How Much Did Americans' Financial Illiteracy Contribute to the Great Recession?

We’re working on a new Freakonomics Radio podcast about financial illiteracy, a topic we’ve visited a few times on this blog. Two guests you’ll hear from in the episode have held the same title: chairman of the White House Council of Economic Advisors.

First up is current chairman Alan Krueger, whom I asked what would improve if Americans were more financially literate:

KRUEGER: I think first and foremost, we’d probably have greater savings. People are often in a situation where they have to live paycheck to paycheck. That’s something I think we need as a country to work to improve. Most importantly I think we can improve income growth for the broad middle class. But many people who seem to have the wherewithal to save for the future find it difficult to save. So for example, they don’t take advantage of some of the tax benefits of some of the savings plans, which is really unfortunate because they’re leaving money on the table. And when it comes time to retirement, or when it comes time to needing those savings, they have a very thin cushion. So I think the biggest difference would be if we can improve financial literacy and if as a result people act based on their own personal interest to a greater extent, I think we would see higher savings, which would in the long run translate to greater investment and probably higher income growth for the country.

You’ll also hear from Krueger’s predecessor in the job, Austan Goolsbee, who’s now back at the University of Chicago. I asked Goolsbee how big a problem financial illiteracy really is. I was surprised to hear him list it as a major contributing factor to the Great Recession:

GOOLSBEE: I think it’s pretty important at most times, but as we saw in this last financial crisis it can become unbelievably important. So just for your own sake, you know, your own retirement, or your own making sure that you can send your kid to college and this sort of thing, you’ve got to at least know the basics of how to save money — if you’re going to invest the money, where are you putting it, that you’re not taking crazy risks that you don’t understand, and things like that. But then, you know, we saw through the 2000s as we in some ways ripped up the rules of the road and took away some of the restrictions that financial institutions had in offering financial products to consumers, there were a lot of people with limited financial literacy who got into extremely complicated mortgages. And those mortgages blew up, and that the magnification of those explosions essentially caused the financial crisis and the worst recession of most any of our lifetimes.

Keep an ear out for the entire episode, in a week or so.


rationalrevolution

"How Much Did Americans’ Financial Illiteracy Contribute to the Great Recession?"

Not as much as Wall Street's either economy illiteracy or outright deception and theft.

The American public is not as economically literate as they should be by design, by the design of the top 1%. American economic "education" and information provided via corporate media is nothing but propaganda.

Mike B

People's attitude toward savings mirrors their attitude toward wasting money. You won't believe how much stuff people buy that they don't need, or worse, how much a premium they pay for convenience. Some of it is big stuff, but others are like plunking down $2 a pop for bottled water or $3-5 for fancy coffee. Over the course of a year these little things costs the average person thousands of dollars. Pay television and rip off wireless plans are another source of money bleed.

rationalrevolution

The fact is that people tend to do things that they are repeatedly encouraged to do. What people are repeatedly encouraged to do in our society is spend all the money they have, plus borrow more to spend what they don't have. Not only this, but our economy relies on people over borrowing to drive demand, because workers are summarily under paid, thus the wages of workers cannot possibly support the production of the economy, unless workers over borrow.

Workers are encouraged to over borrow because this drives the profits of the capitalists. Profits are driven by under paying workers and getting them to borrow money to over pay for the commodities that they produce, thus widening the gap between the cost of production and the revenue from sales.

All borrowing essentially accrues to profits of capitalists, hence, in our capitalist society, everyone is encouraged to over borrow.

The American public is simply doing exactly what the economic system has been designed to encourage them to do.

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So who actually has an incentive to encourage people to save?

I'm thinking about the most basic level of saving here, like having a little emergency cushion. I've read that the typical American family has "unexpected" expenses that amount to $2,000 a year (a car breaks down, one of the kids broke his eyeglasses, you have to travel to a funeral, that kind of thing). So it follows that every family ought to have a readily accessible cushion of about that amount, which means setting aside about $180 a month.

