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TED@AllianzGI Video | November 2011

Dean Karlan: Increase the price of vice or lower the price of virtue?

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At the TED@AllianzGI conference at the Time Warner Center, New York, professor Dean Karlan of Yale University focuses on the difference between debt and credit in developing economies and helps the audience understand the challenges in determining when savings and microcredit programs work, and when they don’t. He discusses how commitment strategies can improve the results of saving and microcredit programs in any economy.

Dean Karlan: Increase the price of vice or lower the price of virtue?

Introduction:

TED – Ideas worth spreading.

Dean Karlan:

Right now I can give you the name of two organizations. Both are charities, and you can get a tax deduction for supporting both of them. One of them is working tirelessly here in America to help people get out of debt. The other one is working tirelessly in Ghana to help people get into credit. So these loans that we’re talking about in both situations have similar terms and conditions. What is going on here? So why the dichotomy? Why are we talking about credit is good and debt is bad?

A lot of it has to do with our choice of words. Money is very emotional for us. And these words that we use to describe a good situation or a bad situation are very predictive of how we’re actually going to behave. So the thing to remember is that a loan in and of itself is not good or bad. And this is a basic mistake that we’re led to through this jargon. And there isn’t one single answer. And if we think of credit as simply something that’s good, that is going to help us alleviate poverty, we’re probably going to be making a mistake.

So there’s two basic points I want to leave you with. The first is that we need to understand more about the needs that people have and how they actually use financial services in order to think harder about how to make financial services work harder for the poor to help solve problems. And to do that, we need to think a lot more about what we ourselves do. What do we need? So credit, for most people in this room, probably served some really good things for us. Allowed us to buy homes and cars and pay for education. But it’s also the case that we can probably point to a time when credit might have done something bad for us. Maybe there was something that we purchased because we had access to credit that we later regretted.

The second thing I want to leave you with is more about the journey and the process of how we go about figuring all of this out. How do we determine whether or not something is actually working to help alleviate poverty or not? And I’m gonna talk more about that. But let’s go back to the first point about microcredit and let’s talk more about that. At the risk of being a little too personal, let me tell you how I got involved. I spent two years after college in investment banking, and I wanted after that before going off to business school to go to travel in Latin America and work for some sort of development organization. That’s about as focused as I was. So I found out about microcredit and I saw this brochure and it really appealed to the banker inside me. Here was the promise: it said we’re going to find hardworking inspiring entrepreneurial women who are fighting their way out of poverty and we give them access to a loan – ‘cause banks are not doing that. And with that loan, they invest it in their enterprise, their enterprise gets bigger, they take that extra money, they have more power in their household for making decisions, with that money and that power they invest in health and education for their children, and they get out of poverty. So I was very excited.

So I go down to El Salvador, and I was struck by two things. The first thing that I was struck by was, here I was, about to go to business school to learn how to run a business, basically, more or less, and these were not so easy businesses that a lot of these women were running, and this required a lot of skills, a lot of savvy-ness [sic]. So I really wanted to know, what are you actually doing with this loan and are you clearing the principle and the interest so that your business is actually getting bigger? So that begged the question: what is the interest rate? That was the second surprise. So I learned that the interest rate was 72 percent per year. Okay, so this is a pretty big hurdle. Think about running your business and needing to clear a 72 percent hurdle rate in order to actually make money, and this is in the name of poverty alleviation. Now I’ve since learned that 72 percent, that’s not gouging, the interest rates are actually not that high relative to cost. But it really made me want to know – what was the impact of this program? So I asked this organization, what is your impact? Do you have evidence? And they showed me their impact studies. This was a moment that really changed my life and set me on the path that I’m on now, to doing research on impact of programs in developing countries. This study that they showed me satisfied them, satisfied their donors, and to be perfectly blunt was state-of-the-art; it was no different than what everybody else was doing, so I’m not trying to make fun of them. It had three questions among others in their survey that asked existing clients: are you eating better than you were before you joined this program; are you healthier than you were before you joined this program; and is your business bigger than it was before you joined this program? They got three resounding yesses to this and then they concluded from that microcredit caused these things to happen and is alleviating poverty.

