Poor Economics: Rethinking Poverty & the Ways to End it

by Abhijit V. Banerjee

In order to be able to collect on the loan, the lender needs to know many things about the borrower. Some are things the lender would like to find out before deciding to lend, such as whether the borrower is trustworthy. Others, such as the borrower’s whereabouts and nature of the borrower’s business, help in collecting on the loan should there be a problem. The lender may also want to keep an eye on the borrower, visiting her from time to time to make sure the money is being used as promised and nudging the business in the desired direction if need be. All of these efforts take time, and time is money. The interest rate has to go up to cover them. Moreover, many of these expenses do not scale with loan size. There is no way to avoid collecting some basic information about the borrower, even if the loan is very small. As a result, the smaller the loan, the larger the monitoring and screening costs will be as a fraction of loan size, and because these costs have to be covered by the interest collected, the higher the interest rate will be.

Because the main constraint on lending to the poor is the cost of gathering information about them, it makes sense that they would mostly borrow from people who already know them, such as their neighbors, their employers, the people they trade with, or one of the local moneylenders, and that is exactly what happens.

But why couldn’t someone more local do the lending? The most likely answer is that these men had a reputation for being fierce and implacable, a stereotype sealed by a story that all Bengali schoolchildren have in their textbooks, in which a good-hearted but violent Kabuliwala kills someone who was trying to cheat him. The same logic also explains why the Mob in the United States was for many people the “lender of last resort.”

The report describes debt collectors in India making use of the old social prejudice against eunuchs to collect from long-standing defaulters. Because people believe that seeing a eunuch’s genitals brings bad luck, the eunuchs were instructed to show up at the defaulter’s house and threaten a “showing” if they continued to be uncooperative.

This also explains why banks do not lend to the poor. Bank officers are not very well placed to do all the necessary due diligence: They don’t stay in the village, they don’t know the people, and they rotate frequently. Respectable banks are not in a position to compete with Kabuliwalas. They cannot easily threaten to break people’s kneecaps or even send them eunuchs. The Indian branch of Citibank got into serious trouble when it was discovered that it was using “goondas” (local hooligans) to threaten borrowers who did not repay vehicle loans.

Nachiket Mor, who was then one of the vice presidents of ICICI Bank, once described to us what he had thought was an absolutely brilliant way to get farmers to repay their agricultural loan. Before disbursing each loan, he would ask them for a postdated check for the same amount. The great insight was that if the farmer did not repay, the bank would then be able to send the police to collect on the check, because not honoring a check is a criminal offense. This worked for a while, but then it began to unravel. When the police realized that they had hundreds of bounced checks to track, they politely told the bank that, really, this was not their job.

The typical MFI contract involves loans to a group of borrowers, who are liable for each other’s loans and hence have a reason to try to make sure that the others repay. Some organizations expect the borrowers to know each other when they come to borrow, whereas others bring them together by making them come to weekly meetings. The very act of meeting together every week helps clients know each other better and become more willing to help out a group member who faces a temporary difficulty.

However, the power of shame seems to be sufficient. A borrower we met in Hyderabad was struggling to repay loans from several MFIs. But she said she never missed a payment, even if it meant borrowing money from her children or going without a meal for a day: She loathed the idea of having the credit officer come to her doorstep and “make a nuisance” in front of the whole neighborhood.

In addition, loan officers are paid on steep incentive contracts, based on recruiting new clients and making sure that everyone repays.

The rigidity and specificity of the standard microcredit model mean, for one thing, that since group members are responsible for each other, women who don’t enjoy poking into other people’s business don’t want to join. Group members may be reluctant to include those they don’t know well in their groups, which must discriminate against newcomers. Joint liability works against those who want to take risks: As a group member you always want all other group members to play it as safe as possible.

Weekly repayments starting a week after the loan is disbursed are also not ideal for people who need money urgently but aren’t exactly sure when they will be able to start repaying.

