Financial illiteracy, responsibility and the financial crisis

Over at Stephen Dubner’s website (http://bit.ly/Aimhvn) (and thanks to Tim Harford for pointing this out on Twitter) there’s a piece with two short interviews about responsibility for the financial crisis. The first is from Alan Krueger (who is on the White House Council of Economic Advisors) where he suggests that Americans need to become more financially literature so that they save more. At one point he admits that the middle classes might look to have their incomes improved, but fundamentally, if US citizens were to become more financially literate, they would learn to save more.

The second quote is from Krueger’s predecessor, who makes similar points about saving, but also points to the 2000s as being a period in which the financial rulebook was thrown away, and so financially illiterate people got themselves into mortgages they didn’t understand, which in turn magnified the effect of the crisis.

Now there’s nothing too much factually wrong with these statements. It would be good if people in the US saved more, as they’d have a cushion against unemployment and illness and the expected generally. And it would be good if people hadn’t got themselves into such awful mortgages in the 2000s. The problem is that this grossly over-simplifies ideas about responsibility and financial illiteracy.

First, and in contrast to most economic theories, firms don’t make good profits from operating in competitive markets – they make money by deliberately making their markets less competitive. They launch brands to differentiate their products and massive marketing campaigns to persuade us that very similar goods are, in fact, not substitutes. This allows them to raise their prices and achieve brand loyalty. This is Marketing 101.

In the financial services industry, the situation is even worse. What are intrinsically bland products such as savings accounts and mortgages suffered from massive financial innovation (to give it a charitable name) from the 1980s onwards, reaching a point of sophistication where it was not only those buying the products that did not understand them, but also those selling them (Michael Lewis is good on this in The Big Short, as is Gillian Tett in Fool’s Gold). Now ideally, people would have laughed at the mortgages they were being sold as they were often incomprehensible, and demanded simple, straightforward products, but they were quite often not even offered the vanilla form products because greater profits could be made from selling the more complex versions (or so it seemed). Those who bought products they did not understand have to take some of the blame, but when those who sold them did so in bad faith (as very often appears to have been the case) then their liability is somewhat reduced.

Equally it seems utter madness to blame most Americans for not having any savings. Income inequality has grown massively since the 1980s, with most blue-collar workers seeing their wages stagnate in real terms. Little wonder that the fancy mortgages which promised them new wealth seemed to attractive – what are you meant to do when the world is getting more expensive and your pay is stagnant? Where exactly where these savings meant to come from? Blaming the poor for not saving and grasping what was sold to them as a chance to improve their lot is disingenuous to say the least.

There is one thing that would result from US citizens being more financially literature. They’d be a lot more angry about the lack of financial reform we’ve seen, and a lot less accepting of the ridiculous justifications that have come out of Wall Street for the financial crisis. There would almost certainly be bankers in jail, and a rather different economic plan in place to take the nation forward that regulated financial services more tightly for the future. Equally, some difficult questions about the riches made by financiers in the last thirty years would require answering when the majority of Americans have seen their incomes stagnate. Greater financial literacy would be a good thing – but not for the reasons Dubner seems to be suggesting.

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