Saturday, October 10, 2009

Financial Illiteracy

I am finding that retrospection is an interest exercise. Looking back at things I wrote or jotted down or observed 1, 2, 3 or more years ago and see how they relate with 2009 reality.


This is one of them. A text I wrote 22 months ago, December 18, 2007, ie right at the beginning of the current crisis.



"Financial Illiteracy"

December 18, 2007: Russia's MICEX published a report today on stock and other financial investing by Russians. It estimates that 0.5 million Russians invest in the financial markets, compared to a figure of 88 million in the US.

In my opinion, the most interesting part of the report is the notion of "financial illiteracy" that the authors of the report use to describe the level of financial knowledge that most Russian investors possess and its effects on the financial markets and their investing success!

Which makes me think:

1. How "financially literate" are most individual investors around the world?
2. The institutional ones?

How "financially literate" was the decision of the major and reputable and allegedly savvy financial institutions that over-invested in the US subprime instruments? Did they not "realise" the default risk they were undertaking that was embedded in these high yield promising (in return for high risk) financial instruments?

Rationality, Literacy, Greed, etc.

Which brings us to the following questions, food for thought:

  • Can the mere/generic/vague notion or concept or factor of "greed" explain these over-exposures?
  • How "rational" are not only the individual but the institutional or other "professional" investors?

The decision of the US president, the US Capitol Hill, the US Central Bank (the Fed) and many other central banks (eg the European Central Bank (ECB), the Bank of England, to offer either:

a) Some facilitation to some of the mortgage holders
b) Low interest "facilitation" to commercial banks (for helping borrowng and lending between them) and other private institutions to help them weather the storm and avoid major failures (in the interest of their image and trust value, as well as in the interest of avoiding banking crises and a nasty cascade of major economic and social effects)

How policy rational, how policy literate, how ideologically capitalist or free market are they?

The rush to invest in these fundamentals lacking subprime mortgage instruments, by both the borrowers and the lenders (and the subsequent holders of those instruments, almost all over the world, eg England, Europe, Germany, etc.), what "symptoms" does it show for the US, European and global financial system, capitalism, global entrepreneurship, etc?

In my personal opinion:

  • The subprime crisis does show a serious structural fault in the financial capitalist system, but one that is not serious enough to bring the whole system down or call for philosophical or systemic re-thinking of the whole.

  • But it does call for some major thinking on these "local" (in the financial world) systemics.

  • Does it call for policy or regulatory action? I do not think so. But while I am ideologically opposed to the idea of the bailing out of profit making, non state, businesses (banks and other financial institutions) by Central Banks, I must admit that practically the action is justifiable.

But that leads us, in my opinion, in the path of enlightenment re a much wider "literacy" problem, one of the average citizen of the world, including the citizens of the US, EU countries, etc:

  • What is the level of Economics, Political and Policy literacy?

  • Plus of literacy on the rules and theory and practices of the capitalist system?

The capitalist system could, IMO, survive the potential "failures" of major financial and banking institutions! The low interest rates subsidies can even be considered unfair "state aid" to the businesses that over-invested in subprime, vs the ones that were prudent or sage or risk-adverse or un-greedy enough to not over-invest or pull out on time!

The moral of this "story" IMO, is that the capitalist world has a literacy deficit in Economics and Capitalism knowledge and understanding and that that is part of the problem that forces certain "money and investment" managers of other peoples' savings or investment moneys to try to impress their (how literate?) cliens that they are "better" managers than their competition!!!!

In the words of one of my Finance Theory professors at INSEAD, when one compares performance of funds, one cannot compare ex post facto (realised) Returns on Investment, one has to take into account the risk that was undertaken in making those investment decisions!!

And that means that the main illiteracy problem is related to the inherent trade-off made between "expected return" and "expected (associated) risk" when one makes an investment or any kind of decision that has uncertainty incorporated into it: that means most decisions by all people and organisations in life!

Plus, is the financial and capitalist system today based/relying too much on confidence and trust? Instead of knowledge/literacy and rationality?

Communism thought that by eliminating the private sector from almost all functions of the economy and life, one could eliminate the effect of greed and/or ambition. It failed in that, because it, IMO, did not understand the human nature of greed, inter alia.

IMO, Capitalism is the best available economic system, much like Democracy is the best available/possible political one. But in the same way that Democracy has many version and "updates", the same IMO applies to capitalism.

The fundamental problem IMO is that most people today suffer from literacy re civics/politics/citizenship and economics, finance and "economic citizenship". Education in the fundamental principls (at least) of Probability and Statistics being one of them.

Which takes us back to the issue of quality of basic education (primary, secondary) in most countries, including the OECD ones. And that is for sure a policy issue (education policy) in most countries.


22 months after I first wrote these thoughts, I am amazed at how more relevant they seem today.

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