For years microfinance, the practice of making small loans to the poor, has been lauded as a promising solution for eradicating poverty in the developing world. The idea is that a small loan could enable some poor people to invest in business opportunities that could improve their income.

For example, a poor woman might be given a loan to buy goats to produce milk or a sewing machine to make clothing. The hope is that microloans have the potential to generate enough income for the recipients that they can both improve their lives and repay the loans with interest.

Enthusiasm for microfinance reached its peak in 2006 when Muhammad Yunus won the Nobel Peace Prize. Yunus helped develop the concept as an academic and then began to apply in Bangladesh through the now famous Grameen Bank. Since then, a growing stream of criticism has fed a furious debate about the effectiveness and side effects of offering credit to the extremely poor. A recent study by a group of economists from MIT and Northwestern on microfinance in Hyderabad, India, provides new evidence that access to credit does not increase income. However, the same study suggests that microloans may be improving lives in other ways, such as giving people in poverty the opportunity to make better long-term financial decisions.

Controlled study

Despite the fierce debate, until recently rigorous data on microfinance has been surprisingly sparse, said Cynthia Kinnan, assistant professor of economics at Northwestern University in Chicago. Part of the problem is that little data has been gathered on people who qualify for microloans but don't actually participate. Without such a comparison group, it is difficult to draw meaningful conclusions about the causal effects of microfinance, Kinnan said.

Kinnan, along with her colleagues at MIT, Abhijit Bannerjee, Esther Duflo and Rachel Glennerster, are determined to find a more precise way of evaluating microfinance. Their proposal is to use randomized controlled trial techniques (the same approach used by the medical industry to test the effectiveness of medications) to identify how microcredit programs are actually working. This would allow them to compare borrowers to non-borrowers in a more precise way.

These researchers conducted a three-year study in Hyderabad. The team selected neighborhoods to observe based on two criteria, absence of financial institutions and residents who were desirable potential borrowers — "poor, but not the poorest of the poor," Kinnan said. Loans were offered through an organization called Spandana, which unlike other microfinance providers, does not require borrowers to start a business to qualify for a loan. Spandana charges a 24-percent annual interest rate, which while high by American standards, is less than what local moneylenders charge.

The findings, published in an April 2013 report, show that "at the highest level and in the broadest terms both claims (about microcredit) are true," said Kinnan. While it hasn't cured poverty just yet, that doesn't mean it is an entirely useless program.

Affect on income

One of the first things that jumps out in the summary of findings from the Hyderabad study is that the demand for microloans wasn't robust. "By the end of our three-year study, only 38 percent of households borrowed," Kinnan said, "and this is among households selected based on their relatively high propensity to take up microcredit. These are neighborhoods that are booming, so if there is any place people have investments that would yield a 24-percent (return on investment), it would be Hyderabad," she added.

If microcredit helps people get out of poverty, as proponents argue, why didn't more people use it?

Kinnan suspects part of the reason is that most households don't have a project that will yield a rate of return to make borrowing worth their while. "If they borrow 10,000 rupees at the beginning of the year, they need to have 12,400 rupees at the end of the year," Kinnan said. This is difficult for anyone in their first year of business "but particularly so in competitive markets where the profit margins are slim," Kinnan said.

Among those who borrowed money, businesses were started and expanded, but in most cases this industry did not free borrowers from lives of grinding poverty. Monthly consumption, the best indicator of overall welfare according to Kinnan, did not change. Business profit in the vast majority of cases did not increase either.

Kinnan and her colleagues found no evidence in the short or long run that access to microcredit has a positive impact on education outcomes, health or women's empowerment in the short run or long run. Overall, it doesn't "paint a picture of dramatic changes in basic development outcomes for poor families," said Kinnan.

Improved spending

At first glance these findings make microcredit programs seem like a complete failure, but Kinnan and her colleagues are quick to point out some important benefits. Although microcredit doesn't increase overall consumption, it does appear to impact the kinds of things people buy. With a lump sum of money families can invest in durable goods like a tin roof, a television or a sturdy cooking pot. These goods provide long-term benefits that result in higher overall welfare when compared to the purely temporary purchases that the poor might be forced to make without access to credit.

Kinnan and her team found that borrowers were much less likely to spend their money on temptation goods such as dining out, gambling, cigarettes and alcohol. When asked why they weren't spending as much on these things, borrowers said that regular meetings where everyone in the area repaid their loans made it easier to resist the lure of luxuries. No one wanted to be the family that shows up for the meeting without their payment.

A change in what people buy may have a significant impact on their well being. "Different types of spending have different utility," Kinnan said. For example, if someone buys a tin roof that lasts 50 years they can avoid continuously spending money to fix a thatched roof. Even if the roof doesn't provide additional income it can be a wise investment that allows the family to increase spending on unrelated goods. Avoiding temptation purchases in favor of saving money may also have a positive psychological impact on people. In essence overall consumption might not change, but that doesn't mean they aren't doing better.

For Esther Duflo, one of Kinnan's co-authors on the study, the real problem with microcredit is that expectations about how quickly and completely microcredit would lift people out of poverty are unreasonable. In an interview with Philanthropy Action, Duflo put it this way: "If microfinance suddenly doesn't make all babies do calculus by the age of 5, it is deemed a failure." If we expect microfinance to instantly change people's lives, anything less will seem inadequate, she added. Duflo warned that people should not to be too quick about passing judgement on the efficacy of microloans because we aren't satisfied with the rate of change. "The fact (is) that results are showing (microcredit) is doing some reasonably good things."

Eradicating poverty is complex and tedious, Duflo said, mostly because we don't really know what works.

"We don't really have the levelers to make everything work. ... I think a few things worked, (but) it takes time," she said.

Study co-author Abhijit Banerjee agrees that a realistic time frame for addressing this problem is crucial.

"Poverty has been with us for thousands of years. If we have to wait another 50 to 100 to eradicate it, so be it," he said.