A recent New Yorker article by James Surowiecki on the Dangers of Financial Illiteracy is a must read, especially by the financially literate and the lucky "quants" among us. It is also a must read for anyone who believes that we can rely on (and blame when they default) individuals who "pick a loan payment".
Lest you read the article and assume that the financially illiterate are all at the bottom of the education-economic pyramid, let me assure you they are not. Twice during my lifetime, I have had friends approach me (I think because people often assume that a PhD in econ qualifies one to give financial advice) with a question about paying off credit card debt. The questions took the form of "should I pay off the balance on my credit card or should I (do something else)?" In one case the person was an extremely intelligent, well-read PhD candidate in a non-quantitative field. The other person was also smart and college educated.
In both cases, I explained in words how they would end up paying way more than their balance if they paid the minimum balance each month (which one was doing). In both cases they seemed unmoved by this so I had them plug their balance into the loan amortization spreadsheet that comes with MS excel along with whatever payment they had been making and then note 1) how long it would take them to pay off the balance and 2) the total amount they would pay. Both my friends were truly shocked when they saw the amount and the length of time. Granted these were nominal dollars, but inflation was relatively low (~2%) and the interest rates were quite high (~10%)in both cases. One friend had sufficient cash to pay off the loan in its entirety (about $5000) and did so immediately. He has never carried a balance since. The other adopted a payment schedule that resulted in a zero balance within 12 months.
My point here is that Surowiecki's suggestion that we adopt the "financial equivalent of 'driver's ed' " is right on and critical, IMHO. At least one undergrad program I'm familiar with provides exposure to interest/amortization in their basic required "math for poets" course. But, college is too late and interest/amortization is only a start. The material should be placed in a real world context, related directly and graphically to credit card balances as I did for my friends and to home loans.
In some ways this could be thought of as just one facet of a broader effort to improve the relevance of the math that most kids learn in high school and as undergrads. The areas where an informed electorate and informed consumers require math skills over the life cycle are in loans, credit, interest, investment and in probability and statistics, not calculus. This doesn't mean we should stop teaching calculus to the college bound. It means we should be arming everyone with the knowledge they need to avoid predatory lending practices and to make at least an educated stab at understanding and evaluating risk. The latter will matter if we are sincere about improving patient information and giving patients a greater role in medical decision-making.
Financial literacy is likely to yield real macroeconomic benefits for all of us. Until recently, the national savings rate had declined rather dramatically. It appears to be rising now, partly because consumers have finally confronted the true costs of borrowing. In an ideal world, household savings fuel rational, thoughtful, efficient investment and economic growth (as opposed to irrational, inefficient investment in dot.coms, excess housing, and derivatives).
Assuming new financial regulations are adopted and "fix" the moral hazard the bailout has created on the "investment" side, increased financial literacy should contribute to greater efficiency on the savings side. This would almost certainly generate significant and positive side effects for everyone, including those of us who are already financially literate.
The first requirement of financial literacy is debunking the erroneous household-government finance analogy. Everyone understands that they are revenue constrained, and they assume it as matter of common sense that government is too. That is not the case with monetarily sovereign governments that are the sole providers of a nonconvertible floating rate currency of issue, like the US, UK, Japan, Canada, and Australia, but not the EMU, the countries of which have ceded monetary sovereignty.
• Under the present monetary system, the government is not financially constrained (although there are are real constraints). A government that is the monopoly issuer of a nonconvertible currency with a flexible (floating) exchange rate is not financially constrained. As currency issuer, the government neither taxes to fund disbursements, nor borrows to finance them.
• Government expenditure increases nongovernment financial assets. Taxes withdraw funds from nongovernmentGovernment deficits increase nongovernment net financial assets by a corresponding amount. The national debt is the amount of nongovernment savings.
• A monetarily sovereign government does not finance itself with debt, and the securities it issues are bought with currency it issues. Debt simply drains excess reserves from the interbank system, allowing the central bank to hit its target rate. There is no financial reason that such a government needs to issue securities at all. It could just pay a support rate equal to the overnight rate, or set the overnight rate to zero, as the Bank of Canada does.
• A monetarily sovereign government as monopoly currency issuer has the sole prerogative and corresponding sole responsibility to provide the correct amount of currency to balance spending power (nominal aggregate demand) and goods for sale (real output capacity). If the government issues currency in excess of capacity, demand will rise relative to the goods and services available, and inflation will occur due to excess demand relative to supply. If the government falls short in maintaining this balance, recession and unemployment result, due to insufficient demand relative to supply. The government attempts to achieve balance through fiscal policy (currency issuance and taxation) and monetary policy (interest rates), based on analysis of data in terms of sectoral balances — contribution of government, households and firms, and foreign trade. MMT can be viewed as an articulation of the basic equation of macroeconomics, GNP/Y = G + C + I + (X-M), where GNP is gross national product (supply), Y is national income (demand), G is the contribution of government, C the contribution of consumer spending, I is business investment, and (X-M) is the current account balance. The rest is stock-flow consistent macro models.
See L. Randall Wray, Understanding Modern Money (1998) and Godley & Lavoie, Monetary Economics (2007)
From the Amazon product description of Monetary Economics:
This book challenges the mainstream paradigm, which is based on the inter-temporal optimisation of welfare by individual agents. It introduces a new methodology for studying how it is institutions which create flows of income, expenditure and production together with stocks of assets (including money) and liabilities, thereby determining how whole economies evolve through time. Starting with extremely simple stock flow consistent (SFC) models, the text describes a succession of increasingly complex models. Solutions of these models are used to illustrate ways in which whole economies evolve when shocked in various ways.
Posted by: tjfxh | 07/04/2010 at 01:10 PM