Investment special: What is financial literacy?

The banking crisis exposed our weak grasp of the basics of finance. We should all go back to the classroom
January 26, 2011

Listen: Alistair Darling discusses financial literacy with Prospect's editor, Bronwen Maddox

[audio: http://www.prospectmagazine.co.uk/Podcast_Financial_Literacy.mp3]




At a basic level, financial literacy is people’s capacity to understand the consequences of what they do when they open a bank account or enter into a credit card agreement—and the rights and responsibilities that go along with these.

Understanding the implications of having a bank account and borrowing from a bank are the most important areas of financial literacy, followed by pensions and buying a house. At its most fundamental, financial literacy involves grasping the notion that money can be borrowed only at a cost.

At a secondary level, financial literacy is an understanding of how the broader financial world operates. The general landscape of the economy is something that people ought to have at least a rudimentary grasp of.

Of all the areas of finance that people have to contend with, though, I think pensions is the one they least understand. Part of the problem is the gap in time between putting money in and getting it out. People can grasp the concept of a mortgage, which is easier to comprehend; but with pensions, most people have only a very general idea that somehow, somewhere, they are saving up money for the future. The notion of, say, buying an annuity—an income bought from an insurance company and paid for with an accrued pension pot—is utterly foreign. This is especially the case now there are fewer defined-benefit pension schemes and people have multiple careers, so they are not just looked after by one institution with a job for life, followed by a pension.

But the general public’s weak grasp of financial literacy has been only part of our greater financial problems. I would say that financial literacy in the higher echelons of some of our banks has been pretty poor, too. Those who were supposed to know what they were doing did not. They failed to comprehend the extent of the liabilities they had run up.

Although there are consumers who behave foolishly, I think that often the irresponsibility is more with the banks that lend, than with the customers who borrow. I will never forget a constituent of mine, a Royal Bank of Scotland employee and middle-ranking official based in Edinburgh, telling me, referring to the bank’s top brass: “We thought that these people knew what they were doing. They didn’t.” All her savings were in RBS shares and she was cleaned out.

Another individual, a board member of a large bank, once assured me that “We will only take risks in future that we understand.” This, of course, made me wonder why on earth they had taken on risks they did not understand in the first place.

During the worst period of 2008-09, financial and economic messages were hard to get across. People understand hundreds and thousands of pounds—but once you get into billions, it’s a different matter. One of the questions I’m asked most often is: “Where did all the money go that we loaned to the banks”? I try to explain that the bulk of it has taken on the form of shares in those banks. But people just think the money has gone. What is more, people try and understand the banks’ finances by relating them to their own experiences. If an individual’s income drops, he or she spends less. But getting across that this does not apply to banks and the country is a hard concept to convey.

I am not arguing that everyone should study Keynes’s General Theory. But when you talk about debt and deficits, people instinctively think these are bad things. Yet if the government cuts spending in a recession, it can bring on a depression.

Financial literacy is vitally important, and, although I would be unwilling to further burden the national curriculum with another subject, I do think that before teenagers leave school they ought to be taught some of the concepts involved in finance. It should be part of every young person’s all-round education. For older people there should also be opportunities to learn the basics.

But wherever the subject is taught, it is particularly important that the information is communicated in plain, simple language. That alone would make finance more accessible.

How many times when you read the money pages, do you find words being used that people do not understand? The language that surrounds money and finance is extraordinary. Many people had no idea what a “CDO-squared” [ a kind of collateralised debt obligation, the derivative at the heart of the financial crisis] was, and by the time they had worked it out, it was too late. Most do not understand it still.


Also in Prospect's investment special:

Jim O'Neill: A great American revival

John Kay shows Max Hastings how to invest

Charles Batchelor: Where to put your money

Best and worst investments

Jim Rogers: The Chinese century

Vicky Pryce: Stop the Greek exit