5
in
role in promoting innovation in the crafts.
As
many
a point of fact,
new
of the
high-
yielding varieties in agriculture were developed by agricultural scientists working for
governments and international organizations, despite the
fact that the basic techniques
used in developing them were based on the idea, familiar
hybridization.
The same
is
every farmer, of
development of chemical
true of the
number of basic advances came from
to
A
fertilizers:
large
publicly funded research laboratories in mid-19"'
century Germany.*"
of course, exactly what
This
is,
may
under-supply innovations
This
is
clearly an even bigger
we would expect. The
is
standard reason
why
the market
the inadequacy of intellectual property right protection.^
problem for craftsmen than
it
is
for large corporate
innovators with their armies of lawyers and other resources. In addition,
some
at least
innovations rely on specialized scientific knowledge that the craftsman does not have,^
and given
his scale of operations,
it
does not pay to employ someone
who
has that
knowledge.
Even when
before
it
a better technology
becomes
available in one of the crafts,
becomes widely implemented. This was
U.S., which took
varieties of
many decades
before
it
became
wheat took over two decades before
regions in India and
HYV
most pineapple producers
rice took
in
it
takes a long time
the experience of hybrid
universally accepted.^ High-yielding
it
covered most of the wheat-growing
Ghana use
less than the optimal
fertilizer
use over
crafts,
much of the observed
See, for example,
This
is
Mokyr
of the
new technology
—
it
might need
(1990).
not the only reason. For a
(1998).
Chemical fertilizers, for example.
See Griliches (1957).
'°
See Munshi (2000).
" See Ahmed (1992).
" See Banerjee and Nihila (1995).
'
many
range
such as fishing" and leather-processing.'^
In part, the slow diffusion reflects the limitations of the
'
that
amount of fertilizer, even
of usage. Slow adoption of the latest technology has also been observed in
common
in the
even longer. '° Conley and Udry (2000) argue
though profits are sharply increasing from
other
com
much more
detailed discussion of the issues, see
Aghion and Howitt
too
much
capita], or skills that the
very risky. But
ideas.
farmer does not have and cannot buy. Or
likely that there is also a lot
it is
For example, there
is
now
known
that this
may be
of {ex post) unjustified resistance
a lot of circumstantial evidence'^ and
direct evidence''* that farmers base their decisions
well
it
some
to
recent
on what other farmers are doing.
new
more
It is
can lead to inefficient herding, with each farmer deciding against the
new technology because no one
gone for
else has
it.
Not surprisingly
countries have publicly funded extension programs which
people to switch to the better technology, and
NGO's
therefore,
employ experts
to
most
persuade
have traditionally seen the
dissemination of best practice technologies as part of their brief.
Note
that the case
I
am making for the
technical experts are always right
claiming that economists are
(I
role of experts does not rely
certainly
would not want
As long
infallible).'
as there is
empirically evaluating and screening out their bad ideas,
it is
to
on the
be put
fact that
in the position of
some mechanism
enough
for
that they are right
reasonably often and that the value of their good ideas outweighs the cost of trying them
out.
For some or
all
of these reasons, most economists do accept the idea of an autonomous
role for experts in the crafts,
though they
for promoting better technologies. '^
making be any
may
question the efficacy of specific programs
Why then
should the craft of economic decision-
different?
" See
14
15
16
Foster and Rosenzweig (1995) and Munshi (2000).
See Conley and Udry (2000).
See Banerjee (1992) and Bikhchandani et al. (1992).
This
is
not to say that experts do not often get
practitioners (see
World Bank, 1999, page
it
wrong or that they have nothing to learn from
example of how women farmers in Rwanda and
38, for a nice
Colombia helped agronomists evolve better varieties of beans).
'^
To take an example from an area where there is a lot of research, Evenson and Westphal (1995) in their
survey of 'Technological Change and Technology Strategy" in the Handbook of Development Economics
report that the mean rate of return to public investment in agricultural research is 80% in all developing
countries if one includes the output of the international crop research centers, and around 50% if one does
not include them. They also suggest that the attitude towards agricultural extension programs had shifted
between the 1970's and 1980's. In the 1970's, the view was that extension programs were only valuable
when there is a new technology, but the emerging consensus in the 80's and 90's was that there is scope for
substantial improvement in farming practice even without new technologies, especially in sub-Saharan
Africa. They then summarize the results from 23 studies of public sector agricultural extension programs
and report that 13 of them report rates of return of over 50% and that mean rate of return reported in these
studies is 50% for developing countries and 63% for developed countries. While many of these estimates
of the rate of return suffer from potential endogeneity problems, these results clearly reflect the common
sense of the discipline.
