Financial Literacy and the Current Crisis

I was asked in a TV interview whether financial illiteracy has contributed to the current financial crisis. I do not have data yet on the current crisis, but the data I collected last year on debt literacy indicate that many people do not know about the power of interest compounding and tend to underestimate how quickly debt can grow if one borrows at high rates. Most importantly, those who had low debt literacy were more likely to report having difficulties paying off debt. So, my suspicion is that individual debt illiteracy has played a role in the current crisis. Exacerbating individual lack of financial literacy has been the role played by those lending institutions that did not do their part in checking borrowers’ backgrounds or calculating how much debt those borrowers could really afford to take up.

And in this current world of derivates, ARMs, subprimes, and preferred stocks, it is even harder to understand what is going on in both individual accounts and in global markets and what people need to know in order to successfully navigate the financial system. In my view, we need to stick to a few fundamental concepts: the power of interest compounding, the effects of inflation, the principles of risk diversification, the incentives offered by the tax system. Knowledge of these simple principles can go a long way in helping us make sound saving and investment decisions.

People have been crying out that financial education is expensive. Well, bailouts can be even more expensive; I think we understand that now. But I have not heard of plans for any money to be allocated to improving financial literacy as part of the rescue plan. This is a pity because, having seen the consequences of illiteracy not only at the micro level but also at the macro level, we need education now more than ever.

If you would like to watch the TV interview (Financial Literacy and You), it can be accessed at: http://www.tvo.org/TVO/WebObjects/TVO.woa?video?TAWSP_Int_20081021_779352_0

Learning From this Crisis: A Discussion About Risk

As the financial crisis continues to unfold, it is important to reflect on the lessons we can learn from this experience and how those lessons can help us better manage household finances. In this blog, I want to focus on risk and risk management. Not only have prices in the stock and housing markets, in which many households invest, been gyrating, new financial instruments have made household balance sheets even more sensitive to the behavior of financial markets. For example, both the assets and the liabilities of households with adjustable rate mortgages, or ARMs, will be affected by a change in interest rates. Risk management is becoming more important than ever. Yet, according to several of the surveys on financial literacy I have conducted, the concept of risk diversification proves to be a difficult one for respondents, many of whom stated that they did not know how to answer to the survey question that dealt with this concept.

I want to discuss here the dangers posed by lack of diversification among the assets that are most common in household portfolios.

1. The danger of investing everything in a single stock.

One of the painful lessons that is right in front of us is the peril of investing in a single stock. Sure, all indexes are down and losses are large, but those who have invested solely in the stock of ailing banks now run the risk of losing everything. The importance of keeping a well-diversified portfolio should not be underestimated, particularly in the current situation. Clearly, in a crisis that is becoming global, most stock markets have been going down and portfolio diversification does not eliminate losses. However, it limits them and can provide a floor that prevents losses from being as extreme as they might otherwise be. While the experience of Enron stockholders may have been easy to forget, the magnitude of the current crisis should send a strong warning about the danger of putting all of one’s savings into a single stock.

2. The danger of investing everything in the house.

While we may not think of our house as an investment, in fact the house is often the most important asset we have. In some cases, it is the only asset people have. A large home, a nice backyard, plenty of room where our children can play are all features we want and cherish. However, when we buy, or when we plan to put an addition on the house, we have to consider what that will do to our portfolio. If we put everything we have into the house, we become very exposed to fluctuations in home prices. As the current experience shows, home prices can go down, and go down a lot! And we should not take comfort in the fact that we do not plan to sell our house any time soon. In the current labor market, mobility is important. Today’s workers change jobs many times in the course of a career, and one can hardly expect to be in one place throughout his/her lifetime. Moreover, and particularly in less populated areas, houses are not a good “hedge” against labor income risk. If a big firm in a small city goes under, local home prices are likely to drop. But this means that home values will decrease precisely when workers need their housing wealth the most: they may have to sell and move or they may need a home equity line of credit to offset the loss of employment income.

Risk is a part of our life, negative shocks happen, crises happen, and other shocks may lie ahead. More than ever before, we need to learn to deal with risk to insure the well-being of ourselves and our families.

Some Comments on the Current Crisis

I have not been writing for a while, but have been reading about and watching the current economic crisis unfold. This is humbling, and there are many reasons to worry. One of the assumptions behind the sound functioning of markets is that the agents who stand behind demand and supply are well informed and rational. But, as I have argued in many previous blogs, there is reason to question that assumption in the face of widespread financial illiteracy. Of course, my studies of illiteracy focus on consumers, but the current events make me wonder about politicians. Perhaps there is need for a crash course in financial markets and money and banking down in Washington. I do not mean this in a sarcastic way, but rather express it with genuine concern; the lessons we should have learned from the past are seemingly being ignored. My views may be colored by the fact that I was a student of Ben Bernanke at Princeton, but his article on the collapse of the financial sector as a factor in transforming a recession into the Great Depression still resonates (for anyone interested in reading it, the article was published in the American Economic Review back in 1983). It teaches us that the financial sector is vital to the workings of the economy and that shutting it down may send the economy into a tailspin. The role of the financial system in the economy is critical: it channels the funds of savers to the firms and entrepreneurs who need them. Lack of credit prevents not only businesses from investing but also households from consuming and buffering against economic shocks. In other words, a financial system that is not working or that is limping can affect the macro economy and each of us individually. We do not want the economy to go that route.

There is an inherent instability in both the banking system, with its fractional reserve system (only a small fraction of deposits are kept in the banks, so if all depositors wanted to withdraw their deposits, there would not be enough funds to make it possible) and in financial markets, in which large sums of money can be moved very quickly. Several institutions and mechanisms are in place to counteract that instability, one example being the Federal Deposit Insurance Corporation, or FDIC. Some may argue that these institutions do not work very well; for example, what banks pay to be insured by the FDIC often does not reflect their actual risk. In reality, financial markets continually innovate. Moreover, financial instruments have become very complex in terms of risk. Derivates, such as options and futures, make it possible to take up large amounts of risk. Regulation has certainly not kept up with that.

When a financial crisis occurs, it is important to act quickly. Now more than ever we need to have economics and finance rule politics.