Perhaps there is a natural graduation process—start by borrowing from an MFI, grow your business, and then move on to a bank.

One of their main findings is that the poor find many ingenious ways to save. They form savings “clubs” with other savers, in which each member is supposed to make sure that the others achieve their savings goals. Self-help groups (SHGs), popular in parts of India and found in many other countries as well, are savings clubs that also give loans to their members out of the accumulated savings of the group.

Jennifer Auma, a market vendor in the small town of Bumala in western Kenya, embodies this sophistication. Auma sells maize, sorghum, and beans. During our entire conversation, she expertly sorted beans, the red ones to one side, the white ones to the other. When we met her, she belonged to no fewer than six ROSCAs, which differed in size and frequency of meeting. In one of them, she contributed 1,000 Kenyan shillings, or KES ($17.50 USD PPP), per month, in another one 580 KES twice a month (500 for the pot, 50 to pay for the sugar for the tea, which is an essential part of the ceremony, and 30 for the welfare fund). In another, the contribution was 500 KES per month, plus 200 as extra savings. Then there was a weekly ROSCA (150 KES per week), one that met three times a week (50 KES), and one that was daily (20 KES). Each ROSCA had a specific, separate purpose, she explained. The small ones were for her rent (this was before she built a house), the bigger ones for long-term projects (such as house improvements) or for school fees. Auma saw many advantages to ROSCAs over traditional savings accounts: They don’t have fees, she could make small deposits, and on average she got access to the pot much faster than it would take her if she saved the same amount every week. Moreover, the ROSCA group was also a good place to ask for advice.

As a market vendor married to a farmer, Jennifer Auma probably lived on much less than $2 a day. Yet she had an array of finely tuned financial instruments. We see this kind of financial ingenuity time and time again.

Yet all the ingenuity the poor employ to save may simply be a symptom of the fact that they don’t have access to the more conventional and simpler alternatives. Banks don’t like managing small accounts, largely because of the administrative costs of running them. Deposit-taking institutions are heavily regulated, for good reason—the government is worried about fly-by-night operators running away with people’s savings—but this means that managing each account requires bank employees to fill out some amount of paperwork, which can quickly become too burdensome, relative to any money that the bank can hope to make from these tiny accounts.

Saving at home is difficult, they explained, because there is always something that comes up that requires money (someone is sick, someone needs clothes, a guest has to be fed), and it is hard to say no.

When there is money in the house, things always happen, he said, and the money disappears.

We asked him what he did when he had already purchased fertilizer (but not yet used it) and someone got sick. Wasn’t he tempted to resell it at a loss? His answer was that he never found the need to resell the fertilizer. Instead, he tended to reevaluate the true urgency of any need when there was no money lying around. And if something really needed to be paid for, he would kill a chicken or work a bit harder as a bicycle taxi driver (a job he did on the side when he was not too busy with farming). Although they had never purchased fertilizer in advance, the Modimbas had the same view. If a problem came up but they had no money (say, because they had purchased fertilizer), they would figure something out—perhaps borrow from friends or, as they put it, “suspend the issue”; but they would not resell the fertilizer. It was their opinion that it would be a good thing for them to be forced to find an alternative solution, instead of using the cash at home.

Just as Michael and Anna Modimba and Wycliffe Otieno had predicted, as long as it was brought to their door at the right time, farmers were very happy to buy fertilizer.

It was this small inconvenience of keeping an eye out for fertilizer delivery (asking a friend to check, calling the store) that was holding back their savings and productivity. All our intervention really did was to remove this minor bottleneck.

