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Commentary: Simpler contracts would help people more than financial literacy classes

This article first appeared in the St. Louis Beacon, June 29, 2012 - Lack of financial literacy is a major barrier for the economic prosperity of millions of American households. Individuals with low levels of financial literacy are unable to determine the right combination of financial products and services to attain their financial goals.

A well-known example of this is given by thousands of Americans who took out mortgages they didn’t understand, defaulted on their loans and finally lost their properties. In general, less financially literate individuals tend to use more expensive methods of payment, incur in higher borrowing costs and accumulate less wealth.

In the last decade, millions of dollars have been invested in initiatives oriented to empower Americans to make sound financial choices. These investments have been channeled through hundreds of governmental and non-governmental agencies. Most have focused on promoting financial education (online courses, workshops, seminars, etc.). Some states have gone even further by mandating high schools to provide at least one course in economics or personal finance to their students.

Unfortunately, there are few evaluations about the effectiveness of these efforts, and the results of those evaluations are mixed at best. However, this is not surprising since no systematic research that tells us what are the basic competences that Americans need and the best way those competences should be provided. It is necessary to address those questions using carefully designed studies, and this enterprise will take several years of research. Without this research, the provision of financial education is like administering medications that have not been tested yet.

Financial education is not necessarily the only or the best way to address the financial literacy problem in the U.S. Indeed, we are financially illiterate to the extent that financial products are complex. If purchasing financial products were as simple as the purchase of a toaster, financial literacy wouldn’t probably be a major policy issue. Thus, an alternative way to increase our level of financial literacy is through the simplification and standardization of financial contracts.

Contracts that are easier to understand will improve individuals’ ability to compare the costs and benefits of their financial choices. Thus, the main benefit of a simplification policy is the reduction in the level of financial knowledge required to make sound financial choices. The implementation of this policy would require that the main aspects of financial contracts can be described by few summary indicators.

Simplification of financial instruments is likely to be more cost-effective than financial education. Indeed, the last National Assessment of Adult Literacy reveals that 55 percent of the adult population has only a basic level of numeracy. These individuals are just able to use easily identifiable information to solve problems such as comparing the price of two tickets for a baseball game.

Providing them with the financial education required to choose among the wide variety of financial services is an ambitious task that entails huge implementation costs and very uncertain results. In this context, reducing the complexity of financial instruments seems to be a faster way to address financial illiteracy compared to financial education.

One disadvantage of simplifying financial contracts is a reduction in the variety and flexibility of those instruments. As a consequence, it reduces individuals’ ability to satisfy their specific financial needs. However, since financial illiteracy is widespread, it is not clear that Americans are getting much benefit from this flexibility. In contrast, a simplification policy can negatively affect one source of profit for financial intermediaries. Consequently, they won’t agree with such a policy and there would be political barriers to the implementation.

Except for recent efforts of the Consumer Financial Protection Bureau (CFPB), a simplification policy has not been promoted with the same intensity as financial education. Since the design and implementation of a well-targeted financial education policy will be slow and its impacts can be limited, more attention should be given to a simplification policy. In any case, research is needed to assess the magnitude of their costs and benefits of this policy before ending up administering untested medications for our financial illiteracy.

Fernando Lopez is in the McDonnell International Scholars Academy at Washington University in St. Louis, where he is also a PhD candidate in finance at the Olin Business School.  He received his BA in Economics in 2005 from the University of Chile – Santiago, Chile. 

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