It seems we are idiots. President Obama recently sought to draw attention to Americans' deep ignorance of money matters in declaring April "financial literacy month." In a similar spirit, the NAACP has joined Wells Fargo (WFC), which it had sued for pushing subprime loans on minorities, in opening a center to educate consumers on everything from money management to home ownership. Alan Greenspan (of all people) practically used to tear up about the importance of teaching children basic financial skills. And experts of every kind, along with the media, exhort people to book up on loans, credit cards, investing, insurance, saving for college and retirement planning.
None of which ever seems to do any good.
In short, the idea of financial literacy is largely nonsense. The incessant calls for consumers to wise up, which date back to the 1930s, range from the obvious -- yes, paying bills on time is important -- to the patently cynical, as banks try to paper over their history of predatory lending and weaken the case for greater consumer financial regulation.
Speaking of the obvious, I'll state it now: People should do their best to learn how financial products work and use them wisely. Same goes for kitchen appliances. To that end, financial literacy programs may help (so will paying attention in school). But figuring out what kind of loan to get is harder than learning how to set a blender on "mulch." It is a major leap to assume that sending folks to Banking 101 class will produce a nation of enlightened, empowered consumers capable of consistently making smart financial decisions and protecting themselves against abuse.
That assumption could even make things worse by giving people the confidence -- but not the skills -- to make complex financial decisions. Knowing what a pay-option adjustable rate mortgage is one thing. Being able to compare an ARM to a fixed-rate mortgage is quite another. That requires an understanding of everything from negative amortization, rate caps and discounts to the financial outcome of different payment options. And in a nation where a credit's card APR remains mysterious to most people, good luck with that.
Why little Johnny can't understand loans
There's little question that Americans are ignorant about finance. By the same token, there is also little evidence that the typical financial literacy program actually works. Here's why, according to research by Loyola law school professor Lauren Willis:
- Financial education doesn't necessarily promote competence. Surveys consistently show that financial education among high school students doesn't increase financial knowledge, with students who take a personal-finance course actually tending to do worse than those who don't. Credit, bankruptcy and other forms of financial counseling are also notoriously ineffective.
- In making a financial decision, broad rules of thumb are inadequate. Financial literacy isn't chiefly about encouraging people to read the fine print -- it's about enabling them to understand the fine print and make informed choices. But the complexity of financial products these days makes that very difficult, especially given how quickly markets change.
- Basic financial literacy isn't enough. People often misuse financial products not only because they lack knowledge, but also because certain cognitive biases obstruct clear thinking (housing prices always rise, I can trust my mortgage lender) and emotions come into play (if I don't borrow more money, I'm going to lose my house).
- Sellers have more information than buyers. No matter how savvy the consumer, financial firms always have the edge in resources and expertise in designing products that may be risky or predatory. Even regulators, let alone the average borrower, struggle to decipher new products and keep up with market changes.
- Major financial decisions are unique. Unlike buying a jar of peanut better, personal-finance decisions often involve sums of money beyond most people's everyday experience. That can make it difficult to fully grasp the consequences of these decisions.
- Consumers often overestimate their smarts. That makes them unlikely to ask for help, prone to making financial decisions without doing their homework, poor at forecasting their future financial needs and inclined to misjudge risk.
- People have other things to do. It's unrealistic to think that consumers will devote the enormous amount of time required to understand the intricacies of borrowing and financial planning.
The upshot? Willis writes:
The knowledge, comprehension, and skills necessary to make independent, welfare-enhancing decisions in today's personal-finance product marketplace are prodigious. Decisions about credit, insurance, and investments require knowledge of concepts and terminology; extraction of information from text; understanding of arithmetic calculations; comprehension of fractions, percentages, and probabilities; predictions about one's own future income, expenses, and health; and predictions about market factors such as interest rates, investment-fund performance, and inflation.
Financial-literacy education cannot bridge the gulf between the knowledge, comprehension, and skills of most American adults and those needed in today's market.Here's a final, and telling, reason to question the value of financial literacy initiatives: The financial industry supports them.
Banks, securities firms, insurance companies and even pay-day lenders routinely champion financial education. And yet many of these companies' business models count explicitly on consumers having a poor understanding of their products. For instance, credit and debit card issuers get most of their revenue from applying late-payment, overdraft and other finance penalties.
A smarter shopper, in other words, is a less profitable one. So why would, say, Wells agree to fund a center that exists to make its customers less profitable? Because bankers know that financial education doesn't really work.
At the risk of repeating myself, let me say again that everyone has a personal responsibility to borrow, spend and invest with care. But the focus on improving consumer education is, at best, a red herring. At worst, it's a publicity ploy aimed at deflecting attention from far more serious problems with the financial system.
Encouraging intelligent use of financial services today isn't a matter of equipping people with study guides, pamphlets and interactive games. It requires something considerably more challenging: Stopping financial firms from deliberately peddling confusing financial products that would make anyone's head spin.
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