GIVING Credit where its due
Abhijeet Banerjee & Esther Duflo
AYUSHMAN PARIDA
USE22007
Introduction
Banerjee and Duflo highlight the revitalization of development economics, now central to mainstream
economics and a testing ground for fundamental theories. Economists from diverse fields increasingly
apply their ideas to development contexts, enriching both the discipline and its real-world impact.
A key driver of this vitality is the integration of theory and empirical testing, particularly through
primary data collection and field experiments. These experiments enable precise testing of hypotheses
that observational data alone cannot address.
Using credit markets as an example, the authors demonstrate how field experiments have confirmed
existing theories on informational constraints and psychological factors while uncovering new
challenges that refine these theories. This dynamic interplay between theory and evidence underscores
the field's transformative potential.
Credit
Banerjee and Duflo explore the nature of credit markets in developing countries, highlighting several
key facts based on both historical and recent studies. In these markets, most people lack access to
formal credit and rely on informal sources like moneylenders or friends. The main characteristics of
informal credit markets include:
1. High lending rates compared to deposit rates in the same area, sometimes as much as 30-60
percentage points.
2. Significant variation in lending rates within the same credit market, with some borrowers
paying much higher rates than others.
3. Richer individuals borrow more and pay lower interest rates, while poorer people often can't
borrow at all.
4. Defaults are relatively rare, with default rates generally between 1-4%, even in high-risk
settings.
5. No monopoly power among lenders to explain high interest rates, as multiple lenders are
often available and no lenders report supernormal profits.
The authors propose that these phenomena are due to high fixed costs in administering loans,
especially small ones. These costs, which do not scale with the size of the loan, push up interest rates
for small loans and can even prevent the poor from borrowing at all. Additionally, moral hazard and
adverse selection further complicate the situation. In the case of moral hazard, borrowers may default
once the project is complete, requiring the lender to ensure they have sufficient "skin in the game." In
adverse selection, borrowers who are less likely to repay are still willing to borrow at high interest
rates, driving up defaults.
The paper discusses how experimental research has responded to these insights, with key empirical
questions emerging:
1. Is access to reasonably priced credit a real issue for the poor?
2. Is the multiplier effect of high interest rates, due to moral hazard or adverse selection,
empirically observed?
3. Can moral hazard and adverse selection be empirically distinguished?
4. How does microcredit reduce monitoring costs and improve lending outcomes for the poor?
5. What are the broader effects of making credit available to the poor? Does it help them start
businesses or raise their standard of living, or does it lead to reckless borrowing?
The authors stress that addressing these questions is crucial for understanding credit markets in
developing countries and their impact on poverty. On a personal level, the inaccessibility of credit
traps the poor in historically determined low-income equilibria, limiting opportunities for upward
mobility. Additionally, limited access to credit leaves them vulnerable to biological subsistence levels,
perpetuating cycles of poverty.
Are High Interest Rates Discouraging the Poor from Borrowing?
Banerjee and Duflo explore whether high interest rates deter borrowing among the poor. Despite
informal loan rates averaging 57% annually, many still borrow, suggesting access, not cost, is the
primary issue. For instance, in Hyderabad, India, 68% of borrowers relied on informal loans, while
only 6% accessed banks.
They highlight that small businesses often achieve high marginal returns on capital—55-63%
annually in Sri Lanka—far exceeding typical bank rates of 12-20%. However, credit constraints limit
access to these opportunities. Similarly, subsidized credit for medium-sized firms in India boosted
sales and profits, underscoring the gap between capital returns and borrowing costs.
The authors conclude that improving credit access, even at high interest rates, could unlock significant
economic gains for the poor.
Identifying the Sources of Inefficiency in Credit Markets
This section examines inefficiencies in credit markets, focusing on why banks don’t raise interest
rates to make lending to the poor profitable. High rates could increase defaults through adverse
selection (attracting risky borrowers) or repayment burdens.
A study by Karlan and Zinman (2009) in South Africa tested these ideas by offering former borrowers
loans at varying rates, with some receiving a surprise rate reduction. The study found little evidence
that high rates directly caused defaults but revealed significant moral hazard: borrowers with
promised lower future rates repaid more reliably.
These findings suggest that incentivizing repayment through future benefits and reducing
administrative costs could lower interest rates, boost repayment, and expand credit access. The
research also highlights how microcredit models reduce defaults and calls for further exploration of
effective lending practices to improve traditional banking systems.
Microcredit: Reducing Costs of Lending
This section examines how microcredit innovations reduce lending costs and expand access to small
loans. Key mechanisms include:
1. Dynamic Incentives: Borrowers start with small loans that grow with successful repayment,
encouraging discipline but facing challenges like competition and borrower defaults.
2. Group Liability: Joint liability encourages peer monitoring, reducing risks but sometimes
discouraging risk-taking. Studies suggest frequent meetings and monitoring may be more
impactful than joint liability.
3. Repayment Frequency: Weekly repayments build trust and cooperation, improving
repayment rates. However, less frequent payments may encourage riskier, higher-return
investments.
4. Efficient Loan Collection: Streamlined processes and group leaders reduce costs, making
small loans viable.
Research on microfinance’s impact, such as a study by Banerjee et al. (2009) in Hyderabad, shows
that microcredit expands borrowing, supports new business creation, and influences spending habits.
Borrowers often reduce non-essential consumption to invest in durable goods or businesses.
The findings align with behavioural economics, suggesting that microcredit helps the poor commit to
savings-like behaviour, redirecting spending from short-term temptations to long-term goals.
However, direct savings products, like commitment accounts, could offer an alternative. Studies show
that such tools increase savings, reduce economic shocks, and boost investments.
Further research is needed to refine these insights and compare the effectiveness of microcredit and
alternative saving mechanisms.
Conclusion
Empirical work often tests established theories, uncovers new puzzles, and identifies gaps in existing
frameworks.
Credit Markets: Theoretical models have guided experiments in credit markets, such as why
borrowers repay microcredit loans. One explanation suggests microcredit acts as a commitment
device, providing future access to needed services and fostering repayment. This integration of
empirical insights and theory exemplifies progress in understanding credit systems.
Education Markets: In education, empirical research has outpaced theory. Studies reveal that
traditional inputs, like textbooks, often benefit only top-performing students, while interventions like
targeted remedial education have broader positive effects. For example, a study in Kenya found
tracking students by ability improved learning outcomes for both high- and low-performing students.
This suggests current education systems may prioritize elite students, leaving others behind.
Theory Gaps and Future Directions: The education literature lacks a robust theoretical framework to
explain why certain interventions succeed while others fail. For instance, understanding why teachers
focus on top-performing students could inform policies to improve outcomes across the spectrum.
Theories on pedagogy, teacher incentives, and resource allocation remain underdeveloped.
Empirical research in development economics continues to generate valuable insights, driving
theoretical advancements. While credit market studies have benefited from established theories,
education research highlights the need for new frameworks. The field holds immense potential for
further exploration, combining first-order questions with rigorous data collection and
experimentation.