7
As
see
I
answer
it,
that
may go something
optimization problem
and
The
there are three potential answers to this question.
someone
will hire
like: All the
decision-maker has to do
worst, a game, and
or, at
to solve
it
first is
he does not
if
is
to solve an
know how
The economist does not have
for him.
an a priori
to
do
he can
it
him a
to offer
solution.
This argument misses the point that what the economist does best
not to solve
is
problems, but to explain what the problem needs to be. Mirrlees' 1971 paper on optimal
taxation
was so
influential
because he showed how one would
set
up the problem
in a
range of situations, not because he solved a complicated maximization problem. The fact
that
now any
graduate student
not
mean
set
up a problem
that,
principles that
ex ante,
is
it
knows how
was not a major
to set
up problems
not unlike inventing the internal combustion engine.
went
into the early engines
were
millennium) but someone had figure out
The economic decision-maker who
how
faces a
all
well
to put
even
that he
knows how
give objective advice?
plumber who
to
them
model
to
basic
other applications
for at least a
together.
has to find the model that
into a specific
pose the right question to someone
problem
that
can
is
the economist's motives.
who
could help him.
Why should we
trust
him
to
My sense is that this is not very different from the case where it is
offering the advice.
has a reputation, because he
conscience.
known them
The
way
We have, however, no reason to believe that he knows how to do so or
The second argument questions
the
known from
new problem
describes best his situation and then translate the
problem does
Indeed, figuring out the right
insight.
(according to Mokyr, 1990, the Chinese might have
then be solved.
like Mirrlees'
knows
Why would it be
We trust the plumber (when
that there will
in a
very similar context,
policymaker and his advisor to have interests
if it
jobs in the future, because he has a
different for an economist? In other words, as O'Flaherty
and Bhagwati (1997) have argued
Basu (2000) has argued,
we do) because he
were indeed
because they always have an axe
that
true that
to grind, then
8
more or
it
is
not
uncommon
less coincide.
for the
Moreover
as
economists never give useful advice
people will stop asking them for advice—
this
cannot be a reason for the economist to not offer his advice,
The
third
argument for why the
crafts (and therefore
dismiss.
craft of
if
asked.
economic decision-making
why economics needs
to
be a positive science)
is
different
much
is
harder to
simply the empirical claim that the average economic problem
It is
from other
simpler
is
than the average technical problem. While there are obviously difficult economic
problems
much
claim.
(the
problem of designing
the optimal multi-good auction that has attracted so
attention in recent years, for example),
I
will therefore take refuge in
I
know
way
of no
of refuting the general
one relatively elaborate example, inspired by the
current policy debate about micro-credit.
I
will argue that this debate is less useful than
it
could be, because most of the participants do not recognize the very real complexity of
the design
problem involved
in
coming up with
a really effective micro-credit scheme. In
other words, complexity in economics problems
is
certainly important
enough
to
be a
practical problem.
3.
An Example:
Micro-credit
is
Micro-credit.
now famous
as the revolutionary
are micro-credit organizations
Bangladesh, almost
all
new
tool for poverty alleviation.
everywhere from Arkansas
to
Zimbabwe.'^
There
In
anti-poverty programs are in the hands of micro-credit
organizations.
The Grameen Bank alone has more than 2 million members who receive
$30-40 million
in loans
initiatives for
credit.
every year. In India, the government has decided that
providing income-generating opportunities for
women
all
the
new
be based on micro-
The president of the World Bank. Mr. James Wolfensohn, has been
talking about
a half a billion people becoming beneficiaries of micro-credit by the year 2005.
Micro-credit involves making credit available to the poor at interest rates
high, are
much lower
micro-credit
'^
than those charged by money-lenders.
comes from
the very high
repayment
The most prominent examples include Grameen Bank and
Indonesia, BancoSol in Bolivia, and
FINCA
in
rates
9
though
The excitement about
(90-95%, or even more)
BRAC
Latin America.
that,
in
Bangladesh,
BRI and
that
BKD in
still
many
of these organizations have been able to secure,
to lend
money
at
these relatively low rates and
There are three main features that distinguish
from the long
line
government. The
week
is
possible for
remain economically viable.
them
7ft
breed of micro-credit organizations
first is that
is
each loan comes with a promise of repeat lending,
regular repayment schedules
—repayment
starts
if
repaid
immediately
after
disbursed and the borrower has to repay a fixed proportion of the loan every
(or month).
liability:
this
it
of failed attempts to lend to the poor, usually under the aegis of the
on time. The second
the loan
still
which make
The loan
The
is
made
members of the group
which
last,
is
somewhat
to a group,
gets repaid. If
cost (for example, they
may
which
is
less universal, is
supposed
some loans
to
some form of joint
make
sure that every loan to
are not repaid, the entire
group pays a
be temporarily or permanently suspended from getting more
loans).
