The Great Consumption Loan Debate

*This post is in part a response to an earlier blog entry by Doug Johnson, “Some Notes from the Field.” See complaints 1 and 2 from the list of issues about microfinance that Nachiket Mor and Bindu Ananth heard in the field.

I often forget that once I have come to a conclusion about an issue, the rest of the world does not simply jump on board. From studying the literature and logically considering the issue of whether MFIs should force/encourage/ask people to use their loans for only “productive” purposes rather than for consumption, I now strongly believe that financial providers can do a great deal of good by providing loans with no strings attached (i.e. no rules about how that loan can used).

My opinions about the value of microloans were greatly informed by Jonathan Morduch’s excellent and very readable paper, “Income Smoothing and Consumption Smoothing.” Morduch’s paper discusses the different methods poor households use to smooth their income and consumption, and whether informal markets allows for the kind of borrowing and savings that allows for households to take intelligent risks. The details of the papers arguments go far beyond the scope of a blog entry, but I strongly encourage those interested to read it.

This is nothing new, but what I took out of reading this paper and others on consumption smoothing is that poor households often face unexpected shocks and use borrowing as a form of insurance that allows them to spend enough money on food, health and possibly education or necessary household improvements until their next flow of income. Morduch gives data on how loans are actually used in Hyderabad slums in a recent presentation. Of course, borrowing can lead people to a cycle of debilitating debt or foolish spending, but it is important to focus on the aggregate and not just the worst circumstances. A low-powered study that I discussed in my last blog entry argues for the economic benefits of distributing loans to even marginal clients.

This is not to argue that financial training and programs that give loans with education on how to start a business are not useful or do not have impact, just that they are not they are not the only way to provide social good. Although I have my opinions, the argument about the best and most productive ways to provide loans to the poor is far from settled.

This should probably be the subject its own entry, but another issue that needs more discussion and clarity is what exactly counts as a “productive” or “consumptive” use of a loan. What is buying medicine? Building a latrine? Buying a cell phone (a colleague recently sent me a New York Times article that discusses the cell phone as a development tool)? Paying for a child’s school fees?

Anyhow, it is clear to me that many people do not use their loans solely for starting micro-businesses, and in many cases they probably shouldn’t. It is essential that MFIs consider this issue and try to best understand how they can design loans which meet truly meet their responsible clients needs, whether they want to start a small business or not.