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