So now think about this for a second. Suppose I added a fourth question to this survey: Are you older now than you were before you joined this program? Would we be sitting here today concluding that microcredit causes aging? Hopefully not. So the point is, we can’t just follow people every time, we have to answer the basic impact question, how have the lives changed of someone in the program, compared to how their lives would have changed had this program not existed? That’s the question we have to ask.

So we have to have some people who are not borrowers. We have to take people who are in the program, who are getting access to credit, and compare how their lives changed to people who did not get the loans. Okay. So is it that simple? Well let’s go back to what the basic promise was of microcredit. How did I open up and tell you? I told you that microcredit promised to find hardworking, inspiring women who were entrepreneurial and fighting their way out of poverty. So let’s do the following thought exercise. Suppose that we don’t have microcredit, that we just have a room full of people or a few villages. And we can divide them into two groups: those who are more hardworking and those who are less hardworking. Who’s going to do better over time? The hardworking people. That’s kinda what we mean by being hardworking.

Ok so, let’s go back to this problem. If we just take a bunch of borrowers and compare them to a bunch of people who are not borrowing and we compare their lives over time and we see that the people who participate in this program, who get access to microcredit, do better, how do we know what caused what? Did they get better because the loan helped them get better, or did they do better because they were the hardworking people? I mean this basic problem is fundamental to social science, and this is exactly why, back in 2002 after I finished school I started a non-profit called Innovations for Poverty Action. And the basic goal, among other things, was to run randomized trials, to take the same approach that we demand of pharmaceutical companies for our prescription drugs and take it to social science problems, to problems of poverty, to learn what really works and what not. Now I’m being very simplistic about randomized trials; that’s not what the point of this talk is, there are many issues that one needs to take into account. Not all situations are appropriate for them, and there are ethical issues that one must always take into account to make sure that you’re adhering to certain standards. But let’s jump into the substance of what we’ve learned. There have been four studies so far that have used this approach to study what is the impact of getting access to a loan in developing countries? We did one in the Philippines, one in India, one in Morocco and one in South Africa. The results are shockingly modest. Ok, but by modest I don’t mean uninteresting or unimportant. Just not the panacea in the fight against poverty; it’s not the promise that the biggest proponents hoped it to be. But we have seen some important changes in the way that people manage risk, and the way they make investments.

Now, the interesting thing is that in three of these four studies, the more traditional microcredit – where they did what I said initially, where they reached out to entrepreneurs to help them start small business or grow small businesses – in none of those studies do we see an impact on household income. But in one study we did. In the study in South Africa, we worked with a consumer lender. This looked and smelled more like the payday lending industry here in America. The interest rate was 200 percent annualized. The lender did not ask any questions about what people were doing with the loans; you just had to have a job, you get access to credit, you get a loan. This is the only one where we saw an increase in household income. What happened? People had something bad happening in their life, and access to credit allowed them to absorb that shock and keep their job. What’s the difference between having a job and not having a job? Well it’s the difference between above poverty and below poverty. So it was actually quite positive. Now that doesn’t mean that we should take 200 percent loans and we should peddle them in the name of poverty alleviation. But it makes the very simple point that we need to understand more about why people actually need the financial services that they need and we shouldn’t assume too much about a product on its face being good or bad. We need to understand how it’s being used. So debt is not always good, it’s not always bad; we need to understand better about when it is appropriate for people at what point in their life, and the same thing is true for savings. At not all points in your life do you want savings; sometimes you do, sometimes you don’t. When is it right and when is it not?