The experience of the Indian fruit sellers and the Kenyan farmers suggests that a lot of people fail to save even when they have access to good saving opportunities. This suggests that barriers to savings are not all externally imposed. Part of the problem comes from human psychology. Most of us have some memory of trying to explain to an irate parent that we were just sitting next to the cookie jar and the cookies somehow vanished. We knew eating the cookies would mean trouble, but the temptation was too strong. As we discussed in Chapter 3 on preventive health, the human brain processes the present and the future very differently. In essence, we seem to have a vision of how we should act in the future that is often inconsistent with the way we act today and will act in the future. One form that this “time inconsistency” takes is to spend now, at the same time as we plan to save in the future. In other words, we hope that our “tomorrow’s self” will be more patient than “today’s self” is prepared to be.

Another manifestation of time inconsistency is to buy what we want today (alcohol, sugary or fatty foods, trinkets) but to plan on spending money in more responsible ways tomorrow (school fees, bed nets, roof repairs). In other words, the things we take pride or pleasure in imagining buying in the future are not always what we end up buying today. Knowing that we will have one drink too many again tomorrow gives most of us no pleasure—indeed, it probably makes us unhappy—yet when tomorrow comes along many of us cannot resist it. Alcohol, in this sense, is a temptation good for many people, something that makes immediate claims on us without giving us anticipatory pleasure. In contrast, a television is probably not a temptation good: Many poor people plan and save for months or even years to buy one.

In Hyderabad, we explicitly asked slum dwellers to tell us whether there were any goods they would like to cut back on. They readily came up with tea, snacks, alcohol, and tobacco. And indeed it was clear from what they told us and from the data we collected that significant parts of their budgets ended up getting spent on these items. The same self-knowledge was apparent when Esther, Kremer, and Robinson asked a group of participants in the Kenyan fertilizer program, in advance of the harvest, to choose the day when they would come to sell the vouchers. A large fraction asked them to come early. The farmers knew that right after harvest was when they would have money available, but that it would soon disappear. Given this self-awareness, it is no surprise that many of the ways the poor save seem to be not only intended to keep the money safe from others, but also to guard it from themselves.

Indeed, if the lack of self-control is sufficiently serious, it would be worth paying someone to force us to save. For example, we might prefer to run the risk that the mortar on our freshly built walls might get washed away by the rain so that we wouldn’t have to keep the cash on hand and risk that we might, on a whim, use it all for a party. And somewhat paradoxically, some MFI clients may borrow in order to save. A woman we met in a slum in Hyderabad told us that she had borrowed 10,000 rupees ($621 USD PPP) from Spandana and had immediately deposited the proceeds of the loan in a savings account. Thus, she was paying a 24 percent annual interest rate to Spandana, while earning about 4 percent on her savings account. When we asked her why this made sense, she explained that her daughter, now sixteen, would need to get married in about two years. That 10,000 rupees was the beginning of her dowry. When we asked her why she had not opted to simply put the money she was paying to Spandana for the loan into her savings account directly every week, she explained that it was simply not possible: Other things kept coming up.

The point, as we eventually figured out, is that the obligation to pay what you owe to Spandana—which is well enforced—imposes a discipline that the borrowers might not manage on their own.

Yet most people preferred not to take up the offer of such an account. They were clearly worried about committing themselves to not withdrawing until the goal was reached. Dupas and Robinson ran into the same problem in Kenya—many people did not end up using the accounts they were offering, some of them because the withdrawal fees were too high and they did not want to have their money tied up in the account. This highlights an interesting paradox: There are ways to get around self-control problems, but to make use of them usually requires an initial act of self-control.

Awareness of our problems thus does not necessarily mean that they get solved. It may just mean that we are able to perfectly anticipate where we will fail.

