IT HARDLY NEED BE USURIOUS:

In praise of usury: Ignore credit snobs. It is no sin to profit from lending to the poor (The Economist, 8/02/07)

If loans hurt the poor, why do they take them? Surely they are capable of looking after their own interests. Alex Tabarrok, an influential economics blogger, thinks the anti-usury lobby are “credit snobs”, who think that credit is something only the rich can handle.

Some critics of usury appeal to psychology not snobbery, however. The “behavioural” economists have shown that people's decisions often conflict with the plans they had laid for themselves. When planning for the future, people are willing to defer gratification, forgoing smaller, earlier rewards in favour of bigger, later ones. But when choosing in the present, they give up huge future benefits for immediate gratification. If they anticipate their own weakness, people may quite rationally chop up their credit cards, or tie money up in illiquid assets. It is the financial equivalent of avoiding restaurants with irresistible desserts.

Some governments have concluded that by denying expensive credit to the poor, they would be doing them a favour. In America, many states have crimped payday lending by imposing anti-usury laws or restrictions on lending terms. In Japan, interest-rate caps have, in effect, wiped out much of the formal consumer-lending industry.

In poorer countries, governments are ambivalent. On the one hand, they are anxious to subsidise microfinance, extending small-business loans further than the market allows. But they take the opposite attitude towards consumer credit, imposing interest-rate caps that stop lenders reaching as many people as they otherwise might. South Africa this year tightened curbs on reckless lending and overborrowing.

Is the South African government right to think that credit has gone too far? Rather than relying on theology or theory to answer this question, a recent working paper offers some rare evidence. Dean Karlan, a Yale economist who is co-director of the Financial Access Initiative, and Jonathan Zinman, of Dartmouth College, studied a profit-seeking lender that served some of South Africa's poorer neighbourhoods. Suspecting that its credit standards were too strict, the lender was willing to experiment with a looser provision of credit. It asked its loan officers in Cape Town, Port Elizabeth and Durban to reconsider 325 out of 787 applicants who had narrowly missed out on approval for a loan. The lucky 325 were chosen at random—nothing distinguished them from the remaining 462, except the luck of the draw. This allowed the researchers to establish a causal link between the loan and changes in the lives of the applicants.

Most of the new customers took a four-month loan at an annual interest rate of about 200%: a 1,000-rand loan, for example, would be repaid in four monthly instalments of 367.50 rand. For the bank, the study proved the wisdom of stretching its lending limits. The new clients were profitable, if not as profitable as the borrowers already on their books. The authors reckon the bank made a gain of at least 201 rand per loan.

Did these profits come at the expense of the poor? On the contrary. Despite the demanding terms on offer, those reconsidered for a loan seemed to prosper. Six to twelve months later, they were less likely to go hungry, and their chances of being in poverty fell by 19%. Not coincidentally, they were also more likely to have kept their jobs, perhaps because the credit helped them to overcome emergencies that might otherwise have forced them to abandon their posts. About a fifth of them, for example, spent their loan on transport, such as buying or repairing a car that they might have needed to get to work.

Apparently, just the fact of having to make interest payments--even small ones--is one of the keys to the success of microlending. It seems to focus the borrowers and force them to take the responsibility seriously.

Posted by Orrin Judd at August 4, 2007 6:57 AM