Impact Investors Should Learn These Concepts from Economics

Photo by William Iven on Unsplash

In my relatively long career in impact investing¹, I have attended and spoken at numerous impact investing, social entrepreneurship, philanthropic, or impact start-up conferences and events in South and Southeast Asia, primarily in Indonesia. I had a recent realization that in these conferences and events, although I have met people with diverse background — including entrepreneurs, family office administrators, and officials from international organizations — I have yet to meet a single development economist. I found this rather odd. There should be numerous overlaps between the world of impact investing and the world of development economists. After all, both professions are working with the same objective of improving the livelihood of the poor, albeit in different ways². There must be some benefits of these two worlds to collaborate and provide value to each other.

Until the first decade of 2000s, development economists were the primary movers of activities related to poverty eradication, education, health and sanitation, and economic development in general. Big thinkers like Jeffrey Sachs, William Easterly, Daren Acemoglu, and lately Esther Duflo and Abhijit Banerjee were influential enough to convince policy makers and corporates to contribute towards their projects. The most famous of them, Jeffrey Sachs, together with U2 frontman Bono, started the well-intentioned (but eventually ended with mixed results), Millennium Villages Project (MVP) in 2006 with more than USD 300 million of budget for five years³. Academic debates between the ambitious Sachs and the cautious Easterly was fascinating back in the day. The beginning of the end of this era was the landmark publication of the book “Poor Economics” by Duflo and Banerjee in 2010, earning them the Nobel Prize in Economics in 2019. Duflo and Banerjee practically declared that there is “no sweeping conclusion” in development⁴ and put forward a methodology that they called randomized controlled trial (RCT) that carefully test “small theories” with large-scale experiments⁵.

Post 2010, impact investing gradually took over the center stage. Even Bono himself had moved on from MVP and now advocating impact investing through his public role in the formation of TPG Rise, one of the first impact funds raised by mainstream large PE firms. UNDP (United Nations Development Program) is a supporter of impact investing, not to mention private arms of organizations like ADB and the World Bank. Today everyone under the sun, whether with the genuine intention or just motivated with impact washing, are raising impact funds. Almost nobody talks about development aids anymore, and almost nobody in impact investing are talking about development economics.

With the right approach, development economics have immense value that impact investors are missing out. There are at least four aspects that we can learn from development economics:

1) The Rigorous Impact Measurement Methodology. Since RCT is typically conducted in large-scale projects, it might not be suitable for small impact startups. However, for the more mature impact enterprises, RCT could be one of the preferred impact measurement methodologies to really show what works and what does not work with the enterprise’s business model.

2) Political Economy Analysis. Impact startups might be too small to influence the policies, but they should be aware of how they could be impacted by forces beyond their control. As an example, an impact investor told me that he had learned to think twice in making investments in certain commodity processing sector since the export and import licenses for this commodity are held by certain powerful families.

3) Economics of Natural Resources. Impact investors often have to deal with startups that tackle issues related to finite or depleting resources like fisheries, forestry, or fresh water. Finance alone would not be able to understand the connections and interdependence between human economies and natural ecosystems, an area being explored by economists studying the topic of resources.

4) Building Community Institutions. Most of the time impact enterprises need to forge alliances with other players — for-profits and non-profits — to develop a healthy ecosystem for the enterprise to thrive. In rural areas, in most cases there are no formal or even informal institutions to begin with. For example, there are often no clear land ownership rules or limited means of dispute resolutions. Development economics should be able help with designing institutions⁶ that are suitable for the purpose. There is an interesting book with the title “Who Gets What — and Why” by the economist Alvin Roth, that describes how transactions work in “hidden markets” in modern everyday life, in which the concepts can be applied to designing market institutions in rural areas as well.

5) Behavioral Economics. “Nudge”, a book on behavioral economics by economist Richard Thaler and legal scholar Cass Sunstein, describes how positive reinforcement and indirect suggestions as ways to influence the behavior and decision making of groups or individuals. This kind of research should be applicable to the impact enterprises, often operating in rural areas where market education is difficult and expensive.

Impact investing, although currently dominated by finance professionals, is essentially a multi-discipline sector that immensely benefits from the broader picture often provided by other disciplines like economics. Economists could also venture beyond their ivory tower of talking and writing as if their only audiences are other economists and intergovernmental organizations, and also learn to advise small private players with targeted insights and perspectives rather than just peddling grand sweeping theories. Poverty problem is too complex to be resolved by one discipline alone, even by the high-flying finance professionals. Or should I say especially by the high-flying finance professionals.

[1] Six years — not long by standards of most other professions, but impact investing itself was coined in 2008, so I’ve been around for half of the lifetime of the sector

[2] impact investing is through entrepreneurship, and development economists through macro and micro economics researches

[3] The project did not operate with a single source of budget as many international organizations and companies contribute one way or the other. However, the project claimed to cover 500,000 people with USD 120/person per year allocation.

[4] In their own word in Poor Economics: “we are largely incapable of predicting where growth will happen, and we don’t understand very well why things suddenly fire up”. “We” refer to experts in general, not only the authors

[5] Examples: does giving away bed nets for free decrease malarial infection? Do teenagers in Kenya respond to HIV risk information?

[6] “Institutions” is broader than just “organizations”, but also includes rules and mechanisms as well as roles, capabilities and processes

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