As one might expect given
the hype, there
micro-credit does and does not do.
On
accounts that claim that micro-credit
with raising incomes
among
the very
is
is
a lot of controversy about exactly what
the one side, there are a
number of journalistic
nothing short of a miracle.
It is
credited not only
poor (and especially among poor women, the most
vulnerable group in most societies), but also with diverse forms of consciousnessraising.^'
Some
of these optimistic claims are supported by results from an econometric study of
Grameen Bank by
Pitt
and Khandker (1998). They use an identification strategy based
on a discontinuity in the Grameen Bank's rules for being
eligible to participate in their
program, and conclude that participation in the program raised household consumption
by 18 cents for every $1
lent to
women. They do
not,
however, find any effect on
contracepfion use (a measure of "consciousness") and a slightly positive effect on
fertility.
some dispute about the basis for calculating the repayment rates. Morduch (1998) convincingly
Grameen Bank's claims of repayment rates of 98% or more are exaggerated. When he
recalculates the repayment rates, they fall in the 92-95% range. As he himself acknowledges, these rates
are still very high compared to the rates of 41% that Pulley (1989) reports for IRDP loans in India (to take a
prominent example of an earlier attempt to lend to the poor).
As we will see, what economic viability means is not always obvious.
There
is
argues that the
10
number of shaiply
Oil the other side are a
Bank, w iiicli
is
seen by
many
to
The most important work along
extensively both about the
these lines
is tiiat
and, in two review articles in
the
Joiiiiuil
tlie
basic points. First, he points out that the discontinuity that
Grameen Bank
Grameen does
Morduch compares
eligibility criterion
where Grameen has an operation, with
the
does not have an operation. He comes
to the
Bank
has written
of
World Development,' about micro-credit more generally.
data, invalidating their strategy."'' Instead
who meet
who
of Jonathan Morduch,
basis of Pitt and Khandker's optimistic evaluation of
those
Grameen
tiie
be the standard bearer of the micro-credit movement.""
Grameen Bank"
Eco/ioniic Litcratitrc'^ and in
Morduch makes two
assessments, mostly of
critical
not
show up
the difference
and those
who do
concsponding difference
in the
between
where
in a village
in
the key issues about
it
Grameen
However,
actually had an insignificant negative effect on household consumption.
\\ itii
the
not in a village
conclusion that participation
his difference-in-difference approach does not deal
is
program
placement. If Grameen Bank focuses on areas where the inequality between the rich and
the poor is the greatest,
howe\er
that
Morduch's estimate
to
be biased downwards.
It is
wony
Morduch
uses, also finds no impact.
He
argues that he does not
about program placement issues because the \illages he chooses as
controls were also chosen to be included in the program, albeit in the future.
were
to accept this, there
non-members
in a
treatment group)
even started
worth noting
Coleman (1999), using data from North-east Thailand, and an empirical
strategy similar to the one
need
will
\
is
Even
if
we
remains the concern that the sorting into bank members and
illage
where the program has been running for several years
very different from the sorting
(his control group).
in a village
My sense from all
this is that
where
the
(his
program has not
we have no
reliable
estimates of the effect of the program on income and consumption.
The more damaging point
actually economically
Grameen Bank
"'
""
loses
\
that
iable.
monev
at
Morduch makes about
Morduch (1999)
the
Grameen Bank
reports calculations
is
that
showing
it
that the
the rate of about 10 cents for e\erv dollar of credit
For examples of this genre, see New York Times (1097V Bonistein (1096"), and Counts (1996).
Though many w ithin the micro-credit community are highly critical of Grameen Bank.
-'See
-"See
^ See
-*
See
Morduch (109S\
Morduch (1999).
Morduch (2000).
Morduch (1999).
11
is
not
This reflects a pattern
outstanding.'
among
micro-credit organizations
example,
ffor
CGAP.
a
donor consortium housed within the World Bank:
Otero and Rhyne, 1994. who are micro-credit practitioners opposed
model; or Remenyi, who has written a recent survey
worthwhile
if it
and not the absence of
He
micro-credit
what matters
innovation
means by
One
a
if
subsidies.""^
will
But
the
movement
I will
is to
survive.
is
fact that
am more pessimistic. Morduch
^
^*
^
^
^'
^^
^^
view
is
he too sounds
among
the poor.
is
is
more
I
have
that the micro-credit
in
mind.
movement has
to take the instimtions at face
in
suggesting other ways of
not far away.
however
argues for slow decline, as donors eventually give up.
significant probability
I
on the possibility of a quick collapse,
Once
again, in a
take the theory seriously.
