Q & A with CFSP Member Franciso Buera

Buera Examines Microfinance Effects on Individuals and Countries
September 26, 2011

Throughout the developing world, making small loans available to entrepeneurs is often seen as an effective solution for helping people lift themselves out of poverty. 

But, what might be the consequences for the broader financial system when microcredit programs begin cropping up within an economy? 

This question is central to CFSP member Francisco Buera’s research project "Quantitative Models of Financial Systems and Development."

Buera uses economic models, which he describes as similar to a computerized laboratory, to examine the system-wide ramifications of microfinance initiatives.  He uses these models to look more closely at the impact that microfinance initiatives and financial reforms have on household welfare, on the quality and type of entrepreneurial activity that takes place within an economy, and on economic development. 

Buera hopes that his work will illuminate the benefits and challenges that face microfinance initiatives. He argues that microcredit may have a larger potential as a policy to lower poverty than is currently realized by looking solely at direct effects.

Buera is an Assistant Professor of Economics at the University of California, Los Angeles and also works currently at the Federal Reserve Bank of Minneapolis as a senior research economist. He shared more about his CFSP research and what he expects his work will contribute to the field of development economics in an interview about his work.

Q. How do you describe your research project and the questions you’re seeking to answer to non-economists?

Buera:  What we do is build models; by that I mean computer programs that can be used as laboratories where we understand how changes in policies, regulations or financial innovations affect the macroeconomy and the lives of individuals within an economy. You can think of these laboratories like the maquettes that architects use to see how the different pieces of a building, or an urban design, interact with each other. These models give us harmless environments that can be used to observe the impact of different policies, without exposing real individuals to the negative, unintended consequences that these policies might have.

This is particularly important when you think about policies that can have what are called systemic effects. By this I mean policies that have broad effects in the economy, beyond the effects on the population that is directly treated by these policies. Because of their basic nature, it is harder to anticipate these systemic effects. In modern economies, agents are interconnected, and there are more levels of linkages to other sectors of the economy than the direct, more obvious, effects that the policies may have.

In my CFSP research, I built a model that allows me to understand the systemic effects of scaling up microfinance, a topic that has been widely discussed in policy and development circles. By  scale up, we do not only mean making bigger loans, but we also mean making these loans accessible to everyone in an economy. In the first part of our project we focus on the credit dimension of microfinance (microcredit), but we are also exploring the broader aspects of the microfinance revolution, such as the provision of savings products to the poor who are traditionally unbanked.

Development practitioners often claim that scaling up microcredit is a way to take people out of poverty and a way to make people more productive. There is an attractive rationale for this conjecture to the extent that part of the development problem is the existence of a lot of market failures in the economy. One of them in particular is that people might not be able to get credit to do whatever productive activity they want, or they may not be able to make use of whatever private opportunities they might have. So that’s what this model will allow me to explore: will microcredit lead to more development? By development we are talking both about the narrow view of whether or not it will lead to more income per capita, but also we are interested in understanding whether microfinance can improve the lives of the poor.

Q. What do you hope to contribute to the understanding of financial systems and poverty with your project?

Buera: One of the things that we have learned is that there are a lot of what you can call off-setting effects of microcredit polices. These indirect, systemic effects impact the poor in particular and also impact the distribution of resources across individuals with different income and wealth levels. For instance, in the aggregate, microfinance policies do not seem to lead to more development as measured by increasing per-capita income. On the one hand, microfinance helps undercapitalized entrepreneurs to invest more, and this leads to higher aggregate productivity and higher per-capita income. On the other hand, microfinance distributes income from more productive entrepreneurs, who have high investment rates, towards marginal entrepreneurs. In addition, through systemic effects, microfinance distributes income toward workers who have low investment and saving rates. The distribution of income induced by microfinance leads to a lower accumulation of capital, which instead leads to a lower per-capita income.

At the same time, when systemic, economy-wide effects are taken into account, we realize that microcredit has a larger potential as a policy to lower poverty, a potential that is not obvious when we only look at its direct effects. The direct effects of microcredit are given by its impact on the individuals that take the loans, typically the relatively few individuals that are more likely to become entrepreneurs as shown in the recent work of Abhijit Banerjee, Esther Duflo, Rachel Glennerster and Cynthia Kinnan (2010). But we show that microcredit has important systemic effects. By promoting entrepreneurship, microcredit leads to fewer individuals that are wage earners, depressing the supply of labor, and leading to a higher market wage. The logic of this result is very simple. By helping individuals to finance their investments, microcredit induces individuals, who used to be laborers, to become entrepreneurs. Effectively, microcredit depresses the supply of labor, and, at the same time it boosts the demand for workers as these new entrepreneurs begin to hire.

An important conclusion that we learned from our research is that microfinance operates more as a redistributive policy rather than a broad development policy. In other words, microfinance should be understood as a policy that, when systemic effects are taken into account, targets the income of particular groups, including the poor and the marginal entrepreneurs. In this sense, we should compare microfinance with other alternative income transfer programs, and not think about it as a broad development policy.

Q. What initially got you interested in this path of investigation?

Buera: As many development and growth economists, I am obsessed with understanding why individuals in poor countries are only able to produce a very small fraction of the output when compared with those individuals in developed economies. To me, this is the central development question. I do not see it as a question of why the income is so unequally distributed across countries, but rather, as a question about the conditions in poor countries that impede people from reaching their highest potential.

Within this perspective, there are various alternative explanations of the development problem, all of which ultimately contribute to answer the development puzzle. As an economist, I'd like to understand which policies could be implemented to promote development. On the one hand, we can think about bad policies as those that limit development. In this case, promoting development is associated with the gradual elimination of bad policies. On the other hand, we can think about cases where there is a need for good policies that correct some “market imperfection” that limits development. An important part of my research is devoted to understanding the role of a particular type of market imperfections, those that affect the credit market.

I find credit markets to be important, and therefore, their study to be an attractive area of research, because I see them to be critical to guaranteeing that talented individuals with good ideas are able to implement them. In this sense, economies with good credit markets are economies where talented individuals have more equal opportunities, irrespective of their inherited wealth.