Crawl Across the Ocean

Sunday, January 16, 2011

The Trouble With Credit - Brief Follow-Up

This is just a follow-up to a (somewhat lengthy) post I wrote a while back on why credit is not like other products in that the typical commercial syndrome goals of maximizing competition and hence output does not have the same beneficial effect in this particular market as it odes in other commercial markets.

The topic is micro-credit, and blogger David Roodman, who seems quite familiar with this topic, makes a comment somewhat along the lines on my post in justifying why there should be special regulations in place (for example a cap on profits or return on assets) on micro-lenders,
"Credit is not an ordinary product. It is weighed down by millennia of baggage, for the good reason that it can do real harm. It is like a drug in that it is potentially healthy in small doses, but also potentially addictive. So it stands to reason that sellers of this product must take unusual steps to counteract its special problems of reputation and risk."

In the comments, objections from commenter Bhagwan Chowdhry - who comes across as a classic level 2 thinker - clarify Roodman's opinions further.

Here's the back and forth:

"I don’t understand the bandwagon that everyone has jumped on about MFIs and lenders in general about not making too much profit. Isn’t profit precisely the incentive mechanism to encourage competition which would lead to lower interest rates? This is a robust mechanism that has worked for centuries in many different economies."

"Bhagwan, I probably should have been more precise about this in my post: I think it is reasonable to consider capping (not eliminating) profit in microlending because credit markets are not ordinary. If we were speaking of businesses that sell soap (or savings) to the poor, I would not see the case. If businesses try to sell to much soap to the poor, the market will quickly correct their excess in the standard way. Laissez faire will work pretty well. Not so with credit, as we have seen: the correction is often long delayed, to almost everyone’s detriment. Conceding this market imperfection opens the way for intervention. At the least, I don’t think laissez faire is obviously optimal. Far from being impractical, capping ROA is being done now by the groups I mentioned, and both are seen as leaders in the field in India."

"Simply asserting that “credit markets are not ordinary” is not a compelling argument. One needs to understand more clearly what frictions prevent competitive entry in credit markets."

"Bhagwan, I have blogged extensively on what is going on in Indian microfinance now, so I am not just making that simple assertion of abnormality. In point of fact, the problem is not barriers to entry but, if anything, the opposite.

I don’t doubt that capping ROA is suboptimal. When are real-world solutions ever optimal? Do you have a practical, politically pragmatic alternative that is superior? Please share it. Laissez faire has failed spectacularly."

Bhagwan has the final word (last I checked):
"David, you say, “the problem is not barriers to entry but, if anything, the opposite.” Yes, I understand that you, and others, have written a lot about problems caused by “excessive” borrowing. The question one has to answer is why a profit-maximizing lender would not guard against excessive borrowings? Perhaps, the lenders do not face full consequences of their imprudent lending practices because they might be lending “other people’s money.” We know the solution to that problem – make sure they are not too big to fail."

I only posted this since it's nice to see smart folks like Roodman lending support to my speculative post. Otherwise, there's not much of a moral here, other than that some people never learn, but some do, I suppose.

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