Friday, December 10, 2010

Borrowing to Save and Financial Literacy

I blogged recently about the micro credit crisis that may be emerging in India and other developing countries, where repayments rates are falling. One issue is that poor families often use micro credit as a way to save instead of invest. Micro savings might not be viable as transaction costs are too high (see this post) . The distinction between savings and investment is important in economics. Savings is income minus consumption, while investment is purchasing things that will increase your income later (we call this capital). If you use all left over income to purchase capital then savings = investment.

Ideally micro credit would be used for investment. Since households must repay their loan at 50% interest. In some cases households use micro credit to save but not invest in income improving capital. In other cases micro credit is used to pay for school or medicine, which is an investment but the payoff is likely much further down the road. In any case it is hard to tell what is actually purchased with micro credit, since money as economist say in fungible. That is if you give someone $100 they could say they are using it for their business, but if they would have spent $100 on materials anyway and instead only increased their spending on schooling, then it is actually for school.

Perhaps most important is having financial literacy so that those who use micro credit can make better choices. This post is a couple months old, but Bilal Zia at the World Bank has a good description of current research in financial literacy.

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