There’s been quite a lot of discussion recently about the crippling burden of debt faced by many Americans, and understandably so – the rippling effects of the mortgage crisis have a number of analysts suggesting that the U.S. economy is heading towards recession.
Unfortunately, it doesn’t seem that many lessons from the recent crisis are especially clear, at least as far as policy prescriptions might go. While it is true that many lenders were certainly irresponsible, many borrowers freely admit that they were, too. And while the availability of easy credit certainly contributed to the growth of debt, it’s important to recognize that, in general, access to credit is a very positive thing, provided that it is offered and taken responsibly, with rational pricing of risk all around. To put it more concretely, while access to credit and the resulting growth of debt led to many Americans losing their homes, access to credit helped put some of them in those homes in the first place, and it helped others improve aspects of their lives, if only in the short term given how events played out. Without excusing irresponsibility on the parts of the various players involved in the recent debt crisis, I think it’s essential to note that addressing the problems in these markets entails what might end up being a fairly delicate balancing act, and that the parameters governing such an act aren’t necessarily known.
I can’t help but wonder, though, if we wouldn’t be able to achieve a lot by focusing on some of the informational aspects of the decisions made by consumers. Specifically, I wonder about the role financial illiteracy and opacity played in convincing borrowers to take on risky high-interest-rate loans of various sorts. Was it the case that many borrowers didn’t understand the economic risks they faced in general (e.g. the risk of medical emergencies or layoffs), some of which might be large enough to force them to default? Did they, perhaps, fail to understand the risks associated with ARMs, or the terms underlying their credit-card debt, or the specifics of any of the myriad of other debt instruments that were purchased? It’s an empirical question, surely, though I think it’s somewhat intuitive: who hasn’t been at least somewhat confused by the terms and fees associated with a bank account or credit card? If it is indeed the case that these sorts of misunderstandings were important in the evolution of the current financial crisis, perhaps there is a role to be played by government in promoting financial education or enhanced transparency of financial contracts, independently of any regulation of the terms of those contracts.
From what I know of the literature in general, the evidence about the efficacy of financial education and transparency interventions is mixed. But I can’t help but think that it’s important to continue exploring this area. The economic world becomes more complex every day, and it seems that the importance of the effective management and transmission of information grows with it. Perhaps focusing on better financial education and transparency on the ground will prove to be a more valuable (and workable) approach than playing an outmoded blame game.
What do you guys think?
I don’t see how some financial education could hurt, but to some extent, how do you stop people from taking risks even if they are objectively irrational and how do you stop companies from providing this credit if it is potentially profitable? The reason I might doubt the efficacy of financial education and transparency is that people often do precisely what they’ve been taught they shouldn’t. So, how do we help people not only know what the right decisions are, but actually make those decisions?
Is it that people need to better understand the system, or that the system is flawed and needs reform? If the former, what kind of financial education are we talking about?
Interesting questions.
hlz2 – I don’t think we’ll ever eliminate irrationality, but we might be able to prevent mass irrationality in one direction, if you know what I mean. Irrationality isn’t the end of the world per se, it’s when the market is severely irrational on average that’s the problem. Moreover, I think that getting people to undertake some common-sense thinking about their financial decisions can be really helpful, e.g., getting people to simply look at a projection of monthly mortgage payments under ARMs under a variety of scenarios might give them a sense for what risks they might face, instead of them getting surprised by events that aren’t really as surprising as they might seem. Or getting people to understand that picking stocks is a negative expected value exercise for most people, and that they should diversify their assets broadly, etc.
jaf2106 – I don’t think that the two are mutually exclusive, and I certainly didn’t mean to let the system off the hook- it’s clear that it has problems. I was just trying to focus on one aspect of the issue that I think has been under-discussed, and one that is, I think, more straightforward than the systemic problems, some of which might be really complex.
As for what the education should look like: well, there are lots of instances where laypeople (and trust me, I don’t mean this in a condescending way) make irrational decisions about financial matters (investing substantial proportions of their retirement assets in the company that employs them, not making full use of 401k matching funds, taking on credit of various kinds that could become unpayable given slight perturbations of various economic drivers) that I hope are driven by confusion/lack of information (if not, the people making these decisions are simply irresponsible). I think that assisting people with clearer, targeted information highlighting some of the salient points might be helpful, as might educating them to make sense of the wealth of information available.
This isn’t a particularly new idea – having experts synthesize and simplify information for non-experts is old news (e.g. crash test ratings, consumer reports). I’m just not sure that it’s been explored to its fullest extent in the financial arena.
Interestingly enough, Obama has mentioned this point in one of his policy positions (when I checked during the Dems primary): he suggested a credit card rating agency that would give simplified, digestible pieces of information to consumers about the different credit card options that they had available (I think his was a starred rating system or something). I think strategies like this might help everyone quickly parse through a cacophony of financial information to make smarter decisions more quickly.