Financial education is on the agenda again. You probably know the sales pitch: customers who know about financial concepts, products and transactions will find it easier to build the skills needed to function well in the financial marketplace. Financial education – ideally starting at an early age and continuing into working life – will lead to financial literacy, which in turn leads to good financial behaviour and improved wellbeing for individuals and households.
In other words, being financially literate makes you better off. But is that too simple, and is education alone enough to protect citizens in today’s financial marketplace?
The lack of financial literacy
Recent crises have revealed that the financial sector is very complex and that one needs a particular set of skills to navigate it. Several surveys conducted after the crisis showed that the level of financial literacy among citizens is generally very low, even among those most directly affected by the financial crisis. This ignorance about finance is unsurprising given the complexity of modern financial markets and products. The financial crisis has, however, provided an excellent motivation for citizens to become more involved in financial regulation: with more understanding about how the system works, they can exert influence and help to change it.
Financial illiteracy is a serious problem in even the most developed countries.
In the United States, a 2015 study by financial regulator FINRA concluded that American citizens typically had “difficulty applying financial decision-making skills to real life situations”, and nearly two-thirds could not pass a basic financial literacy test. The study looked at making ends meet, planning ahead, managing financial products, financial knowledge and decision-making.
The results are striking because US citizens are more accustomed than most to taking care of their personal finances and are generally more eager to play on the stock market.
An international survey of financial literacy published this month (OECD/INFE International Survey of Adult Financial Literacy Competencies, 12 October 2016) found that overall levels of financial literacy across 30 countries were “relatively low”, with particular weaknesses around people’s ability to understand concepts such as compound interest and the benefits of diversification. The average score across all participating countries and economies was just 13.2 (out of a possible 21), and 13.7 across OECD countries.
Education as a solution
So far in Europe, policymakers have taken an interventionist approach, applying strict rules on consumer protection and conduct. But they have not stopped financial institutions from luring unsophisticated customers into investing in very complex products. Would tackling financial illiteracy have helped to plug this gap?
For example, would a financially educated consumer be able to see and understand the difference between a structured deposit and a structured investment, even if their financial advisor told them that the returns from both were “guaranteed”? The question therefore seems to be:
Would educating consumers and helping them to be more financially agile make them any safer than they are now?
The answer depends on who you ask. On one side, consumer organizations and academics are sceptical about how much can be achieved through financial education. On the other side, some governments, international organizations and the financial industry argue for the benefits of higher levels of financial literacy.
Let’s start from the basics: education.
We all know that educated people are better off than uneducated ones but what does being educated mean? According to Harvard University’s list of skills that make an educated person, the top qualities are the ability to define problems without a guide, ask hard questions which challenge prevailing assumptions, quickly assimilate needed data from masses of irrelevant information, conceptualize and reorganize information into new patterns, think inductively, deductively and dialectically and attack problems heuristically. 
Now let’s assume that European citizens already have the skills above and add finance to the mix. According to the OECD, financial literacy is a combination of awareness, knowledge, skill, attitude and the behaviour necessary to make sound financial decisions and ultimately achieve individual financial wellbeing. As well as understanding financial concepts and being able to interpret financial data, it can be viewed as an expanding set of knowledge, skills and strategies, which individuals build on throughout life.
Comprehensive research performed by the OECD, European Commission, World Bank and a number of universities shows that financial literacy programs are typically grounded in economic, evidence-based theories that focus on the ability to evaluate financial propositions. Most of these programs focus on collecting data on financial literacy, mapping the missing skills and promoting best practices.
However none of the traditional approaches to financial literacy that the studies looked at (via employer, school, credit counselling, community based…) have generated strong evidence that financial literacy efforts have had positive and substantial impacts.
This has wider implications. Decisions about saving and investing obviously have a profound effect on the financial well-being of individual consumers but collectively those same decisions shape our national economic outcomes. As the financial choices facing consumers become more complex, driven by changes in financial products and consumers’ circumstances, we should always keep in mind that the cost of consumers’ mistakes is borne not only by individuals but by the whole economy.
It follows that if it is hard for the average citizen to make sensible saving and investing decisions, everyone loses.
Those designing financial literacy programs therefore need to build in a few basic objectives, including:
- levelling the playing field between financial end users and product manufacturers,
- equipping financial end users to navigate a complex and fast changing global economy,
- minimizing the probability of future crises (remember sub-prime).
Changing the European model
Consumers in Europe’s debt-fuelled economy are encouraged to engage in cross-border shopping for products and services, thus exercising their political and economic roles as citizens in the functioning of the internal market. The European Commission is keen for this single market to grow to include citizens managing their own financial wellbeing. American consumers already do this in their working years and in retirement, and the EC sees clear benefits in this shift.
