Monday, February 28, 2011

Financial Literacy

In which @CJFDillow reacts to @TimHarford's column on financial literacy.


In his article Illiteracy Rules, Tim quotes a survey where only 7% of Americans knew which of two financial offers was more favourable. We might reasonably worry that such ignorance (Tim calls it financial illiteracy) might leave some of the remaining 93% vulnerable to economic exploitation.

Tim discusses two possible remedies - financial education and regulation. He points out that both remedies have had limited success, so he thinks we probably need both.

In his post Financial Illiteracy - What's the Problem? Chris points out that financial education can be counter-productive.

"For one thing, I fear that the cure here - even if there is one - might be worse than the disease. In some cases, a little learning is indeed a dang’rous thing because our confidence sometimes rises faster than our knowledge. Lessons in financial literacy might therefore increase people’s willingness to take on debt, in the belief that they can handle it."

This suggests the need for something we might call second-order intelligence - being smart enough to avoid trying to be too smart.

Tim's survey compared two possible choices for a purchaser - payment by instalments, or taking out a loan and paying the full sum at the end. Financially literate Americans should be aware of two further choices - paying a smaller amount upfront and not getting into debt at all, or deferring the purchase until you've saved the money. At the interest rates quoted in the survey, both of the choices offered in the survey look almost equally bad. (In which case, why waste time calculating which is worse?)

Chris asks what the real problem is. Is it that people are financially illiterate, or financially irrational, or just financially impoverished. If it's about irrationality, then Chris thinks what matters is not so much financial planning as character planning, and he remarks

"The problem is, though, that it's not obvious that capitalism can thrive if people stick to these principles."

If capitalism benefits from weak-willed consumers, as Chris implies, then the survey reinforces the capitalist agenda by implying that there are only two choices (payment by instalments or loan) and ignoring the choices that would be selected by more strongly willed consumers. Tim tells us to ask ourselves why companies are so keen to let us pay in instalments, as if that were evidence that this is the most profitable for them. (This is not necessarily the case, as payment by instalments probably involves greater transaction costs.) But surely the real reason is not because they would make more money from payments by instalments, but because they are keen to pander to our irrationality and give us as many ways as possible to buy things we cannot afford.

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