In a related vein, see Matin (1997), and Jain (1996).
See Morduch (1999).
See CGAP (1996).
See Remenyi (2000).
are
article."'^
optimistic than Morduch. In another sense
different because
Yaron et al (1998), who
See Morduch (2000).
See Morduch (1999).
a hard budget constraint
however, that what Morduch
more involved
driven by the internal logic of repeat lending.
my
is.
economists have tended
am perhaps more
on the other hand, put a
is
more demanding than what
doing things, perhaps the next wave of innovations
clear,
is
too believe that there has to be
I
My sense
value. If economists can be persuaded to be
I
no program
to ser\'ing the richest
argue in the rest of this section
been hampered by the
In this sense
that
the end of his review
end up limited
"major wave of innovation'"
of things
at
for efficiency
agree with Morduch's assessment.
I
is
of the
absence of a "second major wave of innovation"', the
fears that in the
movement
one sense.
Grameen Bank
does not have financial sustainability without subsidies. Morduch
criticizes this view, arguing that
pessimistic:
to the
article called "Is there a 'State
damns them. Their credo
Art' in Microfinance"^*^)?' this
In
—very few. even
most prominent and successful organizations, break even or make money.
tlie
For many
among
from the World Bank, take
12
a similar view.
way
that will
become
I
I,
A
3.2
Simple Model of the Credit Market.
Before
we
enter a discussion of these views of micro-credit,
model (based on Banerjee, Besley and Guinnane, 1994)
The setup Consider
3.2.1
requires an investment of
otherwise. There
There
is
is
is
R.
where there
whose gross
1
an investor
a competitive capital
market
that
a world
:
who
has wealth
market
of p with
maximum
The only
possible contract
useful to set out a simple
that outlines the
W<
1
and needs
economy and
in this
in this
key
issues.
an investment opportunity which
returns are R(p) with probability
The source of distortion
choice for the investor but
is
it is
to
p and
borrow the
rest.
the (gross) cost of capital in
economy comes from
is
unobserved by the lender. E(p)-pR(p)
is
a loan contract.
is
the fact that/7 is a
a concave function
atp*.
when
the borrower pays the lender
The
contract specifies an interest rate r that
his project is successful.
pays nothing, since he has nothing and there
is
it is
limited liability in this
justify the restriction to just loan contracts
by
(1989), that verifying the realized return
so costly that
is
When
not successful he
economy.
the argument, originally due to
it
We
Diamond
uses up almost the entire
return.
The incentive problem
3.2.2
neutral, has to
choose
choose p such
that:
p
to
:
In this
maximize E(p)-pr{\-W).
It is
is
assumed
to
be
risk-
clear that the borrower will
EXp) = ril-W)
(B)
For
world the borrower, who
W<
I,
this is quite
obviously inconsistent with the social optimum: The borrower
clearly wants to choose p(r,
much
This
W) < p*.
In other words, there is a
tendency towards too
risk-taking.
is
the standard incentive
problem
in credit markets.
13
It
arises
because society cares
about net output but the borrower only cares about what remains after paying
Using the
fact that the
Wand decreasing in
r.
E(p) function
This
is
concave,
us that people
tells
it is
who
easily
are
shown thatp
is
interest.
increasing in
more leveraged and people
facing higher interest rates will tend toward less efficient choices. This ought to be
intuitive
—both higher
and more leveraging tend
interest rates
to increase the degree of
misalignment of incentives between the borrower and the lender.
3.2.3
this
The
role of monitoring:
The lender may want
to limit the distortions that arise
from
misalignment by monitoring the borrower.
Suppose the lender can force the borrower
monitoring him enough.
increasing in the
A natural
choose a project no lower than p by
assumption here
amount borrowed and
to choose, p(r, W),
to
is
in the distance
and what the lender wants him
to
that the cost of monitoring,
between what
the
M,
is
borrower want
choose, p:
M =cM(l-W,/7-p(iy,r)),M,(.)>0,M.(.)>0.
where c
is
a parameter that measures the efficiency of the monitoring technology.^''
3.2.4 Properties of the credit market equilibrium:
and the
fact that the credit
make pure
profits,
we can
market
monitoring cost function
write the lender's participation constraint as:
cM{\-W.p-p{W,r))
^
pa-W)
P
For any given p that the lender chooses,
The key
this
competitive, which implies that lenders should not
is
^^R
.p(3.
