How Do We Know if Financial Innovations Help or Hurt in the Fight Against Poverty?

New Book Establishes Foundation for Analyzing the Impact of Financial Policies in Developing Countries
March 21, 2011

A new book by CFSP Faculty Director and MIT economist Robert M. Townsend explains for the first time how economists and policymakers can merge rigorous economic models with extensive data to answer whether financial innovations in developing countries help or hurt in the fight against poverty.

“I think there is a need for a deeper, integrated understanding of the financial structure of emerging market economies,” states Townsend. “Without a better framework, we risk greatly misunderstanding the effects of ‘helpful’ actions in developing countries. It takes both models and microeconomic data to judge whether policy is helpful or harmful.”

Financial Systems in Developing Economies (Oxford University Press) outlines the theoretical and practical foundations for analyzing the impact of financial systems on growth, inequality and poverty. Townsend demonstrates how researchers can quantify potential gains and losses to individual households and firms, to regions, and to national economies under varying financial policies. 

More importantly, Townsend argues that the impact of innovations, like microfinance programs, and financial repressions, such as holding down interest rates, are best understood as part of a systemic whole. Only then can policymakers and governments discern the true impact of their decisions on households and firms as well as on the overall economy. Townsend believes this framework is the most appropriate context for understanding what truly reduces poverty.

Significantly, the book is also the first of its kind to provide an in-depth evaluation of the financial system of a typical emerging market economy. Townsend draws on data from his long-term research project in Thailand, known as the Townsend Thai Project.  His extensive data allow him to examine the effects of the Thai government’s 2001 decision to pump an equivalent of 1.5% of the Thai GDP into a village-level savings and loan program. Townsend calls this effort “one of the world’s largest microfinance interventions,” and through his analysis, he demonstrates that the program increased consumption and overall lending, the frequency of investment, business profits, and local wages, while simultaneously raising interest rates and some defaults.  This is just one example from the robust analysis of the Thai economy examined in the book.  In another he analyzes an episode in which the Thai government took over the banking system; a model establishes that this stalled growth for several years.

However, the potential impact of Financial Systems in Developing Economies extends far beyond these insights about Thailand. The analytical foundations in the book are immediately applicable to other countries.  Townsend’s work is expected to pave the way for researchers, policymakers and governments to answer with greater certainty whether they are helping or hurting their citizens and their economies.

Financial Systems in Developing Economies: Growth, Economic Policy and Policy Evaluation in Thailand is published by Oxford University Press. ISBN 978-0199533237. $85. March 2011. 352 pages.

This work was made possible, in part, by a grant from the Bill & Melinda Gates Foundation to the University of Chicago for the Consortium on Financial Systems and Poverty.