This is not really a small amount of money for a household making $50K a year, but the choice is pretty much save it in advance or go into debt and pay even more in the end. The credit card company is happy to encourage you to go into debt. Who has the incentive to encourage you to save it in advance?

(For retirement savings, I suppose that the employer's payroll department could issue "public service announcements" with every paycheck, and the retirement plan might have a financial incentive to encourage savings.)

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Shane L

My guess is that few authorities want to risk unpopularity by criticising the public and blaming them for ruining themselves. Here in Ireland I do think a great number of people made mistakes, sinking deeply into debt to buy grossly over-priced houses, talking about getting on the "property ladder" even while newspapers ran stories about how you could buy castles and villas in France for the same price as a pathetic two-bedroom house in Dublin. Since the crisis hit there has been fierce scape-goating of bankers, politicians and developers, and less introspection.

But more than financial know-how, I wonder if just conformity is the problem. People saw others rushing to buy property and simply assumed that this was the right thing to do. It might be hard to create education that cancels out our impulse to conform and to take our behavioural cues from our neighbours.

Pshrnk

Greed is not good.

Joe J

Hmm a course in financial literacy sounds good, can we get politicians to take it and follow it?
Some topics I can see:
If it sounds too good to be true it is.
Just because you want it to be, doesn't make it an investment.
Spending more than you take in for more than a temporary time is bad.
Budgets should balance.

cackalacka

Financial illiteracy is a feature, not a bug, of modern economics.

Google 'George Carlin big club' for a more entertaining explanation of this phenomenon.

moolmaven

Nice points but financial education efforts go up against the Finance Industry's $9 billion marketing budget (http://goo.gl/VH9Wb) and $135 million in lobbying (http://goo.gl/zoqg8) .... Good Luck getting the proper message through :( http://twitter.com/M_Maven

rationalrevolution

Exactly. American financial illiteracy is a product of design by the financial industry itself.

moolmaven

OWS blew it. The overbearing clout of the financial industry should have been their focal point.. it could be remedied with populist political will. I'm no fan of populism but there is a time and place for it in measure.

Mike M

The issue isn't "financial illiteracy" as much as "financial recklessness". Negative-amortization mortgages (among others) were simply ways to enable people to do what they wanted - live beyond their means. You can put anti-lock brakes and air bags in a car but if somebody wants to weave through traffic at 90 mph all the "consumer product safety commissions", financial or otherwise, won't change the result.

Hey - the Basel accords on Capital Adequacy and "mark to market accounting" have certainly worked like magic, haven't they?

Accept it - some people want to live financially fast and die financially young. Design your policies and your regulations around that truth.

Travis

There always seems to be some effort to blame things on the consumers. And while the consumers may deserve some blame, it seems ridiculous to blame them for the big problems.

Taking the recent meltdown as an example, which Goolsbee thinks was significantly contributed to by a lack of economic literacy. There, the situation was three factors, illustrated in his quote: (1) The regulations limiting what banks could do were jettisoned. (2) the banks offered extremely complicated mortgages (to parties they knew or should have known couldn't pay in the long run, a part he missed). (3) And people didn't know better than to buy into the mortgages despite their inability to support them.

So you have two very complex things going on: The lending rules broke down. This isn't a factor the average person could be expected to know. It's hard enough for the SEC or the banks to keep track of those statutory frameworks, let alone the average consumer. Then you have the banks, making extremely risky mortgages and then repackaging those as complex derivatives. Could the average consumer be expected to cut through these purposefully obfuscated products? After all, many consumers were essentially swindled, told what are essentially lies, and they were led to believe they COULD own a house on their salary which was far too low in reality to pay the mortgage and the taxes. When people get tricked by cons, it's usually a "you should have known" situation in many peoples eyes, but in reality the innocent "sucker" isn't the one in the wrong, the person running the con is.

It all makes this highly suspect. After all, the risk taking by the people who were making these bad investments either in mortgages or derivatives was there, but the risk was beneath two layers: The financial institutions assurances and the guise of federal laws to protect consumers.

