How Does Microcredit Work? Testing the Theories of Microcredit

Economists have used a great deal of ingenuity to delve underneath the practice of microcredit and understand the logic that underlies its operations. There is no single theory, however. What we have instead is a bewildering variety of theories; the only common thread binding most of them is the idea that the way microcredit is delivered in practice helps overcome certain market imperfections – in particular, imperfections in information and in the enforcement of contract. But they differ greatly in their understanding of exactly which imperfections are being addressed and precisely how they are being overcome. Most of these theories have some a priori plausibility. Therefore, the only way to discriminate among them is to check empirically which theories seem to fit the reality better than others. Accordingly, researchers have increasingly turned their attention towards testing microcredit theories against empirical data, often using highly sophisticated econometric techniques and increasingly drawing upon the tools of behavioral economics. This is currently a lively area of research and many valuable insights have already been gained. Although a lot more work still needs to be done, it is worthwhile to take stock of the current state of knowledge so that future research can build upon it in a more focussed manner. This is what the present paper purports to do. In particular, the paper examines the empirical evidence on four sets of issues: (a) does the rural credit market really suffer from the kinds of market failure that the theories of microcredit take as self-evidently true, (b) which of the pathways through which, according to theory, microcredit is supposed to overcome market failure are empirically relevant and which ones are matters of mere theoretical curiosity, (c) does the celebrated joint liability mechanism of microcredit models really outperform the traditional models of individual liability, and (d) what do data say about of the role of social capital in making microcredit operations effective?.