Samuel Cohn: Global Social Trends

Finance is one of the greatest tools for economic growth, but it occurs in wild waves of boom and bust. The busts undo a lot of the good that was done by the original monetary expansion.

This is also true for microcredit. Microcredit at one time was rightfully seen as a tremendous tool for eliminating global poverty. Microcredit involves making very small loans to very poor people to allow them to create or support their own businesses.

A woman wants to sell lunches in front of the automobile family. She needs a grill big enough to make eight sandwiches. This would only cost eighty dollars, but there is no way at her marginal level of income that she could possibly afford eighty dollars. In the old days, regular banks would never remotely consider lending to the super-poor. They would never consider making an eighty-dollar loan. So, the woman was closed out of ever starting her lunch stand.

Under microcredit, there are programs designed to make loans precisely this small to people precisely this poor. Often to help encourage repayment, the microloan programs would organize circles of potential borrowers – generally women. They would loan money to one woman in the circle. If she paid the money back, there would be money for the second woman in the circle to get the loan. Then the third. So the network would “work with” the debtor to help ensure the loan gets paid. Yeah, “working with” generally meant nagging and harassing the woman in question. But in the end of the day, nearly everyone in the lending circle received help making a microenterprise and nearly everyone was better off and more prosperous.

What went wrong?

The early programs were small and carefully monitored. The administrators knew the details of the lives and financial circumstances of each woman. Loans were sensibly designed to match the business potential of the microenterprise in question and the financial capacity of individual women to pay. In more basic terms, the underwriting behind these programs was excellent. Every loan made was made by fully informed bankers who had made careful analyses of the relevant risks.

As money poured into microfinance, underwriting deteriorated. With much more money to loan, and higher expectations about how much money was to be put to work, underwriting deteriorated. The focus became volume lending: volume volume volume.

What do banks do if they have to give more money while thinking less about who they were going to give it to? One early response, which was not too awful, was to call their programs microfinance but really engage in meso-finance. Loans were given to richer and richer borrowers – making the programs support for the middle class rather than the poor. This killed microfinance as an anti-poverty program but the newer programs were at least sustainable.

A more savage approach was to follow. Maryann Bylander's work has been essential to documenting this darker side. The newer nastier approach is to assume that without good underwriting, default rates would be high. Interest rates were raised to exorbitant levels. The word “usury” is not inappropriate here. To achieve target volume levels, microloans were marketed marketed marketed marketed. Everyone had to take out a microloan. And to ensure that the banks would not lose out on all their bad loans, major funds were put into collection efforts. Low income people were dunned dunned dunned to repay loans that never could have been repaid in the first place.

The result was a curse for the poor rather than a blessing for the poor. To artificially prevent defaults, borrowers in trouble were sold more loans at higher rates. Ultimately, these houses of cards had to fall and the borrower would default for good. When this would happen, the holder of the last loan would seize every asset they had. Loan default actually became a useful tool of property acquisition as one could seize household plots in areas being primed for development. However, the primary profit mechanism in all of this is loan origination fees. Borrowers who take out loans incur processing fees that go to the issuing bank as pure profit. So long as the original loan is paid off by a secondary loan, the first loan company is made whole plus it has the revenue from the fees.

The banks make money from this. The economic development effect is weak. Some development occurs from some successful loans. Development is hurt from the losses from the unsustainable loans plus the reduced consumption and investment of poor people who lose everything.

Ironically, the same thing happens in global finance at the macro-level. Historically, the world has been characterized by regular thirty year cycles of debt and debt crises. During boom years, banks in rich countries wrote loans to poor nations in the Global South. The original loans were carefully underwritten. As interest in lending to the developed world increased, more and more and more loans would be made. These would be less carefully underwritten and many would be fully unsustainable. The origination fees and syndication fees for creating these loans were enormous. Banks could often write questionable loans and then sell them to other financial institutions. Nowadays, they are bundled into other financial instruments such as derivatives. This allows them to get the immediate short term profits that come from syndication fees while leaving other financial institutions with the downsides for when the loans become at risk for default.

Some of the loan revenues would go to successful development projects – just as some microcredit loans lead to successful microenterprises. Some of the loan revenues went to development projects that failed, just as some microenterprises fail. Some went to military expenditure – often a sad necessity for unstable governments facing violent opposition from within. Some went to pay for welfare state benefits and direct poverty reduction. Both of these would be similar to microloans that are used on consumption rather than investment – something that realistically happens.

In the case of the international loans, some of the monies disappeared into capital flight. Rich elites used the funds to purchase Swiss bank accounts, Miami real estate or other foreign assets that would be beyond the ability of the local nation to reclaim. Those purchases obviously had no development impact.

When the loans went bust, the international banks would impose strict repayment plans on the poor nations. Such programs were generally designed to safeguard the interests of the banks rather than the interests of the borrowers. Money was cut from education to pay the debts. Money was cut from healthcare to pay the debts. Money was cut from public investment to pay the debts. Money was cut from infrastructure to pay the debts.

The huge waves of international over-lending and over-borrowing led to tremendous debt crises – as nations all over the world would go into default all at once. Strict repayment plans would be imposed all over the world at once. The result was a massive global contraction of economic growth. Christian Suter, a Swiss Marxist sociologist, and Carmen Reinhart and Kenneth Rogoff, conservative Harvard economists, have separately documented this long term history of global debt cycles. Reinhart and Rogoff document these crises as a regular phenomenon for the last eight centuries.

Both microfinance bubbles and global finance bubbles are examples of sick speculation. The financial sector has more money to invest than it knows what to do with. With carefully underwriting and prudent fiduciary processes, it would be possible to write loans that stay within debtors’ prudent capacity to pay. Under such circumstances, credit is beneficially both socially and economically.

But origination fees, and pay systems that reward bankers for short term increases in volume or profitability encourage banks to take long term risks that are unsustainable. The push for immediate revenues overwhelms prudence. Risky long term investments become justified not by sound underwriting but by aspirational analyses that use whatever assumptions happen to be necessary to justify a loan going out the door.

This is not serious investment. This is speculation.

What is happening to the lower classes of Kenya and Cambodia and South Africa has historically happened to most of the nations in the Global South.

In sociology, microdynamics and small-group interactions rarely have the same dynamics as the macrodynamics of global historical processes. But sometimes, microdynamics and macrodynamics are exactly the same.

Finance in developing nations is like that. Countries can’t grow without sensible access to capital. But a casino mentality now leads to brutal pain for the poor later.