In reality, much greater risks were being taken by financial institutions, and I'm hesitant to believe that any degree of increase in the general population would have averted the recent "financial crisis." Unless we're talking about on the part of the financial institutions. Perhaps redefining their responsibilities to investors, by changing the focus to short term to long term, would have helped avert the financial crisis.

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rationalrevolution

Right. The thing is that EVERYONE was telling borrowers, "BUY NOW< GET IN WHILE YOU CAN, THE PRICES ARE GOING TO GO UP INFINITELY!"

This is what people were hearing on talk radio, on CNN, from The Wall Street Journal, certianly from FOX News, etc., etc. and then they went in to look into buying a house and they had people telling them, "Look, just buy a house now while you still can. The prices are going to go up, this is a good long term investment, because housing prices never go down. The worst case scenario is if you can't afford it you can just sell it later and make a profit, its a no lose situation!"

And yeah, a lot of people went for it, but before you start blaming the average folks for "being suckered", you first need to look at the folks doing the suckering. You can't lay the blame on "average folks" when we have the TOP HEADS OF THE BIGGEST BANKS IN THE WORLD testifying before Congress saying, "Oh, we had no idea."

The biggest authorities IN THE WORLD, were telling people to get into this market, and as for them, there has been a combination of outright lying about the fact that they had no idea, plus the fact that many of them truly did themselves underestimate the risk and the outcomes. Now if the tops heads of the biggest banks the world, who were being paid hundreds of millions of dollars a year precisely to understand it, failed to fully comprehend what was going on in 2003-2008, then I think claiming that the problems are a product of janitors, bus drivers, clerks, construction workers, and cashiers not having enough financial literary is a bit of a farce.

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JOHN B

As other writers are saying, people are constantly pushed to spend everything they have (and more).

The President has been on TV encouraging people to buy new cars to help GM. These same people are losing their homes, but he wants them to spend $ on a fancy new car.

And the financial reporters claim it is good news when there are more new houses being built. When there are millions of foreclosed homes already available.

So don't blame the people for financial illiteracy.

hanmeng

Yes, there's a lot of financial illiteracy among the public, but it has been exacerbated by government policies like the home mortgage interest deduction and government guarantees of low interest, low downpayment house purchases as well as taxes on investments that encourage spending and discourage investment.

Russell W

The flip side of this is that I am financially literate (B.S. in economics) and I don't participate in many savings plans available to me because of the torrent of stories of government and corporate pensions being put through ringers because of malfeseance. Don't think I trust social security either—it's just I can't get out of the system! Maybe we could create a licensing test that financially literate people could pass so that they could opt-out of social insurance plans and do their own more productive investment. Unfortunately, being literate in public economics, I also recognize that most social insurance can't work efficiently without everyone's participation, but I am getting sick of the excuses for these systems being plundered and/or lost. And on second thought, even if I opted out of social security, etc. the government still gets funding for it through me from taxes on investments, so...

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David Leppik

In other news, the epidemic of computer viruses is caused by computer illiteracy. And religious misunderstanding is caused by Greek, Hebrew, and Aramaic illiteracy.

Look, the world is a complicated place. You need to understand calculus to understand derivatives. You need to understand quantum field effects to know what your computer's hard disk is doing. You need to understand genetics and chemistry to know what your food is made of. And don't get me started on medicine and taxes.

You can't expect consumers to understand the products they buy, especially when the products are constantly changing in imperceptible ways. When did they start adding BHA to baby bottles? What have they replaced it with?

The only possible way for consumers to make smart decisions is if there is someone who is responsible to keep things from going terribly wrong. In the case of mortgages, that was the role of the banker. For as long as there have been mortgages, if the homeowner stopped paying, the banker lost money. So the homeowner could trust the banker to not try to sell them a mortgage they couldn't afford, which left the homeowner to push for the most favorable interest rate and payment schedule.

When bankers turned from lenders into loan resellers, that relationship changed as imperceptibly as when baby bottle makers started adding BHA to their plastic. Nobody told homeowners that they couldn't trust their bankers anymore, not the bankers, not regulators, not real estate brokers.

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