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Sunday, 21 November 2010

Beyond Social Business and Microcredit

The Problem with Microcredit

Wikipedia defines microcredit as follows: "Microcredit is the extension of very small loans (microloans) to those in poverty designed to spur entrepreneurship. These individuals lack collateral, steady employment and a verifiable credit history and therefore cannot meet even the most minimal qualifications to gain access to traditional credit. Microcredit is a part of microfinance, which is the provision of a wider range of financial services to the very poor."

The problem with microcredit is that it is doubtful that it works. What microcredit does is allow poor people to get loans. Making poor people rich with microcredit is like trying to make a young university student rich by giving him a credit card. In theory the young university student, with his credit card, could buy computers and other equipment and then start up an IT business in a garage and then suddenly become a millionaire. This could happen. But it's unlikely. (Read From Uni Dropouts to Software Magnates.) Likewise, a poor entrepreneur could borrow money, start up a business, and become very successful, but it's unlikely.

How do young university students escape from poverty? They get jobs. Once a university student gets a job, he can pay off his credit card bills and start saving up for a house, car, marriage, children, or whatever.

Similarly, for a poor person to escape from poverty, he needs a job! We know this works because it has worked in China. The greatest escape from poverty in human history has already occured China, and it occured through massive employment of poor people in low-skilled manufacturing jobs. This is the answer to world poverty.

Social Business

Muhammad Yunus, who won the Nobel Prize for inspiring a global microfinance movement, seems to be growing skeptical about microcredit. According to Banker to the Poor Goes Beyond Microlending, Muhammad wants to encourage "social business" instead. Social businesses are businesses are designed for social purposes and not profit. They make money only to pay for operating costs.

I believe there are many problems with this idea. The main one being that if there is no profit then the incentives for starting a social business are non-existent. This means that there will not be many social businesses and hence there will be little employment. Because there is no profit to be made, a social business will not be as competitive compared to a for-profit business.

The Solution

Here is my solution. Currently we have the situation illustrated in the diagram below. A worker and a company come together. The worker gives labor to the company and the company gives a salary to the worker. Unemployment is created when the value of labor is less than the salary so that the company has no incentive to hire the worker.


My solution involves a philanthrophic investor stepping in and paying the worker's salary. This may sound like a major sacrifice if we look at wages in developed countries, but many of the world's population can live on about $1 per day, so it is not a big deal for a wealthy philanthropist to pay the salary of a worker. In fact, the philanthropist can set aside about $7300 worth of government bonds whose income will pay the worker's salary, assuming the government bond yields 5 per cent per annum.

The philanthropist will pay the worker's salary and in return the company will give the philanthropist shares in the company. If the worker is being paid $1 per day then the philanthropist can put aside $7300 worth of government bonds to fund this salary. The philanthropist can then demand $7300 worth of shares in the company.

The company should be happy with this because it gets free labor and companies want demand for their shares to be high. Labor for a company is a major obligation. Paying shareholders is optional. This means that the risks for a company is significantly reduced. It is more likely to want to hire more labor and this will reduce unemployment and aid in the reduction of poverty.

The worker is happy because he has a job that provides a stable income. The only damage that is being done is being done to the philanthropist who no longer has converted a stable income into an unstable income from dividends from shares. In other words, the philanthropist will be exposed to more risk.


However, the damage should be very little because wealthy people tend to want to increase risk on their investments anyway because more risk means more return. In the long run, history shows that the returns on the stock market are higher than the returns on safer assets like government bonds. Therefore, there is a reasonably good chance that the philanthropist will make even more money, and because his gains will be in the form of capital gains rather than income, he will get tax benefits as well.

This idea works because rich people are in more of a position to take risk than poor people. Rich people can take risk because they can afford to. If something goes wrong, they have a lot of money to bail them out. A poor person cannot take significant risks because he needs a steady income to buy essentials like food. The relationship between a poor worker and the philanthrophic investor in this scenario is similar to the relationship between an insurane company and a client. An insurance company has vast pools of money that can be paid out to clients to fund some expensive disaster (e.g. if you crash your car or if something is stolen from your house) but in return the client pays the insurance company a regular amount.




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