Roodman microfinance book. Chapter 2. DRAFT. Not for citation. 11/9/2010

Chapter 2. How the Other Half Finances

If I had my way I would write the word “Insure” over the door of every cottage, and upon the blotting-book of every public man, because I am convinced that by sacrifices which are inconceivably small, which are all within the power of the very poorest man in regular work, families can be secured against catastrophes which otherwise would smash them up for ever. — Winston Churchill, 1909[1]

I believe that all human beings are potential entrepreneurs. Some of us get the opportunity to express this talent, but many of us never get the chance because we were made to imagine that an entrepreneur is someone enormously gifted and different from ourselves. — Muhammad Yunus, 2004[2]

Perhaps you remember when you first learned about microcredit. Did it surprise you that one could help the poor by putting them in debt? The root of that surprise is the microfinance movement’s success in replacing, in the public mind, the old story of lending to the poor—on one of usury and entrapment—with a new one: after all, it seems, the poor are not so locked in by the lack of money that credit will only stave off hunger for a few weeks, then leave a residue of hopeless liabilities. Instead, the poor are masters of their fates, incipient entrepreneurs who only lack credit to bloom.

Of course, each of the stories is true sometimes, and neither is true always. Thus is an irony in this modern myth-remaking. The microfinance movement has rightly been animated by a belief that the poor are no less creative or ambitious for being poor. But to live up to that spirit of respect, we ought to minimize our preconceptions about how the poor do and ought to use financial services. Let us define the global rich as the billion or so people who live in relative material comfort and security. If you belong to this group, you can see that your peers are a diverse group, using financial services such as savings and loans and insurance in diverse ways with diverse outcomes. The experiences of the 5 billion or so poor people are at least as varied. Some get trapped in debt. Others, whom we call microentrepreneurs, do borrow money to stock up their corner stores or invest in goats. But even those two stories are not the “whole story.” A family might save to prepare for a wedding, buy insurance to dampen the feared shock of a father’s death, or borrow for antibiotics for an ill son.

Poor people, like everyone else, want financial services for many purposes in addition to starting a business. If anything, in fact, people living close to the jagged financial edge need financial services more than the rich. Unfortunately, and inevitably, while the better-off can usually find services tailored to specific needs, from mortgages to life insurance to retirement accounts, those less fortunate must choose from lower-quality options, which thus are often not well matched to the needs at hand. As the authors of the seminal 2009 book Portfolios of the Poor have shown, the poor must patch together unreliable or inflexible services—loans from friends, store credit, neighborhood savings clubs, and microcredit—to manage money as best they can.[3] This book asks what microfinance does for the poor. Let us start our investigation from the client’s point of view.

How the rich use financial services

The global rich have access to a spectacular variety of financial services: checking and savings accounts, home mortgages, car loans, credit cards, mutual funds, retirement funds, brokerage accounts, insurance for cars, houses, health, life, and disability….Just as it is hard for a New Yorker who samples a new restaurant each week to ken the life of a Guatemalan highlander subsisting on tortillas, so is it hard for those who enjoy a wealth of financial services to empathize with a woman for whom saving means hiding money from her husband in the folds of her sari.

Despite the gulf in experience, the rich can gain insight into the poor’s use of financial services by contemplating their own. Try this exercise. List all the financial services you have used. For each, determine what it helps you do. Transact? Invest? Spend money you have not yet earned? Then confront this question: if you had to give up all these services but one, which would you keep? Here is my full list. It is fairly representative for middle-class American families; but even if you consider yourself part of the same group, your list will probably differ:

Table 1. My financial services

Service / Purpose
Savings account / Prepare for emergencies such as job loss
Checking account / Transact over long distances or in large amounts without cash
Wire transfer / Send and receive money internationally (rare)
PayPal account / Send money to friends; buy things online
Credit cards / Transact without cash; buy things I want before I have the money
Home mortgage / Live in a home I own before I can pay for it
Home equity line of credit / Ditto; and cheap credit to improve house
Car loan / Get a car before I can pay for it
Student loan / Invest in my own skills, for higher pay after graduation
College savings / Prepare to do the same for my sons
Retirement savings / Prepare to support myself when I no longer work
Health insurance / Protect family against financial catastrophe in event of serious health problems; assure access to care
Homeowner’s insurance / Protect family against financial catastrophe in event of serious harm to home
Automobile insurance / Protect family against financial catastrophe in event of serious harm to car, or liability for accident
Umbrella liability insurance / Protect family from liability suits in general
Life insurance / Protect family against financial catastrophe if I die
Disability insurance / Protect family against financial catastrophe if I am unable to work

If you I showed and explained this list to a microfinance client, the luxury would become obvious—the variety and low cost of the services, the college education foreseen, the home valued in six figures. But if I articulated the needs that underlie my use of these services, we might understand each other well. In scanning the list, I discern four major and universal purposes:

  1. To transact. The credit cards and checking account help me move sums too large to be safe in my wallet. They also help me send amounts large and small over long distances. And they make it all easy. My paycheck goes into the checking account automatically; the mortgage payment comes out just as smoothly. A swipe of a card at the pump pays for gas.
  2. To invest. I need to sacrifice now to have more later. I borrowed to help pay my college tuition, and I invest in a fund to do the same for my two sons. Notably, like most people in rich countries, I have not used financial services to invest in my own business, for I have none. I prefer the stability of the salaried job I am fortunate to hold.
  3. To build assets. Notice what I did not mention just above under the heading of investment: buying a house: Some people ascribe an investment purpose to the home mortgage. But I bought my house for other reasons. In fact, on general principles, a mortgage-financed home is a terrible investment. It puts a lot of financial eggs in one basket, violating the principle of diversification. Using credit to buy the home—investing with leverage—multiplies the risk as housing market crashes and foreclosure epidemics have made obvious in several countries. And homes can be hard to sell ( “illiquid” in investmentspeak). Why then make such a terrible investment decision? Owning a home (or bicycle or cow) brings a degree of security.. Someone who holds title to her home need not worry about being forced out by a landlord who does view the building as an investment. Home ownership also strengthens communities by increasing the interdependence: what one neighbor does to her property affects the value of others’. A more collective view encourages people to work together on local institutions such as schools. And secure people think longer-term: a farmer is more apt to husband land he owns than land he leases. Finally, as Peruvian economist Hernando de Soto has famously argued, title to a major asset can also serve as collateral for credit.[4] I once borrowed against my house to fix the roof, and could borrow again as another way to help put my sons through college.
  4. To sustain consumption. I was struck to discover that most of the services on my list serve to secure my family’s access, through thick and thin, to necessities such as food and clothing. The savings account is a safety net if I lose my job. Retirement savings should let me buy what I need when I earn nothing. Credit cards and the home loans let us marshal big sums without starving. The insurance policies take the financial bite out of life’s traumas.[5] Economists call this function consumption smoothing. And to respond to the challenge I posed earlier, if I was told I had to live with just one financial service, I would beg for two, both of which smooth consumption: life and health insurance. They protect my family from bankruptcy in the face of life’s worst.

We can learn more lessons from this exercise. First, risk is intimately intertwined with money. Insurance policies put risk front and center. But they are not unique in involving it, for whenever one party to an agreement to provide financial services commits to delivering money under certain circumstances at some future date, there is risk. Perhaps a borrower will not repay, or a bank holding deposits will go under. Second, many financial services bind even as they serve. The mortgage and other loans force me to set aside money each month to make the payments. Before retirement, the retirement accounts can only be accessed at a penalty. In appropriate doses, this discipline is healthy; we all need help resisting the temptation to fritter away today. Of course, sometimes discipline becomes punitive. This double-edged nature, of credit especially, is the germ of the ancient and unresolved debates over precisely what constitutes just lending.

Third, the set of financial services you use depends on who you are. If I were a poor American, my inventory would be quite different. I might not have the steady job that makes me an attractive risk to mortgage lenders. My compensation might not include a retirement plan. I might have trouble maintaining a minimum balance in a checking or savings account. And, to borrow a term from the Commission on Thrift, a coalition of U.S. non-profits, the “concierge services” of government-subsidized retirement and college savings accounts would probably disappear from my list.[6] So might all the insurance policies and the checking account. In their place might appear check cashers and payday lenders extending credit at 400 percent per annum. Just as there are more drugs for male impotence than malaria, the financial services available to the rich outshine those within reach of the poor—in quality, diversity, and cost. This too is worth noting: my wife’s inventory is identical to mine. But in many countries, law and custom keep women out of formal finance.

Perhaps the most important lesson from this exercise is about how financial services, like roads and piped water, undergird the comfortable life. Imagine having to conduct your life without financial services: no bank accounts, no bank loans, no credit cards, no insurance, not even payday loans…just cash. The intangibility of these services belies their importance. Their chief benefit, I would argue, is in serving the purpose on my list: helping people manage and maintain consumption during lean seasons and catastrophes. In the vocabulary of Amartya Sen, financial services give people more agency, more control over their lives—more freedom. However, as Sen emphasizes, freedom begets freedom. Those who already have more agency, thanks to being rich or male, say, can access better services.[7] Those who come to the financial service marketplace with fewer advantages leave with fewer.

The financial challenges of the poor

In comparing and contrasting the rich and the poor, the famous exchange between F. Scott Fitzgerald and Ernest Hemingway comes to mind. “The rich are different from us,” Fitzgerald observed. “Yes,” retorted Hemingway, “they have more money.”

Actually, that never happened. The story is a Hemingway fiction, a put-down of his rival’s fascination with the rich.[8] But this apocryphal exchange does capture a real question for us: is there much difference between being rich and being poor? When it comes to solving financial problems, are rich the same as poor, except with more money?

Yes and no. Broadly, rich and poor are no different: all need to transact, invest, build assets, and sustain consumption. On the other hand, the financial circumstances of the poor are qualitatively, not just quantitatively, distinct. Their needs, especially to sustain consumption, are more acute, and the strategies they use to meet those needs are in several respects quite different.

Poor families, for example, are more apt to dispatch members to find work. Migrating for work can increase earnings as well as smooth them through spatial diversification. Living in 1995–96 in a village in southern Bangladeshi served by the Grameen Bank, graduate student Sanae Ito discovered that the surest way for residents to get out of poverty in that village was to get out of the village. A family would save up or borrow to send a spouse or child to the capital, Dhaka, to do day labor or even get a job.[9] In Kenya, the wildly popular mobile phone–based money transfer service, M-PESA, got its start with the slogan “Send Money Home.” The target client lived in Nairobi and needed safe ways to send funds to his parents, wife, or children in the countryside.[10] Bangladeshi and Kenyan villages also export workers even farther afield. Bangladeshi men working construction and other jobs in the Middle East are sending macroeconomically significant flows of money homeward. Many Kenyans go to the U.K. Companies such as Western Union and MoneyGram help these workers remit funds across borders. In Bangladesh, BRAC Bank, a spin-off of the giant non-profit BRAC, has teamed up with Western Union to turn its branches into money transfer points. In Kenya, Safaricom, the creator of M-PESA, is working to bypass money transfer major by extending its network internationally. (See Figure 1.) Already, amazingly, M-PESA does more transactions domestically than Western Union does globally.[11]