Undercover Economist

Illiteracy rules

I hope you won’t mind me setting a little test of financial literacy. You buy a new £1,000 computer and borrow money to pay for it. You have a choice: either (a) pay 12 monthly instalments of £100; or (b) borrow money at an APR of 20 per cent, meaning you pay back £1,200 at the end of the year. Which offer is better – or are they (c) identical? (The answer is at the end of this column.)

If you don’t get it right, don’t worry: 93 per cent of Americans don’t either, according to Annamaria Lusardi, an economics professor and director of the Financial Literacy Center. (Financial illiteracy is also widespread internationally, she adds.) Far more obvious financial questions baffle the majority of people. And if you think the question is academic – and would like a hint at the answer – just ask yourself why companies are so keen to let you pay in instalments.

The sophistication of financial products has increased dramatically; the sophistication of consumers has not. “Knowledge hasn’t caught up with the real world,” says Lusardi. “The important word is ‘literacy’. You can’t live in society without being able to read and write, and now you can’t live without being able to read and write financially.”

The obvious answer is financial education. But it has been tried and doesn’t seem to work terribly well. According to a survey published by Lewis Mandell of the University of Washington, financial education seems to have no impact on formal measures of financial literacy, although, puzzlingly, it does seem to improve financial decisions a little later in life.

For this reason, financial education sceptics such as law professor Lauren Wills argue that the whole project to boost financial literacy is misconceived and actively harmful. (My analogy: why not improve medical outcomes by teaching people to practise surgery on family members?) Wills would prefer regulators to simplify the financial landscape – presumably with a combination of bans and regulatory “nudges” – and simply abandon the financial education project entirely.

Professor Lusardi disagrees. While the track record of financial education is not encouraging, she says “the evidence that is available now tells us very little” about whether it would work if done right. Classes are often offered by poorly trained teachers, she says, or courses for employees might be a single lunchtime chat about pensions.

“A one-hour seminar is not going to work, for sure,” she says. In short, perhaps the reason that financial education doesn’t seem to work is that nobody has tried it properly.

The Financial Literacy Center is trying more creative approaches. One promising technique is to use video testimony from workplace peers; another tactic, in partnership with a not-for-profit organisation, D2D, is to develop computer games that incorporate some financial concepts. Lusardi says initial results are promising and full randomised trials are in progress.

I sympathise with both sides of this debate. I simply don’t believe that financial education is impossible, or more trouble than it is worth. But without some intelligent regulation to preserve transparency and protect consumers – at the very least, from the most egregious abuses – I fear that the ability of educators to clarify how finance works will be outpaced by the ability of credit-card marketers and subprime mortgage peddlers to muddy the waters again. The financial educators should do better, but the financial regulators may have to meet them halfway.

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The answer is (b). The instalment payments hide a deceptively high interest rate. Because capital is being repaid almost immediately but total interest is still £200, the true interest rate is much higher than 20 per cent. Reader Ian Nicol informs me that Excel uses the formula (RATE(1*12,–100,1000)*12) to calculate interest rate, in this case more than 35 per cent.

Also published at ft.com.