The Economics of Microfinance

Armendariz and Morduch wrote the standard academic textbook on microfinance, examining the economic theory behind its mechanisms and the empirical evidence for its effects.

The theoretical content is the book's contribution. It explains why formal lenders exclude the poor, using adverse selection and moral hazard models to show that in the absence of collateral a lender cannot distinguish borrower quality or enforce effort, so credit is rationed regardless of the interest rate. It then analyses the mechanisms microfinance uses to solve this: joint liability group lending, where the group's members have information about each other that the lender does not and an incentive to use it; dynamic incentives, where access to larger future loans depends on repayment; frequent repayment schedules, which give early warning and impose discipline; and the targeting of women, examined empirically rather than assumed.

The empirical chapters are careful and are what distinguish the book from the advocacy literature. They cover the difficulties of measuring impact, the selection problems in comparing borrowers to non-borrowers, the results from randomised evaluations, the tension between financial sustainability and reaching the poorest, the level and justification of interest rates, and the consequences of commercialisation.

The authors are sympathetic to microfinance and are honest about what the evidence shows, which is that microcredit expands business activity modestly and does not reliably raise income, consumption or poverty exit at the levels the movement claimed. Later editions incorporate more of the randomised evidence.