Thursday, October 4, 2012

Financial Literacy or Financial Capability?

There has been a lot of debate about the definition of financial literacy and whether policy and research should focus on financial literacy or on financial capability. Many institutions have opted for the latter arguing it is more encompassing and we should focus on behavior. I am going to argue in favor of financial literacy, for three main reasons.

First, nobody knows what financial capability really means. What are the set of behaviors that make a person financially capable? Is it that a person save? Well, there are times in the life cycle when we should borrow rather than save. Is it that a person is always paying credit cards in full? There are times when liquidity constraints are tight and borrowing on credit cards is appropriate. Is it that a person has a bank account? A bank account may be not practical if the bank is 50 miles away (think rural areas) and one cannot maintain a large enough balance to avoid paying a monthly fee. I could go on and on. The point I want to make here is that what is “good” behavior or, as we economists like to call it, “optimal” behavior, depends on a lot of factors, making it very hard to come up with a set of behavioral guidelines that are applicable to everyone. Moreover and most importantly, behavior depends on preferences in addition to economic circumstances, and this makes it very hard to judge what “good” behavior is and to recommend what people “should” do. For example, I should not invest in education if my passion is to tinker with tech devices in my garage, particularly if those devices one day become known as Macintosh computers. When policy tries to dictate behaviors, the risk of becoming paternalistic is very high. And mistakes have resulted from the trumpeting of “good behavior,” for example, the recommendation that everyone should own a house. (We saw what a good idea that was!)

The financial literacy approach recognizes that it is the individual who is in charge of making decisions and is the one we are putting at the center of the attention. It also recognizes that people are different and that one size is very unlikely to fit all, contrary to many recommendations that advocate for what we all “should” do. Empowering people may be a modest step, but even ice cream comes in many flavors (Italian gelato even more and very good too!), so it is not clear why we should have a single-flavor recommendation. We can choose according to our tastes.

Second, knowledge is power. Rather than focusing on behavior (whose optimality is in the eye of the beholder), financial literacy makes us focus on the inputs that shape behavior. One of those inputs is knowledge. We require and want knowledge in almost every field I can think of that requires some judgment, from driving a car to working in a factory to extracting a tooth (try that on my niece Giorgia and you will get a lesson!). The world has changed and we require new skills to be able to succeed in today’s society. I love the definition that the Programme for International Student Assessment (PISA) has used to measure students’ knowledge: “Are students well prepared for future challenges? Can they analyze, reason and communicate effectively? Do they have the capacity to continue learning throughout life? The OECD PISA answers these questions and more, through its surveys of 15-year-olds in the principal industrialized countries. Every three years, it assesses how well students near the end of compulsory education have acquired some of the knowledge and skills essential for full participation in society.” This is not a definition of financial literacy, but it could well be as it articulates what people need today to “participate in society.” Also, note that we are able to articulate what a financially literate person should know. As I have mentioned in a previous post, we have just finished writing a set of national standards, which will be soon be available from the Council for Economic Education.

Third, simply stated, the reason I favor financial literacy is because it is easy to understand, we know what we are talking about, and it is the term that successful organizations have used in describing their programs. One of the most successful countries with regards to financial literacy, i.e., New Zealand, has the “Commission for Financial Literacy and Retirement Income.” The OECD as well, which has been a pioneer in this field, is all about financial literacy and financial education programs.

Let me close by saying that we need to be humble when it comes to guiding individuals via policy and information. We need to respect people’s unique characteristics and their differences, but we must have the audacity to aim high, believe that we can empower people to make good decisions. In my view, this is what financial literacy is all about.