This explains the EC’s enthusiasm for European citizens to develop capital market savvy (as described in its Action Plan on Building a Capital Markets Union)because it wants to move retail savings and unlock the capital markets. The former financial services Commissioner, Jonathan Hill, said during the Commission’s Public Hearing on the Retail Finance Green Paper that “… by definition, retail investors and consumers lie at the heart of this project (CMU). They do so because they provide the pools of capital the financial service industry needs to invest. So the more we deepen the single market for the financial products that consumers buy, the more investment we can unlock. And of course for them as consumers, we could improve the quality of services and reduce the prices they have to pay.”
But before consumers go on a financial shopping spree, they first need to take responsibility for financial management and be more financially literate. In this view, financial education could be seen as an important tool for governments seeking to introduce changes in social policy objectives.
The financial industry is, of course, strongly in favour of this. According to the European Banking Federation “…it is easy to be passionate about financial education. When you look at the potential it is clear that there are tangible benefits for many. Financial education is about helping people make well-informed choices, about encouraging financial responsible behaviour. There is plenty of evidence that proves that people who are financially literate are more likely to succeed in life.”
But can citizens keep up with the financial sector?
At Finance Watch, we find this opinion a bit overly simplified, if one considers the desired policy objectives and economic shift. While education is generally a good thing, we doubt that citizens’ knowledge, comprehension, skills, and willpower can be brought up to the level needed in today’s market for financial products to ensure the best outcomes for civil society and the economy.
There are several reasons for this:
- The financial industry has the means and motivation to run circles around financial educators and government agencies, as well as financial end users. Consumers are most open to learning at the time they need to use the information. These “teachable moments” are also moments when consumers are under the influence of the sellers of financial products. Even when financial education is given before the transaction, consumers often cannot outwit salespeople.
- Academic research by Barber and Odean (2001) shows that financial education can give citizens the “illusion of knowledge.” When people are given more information about investments, for example, they become overconfident in their ability to invest well, believing that the information gives them more knowledge, even when it does not.
- Making financial decisions typically requires both substantial reasoning and self-control. We often make decisions (including financial ones) impulsively and we depend on the professional advice of others. When sales incentives are present, retail investors will always be subject to influence by those advising them.
- Citizens are faced with a tremendous choice of financial products and reams of information about each one. This can lead to oversimplified decision strategies or inertia (a failure to make any decision).
“If you can have everything in 57 varieties, making decisions becomes hard work”
- Personal finance decisions often involve judgements about one’s susceptibility to unemployment, illness, and other financially taxing circumstances. Despite the high stakes, many people are overconfident about their own probability of experiencing misfortune.
- Most people find financial decisions, and even financial education, stressful, and as stress occupies cognitive resources, it can reduce decision quality.
For all these reasons, in the changing environment that the Commission is promoting, we believe that financial education alone is unlikely to improve household financial well-being and generate economic growth.
The OECD also believes that financial regulation has a major role to play in protecting consumers. As it concluded in its recent survey:
“Financial regulation and consumer protection frameworks can also further help people to become more resilient, for example by helping them to avoid becoming trapped in a cycle of debt through using high-cost credit or being fined for falling behind with payments, and by reducing the likelihood that they will choose unsuitable financial products that further weaken their financial situation. Regulated, independent advice services are also essential to guide people through the rapidly evolving financial landscape and meet their long-term goals.”
Financial education can give citizens valuable quantitative and decision-making tools but financial literacy on its own is not enough. Consumers will never win an arms race against financial complexity; some things are better addressed through regulation, stricter conduct rules, standardization of products and a bigger role for financial watchdogs and authorities with sanctioning and enforcement powers. Financial literacy – although important – cannot replace that.
Last but not least, the issue of financial education should make us take a step back and ask a bigger question – what exactly are we trying to create? Do we want a market for citizens to buy suitable, standardized investment products that address their long-term financial welfare and the needs of the economy, or a society of speculative retail investors who supply capital via the full range of techniques that financial markets choose to offer, regardless of the consequences?
This article was updated on 21 October 2016 to include the results of an OECD survey.
 Study participants were asked five questions covering aspects of economics and finance encountered in everyday life, such as compound interest, inflation, principles relating to risk and diversification, the relationship between bond prices and interest rates, and the impact that a shorter term can have on total interest payments over the life of a mortgage. Source: National Financial Capability Study, Financial Industry Regulatory Authority (FINRA) http://www.usfinancialcapability.org/results.php?region=US