Our Development Economics Research Approach

Letter from Principal Investigator, Robert M. Townsend

The goal of the Consortium on Financial Systems and Poverty (CFSP) is to understand how the financial systems of underdeveloped and emerging market countries are, or should be, put together. Our emphasis is on improving the lives of the poor and reducing poverty through savings, enhanced financial services, and improved financial systems.

At one level, our essential research questions are simple yet of great importance: Are the poor living in isolation from the financial system, with little or no access to savings, insurance, enhanced payment devices and credit? If they do not have formal sector savings accounts and, more generally, are not directly connected to the financial system, how can this best be remedied? That is, how can the poor be more fully integrated and how can the system be changed to accommodate the economic lives of the poor? These questions, then, are a key part of our mission.

But these questions are not the whole story. Though financial access for the poor has the potential to change the lives of millions around the world, we still have much to learn about how such changes should occur and what kind of impact such changes could have. In fact, the focus of the Consortium is based on an even more ambitious vision: We seek to make progress in determining the role of the poor in an efficiently operating financial system.

Under this vision, the number of savings accounts and degree of household financial access are not the only criterion used in making policy decisions. Rather, researchers and policymakers should also consider the degree of financial system inefficiency. Without the poor, financial systems are almost invariably inefficient. But what is the new goal? What should an ideal financial system look like when the poor are included, both in the mobilization of savings, with resources flowing from the poor to the rest of the system, and in the provision of other financial services, with resources from the rest of the system flowing back to the poor. These flows do not necessarily balance each other.

CFSP thus explores questions about savings and the efficiency of financial intermediation. We ask to what degree should the savings of the poor be channeled to the productive investment of borrowers? What is the trade off between the expected rate of return on savings and the associated risk? Are the poor with savings in varying forms vulnerable to financial crisis or inflation and what, if any, is the optimal exposure? Similarly, we explore whether financial intermediaries can make profits by providing the poor with insurance, credit and other financial services. What is the optimal degree of securitization of credit and insurance as financial assets and what are the implications for financial system stability?

Finally, improved intermediation of savings and credit can bring indirect but important changes, such as economy-wide shifts in interest rates, prices, wages, growth in the number and size of firms, or increased employment. Thus, we ask who are the winners and losers from these changes. We take into account both the direct impact on the savings and credit sides of the markets and also the indirect impacts in general equilibrium. Because winners and losers can lobby for, or against, changes that help the poor, we include such groups in our overall analysis and in our vision of how to design an efficient financial system.

We have structured the Consortium’s research to make progress in answering these questions. We are designing a robust and rigorous algorithm for identifying, analyzing, and implementing solutions to global poverty through improved financial systems.

First, we ask what do selected, contemporary economies look like, not just in their individual parts, but also in their entirety? That is, what is occurring in the markets and institutions, including the extent of financial intermediation within the entire financial system, as great or limited as that may be? What do enhanced flow of funds accounts and national income and product accounts, tell us about linkages within the system and the level of intermediation? Are the poor isolated financially from the rest of the system? Or, are there two-way links, not only from the rest of the system to the poor but also from the poor to the rest of the system? What are these and how big are they?

Second, are financial systems efficient or inefficient, at what geographic or entity level, and in what aspects? How do we develop theory, measure appropriate variables, and proceed with analysis so we can judge whether local, regional and/or national economies are efficient financially, or not? For example, a collection of households in a family network or poor village may share risk efficiently by gifts and borrowing/lending, yet be vulnerable to common local shocks such as drought or disease. We look beyond simple indicators of access and consider metrics about the welfare and well-being of households directly.

Third, drawing on financial accounts, metrics for efficiency, and other data and financial system descriptions, can we develop operational but realistic models that aid in policy analysis? For example, when the financial system of some country under study seems limited, with little formal savings or other access for the poor and with seemingly inefficient intermediation, can we build and test models that determine the potential cause or causes? Is government regulation appropriate or does it create obstacles? Can we use models to help differentiate, for example, needless or misguided regulation versus more fundamental obstacles such as transaction costs, information problems, spatial separation, limited communication, or limited commitment? If we discover any of the latter fundamental obstacles, are there remedies that take those obstacles into account yet help the poor and improve the system more generally? Regulation or existing market structure is not something we take as a given. Regulations and market should be part of the optimal design.

Fourth, where a financial system is inefficient and the poor could be made better off, what realistic steps can be taken to move the economy toward better outcomes? Would the immediate, obvious remedies that help the poor and move the economy to the efficiency frontier actually harm other participants? For example, would there be political forces for repression that would prevent change? If so, how do we move to the efficiency frontier in such a way as to achieve quantitatively significant welfare gains for the poor while compensating those who may lose so that they do not block that change? That is, how do we engineer a move for a given developing nation from an interior point to a point on the frontier, which, in principle, everyone can endorse regardless of their politics or level of wealth.

Fifth, is there is more than one optimal design? More specifically, what are the trade-offs as we move along the efficiency frontier that make, by definition, some participants better off and others worse off? We want to distinguish changes that come from altered distributions of income from changes that result from improving efficiency.

Making progress on answering these questions, then, is the primary work of the Consortium on Financial Systems and Poverty. We bring together a diverse group of economists who use a variety of approaches and methods, and we support their research on financial systems and poverty. Our projects reflect the ambition of our questions. To date, we have awarded over $2 million in research grants to our Members, who are leading economists in the field: Juliano Assunção, Abhijit Banerjee, Francisco J. Buera, Roberto Rigobon, Tavneet Suri, Robert M. Townsend, Kenneth Singleton, Christopher Udry, Gabriel de Abreu Madeira, Weerachart Kilenthong, and Christopher Woodruff.

Our seed grant recipients, who have received more than $200,000 in research grants to date, are up-and-coming or emerging scholars in the field. They also are contributing important insights through their projects: Arun Chandrasekhar, Saide Aranzazu Salazar-Altamirano, Sirenia Vazquez Baez, Emily Breza, Enrique Seira, Carlos Serrano, Warren E. Weber,  Joseph Kaboski, Cynthia Kinnan, Horacio Larreguy, Tae Jeong Lee, Emmanuel Maliti and Esteban Puentes.

In addition to research, we facilitate a series of ongoing workshops that are designed to foster productive dialogues and scholarly progress in specific topic areas. Our workshops include, Flow of Funds Accounts, Savings and Underpinnings of Macro Models: The Impact of Policy Change and Innovation, Financial Systems, Industrial Organization, and Economic Development, and The Optimal Design of Payment Systems.

We form teams to understand the financial systems of specific economies in an attempt to bring all of the pieces together. We seek to generate tangible and objective results that have meaningful lessons for policymakers on what works and what does not, under what conditions, and with an array of alternatives.

I invite you to investigate this website further and review our research projects and workshops currently underway. Our projects will yield insights that contribute significantly to progress in designing a framework that identifies the most effective solutions for reducing global poverty.

Robert M. Townsend
MIT
September 2010