Financial literacy

While no universally-accepted definition of financial literacy exists, one that is broad and often cited comes from the United States President's Advisory Council on Financial Literacy (2008, p. 4): "the ability to use knowledge and skills to manage financial resources effectively for a lifetime of financial wellbeing." Economists (and other researchers), however, are particularly concerned about two issues regarding financial lit- eracy: (i) how best to improve financial literacy; and (ii) how much of an impact (if any) higher financial literacy rates will have on actual financial behaviour.

One of the most comprehensive studies of Americans' financial knowledge, skills and behaviour comes from the FINRA Investor Education Foundation (2009). They sur- veyed over 28,000 people across the United States in October 2009. The survey included a basic financial literacy test that resulted in a failing average grade (less than 60 per cent). Also, they found that only 35 per cent of households had enough savings to cover three months of expenses (rainy-day funds). 73 per cent of households had at least one credit card, but only 41 per cent of them reported that in the last 12 months they always paid their debts in full. Despite these findings, over two-thirds of people surveyed ranked themselves as highly knowledgeable about personal finance overall.

Financial illiteracy is a worldwide problem. Recent cross-national studies (see Atkinson and Messy, 2012; Xu and Zia, 2012) show that people in many countries (including the United States) have difficulty answering basic personal finance questions. These studies also found significant similarities between countries as to the most financially illiterate groups. For example, women had comparatively lower financial literacy scores in almost all countries. Further, financial literacy follows an inverted-U shape where younger people and older people have the lowest levels of financial literacy (Xu and Zia, 2012).

The need for improved financial literacy has grown over the past 30 years as the com- plexity and availability of consumer financial products has expanded (student loans, credit cards, complex mortgages). Also, people are increasingly responsible for their financial planning. For example, in the United States (and other countries) a shift from defined benefit plans (for instance, pensions) to defined contribution plans (for instance, 401(k) plans) has placed a greater burden of retirement planning onto individuals - many of whom, as shown in the FINRA survey quoted above, have trouble managing their basic personal finances. Thus, many 401(k) plans have lower returns and lack long-run risk pooling (Ollerman and Boivie, 2011; Olen, 2012).

Among younger people, the Jump$tart Coalition for Personal Financial Literacy devel- oped a comprehensive personal finance test that they administered to high-school seniors biennially from 1997 to 2008 (a total sample of over 16,000 students). Students taking the test in 1997 scored an average of 57.3 per cent (the highest score of all six years) com- pared to 48.3 per cent in 2008 (the lowest score in all six years). The number of students passing the exam (scoring at least 60 per cent) fell from 47.2 per cent in 1997 to 31 per cent in 2008. Perhaps the most disturbing result from Jump$tart's surveys is that after controlling for factors such as teacher quality and student interest/ability, students who took at least a one-semester course in personal finance performed worse than all other students (Mandell, 2008).

Therefore, it is unlikely that financial literacy alone will keep many people from making adverse financial decisions. Some researchers (see Garon, 2012; Olen, 2012) argue that the reasons people have difficulty managing their finances has less to do with inadequate knowledge and skills and more to do with the domestic economy. Stagnant median wages, rising income inequality, rising costs of health care and education, among other factors, are squeezing the balance sheets of households. As a result, many people accu- mulate debt - less out of ignorance than a necessity to maintain a standard of living. Financially savvy people are not immune to unemployment, health problems, and rising college costs. Also, significant financial literacy (and legal knowledge) is needed to under- stand complex credit card contracts, fraudulent mortgage loans and other predatory lending practices.

In addition to these macroeconomic effects, many behavioural economists (and psy- chologists) argue that personal finance decisions are as much (or more) influenced by emotion as logic. Much of this emotion is culturally driven. As Veblen (1899 [1994],

p. 109) wrote, "[p]ropensity for emulation [. . .] is a pervading trait of human nature". Financial education, therefore, should not only teach basic finance concepts, but also explore the behavioural aspects of spending, saving and investing. An innovative attempt at influencing behaviour while teaching finance skills is through videogames (Tufano et al., 2010). If the argument is valid that violent videogames can beget violence, then it is possible that games promoting financial responsibility can result in greater financial responsibility in the real world. Game on.

See also:

Financial crisis; Financial innovation; Housing bubble.