Getting to the Bottom of "Bottom-Up" Approaches

Now that Muhammad Yunus was awarded the Nobel Peace Prize for developing and promoting microfinance banking to help the poor, the media spotlight will shine on his pioneering model.

The Grameen Bank success in Bangladesh with "bottom-up" aid in the form of small loans deserves lavish praise. What's not to like? Countless disempowered people, primarily women, have been lifted out of poverty through the opportunity to become small entrepreneurs and access financial services for the first time. Equally important is the fact that this model has inspired a generation of idealistic young entrepreneurs in the rich nations to flock to this approach.

The idea of harnessing the power of the marketplace to help solve the world's social, political, and environmental problems—through microfinance banks, "social enterprises," and the like—goes back at least as far as 1462, when an Italian monk opened a pawn shop to counter local usury practices. But it has never been hotter.

Two decades ago, for example, you would be hard-pressed to find a single business or public policy graduate school program devoted to such an agenda. Today, there are some 50 such programs and counting, and their ranks include top-tier universities such as Harvard, Stanford, and Oxford.

A recent study by the University of Maryland found that "asset-based" social institutions that combine lending, financing, and other profitable activities with social aims now represent more than $1.5 trillion in assets in the U.S. alone.

Social enterprises have become so pervasive that several years ago Britain developed a special oversight unit and a formal strategy to incorporate such activities into long-range public sector planning.

Yet this trend deserves much more scrutiny. The returns from this new social marketplace, while encouraging and even inspiring in places, often come closer to "random walk" variability than a Buffett-like bonanza.

Far too little before-and-after research has been conducted on the actual social and developmental impact of such enterprises. The vast majority of social enterprises, especially those in the developing world, are still too young to demonstrate conclusive results, and most such enterprises have never reached scale. Thus one can fairly question whether a dollar going to create a new social enterprise has the same impact as, say, a dollar for an existing humanitarian relief program.

For those who rue the lack of transparency and accountability in government and corporations, hybrid enterprises pose a case of special risk. They frequently combine soft money in the form of subsidies with commercial revenue, making it exceedingly difficult to assess the effectiveness of specific products and services. In addition, as they are often marginally integrated with a country's mainstream financial system, they are often neglected by regulators.

By some lights, an unregulated Wild West of aid and development might not be such a bad thing. Why not let a freewheeling "market for good" emerge? Were market forces allowed to run free in aid and development, the results would no doubt be more than a bit of creative destruction.

However, it is not uncommon for social enterprises to secure a privileged position that proves beyond the practical reach of market forces.

Recent research has shown that governments in developing nations subsidize microfinance banks, rural credit banks, and other "alternative" finance providers while also imposing formal or informal interest-rate ceilings, which dilute rather than accentuate market signals and churning.

As a result, such enterprises are more subject to political meddling, loans are skewed toward well-heeled clients to meet volume targets, and a climate of weak credit discipline can send default rates to between 40 and 70 percent.

Finally, functioning markets require more than new entrants. They require exit doors. But allowing exit from the aid and development market is precisely what most governments, poor or rich, seem disinclined to do.

Among government-sponsored aid and development banks, for example, the trend in recent decades has been to denounce fragmentation and inefficiency even as officials create new institutions, recapitalize laggards, and repackage poor performers.

Instead of the "white elephant" pathology of funding massive but financially untenable showcase projects, for which the World Bank Group and other multilaterals have often been blamed, we may have a growing number of white-elephant development institutions, a good number of which are funded by poor nations themselves.

Our frameworks for measuring government performance and holding public servants accountable are highly evolved. Counterparts for the corporate world are rapidly evolving. But our understanding of how this new creature, the social enterprise, operates at a market level is rudimentary at best. Perhaps the Nobel prize will both spotlight the visionary Mr. Yunus and help redirect the gaze of academic, foundation, and government researchers.