Using
fact that
I
want
to
this
emphasize about
This formulation of the monitoring technology
of projects and
it
is
equation determines
this
equation
is
r.
that r enters positively
on
consistent both with monitoring being ex ante screening
being an ex post check on the borrower.
14
AJeem (1990)
describes these as the two most
both sides of
this
equation
—an
increase in the rate of interest that he has to pay inclines
the borrower towards greater risk-taking,
Monitoring being costly,
An
this
in the efficiency
the
need for monitoring.
pushes up the interest rate even further.
implication of this observation
changes
which increases
is that
the interest rate can be highly sensitive to
of monitoring. Formally, using the equations (B) and (PC),
we
get:
dlnr
1
d\nc
where
X and Y are
+
l
1
Xl + 7
defined as
cM
pE'
Y
is
negative because
E"
is
negative.
rate with respect to the cost of
When
it
of monitoring has a multiplier effect and the ultimate
change
change
be larger than the change that sets
will
Moreover, since we have kept p fixed, the
is
entirely
due
to the fact that
More
monitoring will be very large, as claimed above.''^
generally, a
in the cost
close to -1, the elasticity of the interest
is
we
pure social gain. In other words,
it
fall in
off.
the interest rate resulting
are using less resources in monitoring,
if 1
+ Y is close
to 0, there
is
from a
c
fall in
which makes
it
a
the prospect of large
social gains from small improvements in the technology of monitoring.
Is
there any reason to think that the multiplier is large
some places?
I
am
knowledge, there
is
(i.e.
that
1
+ 7 is
not aware of any direct evidence on this point:
no study
that tells us
how much each
To
small), at least in
the best of
my
individual loan costs to monitor
important and costly things that a lender has to do.
^'
The argument here assumes thatp does not change when c changes. However in Banerjee (2002) I show
same argument goes through even when p is endogenized. Intuitively, a cut mp does reduce the
need for monitoring but this is counteracted by the direct effect of p going down, which is to raise p.
that the
15
The
what we need
to estimate
cM2)-
closest thing to such a study of
which
(which
is
average amount spent monitoring loans per
Chambhar
give us
in Pakistan.
some
While
am aware
I
money
this is quite far
circumstantial evidence that
is
is
Aleem
lender,
(1990),
which gives
the
based on a sample from
from what we want, Aleem' s study does
suggestive. First, real interest rates in his
sample are very high; and high monitoring costs are the reason. The average annual
nominal
his
interest rate he reports
sample of money lenders
of capital. The
rest, i.e.,
monitoring. This
is
78.65% and
between
is
the average annualized cost of lending for
68% and 79%,
out of which
between 36 cents and 47 cents per dollar
clearly
large variations in the
is
32%
lent,
was
good news from the point of view of arguing
amount of resources devoted
average cost
is
the cost of
that there can be
to monitoring.
Second, and more importantly, interest rates in his sample vary enormously. The
standard deviation of the observed interest rate
78.65%, says
that interest rates
of the mean.
By
is
that
old customers
it
and 160%
are within
4%. One obvious candidate explanation of the
comes from
two standard deviations
who
variation in
variations in the technology of monitoring
are easier to monitor, etc.)
None of this, of course, comes
One
0%
38.14%, which given the mean of
contrast, interest rates for real estate lending in the U.S. rarely
outside a band of
sample
between
is
combined with
go
Aleem's
(some people
are
a large multiplier.
close to proving that our conjecture about
alternative possibility, for example, is that the interest rate varies so
1
+ 7 is
correct.
much because
people borrow very different amounts. Note, however, that from equation (PC),
increasing the
amount borrowed,
which perhaps makes
There
is
prima facie
Aleem's study
facts, that there
is
is
unique
-
W, has an unambiguous
on the
effect
interest
rate—
explanation less compelling.
no reason, however,
establish the
of which
this
1
to
push
this point
any
further:
Our
goal here
possibility that reducing the cost of monitoring
in actually
was simply
to
borrowers has
measuring the different elements of monitoring costs. The two basic
appears to be large gap between the interest rate charged and the cost of capital (a large part
likely to
lot, show up in many
number of such studies.
be monitoring cost) and the fact that the interest rate varies a
other studies as well. Banerjee (2002) summarizes the evidence from a large
16
We now return
large welfare benefits.
to the discussion of micro-credit.
3.3 Implications for Micro-credit.
3.3.1
An
Group Lending?
on-going debate within the micro-credit movement
group loans a
Grameen Bank and
la
who
those
is
between those
and Remenyi
length, though both avoid taking a stand.
which
is
made both by
mechanism
the case.
