Old and new paradigms in development finance : should directed credit be resurrected?

The reasons for the popularity of directed credit are many -- the ease with which lending projects can be done, flaws in local financial markets that constrain the flow of loans to worthy individuals, the effectiveness of directed credit in transferring subsidies to preferred groups, a general distrust of markets in centrally planned countries, and certain aspects of Keynesian thought in capitalist countries. The DCP dominated development efforts until the 1980s, when the Financial Market Paradigm (FMP) emerged due to the problems arising within DCP projects -- loan defaults, subsidy dependency, insolvent financial institutions, the limited number of clients reached through the DCP, and overall costs. The new approach has made inroads into development activities and resulted in substantial jousting between proponents of these vastly different models. This report summarizes the major elements of the two paradigms, briefly discuss criticisms of the old model and then lists the benefits claimed for the new one. It moves on to discuss and evaluate two recent sets of arguments put forward in defense of DCP, one arising out of evaluations done by the World Bank and the other stemming from academic work by Stiglitz and Weiss. The overall conclusion is that the DCP lost its predominance because of design flaws. Furthermore, the DCP is inconsistent with the economic reforms being implemented in an increasing number of countries. Directed credit is out-of-step with the enhanced reliance on the private sector and especially on the role of prices and markets in these economies. Given this, the authors judge it inappropriate to resurrect the DCP. (Author abstract, modified)