This effect is reinforced by the fact that a lot of the goods that the poor might really look forward to having, such as a refrigerator or bicycle or admission to a better school for their child, are relatively expensive, with the result that when they have a little bit of money in hand, the temptation goods are in an excellent position to stake their claim (You’ll never really save enough for that refrigerator, the voice in your ear insists. Have a cup of tea instead …). The result is a vicious circle: Saving is less attractive for the poor, because for them the goal tends to be very far away, and they know that there will be lots of temptations along the way. But of course, if they do not save they remain poor.10

The richer we are, the more these decisions are made for us. Salaried workers contribute to Social Security, and their employers often contribute something more to a provident fund or a pension plan. If they want to save more, they have to decide just once, and the money is then automatically deducted from their bank accounts. The poor have access to none of these props: Even the savings accounts that are supposed to make it easier for them to commit to a goal still require an active step of depositing money. To be able to save every week or every month, they have to surmount self-control problems over and over again. The problem is that self-control is like a muscle: It gets tired as we use it, and therefore it would not be a surprise if the poor find it harder to save.11 This is compounded by the fact, which we discussed in Chapter 6 on risk, that the poor live under considerable stress, and stress-induced cortisol makes us choose more impulsive decisions. The poor thus have to do a harder job on fewer resources.

Most microcredit institutions disapprove of borrowing to buy consumption goods—some actually put a lot of effort into making sure that their money gets spent on some income-earning asset. Padmaja, on the other hand, is happy as long as the clients use the money to realize any of their long-term goals. Thinking about long-term goals and getting used to making short-term sacrifices in order to get there are the first steps, she thinks, toward liberation from one of the most frustrating aspects of poverty.

The sense of security that any of these would provide would encourage savings for two reasons: by creating a sense that the future holds promises, and by lowering the stress level, which directly impedes decisionmaking ability.

The bigger point is that a little bit of hope and some reassurance and comfort can be a powerful incentive. It is easy for those of us who have enough, living a secure life, structured by goals that we can reasonably confidently aspire to achieve (that new sofa, the 50-inch flat screen, that second car) and institutions designed to help us get there (savings accounts, pension programs, home-equity loans) to assume, like the Victorians, that motivation and discipline are intrinsic. As a result, there are always worries about being overindulgent to the slothful poor. Our contention is that for the most part, the problem is the opposite: It is too hard to stay motivated when everything you want looks impossibly far away. Moving the goalposts closer may be just what the poor need to start running toward them.

But here is the catch:The profits of micro-entrepreneurs who received the $500 grant did not increase any more than the profits of those who received the $250 grant, in absolute terms. In part, it is because those who received the $500 grant did not choose to invest all of it in their business: They invested about half of it, and used the rest to buy things for their home.

Perhaps the sense of control over the future that people get from knowing there will be an income coming in every month—and not just the income itself—is what allows these women to focus on building their own careers and those of their children.

First, the poor often lack critical pieces of information and believe things that are not true. They are unsure about the benefits of immunizing children; they think there is little value in what is learned during the first few years of education; they don’t know how much fertilizer they need to use; they don’t know which is the easiest way to get infected with HIV; they don’t know what their politicians do when in office.

It seems that in order to work, an information campaign must have several features: It must say something that people don’t already know (general exhortations like “No sex before marriage” seem to be less effective); it must do so in an attractive and simple way (a film, a play, a TV show, a well-designed report card); and it must come from a credible source (interestingly, the press seems to be viewed as credible).

Second, the poor bear responsibility for too many aspects of their lives. The richer you are, the more the “right” decisions are made for you. The poor have no piped water, and therefore do not benefit from the chlorine that the city government puts into the water supply. If they want clean drinking water, they have to purify it themselves. They cannot afford ready-made fortified breakfast cereals and therefore have to make sure that they and their children get enough nutrients. They have no automatic way to save, such as a retirement plan or a contribution to Social Security, so they have to find a way to make sure that they save.

This means that their lives could be significantly improved by making it as easy as possible to do the right thing—based on everything else we know—using the power of default options and small nudges: Salt fortified with iron and iodine could be made cheap enough that everyone buys it. Savings accounts, the kind that make it easy to put in money and somewhat costlier to take it out, can be made easily available to everyone, if need be, by subsidizing the cost for the bank that offers them. Chlorine could be made available next to every source where piping water is too expensive. There are many similar examples.

When a situation starts to improve, the improvement itself affects beliefs and behavior.