Unit 4 Macro: Fair Trade and Micro Finance - Spurs to Development?

Mark Austen writes on this essay title: Evaluate the impact that the micro-finance and Fair Trade movements can have in supporting development in some of the world’s poorest countries.

Micro-finance and fair trade are two movements which have emerged in the last few decades as a means of improving the lives of those in poverty, offering an alternative to traditional measures, which often involve large cash injections of aid. To some extent, both movements have met with great success; however, it is debatable how far it can be said that they are sustainable large-scale tools for supporting development.

The aim of micro-finance is to reduce poverty by increasing the availability of financial services to the poorest in developing economies – in particular, credit and insurance. The theory is that this allows entrepreneurs to have access to the funds and certainty to build businesses and increase their sources of income. Chang (2010) argues that the difficulty of surviving in poverty in these economies means that these people may be, by necessity, more ingenious and entrepreneurial than those in developed economies, who often have the security of a welfare state to rely on, meaning simple survival is much easier. In theory, micro-finance allows this entrepreneurial spirit to be utilised, allowing people to lift themselves out of poverty. Furthermore, the fact that micro-finance banks require a degree of saving before loans are granted means domestic savings may rise, allowing greater security and investment throughout the country. A similar degree of increased certainty is granted through the availability of insurance; it is near impossible, for example, for farmers to invest in growing their farm if they may have to spend all their savings protecting their business if one year’s crop fails. Insurance allows them a degree of certainty that means they can invest more reliably. Finally, micro-insurance is often targeted at women, causing gender empowerment, and allowing a potentially quite unproductive group – not by any fault of their own, but by the social norms of the society they inhabit – to become productive earners.

The benefits are clearly very attractive in the pursuit of reducing poverty, and micro-finance promises to provide these benefits at low interest but high repayment rates. The idea is not without its flaws, however. Perhaps greatest amongst these is the fact that there is no solid evidence that micro-finance actually makes a significant impact on poverty levels. Jonathan Morduch, a long-time supporter of micro-finance, recently admitted that there is “little solid evidence that it improves the lives of clients in a measurable way.” Moreover, despite impressions being given to the contrary, what is achieved can only be done so through the use of subsidies – the Grameen Bank, for example, which pioneered the micro-finance model, relied heavily on subsidies from the Bangladeshi government to keep interest rates low. This fact was kept suspiciously quiet for a long period. Without this subsidisation, rates climbed to 30-40% in Bangladesh (and in extreme cases, 80-100%, as seen in Mexico). In other words, micro-finance is largely funded by aid, an ideal that the movement was attempting to move away from.

Moreover, the long run effects of micro-finance are somewhat dubious. Even in the short run, it may not have a positive effect on income – by some estimates, as much as 90% of loans are now used to fund consumption, which is perhaps testament to the decreasing quality of loans as a result of the increasing scale of the institutions issuing them. The increased scale of these businesses may mean loans are not assessed in as much depth, not only because the success of micro-finance is now under less scrutiny than it was initially, but also because for larger businesses, the effect of a single loan failing is much less. Despite this, short run effects are usually positive; for example, a pilot scheme in Bangladesh run in conjunction with a Finnish telephone company saw the incomes of the recipients rise from below the national average of $350 to $1200. The women were loaned money to buy telephones, which they used to provide a service to their village for a small fee. However, this example also demonstrates that in the long run, the effects are much more limited. The scheme became so popular that the market became flooded with “telephone women”, whose profits eventually fell to an average of $75 annually, despite the national average rising to $450. Critics such as Bateman have used examples such as this to suggest that overall the main effect of micro-finance is to simply increase debt – particularly because the increasing occurrence of events such as the one detailed may lead to what would have previously been secure loans becoming sub-prime. As a result, Bateman argues that in order to fund debt, informal debt between family members and villagers increases, leading to a net of indebtedness and reducing overall incomes.

Micro-insurance, an aspect of micro-finance that receives much less criticism than micro-credit, provides a level of certainty to farmers similar to that which is provided by the Fair Trade movement. Fair Trade guarantees a price for member farmers; they receive the market price unless this price falls below a given level, in which case a previously set fixed price is received. This means there is an artificial floor below which prices cannot fall. There are two fundamental benefits of this: firstly, it reduces poverty by guaranteeing a minimum living wage, and secondly, like insurance, it provides a base of certainty that provides scope for diversification and investment without the fear of spending contingency savings. The effect of this is to shift power in the market back towards the primary producers. In the production of coffee, for example, many regions are subject to monopsony buying power, meaning a single buyer, or a small number of colluding buyers, can effectively set prices at very low levels. With Fair Trade, farmers are guaranteed a certain price, negating the effects of monopsony power and putting them in a stronger position for negotiating. In the long term, as a result of the increased certainty for investing, production standards may improve; this will be particularly true if, as has become more common recently, a “social premium” price is added to the minimum price. The money from this goes towards improving human capital in the industry and country.

Fair Trade may seem like a win-win situation, and it has certainly met with considerable success. However, several notable issues remain. Although an obvious statement, it is sometimes overlooked that Fair Trade inevitably raises the costs of commodities, particularly compared to trends in some markets for decreasing prices (the market price of coffee, for example, has trended downwards over the last few years). Some of this money may be raised by reducing steps in the supply chain – by cutting out the middlemen who add costs in order to make profit – but in most cases, consumers must pay a premium for Fair Trade products. This means that the success of the scheme largely relies on consumers’ willingness to buy these goods. It seems a somewhat naive view to believe that it is possible to inform all consumers of the implications of this choice, and even if this can be achieved, that all consumers will therefore purchase Fair Trade goods. Unless more major buyers can be convinced to sign up for Fair Trade, the movement depends on influencing consumer choices. And given that prices of commodities not produced by Fair Trade farmers is likely to fall as a result of the movement, it will become increasingly hard to convince other buyers to use Fair Trade commodities, as the incentive not to may grow.

Falling prices may be a result of Fair Trade because being offered a guaranteed price incentivises farmers to over-produce. As such, the market becomes flooded with a commodity, driving the market price down. This does not affect Fair Trade producers, who are guaranteed a price, but it does negatively affect non-Fair Trade farmers. Consequently, Fair Trade may well increase the poverty of the farmers it excludes, which is the majority. Furthermore, the benefits of Fair Trade to the farmers who are part of it may have been overstated; some estimates place the percentage of the extra price paid by consumers that reaches the farmers at just 25%. Besides the price benefits of Fair Trade, the scope of the movement may be limited by another factor besides consumer will – it fails to solve the underlying systemic problems causing the issues it is attempting to solve. Fair Trade is attempting to artificially raise prices in a free market context, a proposal which seems highly unlikely to be sustainable on a large scale. The price of commodities suggests in an ideal world, fewer would be producing them; there is an unsustainably large number of people depending on commodity production. Two-thirds of Ethiopia’s exports, for example, are coffee, despite the percentage of income being spent on coffee by consumers in the developed world being low. Perhaps a better long term strategy would be to subsidise the movement of commodity farmers to other industries further up the value chain, thus redressing the global balance in incomes and production.

Fair Trade, as such, seems a useful but somewhat limited tool for aiding growth – it fails to address systemic problems, but it does succeed in providing some degree of short run support. Micro finance seems to have served a similar role: it encourages short term income growth without the evidence suggesting it benefits long term development. There are undoubted benefits of growth but I believe these to have been overstated – there is no silver bullet for increasing development. For real long term development, it seems that different strategies must be used.