So let’s talk about savings now. So the thing that’s striking about saving is how often we talk about under saving. It almost goes hand-in-hand; we just assume when we talk about savings that we’re trying to increase peoples’ savings. And in fact there is a lot of philanthropic effort going to help improve savings; the Bill and Melinda Gates Foundation a few years ago took a big shift away from credit into supporting mobilization of savings. So let me tell you what we don’t mean by under saving. Raise your hand here if you’d like more savings. Right? Ok. That’s not what we mean. But sometimes, believe it or not, we get slippery and that’s actually what we end up saying when we talk about under saving. And it always reminds me of one of my favorite lines from The Simpsons when Homer Simpson turns to Montgomery Burns and says – Montgomery Burns being the über-rich guy – “Mr Burns, you’re the richest man I know.” And what does Montgomery Burns say? “Yes, and I’d give it all up in moment for just a little bit more.”

So under saving does not mean we just want more savings. It has to mean one of two things. We either made a mistake – and I’m going to get back to that in a moment, what I mean by that – or, it could also just mean that there’s something wrong in the market; banks want to give you savings accounts, people want savings accounts, but the transaction costs are too high. This is a big problem in rural parts of the world. Take rural Mali. If you’re living in rural Mali and you want a bank account, there’s no bank near you. So we’re seeing innovations in the cell phone world that are really revolutionary and transforming that market and it’s very exciting. But let’s focus on the mistakes.

So when we’re talking about mistakes, let me just give you three examples. One is temptation. So I have a plan, I have how much I want to save, how much I want to consume, but then my day-to-day life takes over, things happen in a given day that tempt me and I end up spending more than I said I would, and then later in life – maybe it’s six months later, maybe it’s five years later – and I don’t have as much savings as I’d like to have.

We can also make mistakes in terms of our projections, our expectations. Maybe I’m just not always thinking about everything I’m going to need to save for. So I add it all up and it just doesn’t add up to what it’s really going to add up to and so I don’t save as much, because I’m just forgetting about some future things I’m gonna need.

We also make mistakes not only because of individual failure, which is the focus of this TED session, but because of societal failures. This is a big issue in developing countries, for instance for women. A woman might want to save, might have the self-control to save, but might not have the spousal control. Okay what do I mean? What I mean is they can put the money in the mattress or they can put it somewhere but the husband tomorrow or a week later or a month later is gonna come and is gonna demand that money. So what does she do? If she can’t hide it, what does she do? She doesn’t save. And that’s a shame, and that’s a problem.

But let’s focus on the first, let’s focus on temptation. So we all have different temptations. Right? Here we’re talking about money and savings but there are other facets of life where we all have problems with temptation. So take, for me, my biggest weakness is food. Quite specifically, like chocolate pies or tortes with nuts and berries and nice cream and things like that. So if you’re like me, I probably just lost you for the rest of the talk because you’re gonna think about chocolate tortes. So if I go to a restaurant, what do I really wanna do? I wanna have wine, I wanna have a nice entrée, and I actually don’t wanna have dessert. I like it, but I wanna resist that temptation. That’s my sweet spot, that’s what I really wanna do. But what happens? I go to dinner, I have wine, I have the entrée, but after drinking wine my self-control kinda goes away. Dessert menu comes; I order dessert. Well, this is not what I wanna do. I wake up the next morning and I feel silly – why did I do that? So what do I do? What I do is, when the wine menu comes, I don’t order wine, because I’m thinking ahead to my future self that’s going to be ordering dessert in just a half an hour, and I say a-ha! – if I order wine, then I’ll order dessert, so I actually don’t order wine. And this is a shame, ‘cause I like wine, but I end up drinking a lot less! So I can only do this with a friend that I trust but has a bit of an edge to them. I can’t do this with my wife cause we share money. So we sit there at the beginning of the meal and I say to my friend, if I order dessert then I owe you a thousand dollars. Now I don’t care how much wine I have had and how inebriated I am, I’m not gonna spend a thousand and eleven dollars and ninety-five cents on dessert. So when that dessert menu comes, I say no, and all is well. I’m very happy. So we tried this in the Philippines to help people stop smoking. We worked with a bank who went out into the community who were smoking who said they wanted to stop smoking and the bank offered them an account. An account where they took the money they were spending on cigarettes and put it into the bank account. And basically they go back in six months and they made them pee on a stick; if they were still smoking, their money was sent off to a local orphanage, and if not they got their money back. We did this with a randomized trial – why? Very simply put, people who sign up for this are going to be more likely to stop smoking than people who do not - we have to have a comparison group. We found that they were thirty percentage points more likely to stop smoking. But the best part was that six months later, even after the contracts ended, even after the bank accounts were closed, they were still not smoking. So it lasted – the results lasted.

