Indian woman Amina Shah, a microfinance beneficiary, stitches a shirt as she waits for customers at her shop in a slum in Mumbai, India, Monday, March 7, 2011. (AP Photo/Rafiq Maqbool)
Indian woman Amina Shah, a microfinance beneficiary, stitches a shirt as she waits for customers at her shop in a slum in Mumbai, India, Monday, March 7, 2011. (AP Photo/Rafiq Maqbool)

Adam Smith said it best: in his magisterial work, the Wealth of Nations, he argued that governments have an essential role to play in enforcing contracts and promoting institutions to promote the quintessential Canadian virtues of "peace, order and good government." While others may disagree, my interpretation of Smith is that, in the real world, where the assumptions of the Fundamental Theorums of Welfare Economics don't hold, contract enforcement and institutions help to ensure that markets work — that the "invisible hand" of the market needs the visible hand of government to establish and enforce the rules of the game.Moreover, there is a corollary to this rule which states: where institutions don't exist by dint of government fiat, they will evolve endogenously to facilitate more efficient market outcomes. Call this a Coasian view of institutions.

Of course, there is a caveat. It is possible for government to be captured by special interests and used to thwart what would be — what should be — the evolution of private arrangements for the better allocation of resources. I think it is fair to say that in societies marked by large inequalities in wealth, markets tend to be dominated by a few firms controlled by a lucky few. Where monopoly power is exercised, is it any wonder that poverty and inequality become deeply entrenched?

Consider the case of financial markets and lending to the poor. High borrowing charges undoubtedly reflect the high expected rate of default on loans: if you are just barely making do, any unexpected expense or shortfall of income will force you to choose between feeding your family and servicing your loan. It really isn't a choice. The problem is that because lenders can't differentiate ex ante between those who are likely to pay their loans and those who will default, ex post, they have to assume that all borrowers are potential defaulters. All borrowers suffer as a result of the information asymmetry.

Good development policy would find a way to assuage this information problem and transform the credit decision process from a "pooled" equilibrium to a "separating" equilibrium in which good credit risks are differentiated from poor risks. The benefits of this would be lower borrowing rates for those who can support the debt burden.

But this is only half of the story. High borrowing rates will also include a risk premium to compensate for the risk of macroeconomic instability and change in policy frameworks. Strong policy frameworks that reduce this risk; macroeconomic stability and, as Adam Smith argued, sound, stable institutions are good for development. At the same time, if the financial system is controlled by a few, with little competition, high lending margins will keep the poor trapped in a never-ending cycle of debt and poverty from which they can't escape. If the poor don't have access to credit at reasonable rates, they literally can't invest in their own futures.

This underscores the point that policies that break down barriers to competition will be good for development. It is no wonder that George Ackerlof's path-breaking "market for lemons" analysis of adverse selection was based on his development work on credit markets in rural India. And it underscores the importance of development initiatives designed to foster robust, competitive financial markets — as Nobel laureate Robert Shiller might say, to "democratize finance."

 

1. These assumptions include, for example, perfect, symmetric information and competitive markets in which price equals marginal cost, and lump-sum transfers to maximize social welfare.

Where monopoly power is exercised, is it any wonder that poverty and inequality become deeply entrenched?
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