Context
Financial markets and products have become increasingly complicated, and consumers are now required to make complex decisions about their day-to-day finances and future financial planning, such as how much to save and invest, which products to choose and how to decumulate assets.
However, many of the financially complex products that are available to consumers can be difficult to understand, and many consumers may be ill-equipped to make informed choices. This review looks at the relationship between financial literacy and financial decisions, and the impact not only on individuals but on the wider national economy, in the light of the global financial crisis at the end of the last decade.
The study
The review drew evidence from a range of sources. These were primarily academic papers and while the majority were published in the US and dealt with US consumers, the review also included evidence from a variety of other countries, worldwide. There are four stages to the review:
- A review of theoretical research that looks at financial knowledge as human capital;
- A review of primary research that assesses the status of financial knowledge, and looks at demographic variables such as age and gender to understand which groups have higher and lower knowledge;
- A review of literature on the effect of financial knowledge on economic decisions; and
- A concluding section that discusses the knowledge gaps that remain in the study of the economic effects of financial literacy.
The review sets out to answer the following questions:
- How well-equipped are households to make complex financial decisions?
- How does financial literacy affect economic behaviour?
- How can policy efforts to improve financial knowledge be better targeted?
Key findings
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The theoretical framework for financial literacy: Conventional microeconomic models assume that individuals make rational decisions about saving and spending so as to have optimal financial wellbeing over a lifetime. However, these models assume that individuals have the financial knowledge and capability to do so, whereas there is evidence relatively few people have this much financial knowledge. More recent research has focused on the acquisition of financial knowledge and links between knowledge, investment and saving behaviour.
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Benefits of financial knowledge : Research is still ongoing, and it is challenging to establish a causal link between gaining knowledge and realising benefits but the benefits of better financial knowledge appear to include better spending, saving and investment decisions, better debt management, more retirement planning and participation in the stock market, and greater wealth accumulation.
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Objective vs. subjective measures: Research in the US and Europe found that people are over-confident about their level of financial knowledge. Where people were asked to self-assess and also self-test, they assessed themselves as more knowledgeable than the test results showed. This was not the case, however, in Japan where people assessed their knowledge as low.
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Effects of financial literacy programmes: Financial literacy programmes are not always evaluated based on a theoretical framework or using rigorous empirical design. If financial literacy is thought of as human capital, not everyone will choose to invest, so not everyone will benefit in the same way, meaning that financial literacy programmes will not change behaviour for everyone. Carefully targeted programmes that address specific issues are recommended.
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Regulation and default solutions: As well as financial education, there are other ways of protecting people from the effects of low financial literacy. One way is through regulation which could be used, for example, to set uniform standards for financial products or to reduce search costs through providing centralised information. The other is to reduce the complexity of the choices that people have to make by giving them default options, such as auto-enrolment in pension plans.
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Remaining questions: There remain a number of questions including the following:
- Which types of financial education would be most effective to raise financial literacy?
- In which cases should education be used and in which would regulation, simplifying financial choices or ‘outsourcing’ to financial advisors work better?
Points to consider
Methodological limitations:
- The authors do not give any details of how the literature sources were chosen, or criteria for inclusion. However, this was an extensive review of literature, primarily from academic journals and policy documents in the US, Europe and other countries worldwide. The list of references ran to over six pages, which suggests that the process was thorough and inclusive.
Relevance:
- The view of financial literacy as human capital and the impact on economic behaviour and wider economic health is topical in the light of the recent global recession and ongoing economic uncertainty.
Generalisability/transferability:
- The review took in literature from around the world. The authors note that financial literacy and financial behaviour are heterogeneous and that any solution should be targeted at specific groups rather than one size fits all.
Applicability:
- This report is applicable to anyone with an interest in financial literacy, such as financial services providers, government, support agencies, policy makers, regulators or educators.
Full report
The economic importance of financial literacy: theory and evidence - full report