One
is
Two reasons
that there is social
groups, which
makes
second
there
is that
it
The
easier for
argument
is that
are brought
in his
up
in favor of
the group
to explain
is
at
review
some
group lending,
an efficient
why
this
ought
be
to
and physical contiguity among members of most
them
to collect infonnation
social capital within the
is
typical
and evaluators,
practitioners
for monitoring.
Morduch
on the "State of the Art", discuss the issue
in his report
in
believe in individual loans a la BRI.
Policy-oriented economists thinking about micro-credit, such as
article
who believe
about each other. The
—members of
group
the
group can shame
or bully each other into behaving well, while a banker can only use legal threats.
The case
against group loans
each other, and
is in
in part worries
part doubts about whether
group members do monitor
about the cost of running a group. In addition, there
suggestion by Madajewicz (1997) that group loans
may
constrain the
is
the
dynamism of
individual members.
It is
unfortunate that the debate has gotten framed in terms of the relative advantages of
group and individual loans. As
1
Even small savings
in
I
see
it,
the facts are:
monitoring costs
may be
valuable in this context because of the
multiplier.
2.
'^
"
Most people agree
that
(bank
example) in monitoring loans. ^
officials, for
group members have some advantage relative
to outsiders
While most of the evidence on
Here monitoring is assumed to include both ex ante screening and ex post monitoring of the project.
See Guinnane (1994) for a discussion of the contrary view that sometimes the closeness of the group may
actually
make monitoring
harder.
17
this point is anecdotal.
''^
a recent paper
FINCA
this view.
He
come
serve basis and therefore their composition
first
in the first
observes that the
few months
who
live near
same socio-economic stratum. He finds
the
significantly better
Anyone who
formed on a
village banks in Peru are
is
more or
less
for
first
random,
at least
have been formed. Some of these groups end up
after they
with a greater concentration of people
3.
by Karlan (2002) provides strong support
each other and/or are a part of
that these village
banks have a
repayment record than the more diverse groups.
monitors, whether a
member
who
of the group or someone
is
hired for
the task, has to have the right incentives. In fact, giving incentives to a hired monitor
can be quite costly, as most bankers will acknowledge. Indeed
member
presumably, a
When we
used.
When
give a house loan,
Bank and
we watch
the
Only then do we
until it's finished.
Janata
said:
Then we check up how
"....we go to the borrowers.
checking
why
of Grameen Bank was implying when, on being asked
were so high, she
the repayment rates
this is what,
the loan
is
being
house go up, and we keep
say,
'Yes they built a house.'
Krishi Bank"^ give a loan for a fish pond, they
never watch whether anyone throws fingerlings into the pond", (quoted in
Bomstein (1996), page 105).
Group loans or joint
4.
is
only one
way
to give incentives to monitor. Indeed,
we understand why joint
adverse selection
There
is
liability
generates better peer selection in
settings.**'
no evidence
that the current "State of the Art" in micro-credit
through extensive experimentation.
My sense
micro-credit organizations, they
started out with
and individual
all
Grameen Bank and
Morduch (1999) concludes
is
that despite there
one of two
was arrived
being hundreds of
models— group
loans
BRI— indeed many of the later micro-credit
that the very limited "hard" evidence
we have on
this issue tends to
support
these arguments.
Janata
More
field are
""^
There
Bank and
Bank are two banks in Bangladesh that give loans to individuals.
work on these issues is less than twelve years old— the classics of the
generally, theoretical
Varian (1990) and
is
much more
For example,
but
Krishi
there
is
at
This probably reflects the very strong influence of early
loans.
successes like the
'"'
it
only after the recent work of Ghatak (1999) and Armendariz de Aghion and Gollier
(2000), that
5.
liability is
Stiglitz (1990).
variation and experimentation within the class of group-lending organizations.
a lot of experimentation in group size:
at the early stages also tried
Grameen Bank believes
groups of 10 or more (Hossain, 1988).
HNCA,
works with groups of 30 women. There is also some theoretical work on
size (Armendariz de Aghion, 1999; Ghatak and Guinnane, 1999).
18
in
at the
this issue
groups of five
other extreme,
of optimal group
organizations actually set out to be
Grameen
My view is that the economist's task in
mechanisms
that
make
that
is,
we
ought to be to try to design
this setting
the best use of the monitoring advantage that
might have. By narrowing down the problem
between group
replicators.
versus individual
liability
are allowing the
world
to
some members
be one of identifying the trade-off
liability,
to dictate to us
we
are being positive
economists
what the options should
possible, and indeed likely, that neither of these options
is
be.
It
is
really optimal and everyone
should switch to some other mechanism. For example, given that not everyone's time
is
equally valuable, people should have the option of self-selecting to the contract that suits
them
best.
If there are
those who, as Madajewicz (1997) has suggested,
better off with an individual loan, the
group loans and allow people to
much
time, perhaps the
options that are decided
we need
that
is
a structure
some member
is
program should perhaps
self-select. If the
who would be
offer both individual
group meeting
is
seen as taking up too
meeting should be radically abbreviated by limiting the
by the
group."*^
Perhaps joint
where members of
lying.
the
Perhaps group
liability is
group get rewards
liability
and
set
of
unnecessary: Perhaps
if
they
manage
to
all
prove
should be combined with some
outside monitoring, or individual liability supplemented by reports from neighbors."*^
One could go even
further:
We know
from
the
Nash and Sub-game Perfect implementation
same
fact,
it
is
game. Given
usually possible to get
work
theory, that
to reveal
it,
two or more people know
from the members
is
an integral
it is
clear that there
once economist theorists recognize
that they
is
potentially
have something
much good
to offer
here.
''^
ASA,
a
new
the
one should consider bringing some of these message
into praxis of micro-credit. In general
to be done,
if
by making them play a message
that the efficient extraction of information
part of the group-lending strategy,
games
them
work of Maskin (1977) and others on
micro-credit organization in Bangladesii, has taken this approach (everyone gets
same size of loan, on the same day, etc.) and has been able to cut costs and grow fast (see
Morduch, 1999; Rutherford, 1998).
These doubts are reinforced by a series of new papers by Laffont and N'Guessan (1999),
the
'*'
Laffont (2000) and Rai and Sjostrom (2000), showing that
in a wide range of cases, group
dominated by other types of mechanisms. These papers do not however always make
clear whether they see their task to be interpreting what Grameen Bank type institutions actually
do or suggesting new ways of organizing micro-credit.
liability is
19
By opening up
the discussion to include
underscore the fact that there are a
which only a few have been
experimentation, as far as
liability or
pure group
tried.
who
I
I
hope
to
of potential ways to organize micro-credit, of
While there
One could
is
a lot of discussion of the need for
either pure individual
argue that this reflects the superior
started micro-credit organizations, but given that
economists are only beginning to explore
implausible.
of these different mechanisms,
know, micro-credit organizations have
I
liability.
understanding of those
lot
all
this class
•
even trained
of mechanisms, this seems
therefore see this as evidence that there
is
considerable scope for
innovative thinking by economists in this area.
3.3.2 Repeat
Lending
Rather surprisingly, the feasibility of enforcing credit contracts through repetition
rarely questioned.
Morduch (1999) does have
is
a lengthy discussion of the issue but he
focuses on the implications of competition and the possibility of people switching to
other lenders after they default. This seems to
Ghosh and Ray (1996),
out by
reputation
v/5-
a vis their
new
me
to
be the less serious issue: As pointed
the fact that borrowers
who
switch have to acquire a
lenders (otherwise they will get small loans), should
discourage people from adopting this strategy.
I
am more concerned
about the possibility suggested by
context of sovereign debt. Their argument
much
goes
till
a borrower can ever get in loans,
down
with more and
he can borrow the
bank
is
that there will typically
more investment. Knowing
that
be a limit
to
in the
how
only because the marginal product of capital
if
maximum amount and then
—once he knows
Bulow and Rogoff (1989)
this,
the borrower will want to wait
default and put the
money
in the
he will only get the same amount next period, there
is
no
incentive to repay.
This
is
potentially a very serious
have no other way
to
problem
punish defaulters. In
deal with very poor borrowers
borrowers. Individual loans
and those
may
for micro-credit organizations,
fact,
like
it
BRI
affects equally the organizations that
that deal with
be somewhat more affected by
20
which typically
somewhat more
it
affluent
than group loans,
since
it
is
more
but essentially
The
likely that there is
is
it
fact that this is not taken seriously
a big problem. There
pessimistic view
before
group
in the
who
has not
seem
once again
to
is
that
reflects the
be a big problem
may be many reasons why
this
in the world, therefore
The
optimistic
after they default they will
is
that
it
reflects
some
Grameen Bank
will use
they were to default. Perhaps they fear that
be flush with money and
social sanction against people
who
all
structure of the
this will
induce them
to
spend
it
too
and then they would rue the fact that they cannot borrow any more. Perhaps there
some
is
if
After
yet.
routinely argued that repeat loans can
view
considerable political clout against them
not
is
it
has not yet been a big problem.
world, hitherto undiscovered. Perhaps people are afraid that the
fast
out" yet,
tendency to take the
no one has figured the optimal default strategy
Bulow and Rogoff (1989), economists
sustain sovereign lending.
its
"maxed
bad news for everyone.
positive view: This does not yet
The
someone
is
deliberately default against an organization that
seen to be contributing to the public good.
