Thursday, February 24, 2011

Saving for a rainy day

This week, February 20-26, 2011, is America Saves Week and I would like to write about the importance of precautionary saving.

One of the most worrisome statistics from the 2009 FINRA Financial Capability Study is that, when asked whether they had said aside sufficient funds to cover expenses for three months in case of sickness, job loss, economic downturn or other emergency, 51% of respondents (in a sample representative of America) said they do not have such precautionary funds. The crisis may have depleted some of these funds, but not having a buffer stock of savings exposes both the individual and the economy not only to a large shock but also to a small shock, such as the car breaking down, the house needing a small repair, or a sudden out of pocket health cost. And with unemployment rates as high as 10%, the lack of precautionary saving makes people not just vulnerable but also hit hard by the loss of their job.

The expansion of the opportunities to borrow may give the idea that, if an emergency arises, one can turn to credit cards or find other ways to borrow. The problem is that, in a moment of need, borrowing at high interest rates is not only problematic, but can turn quickly into higher costs and fees if one were to miss a payment, go over the limit, or use the card as a cash advance. Turning to payday lenders or similar types of loans would only further increase the cost of borrowing. The problem with these methods is that they do not provide insurance at all. One wants an instrument, like saving, that can help in time of needs, not turn to an instrument that becomes pricey when most in need.

Because it deals with emergencies that happen unexpectedly, these funds are better be liquid. One does not want to sell possessions: a car, the home, or other such items when faced with a shock. Even selling stocks may come with a stiff cost if one has to sell when the market is down. As we have experienced in the past few years, having high unemployment when the stock market plunged only accentuates the pain of job loss.

This principle is perhaps so important that even Aesop illustrates it in a fable known as The Ant and the Grasshopper. The fable concerns a grasshopper that has spent the warm months singing while the ant worked to store up food for winter. Sure enough when the winter came, the grasshopper found himself in great difficulty. I would say there are not many cases when economics crosses path with literature, but it is great when it happens. As the story says perhaps better than any equation I would write, it is a good idea to store up a little bit for those winter rainy days.

If you want to look at the statistics about who has saving for a rainy day, here is the link to the state-by-state Financial Capability Study data:

Friday, February 18, 2011

Some questions about financial literacy

A reporter from Germany contacted me recently to discuss financial literacy. Because we were not able to speak on the phone, she sent me her questions and asked that I write back to her. Since these are very general and important question, I thought I would also post them on my blog. Here they are:

1. How much do Americans know about finance? Do you have actual research results that show that there is a lot that needs to be improved?

For several years and in many published papers I have documented the lack of financial literacy among Americans. I would like to describe the most recent results, which I presented to the Financial Crisis Inquiry Commission last year and which are part of a new survey, the Financial Capability Study, by FINRA Investor Education Foundation in collaboration with the U.S. Treasury. According to that survey, less than half of Americans can correctly answer two simple questions about interest rates and inflation, and only 30% of Americans can correctly answer these two questions and a question about risk diversification. As I mentioned when I testified to the Commission (a link to my presentation and the full report on the findings of the Financial Capability Study are below), these levels of financial illiteracy are very worrisome.

Link to report prepared for the Financial Crisis Inquiry Commission:
link to the video presentation:

2. What do you regard as the main causes for a lack of financial literacy in America?

In America, as in other countries, changes in demographics (aging of the population and reduced fertility), increased mobility in labor markets (by the time workers turn 35, they have already held many jobs and they need to have portable pensions), and changes in financial markets have shifted the responsibility of financial well-being from the government and employers onto individuals. However, this has not been accompanied by changes in school curricula or workplace programs to equip people to deal with increased personal financial responsibility. In other words, it is not the case that financial knowledge is getting worse, simply that the world has changed and is still changing rapidly. The financial knowledge people are equipped with is inadequate to deal with the complexities of the current financial system and market structure.

