Can micro-credit bring development?

We examine the long-run effects of micro-credit on development in an occupational choice model similar to Banerjee and Newman (JPE, 1993). Micro-credit is modeled as a pure improvement in the credit market that opens up self-employment options to some agents who otherwise could only work for wages or subsist. Micro-credit can either raise or lower long-run GDP, since it can lower use of both subsistence and full-scale industrial technologies. It typically lowers long-run inequality and poverty, by making subsistence payoffs less widespread. Thus, an equity-efficiency tradeoff may be involved in the promotion of micro-credit. However, in a worst case scenario, micro-credit has purely negative long-run effects. The key to micro-credit's long-run effects is found to be the “graduation rate”, defined as the rate at which the self-employed build up enough wealth to start full-scale firms. We distinguish between two avenues for graduation: “winner” graduation (of those who earn above-average returns in self-employment) and “saver” graduation (due to gradual accumulation of average returns in self-employment). Long-run development is not attainable via micro-credit if “winner” graduation is the sole avenue for graduation. In contrast, if the saving rate and self-employment returns of the average micro-borrower are jointly high enough, then micro-credit can bring an economy from stagnation to full development through “saver” graduation. Thus the lasting effects of micro-credit may partially depend on simultaneous facilitation of micro-saving. Eventual graduation of the average borrower, rather than indefinite retention, should be the goal of micro-banks if micro-credit is to be a stepping stone to broad-based development rather than at best an anti-poverty tool.