Blogs & Comment

The hazards of knowing too much

Why improving financial literacy may not avert a consumer debt crisis

Poor financial literacy allegedly contributed America’s recent financial crisis. No less an authority than Ben Bernanke, chairman of the U.S. Federal Reserve, has drawn the link. “The recent crisis demonstrated the critical importance of financial literacy and good financial decision-making,” he told a U.S. Senate committee last month, “both for the economic welfare of households and for the soundness and stability of the system as a whole.” Bernanke opined that it is particularly important to educate young people on the hazards of taking on debt. “The earlier that young people can develop basic financial skills,” he added, “the more likely it is that they will make good financial decisions when they become adults.”

Financial literacy and general education are linked. Research consistently reveals that many Canadians doubt their own financial skills. “We also know that as a person’s level of completed education decreases, their room for improvement increases,” observed Sean Simpson, Associate Vice President at Ipsos Reid, earlier this year when releasing statistics from a consumer survey. As in the U.S., this lack of sophistication is often mentioned in the same breath as observations about the lack of savings, or high consumer debt. Improved education, it has been suggested, might be the solution.

Kingsley Amis once said this of higher education: “More will mean worse.” Surprisingly, it seems more education also means something else: more debt. Don’t take my word for it. Consider this passage from a recent Statistics Canada paper on seniors retiring with debt:

As the level of schooling goes up, so does the incidence of holding debt. While 26% of those with less than a high school diploma had some form of debt, 36% or more with at least a high school diploma had debt. The regression results indicate that only the difference between retirees without a high school education and those with high school or some postsecondary schooling was statistically significant. Other research has shown that higher education is associated with an open or positive attitude towards borrowing. As a person’s financial knowledge score increases, so does the likelihood of having debt.

This seemed counterintuitive to me at first reading. I’ve tended to regard retiring with debt as being generally a bad idea, because that’s when most people’s incomes decline markedly. What was a manageable debt before receiving the gold wristwatch can suddenly become a heavier burden. I’d previously reasoned that more education would correlate with higher income, which should help people eliminate their debts before leaving the workforce. And more numerate people would be better situated to run the numbers and understand the risks.

My thinking would appear to be wrong-headed. “Understanding of financial concepts may be associated with borrowing to finance investments or smooth consumption,” the StatsCan paper suggested. Put another way, people with a greater understanding of debt are more likely to use it. Moreover, other StatsCan research has shown that at all income levels, people who have a credit card score better on financial knowledge tests than those who didn’t. In other words, those who use debt understand it.

Debt, of course, is not necessarily a bad thing. Smoothing consumption over one’s lifetime can be a perfectly rational thing to do. But the excessive leverage seen among large and growing segments of the Canadian population seem hazardous. And if education really does lead to higher debt levels, investing in financial literacy may deliver results opposite to those intended.