You should need a license to take out a mortgage
1. Suppose you had $100 in a savings account and the interest rate was 2 percent per year. After five years, how much do you think you would have in the account if you left the money to grow? A) more than $102; B) exactly $102; C) less than $102; D) do not know; refuse to answer.
2. Imagine that the interest rate on your savings account is 1 percent per year and inflation is 2 percent per year. After one year, would you be able to buy A) more than, B) exactly the same as, or C) less than today with the money in this account?; D) do not know; refuse to answer.
3. Do you think that the following statement is true or false? "Buying a single company stock usually provides a safer return than a stock mutual fund." A) true; B) false; C) do not know; refuse to answer. [The Atlantic]
These questions were asked to people around the world, and the correct answers are A, C, and B. Did you get them all right? If you did — congratulations, you understand the basics of how interest rates, inflation, and portfolio diversification work. Most people surveyed around the world didn't.
In Russia, 96 percent of those surveyed failed to answer the three questions correctly. In the U.S., 70 percent failed. The highest performing countries were Germany where 47 percent failed and Switzerland, where 50 percent did. But this isn't rocket science. The questions reflected basic financial concepts that are essential for saving for the future, using credit cards, taking on a student loan, purchasing a home, investing, and building up a pension.
Worse than this, Americans also showed overconfidence in their abilities. Asked to rank their financial knowledge on a scale of 1 (very low) to 7 (very high), 70 percent of Americans surveyed ranked themselves at level 4 or higher. Yet only 30 percent answered the questions correctly.
These surveys provide some pretty scary food for thought, because uninformed, overconfident people are more prone to make bad decisions that endanger their own financial health and the wider economy. As this paper from the World Bank shows, individuals who are financially literate have better financial situations.
One key aspect of the 2008 financial crisis was individuals taking out loans and mortgages that they couldn't afford to pay back. Now, it's true that lenders were also culpable — they were lending this money, and then selling the debt to a greater fool, which was irresponsible and dangerous, if not illegal. But how many of the bad subprime mortgages that triggered the 2008 crisis were taken on by people who didn't understand what they were getting themselves into? Given that nobody wants to end up bankrupt and have his or her home repossessed, it's safe to conclude an awful lot. As early as 2008 John Bryant, the vice chairman of President Bush's financial literacy council argued: "Take the greed and the financial misrepresentation out of it, and the root of this crisis is massive financial illiteracy."
Every time the specter of financial illiteracy raises its head on the national stage, the widespread reaction tends to be to demand more spending on and resources for financial education, for example by including household finance in the basic high school curriculum. If the problem is lack of knowledge, give them more knowledge. But, as the economist Richard Thaler argues in The New York Times, it's not as easy as that. Thaler points to a 2013 paper that concluded that those who receive financial education do not perform much better at saving, or avoiding massive debt. Additionally, he notes, "the results of efforts to increase financial literacy aimed at low-income people are particularly weak."
And it's not like the rollout of nationwide economics and financial education has eliminated financial illiteracy, or even reduced it to world-leading levels. According to the National Assessment of Educational Progress in 2008, 9 out of 10 high school students were exposed to some economics education, up from 1 in 4 in 1982. And 17 states now require students to take an economics course to graduate, up from 13 states in 1998. Yet financial illiteracy still plagues us.
What gives? Well, how much high school level chemistry do you remember? Probably not a lot if you don't work in chemical engineering, or as a high school chemistry teacher, or in a related field like medicine. I remember dropping potassium into water and watching the explosive reaction, and little else. Point being that lessons delivered in an abstract way in high school tend to just not stick, especially if students don't realize its importance in later life. People memorize for exams, and forget afterward.
Of course, that doesn't mean that we should give up on financial education. Some like Thaler argue that instead of delivering it in school where its relevance may not immediately be apparent, financial education could be delivered at the point it is needed.
I'd go one step further, and suggest financial licensing. People wanting to take out a mortgage or get a credit card or a loan would face compulsory basic finance literacy testing. You can't get a mortgage unless you can demonstrate you understand how interest payments, inflation, and other basic financial concepts work. If access to financial services depended on financial literacy, financial literacy rates would shoot up.
After all, we demand that road users demonstrate their competence behind the wheel. Why not demand that mortgage and credit card users demonstrate their financial literacy as well? A "financial license" might be a pain to busy people trying to get a mortgage or loan or credit card. And obviously, this won't stop all irresponsible lending and borrowing — just as a driver's license doesn't stop all dangerous driving. But on the other hand, if it reduces delinquency and repossession, it could save a lot of people a lot of misery and, perhaps most importantly, prevent banks from taking advantage of people's ignorance.
And it might even prevent a few financial crises.
Editor's note: This article has been revised since it was first published in order to more clearly include proper attribution to source material.