James Suroweiki of “Wisdom of the Crowds” fame has a piece that tries to reality check the current enthusiasm for micro-loans.

Mohammed Yunus. Good vibes.

Suroweiki clearly agrees that loans are a Good Thing by nearly any measure, BUT their ability to solve problems of the scale required in India is doubtful -

There’s no doubt that microfinance does a tremendous amount of good, yet there are also real limits to what it can accomplish. Microloans make poor borrowers better off. But, on their own, they often don’t do much to make poor countries richer.

This isn’t because microloans don’t work; it’s because of how they work. The idealized view of microfinance is that budding entrepreneurs use the loans to start and grow businesses—expanding operations, boosting inventory, and so on. The reality is more complicated.

The core issues are 2 fold. First, Microloans generally don’t go into job-creating ventures. Second, the ventures that really do create jobs are often far outside of micro-loan territory and subject to many other local constraints (for ex., corruption, infra, etc.)….

Suroweiki touches only a bit on a more subtle issue, however — the “meta-narrative” and lessons learned from microfinance on capitalism and charity. This last issue has sorta been nagging at me since I saw Muhammed Yunus speak in San Francisco back in January (its worth ipod-ing the MP3) and I’ve been reading up on microloans quite a bit since Yunus won his Nobel Prize.

But first, some empirical research on how loans are actually used -

…Microloans are often used to “smooth consumption”—tiding a borrower over in times of crisis. They’re also, as Karol Boudreaux and Tyler Cowen point out in a recent paper, often used for non-business expenses, such as a child’s education. It’s less common to find them used to fund major business expansions or to hire new employees. In part, this is because the loans can be very small—frequently as little as fifty or a hundred dollars—and generally come with very high interest rates, often above thirty or forty per cent. But it’s also because most microbusinesses aren’t looking to take on more workers. The vast majority have only one paid employee: the owner. As the economist Jonathan Morduch has put it, microfinance “rarely generates new jobs for others.”

Make no mistake, Children’s education is a Very Good Thing. And many of the “strings” that come with microloans (group loans, fostering initiative, female empowerment, etc.) almost certainly have important social capital impacts. But, as “consumption smoothing”, and to use a Western consumer analogy, the majority use case is more akin to “credit cards” rather than “small business loans”. In this regard, the critique that microloans are a bandaid probably mirrors much of the dev-econ brouhaha around remittances -

“Remittances: the New Development Mantra?” asked an article by Devesh Kapur of the University of Pennsylvania. He sees the money as a palliative that, while at times helpful in easing poverty symptoms, leaves underlying structures unchanged. “If I ask can you name a single country that has developed through remittances, the answer is no — there’s none,” he said.

Second, Suroweicki notes the types of ventures that create real jobs by the bushel are often far outside the purview of Microloans -

…Sustained economic growth requires companies that can make big investments—building a factory, say—and that can exploit the economies of scale that make workers more productive and, ultimately, richer.

..What poor countries need most, then, is not more microbusinesses. They need more small-to-medium-sized enterprises, the kind that are bigger than a fruit stand but smaller than a Fortune 1000 corporation. In high-income countries, these companies create more than sixty per cent of all jobs, but in the developing world they’re relatively rare, thanks to a lack of institutions able to provide them with the capital they need.

I’ve noted in the past that the size / scale of a single Chinese factory can regularly exceed the largest desi outsourcing shops. And Chinese manufacturing firms exist in the thousands thus employing 10s of millions. That’s the sort of scale that can really transform India…. - And those factory workers were far more likely to have been rescued from the cusp of poverty. Some Microfinance critics like Aneel Karnani, put it far more bluntly -

Despite the hoopla over microfinance, it doesn’t cure poverty. But stable jobs do. If societies are serious about helping the poorest of the poor, they should stop investing in microfinance and start supporting large, labor-intensive industries. At the same time, governments must hold up their end of the deal, for market-based solutions will never be enough

…To understand why creating jobs, not offering microcredit, is the better solution to alleviating poverty, consider these two alternative scenarios: (1) A microfinancier lends $200 to each of 500 women so that each can buy a sewing machine and set up her own sewing microenterprise, or (2) a traditional financier lends $100,000 to one savvy entrepreneur and helps her set up a garment manufacturing business that employs 500 people. In the first case, the women must make enough money to pay off their usually high-interest loans while competing with each other in exactly the same market niche. Meanwhile the garment manufacturing business can exploit economies of scale and use modern manufacturing processes and organizational techniques to enrich not only its owners, but also its workers.

Alternative charity: get homey to apply for a microloan instead.

My last point is a little more subtle. While I’m a huge fan of microloans in general, I fear that for many, the lesson drawn is that micro-loans somehow subvert “traditional” capitalism (whatever that may be). It’s a flame that Yunus certainly fans and that many, but clearly not all, boosters latch onto (esp. at the SF Commonwealth Club) ; for ex -

Grameen Bank succeeded by abandoning the traditional banking model

* Traditional banks: the more you have, the more you get; Grameen: the less you have, the more you get

* Banks look at skills and experience in potential borrowers; Grameen looks at intent and ambition

* Banks are interested in your history; Grameen is interested in your future

…Without compassion, capitalism would consolidate all wealth into the hands of a few.

While you could make “traditional banking” defenses to every one of those points (ever get an unsolicited credit card as a zero-collateral student? ever see a VC invest in an entrepreneur’s intent & ambition?, etc.), there’s a deeper, underlying thread in these arguments.

I’d argue that instead of reenginering capitalism to help the poor, microloans are far more profoundly reengineering charity to help the poor help themselves. Why point out this seemingly semantic difference? It’s about identifying the long term goal and the moral high ground.

Trade has always “expected” something back from the guy you give your $$$ to. Charity, however, is far more often the proverbial blank check given on the basis of need rather than “what can I expect of you?”. The second there is an up front commitment to downstream reciprocity (of any form), you’ve made a major conceptual leap between the 2 modes of exchange. And with microloans we’re encouraging the discipline of reciprocal behavior even if the “donor” didn’t really need the money in the first place.

Secondarily, once you’ve gotten over the short term consumption hump that microloans fix, what’s next? Microloans are ideally a new on-ramp helping these individuals participate in the virtues of Global Capitalism (and eventually graduate into traditional banking) rather than some sort of bypass.

Of course, with that frame, a 100,000 employee factory in China is arguably more virtuous than a Grameen bank - not quite the conclusion some folks are looking for… .