3. What is it that makes financial literacy so important?

What makes financially literacy so important are the many changes we are experiencing in the following areas:
1) The pension system. Pensions have been shifting from defined benefit to defined contribution programs. As a result of this shift, workers are now in charge of deciding how much to save and how to allocate their pension wealth. Moreover, when they retire, they are in charge of decumulation of their pension wealth, and have to make decisions such as whether to annuitize or to take their pension as a lump sum: a very difficult decision with important consequences for financial well-being after retirement.
2) Financial markets. Consumers are confronted with much more complex financial instruments than ever before; consider, for example, adjustable rate mortgages or mutual funds that invest in foreign markets.
3) Opportunities to borrow. Opportunities to borrow have increased dramatically in recent years. One of the features of credit cards and sub-prime mortgages is that decisions about how much to borrow are entirely in the hands of borrowers. One can borrow a very large amount on credit cards simply by using more and more cards. Similarly, with sub-prime mortgages banks were leaving the decision of how much to borrow in the hands of the borrowers. In these situations, it is important that the borrower is financially literate and can understand key concepts such as interest compounding.

4. What are the difficulties when you want to improve the financial literacy of the American citizens?

Improving financial literacy requires a consistent set of programs aimed at different groups of the population. We cannot necessarily bring adults into the classroom, but we can and should provide financial literacy in schools to prepare young people for the new world they are facing. Most adults would fare better with programs at work (this is where workers are and where they often have to make financial decisions). It is difficult to coordinate all of these efforts and engage the various institutions that should be part of a consistent strategy to improve financial literacy, from the Department of Education to the U.S. Treasury to the regulators to the business community. Moreover, education and programs require resources. Education is going to deliver results in the long run, yet very few politicians or institutions have a long-run horizon.

As an aside, when presenting my research and work on financial literacy and financial education, I used to receive objections from people who insisted that financial education is too expensive. I think that the financial crisis has shown us that it is too expensive NOT to do financial education.

5. Do you think that politicians give enough attention and efforts to this issue?

Some politicians do, and they need to be praised for that. I travel a lot and give talks in many countries, and I think that several countries have become aware that they need to address the problem of financial illiteracy, as they will end up paying for it one way or another. For example, lack of financial literacy can mean costlier welfare benefits for some groups, and some countries understand that prevention is cheaper than the massive costs incurred when crises erupt.

6. With great interest I have read your current blog entry about two new videogames called "Bite Club" and "Farm Blitz", which were developed by Doorways to Dreams Fund. How do you promote these videogames in order to make sure that many people play these games and gain knowledge? Do you know anything about the success of the former games Groove Nation and Celebrity Calamity?

These games were targeted to a specific subgroup of the U.S. population. As a result, they will be distributed at places such as Walmart stores. Of course, we can’t force anyone to play, so the game creators have used social marketing techniques to encourage play and have made sure the game is as fun and engaging as other popular online games. We have submitted proposals to formally and rigorously evaluate the effectiveness of these games, and we will know soon how effective they are. So far, we have done a qualitative evaluation via focus groups and in-depth interviews. It is very important to know what works and what does not work in financial education. This why the projects we do at the Financial Literacy Center always have an evaluation component built into them. Please look at the projects we have completed in year one and the new projects we are doing in year two:

Tuesday, February 15, 2011

Annie Sullivan of personal finance

Beth Kobliner wrote in her most recent blog post that I am the Annie Sullivan of personal finance. I have received praise for my work, but this is the best I’ve ever gotten. I must say that the association with Anne Sullivan almost made me cry (yes, you students who took my classes, I do have a heart). It is very humbling and is also giving me energy to do more.

I am deeply honored and gratified by Beth Kobliner’s praise, but I want to point out that she is doing some truly excellent work to benefit young people. While I write a blog—not as often as I would like—and do research work on financial literacy, Beth Kobliner has written a best-selling book geared to helping young adults make good financial decisions and has been very active in youth financial education. In recognition of her important work, President Obama nominated her to the President’s Advisory Council on Financial Capability. The Council has held their first meeting this year, and Beth is already very active in its Youth Education Subcommittee.

Every day we have a chance to make a small difference in improving financial literacy. Someone said, “People seldom see the halting and painful steps by which the most insignificant success is achieved.” That someone was Anne Sullivan.

Here is a link to Beth Kobliner’s blog: