REQUIRED READING: The past year has been tumultuous for our nation's financial system, for our economy and, of course, for many of our citizens.Â Financial transactions entered into by those individuals, and the financial market securities derived from those transactions, were at the heart of the turmoil.
With the economy and financial markets apparently on a recovery path, this is a good time to reflect on what effect this whole episode will have on financial education. In particular, what lessons should educators take away to help people make more informed financial choices not only today, but throughout their lifetimes?
Before discussing potential new directions for financial education, I would like to pose a fundamental question: Why do we need financial education at all? This might seem obvious. But I don't think it necessarily is – and I think the answers may help us frame the broader discussion.
For many purposes, economists find it useful to assume that people are rational and that they will acquire the information necessary to make decisions that will benefit themselves, as well as their families. And there is certainly plenty of financial information and advice out there. The problem is, not all that information is necessarily helpful, especially given the varying financial situations in which people find themselves.
When consumers buy durable goods, such as a car or a refrigerator, they are often able to rely on information from friends who have made similar purchases. What's more, these are products that they will buy multiple times in their own lifetimes, so there is an opportunity for learning. In contrast, a home mortgage is a less frequent transaction – and one that people often don't discuss in detail with others.
In addition, the nature of many financial instruments is fundamentally different than that of many durable items. For instance, we don't need to understand thermodynamics to buy a suitable refrigerator. But we do need to know a fair amount about the terms of a mortgage contract – and what that will mean for our overall financial well-being in various circumstances – in order to make a sound decision about financing a home.
Finally, although a refrigerator is an expensive item, it is unlikely to be a purchase that will put someone in financial peril – unlike some financial products that can, indeed, have significant and long-lasting effects. Therefore, consumers need to pay careful attention to those decisions and seek out the requisite information to make a choice that is good for them.
Education or regulation?
As you know, there is a relatively widespread belief that a lack of regulation was to blame for the financial crisis – especially, perhaps, in mortgage lending. Proponents of this argument commonly argue that consumers would be better off if there were tighter constraints on the set of financial products that they can obtain.
To be sure, there were some unscrupulous mortgage lenders who did not act in the best interests of the borrowers and investors they were supposed to serve. But it is also the case that financial innovation – including innovation in the mortgage industry – has benefited consumers. It allowed many people to obtain credit who were previously unable to qualify for credit. This allowed them an expanded range of financial options for rearranging their spending over time in a way that best suited them.
But to many observers, some of those financial choices may seem to make little sense. Consider, for instance, a person with little savings who takes out a high-interest loan to fund car repairs. This is a costly endeavor – one that might appear misguided. But it may be money well spent if the car is necessary to get to work, especially if the job provides health insurance.
Someone with greater wealth may have been able to fund the repairs out of savings – clearly a more desirable option – but one that is not available to every consumer. Therefore, it is often difficult to judge the merits of an individual's financial decision without knowing the circumstances that a particular household is facing.
Still, people do make bad decisions at times, and a lack of information is often the root cause. Sometimes, this information is what economists call ‘asymmetric’ – that is, one party has far more information than the other party.
With financial products, it is usually the provider that has more information about specific provisions in the contract – in which case, the provider may have an incentive to distort or obscure that information. This can place the consumer in a vulnerable position that may result in a choice that turns out poorly.
How do we help solve such information asymmetries? I would suggest using a balanced combination of sensible regulation and financial education.
Disclosure requirements are an obvious place to start. Some financial products can be quite complex and difficult to understand, even for relatively savvy consumers. For instance, making the terms of a contract clear and explicit is likely to improve many consumers' ability to make informed decisions about that contract and to evaluate alternatives.
The Federal Reserve recently adopted a series of rule changes to improve disclosure requirements for a range of consumer financial products. Many of these changes were based on the results of consumer testing – a typical private-sector practice in designing consumer communications.
One common lesson of such testing is that, paradoxically, disclosure requirements may be most beneficial if less information is disclosed. Home mortgage disclosures are a case in point. After all, the housing boom and decline occurred in an era when lenders were required to disclose a huge amount of information to borrowers. It is arguable that if only the most significant terms of those mortgages had been disclosed – or at least highlighted – consumers may have been able to more easily evaluate their merits.
Well-designed disclosure requirements are likely to improve the functioning of markets rather than hinder them, as well as improve consumer welfare. But regulations that would limit consumers' ability to access financial products – even those products that may appear detrimental to some consumers at first blush, such as the aforementioned high-interest loan example – may harm the very people they were intended to protect.
In addition, it is quite possible that, in the longer term, firms will develop new financial products to bypass existing regulations, and households will be confronted with decisions regarding those products before the regulatory structure can catch up.
I would prefer to see more emphasis on giving people the information they need in a clear and understandable format – especially targeted information that will help them avoid making serious errors – rather than restricting their access to financial products.
Not for everyone
I think it is also important to note that homeownership itself is not a wise choice for everybody. For example, for those who value mobility and are apt to move relatively frequently to pursue better job opportunities, the search and transaction costs of purchasing a house can be prohibitively large.
More critically, purchasing a home usually means sinking a considerable amount of a household's savings into a single asset that is often costly to trade. This move may be particularly risky for a household with a variable income stream and low levels of savings, as is true of many low-income households.
When one considers such factors, I think it becomes clear that renting does not necessarily mean ‘throwing your money away,’ as is commonly suggested. It is simply another way to consume housing stock – one that is appropriate for some people, just as buying is for others.
Given the financial risks associated with homeownership, as highlighted by the events of the past decade, it should be clear that educating people about the homeownership decision is particularly important.
I believe we should think of financial education and economic education as being inherently intertwined. How, for instance, does one adequately consider home buying versus renting without understanding the concept of opportunity cost? Or, similarly, in order to understand why there is now a wage premium in the U.S. associated with greater skills, it is useful to understand the theory of comparative advantage.
This isn't to say that financial education is only about economic education – clearly it is not. But economic education is an important component.
Conversely, it's hard to imagine teaching about the recent financial crisis without discussing financial decisions like financing a home, or saving for retirement. More generally, it is hard to teach economics without teaching how to make financial decisions.
As for how best to implement such programs, my reading of the literature suggests that there is still no professional consensus.
There are ongoing efforts within the Federal Reserve System to measure how some of the Fed's financial education programs have fared and which have been most successful in achieving their intended outcomes. I hope those results will be useful as you continue your efforts to help people achieve their financial goals – and to avoid mistakes that could prove financially crippling.
Jeffrey Lacker is president of the Federal Reserve Bank of Richmond. He can be reached at (804) 697-8000. This article is adapted from a speech delivered at the Council for Economic Education's annual conference in Washington, D.C.