So we’ve also done this a lot in savings. Three different studies that I’m in the middle of apply this concept for savings. In Kenya, a big problem is fertilizer use. Farmers find that when it’s time to use fertilizer, they don’t have enough money to buy fertilizer. And you say “why” and they say “well I wanted to but I forgot to save, I didn’t save enough.” So researchers at IPA went to the farmers at harvest time when they’re flush with cash and offered them a fertilizer voucher that was good for three months later when it’s planting season. And fertilizer usage goes up. In Uganda I was there visiting a project that works in schools. There the families report to us that the children are not going to school because they never accumulated enough savings to pay for the fees and pay for the school supplies and so the kids are not going to school. So we offered them a savings account that would be locked in where the money would be spent on educational expenses. The study is still underway but we’re already seeing important improvements on school attendance and school supplies. A third study which is actually one of the original ones I did was on savings, just plain savings, in the Philippines. Here I was trying to address the first problem I mentioned – people say they want to save, they have some goal they want to save up for, but things get in the way – life gets in the way and they never manage to accumulate enough to get to that goal. So we offer them a savings account in which they could not withdraw their money until they reach their goal. Savings went up by three hundred percent for those who were offered this account and took it up. So it was very successful. And, for the women who got this, it actually increased their decision-making power in the household, which was a very important lesson in terms of gender issues. So what does this all mean? What is the basic theme through all of this? It’s how do we find ways to increase the price of vice or lower the price of virtue. Now I can’t call up the M&M Mars Company and beg them to increase the price of peanut M&Ms, so I have to find other ways of doing it. One thing we did is we started a website called “stickK”. It’s a website where you can go on and you can write your own commitment to vice. So can go on and you can say I’m going to lose weight and stop smoking, and there, if you fail, you could lose your reputation by your friends being told, or you can lose money. One of the most popular options is people choose their anti-charity where their money gets zapped away to if they don’t achieve their goal. So the Republicans for instance can choose the Bill Clinton Library, the Democrats can choose the George W. Bush Library. Now a lot of these contracts we see are very interesting and fun and creative. Two of my favorites: someone wrote a contract that said I will stop cursing when the Phillies lose; and my other favorite contract was someone said I’m going to stop dating losers and the fun part was that they actually named a friend as the referee to adjudicate whether they succeed or fail.

Now it’s also important to be realistic. If you make a commitment contract with a commitment to a vice that’s too strict, you’re gonna weasel out of it. So one of my other favorites in this spirit was someone who committed to stop smoking marijuana… Monday through Friday.

So many more examples abound of this type of approach. This type of approach of learning more about how people actually make decisions, then think about how we can design programs that address issues of poverty. And the striking thing about it, as I explained with the examples from stickK, these examples don’t just apply to the poor – they apply to the rich as well. The key is to remember that we need to think more about people’s strengths and weaknesses and we need to understand that there isn’t one single answer. It’s not going to be “credit is good or credit is bad”, but it’s going to be more about understanding the actual needs that people have at that point in their life and for that purpose. And ultimately in the end, there’s two points of humility that I think are really critical for us to remember. The first point is that it’s really easy for us to say things like “oh, you shouldn’t have that loan; oh you need to save more.” But we need to think more than just saying “oh I think you should save more” and achieve more or less. We need to say what the actual problem was in the first place; was there an actual mistake made given their set of preferences and aspirations in life. And the second point of humility goes back to this point of testing. It’s much easier to say something works in theory than to see it work in practice. And so we need to do more work that takes these ideas and goes out into the field and actually tests and sees what is the impact of doing something, and actually replicating things in other settings to see that the results are actually quite robust and last and persist - and that search for that evidence is critical for using these ideas and using these theories to make the world a better place.

Thank you

(applause)
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