Career: Assistant Professor of Finance | Universidad Alberto Hurtado | Santiago, Chile
Is Financial Education the Best Way to Understand Complex Financial Instruments?
In recent years, the U.S. government has tried several times to address Americans’ poor financial literacy. The latest effort is the Consumer Financial Protection Bureau (CFPB), which started its operation on July 21, 2011, as part of the Dodd-Frank Wall Street Reform and Consumer Financial Protection Act. The objective of the CFPB is to address Americans’ financial illiteracy by “ensuring that consumers obtain the necessary information to make the financial decisions they believe are best for themselves and their families.”
The lack of financial literacy becomes a policy problem when individuals make major mistakes. In general, this occurs when they (1) do not understand their financial needs and, because of the complexity of financial instruments, (2) are unable to determine the right combination of financial products and services needed to attain their goals in a cost-effective manner. Consider, for example, the large number of Americans who took out mortgages they could not afford and the subsequent defaults and foreclosures. Moreover, several studies show that less financially literate Americans tend to incur higher payment and borrowing costs than necessary, accumulate less wealth and engage in less financial planning than others. In this context, the CFPB promotes financial education as a policy tool to help Americans undertake optimal financial decisions.
It makes sense to think that financial education could provide Americans with tools to assess their financial needs, but in fact this may not be the best way to address the complexity of financial markets.
The key may be in recognizing that people are financially illiterate to the extent that financial products are complex. If purchasing financial products were as simple as purchasing a toaster, their complexity wouldn’t be a policy concern. An alternative, then, is to simplify and standardize financial instruments themselves. In order to do this, we could create financial contracts that are easier to understand and allow the comparison of costs and benefits in more straightforward ways. Hopefully, this could result in financial products and services that can be described in just one or two summary indicators, thereby significantly reducing the education required to empower Americans to undertake wise financial decisions.
The design and implementation of such financial instruments may be more cost-effective than financial education. Consider the fact that the last National Assessment of Adult Literacy, which measures the English literacy of Americans above 16 years of age, showed that only 55 percent of adults have a basic level of numeracy. This means that they are only able to use easily identifiable quantitative information to solve simple, one-step problems. An example is comparing the price of two tickets. For such people, reducing financial instruments down to a few summary indicators would seem to be crucial for their optimal financial decisions. In contrast, providing them with financial education required to equip them with the skills for choosing among existing financial instruments is a much more ambitious undertaking.
While a combination of financial education and simplified forms might prove most cost-effective in the long term, simplification and standardization of financial instruments would appear to be the tool of choice for the CFPB in the short term. In reality, existing studies of the effects of financial education are scarce and inconclusive, so it would be years before the CFPB could hope to know what type of financial training works and for whom. And in fact, we don’t know the basic competencies Americans should have in order to define their financial needs and make effective use of financial markets. Only when we know this will we know the contents that should be taught in financial training programs, and this process obviously will take several years. One possible downside in simplifying and standardizing financial instruments is a reduction in the variety of contracts Americans can choose from and thus their ability to satisfy their specific financial needs. However, in a context of widespread financial illiteracy it is not clear that Americans are getting much benefit from having flexibility in the supply of financial products and services. It simply may make more sense to intervene by simplifying the most commonly used financial instruments such as mortgages, and credit and debit cards. The bottom line is that simplifying and standardizing financial instruments may be preferable over financial education, at least in the short run, and this should not be disregarded without thorough consideration.