Greater Fools

James Surowiecki writing in the July 5th New Yorker presents us with the startling news that if we were more financially literate as a nation we might have avoided some of the problems of the past two years. George W. Bush called on the country to "build an ownership society". He encouraged and trumpeted the news of the soaring rate of homeownership in the U.S. and extolled the virtues of giving individuals more control over their own financial lives. But we discovered there was a bleak reality--the subprime loans, the mountains of credit-card debt and shrinking pensions. The fact of the matter is that Americans don't have a clue.

James Surowiekci writes that our financial ignorance is startling. Annamaria Lusardi, a Dartmouth economist and the head of the Financial Literary Center, has conducted studies about what Americans understand about finance. About half couldn't answer two questions about inflation and interest rates correctly and slightly more sophisticated topics baffled the majority. Most people don''t know the terms of their mortgage or the interest rate they're paying. At a time when Americans have borrowed more than ever, Americans can't explain what compound interest rate is.

These issues become very serious when individuals are being asked to take more responsibility for their own financial decisions. Pensions have been replaced with 401 (K)s and more people have to pay for their own health insurance. Because the marketplace is so varied and the options are so diverse, economic decisions have become more numerous and complex than ever. And this makes people ripe for exploitation and fraud.

A study by economists at the Atlanta Fed found that 32% of people in the lowest quarter of financial literacy thought they had a fixed mortgage when it was really an adjustable rate . A study of subprime borrowers in the Northeast found that people in the bottom fourth of calculating skills 20% had been foreclosed upon, compared with just five percent in the top quarter.

One of the possible solutions to this is contained in the Wall Street reform bill--the creation of a consumer financial portection agency. But what Surowiecki urges is the need for proper financial education. A program like drivers' ed for financial literacy. In the few states where financial education is mandated in school, there has been a surprisingly large impact on the savings rate.The Center for American Progress found that education and counselling by non-profit organizations have helped low-income families buy and hold onto homes even during the housing bubble.

The Consumer Agency and financial education are controversial because economists call our illiteracy "rational ignorance"--inattention that is justified because of the costs of paying attention outweigh the benefits. As Surowiecki notes, few decisions affect us more directly than the ones we make (or make by default) about our money.

One anecdote is revealing. In a German study, 80% of those surveyed described themselves as confident in the answers on a questionaire, even though only 42% got even half the answers right. This apparently is known as the Dunning-Krueger effect: people who don't know much tend not to recognize their ignorance, and so fail to seek better information. The least knowledgeable people ,according to the Atlanta Fed, were also the least likely to do research before getting a mortgage. But more well-informed people are more likely to ask others for help.

I like the whole concept of the Dunning-Krueger effect. I think we can apply it to American politics in general