The Financially Illiterate Public: Causes, Effects and Implications

‘Generation X is not saving enough’, ‘baby boomers are out of retirement savings’, ‘the student debt is at an all-time high and is continuing to increase’, and many similar headlines appear in the news every day. Have you ever wondered why the general public tends to continuously face financial problems? Or why financial problems persist despite the advances in the average quality of education? In this week’s post, we will explore some of the reasons for why such problems occur and provide potential ways to tackle them.

It turns out that economics is infamously hard to comprehend, and the human mind is not particularly equipped to think about the prevailing cause and effect relationships in the macroeconomy. Even then, the understanding of it does not translate into rational decisions. Furthermore, despite the apparent difficulty of understanding economics and utilizing the concepts in one’s decisions, the information provided to the public conveys that people are expected to understand it. There can hardly be an engineer found explaining to the public the precise technicalities that caused a building to collapse on the news, and yet, the newscasts continuously discuss economic matters such as daily stock returns and economic consequences of the US-China trade war, expecting people to understand and make significant life decisions based on the provided information.

Making sense of the unknown

Confronted with the implicit expectation to understand the intricacies of economics and take corresponding actions, individuals attempt to cohere information. In particular, they superimpose economic concepts into acquainted structures and utilise simple heuristics to understand unknown information. In doing so, distorted information – characterized by misconceptions and oversimplifications – is derived.

As Dan Ariely remarked, in this case, the mechanism used by the public to understand incongruous information follows a pattern, which, is predictably irrational. On the one hand, to provide a ground for their judgment, individuals consider changes in economic variables to be either good or bad. Subsequently, if one economic variable is perceived as bad, such as unemployment, people expect it to have a causal relationship with the other ‘bad’ variables. This thinking, good-begets-good heuristic, leads to drastic conclusions. For instance, since people dread unemployment and believe it is the result of inflation, undue support is given to erroneous political campaigns. On the other hand, individuals utilise metaphors – such as perceiving inflation as a ‘monster eating up the purchasing power of money’ – to assimilate unknown information.

Effects of having the wrong judgments

When one makes the wrong judgment, it is highly probable that an erroneous action will ensue. In the case of the general public, the piecemeal understanding of economic events translates into drastic financial decisions. It is of no coincidence that after the shift from Defined Benefits to Defined Contribution Plans, which gave the financial management authority to the individual, the number of Americans who are predicted to not have enough retirement savings increased from 49% to 64%. Reasonably, this will lead to increased borrowing in the future as individuals will want to preserve their standard of living, and create a debt-spiral, which, has already started to take place.

How to alleviate the problem: policy implications

Individuals give high importance to having freedom in their choices, and yet, when given the autonomy in the financial domain, they tend to make the wrong decisions. One solution proposed by academics to alleviate this problem is to increase the public’s financial literacy through educational programmes. Although education certainly needs to be promoted, the results of comprehensive academic research challenges the effectiveness of an educational approach in improving financial capacity. This is instantiated by the behaviour of Nobel Laureate Harry Markowitz, who has devised the modern portfolio theory of investing. When asked about his investment decision, he said that he doesn’t engage in high level stochastic mathematical calculations, but simply purchases certain stocks. In addition, as Thaler and Sunstein indicated, even the economics professors in the University of Chicago are not saving enough for their retirement. Hence, it can be deduced that financial education does not necessarily translate into correct financial decisions; statistical reports suggest that the translation is as low as 0.1%.

Therefore, another approach that – instead of going against – understands human nature should be taken. This will necessitate reverting back the way people make sense of the unknown. Even though the utilisation of metaphors can increase the level of understanding, this needs to be combined with the action stage. Accordingly, evidence from behavioural economics suggests that the best approach is to ‘nudge’ people, using different techniques such as default options, towards the right decision. In the upcoming blog post we will shed light on the nudge theory of behavioural economics.