Tuesday, October 17, 2006

A Second Nobel for Economics

The Norwegian Nobel Committee awarded the 2006 Nobel Peace Prize to the Grameen Bank, a for-profit business, and its founder, Bangladeshi economist Muhammad Yunus. The Committee's citation lauded Grameen Bank's innovative efforts to reduce poverty through micro-lending schemes that provide some of the world's poorest citizens with access to credit. So, what's microcredit and how do Yunus and Grameen use it to reduce poverty?

Citizens of developed countries like the United States take credit access for granted. With a stable source of income or a bit of collateral, like a house or a car, an American can take out a loan to start a business, remodel the bathroom, or buy an engagement ring.

Access to credit in less developed countries is far scarcer.

Poor peoples' incomes are inherently less stable and often too low to qualify for lending. The ill-defined property rights in many developing nations make it difficult for poor residents to prove that they own the housing or land that they occupy. Lacking income and legitimate titles to what little collateral they actually have, the credit prospects for most of the world's poor seem bleak. As a result, traditional credit schemes ignore low-income entrepreneurs whose business ideas can help their communities escape poverty.

Yunus had the vision to develop a lending model that could reach low-income entrepreneurs in Bangladesh. He realized that collateral requirements provided borrowers with a strong incentive to pay back their loans rather than defaulting and losing their property. To ensure that poor borrowers faced an equally strong incentive to repay their loans, Yunus replaced collateral with the borrowing circle.

The borrowing circle consists of 5 people--the initial borrower, and four friends who agree to help with loan payments if the going gets rough. (The friends may take out loans as well.) Should the borrower default, all four friends lose access to credit until the loan is repaid in full. Replacing collateral with social pressures worked remarkably well, helping people expand or launch small business ventures. Read this New York Times article to find out more about Yunus and the Grameen Bank.

1. Grameen Bank is a for-profit business, but is it profitable? According to the article, what's the U.S. dollar value of Grameen’s loans since 1983?

2. According to the article, how many borrowers has the Bank served? What percentage of Grameen’s loans is paid back? How do Grameen’s payback rates compare to those of traditional banks in Bangladesh?

3. Why might social pressures provide a greater incentive to repay loans than the threat of losing collateral? What's the downside of defaulting in the Grameen scheme versus a traditional, collateral based scheme?

4. How might credit access change the social standing of Bangladeshi women?

5. How does Yunus feel about relying on charity to battle poverty?

Coincidentally, the Aplia Econ Blog recently asked whether microcredit will reduce poverty.

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