Knowing which of these
is
the right story
is,
of course, central to what advice
we
offer to
micro-credit organizations. Notice that this takes us back to descriptive economics, but
perhaps with a
ask.
Indeed
it
list
is
of questions that a purely positive economist
The
not have thought to
evident that normative economics can only function on a base of positive
knowledge— before we
given.
may
distinction
the scope of positive
design mechanisms,
is in
what questions are
knowledge
clearly
like experimental
need to know what we can take as
interesting
—positive economics,
knowledge of the form: "People have not
Normative economics,
we
and
in
what
is
considered to be
as practiced, rules out positive
yet figured out
how
to default profitably."
economics, thrives on precisely
this type
of
fact.^^
3.3.3 Subsidies
Subsidy
is
clearly a dirty
word
in the
world of micro-credit. Those who cannot
without subsidies, adopt elaborate ruses to minimize dependence on subsidies,
Although
people
"**
how
this
example
is
live
^
while
not exactly ideal since most normative economists would baulk from advising
to default.
For example, the Grameen Bank claims
that
it
made
21
a profit of $1.5 million per year in the
1985-96
those
who can
avoid subsidies are often very
discusses the fact that
Grameen Bank
He
to stay afloat in the long run.
of those
who need
them.''^
Morduch
probably need to raise the interest rate
in order
sees the cost of this being in terms of equity, since the
Remenyi
poorest, he feels, will drop out.
more
will
critical
in his discussion of the "State of the Art" is
categorical in asserting that micro-credit organizations must raise interest rates to
achieve financial viability, which
also the position taken
is
Yet the one immediate implication of the
here promote efficiency.
by CGAP.
theoretical discussion
A subsidy that will
pay
1%
for a
above
subsidies
is that
reduction in the interest rate
will actually generate a substantially larger actual fall in the interest rate through its
multiplier effect. Conversely,
to raise
its
interest rate
from
when Morduch
20%
to
go up and the repayment
be raised by
33%
Our
the cost of monitoring as given.
will
to
is
go down, and therefore the
why most
perhaps
33%
interest rate will
have
financially viable micro-credit
(BancoSol, for example, charges 48%,
but since repayments have to begin immediately after the loan
is
given, the effective rate
almost twice as high).
Once again
the disjuncture
that eliminating subsidies
is
have
will
break even, he takes the repayment rate and
to
organizations have higher interest rates than
is
Grameen Bank
theory, on the other hand, predicts that monitoring
rate will
much more. This
calculates that the
between the theory and the policy debate
may
not in the end be necessary,
talking about the efficiency cost that this will generate
criticizes, is that efficiency will
period when, but
when Morduch
turns out that they were losing
go up once the
striking. It is not
but that there
no one who
is
(CGAP's view, which Morduch
interest rates are raised).
recalculates their profit using
$18 million every
is
more conventional accounting norms,
it
year.
For example, see Otero and Rhyne (1994).
''*
Though
this too is in
the poor in the world,
credit
some sense
most of
it
too quickly accepted. There
programs are relatively successful
Grameen Bank), and
1998). So
why
is it
is
a lot of spending
which
is
nominally for
through inefficient subsidies which often do not go to the poor. The micro-
they use relatively
in targeting the
little
poor (see
Amin
et al.,
1999, on targeting by the
subsidy for every dollar delivered to the poor (see Khandker,
obvious that we should not
try to eliminate all other subsidies
22
and keep
this
one?
Conclusion
4.
How then,
does one practice normative economics? One cannot always be an expert,
always know more than the people
situations
is
the right answer:
and
I
—indeed perhaps
try to
who
this is the
are directly involved. There will always be
majority of situations
We should just assume that people
are right in
understand what makes that the right answer.
have no recipe
to offer,
nor do
I
believe that there
is
—where
positive economics
what they
are doing
Where does one draw
such a recipe.
I
the line?
have only the
following rules of thumb: Trust one's instincts (and the theory that goes into that
instinct), if
something looks wrong, follow
reason to assume that the actors
are
all
the options
discussion
show
more or
that
know what
it
up.
Ask whether
they are doing
less similar, has there
been a
—
lot
people are aware of the alternatives?
there
costly mistakes
to let
them remain
and hurt people
in the
whom we
mire forever because
want
any prima facie
are there only a
few options,
of experimentation, does the
If not,
indeed wrong and people can benefit from the advice. Be brave:
make
is
perhaps something
It is
true that
we can
to help, but the alternative
we were
too squeamish to
tell
is
may be
them what
we knew.
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