Economics: Greater Fools

Unsurprisingly, the less people know, the more they run into trouble. Gary Rivlin’s blistering new examination of the subprime economy, “Broke, U.S.A.,” is full of stories of financially ignorant people bamboozled into making bad decisions—refinancing out of low-interest mortgages, say, or buying overpriced credit insurance—by a consumer finance industry adept at creating confusing products. Such stories are backed up by the numbers. A study by economists at the Atlanta Fed found that thirty per cent of people in the lowest quartile of financial literacy thought they had a fixed-rate mortgage when in fact they had an adjustable-rate one. A study of subprime borrowers in the Northeast found that, of the people who scored in the bottom quartile on a very basic test of calculation skills, a full twenty per cent had been foreclosed on, compared with just five per cent of those in the top quartile.

What can be done? One solution is regulation: the financial-reform bill now before Congress will create a consumer financial-protection agency that should help curb the finance industry’s most predatory excesses. Another solution is to tinker with “choice architecture”—doing things like enrolling people in 401(k)s automatically—in order to “nudge” them toward better decisions. Both of these strategies are necessary, but they’re not enough on their own, because financially illiterate consumers are always going to be easy victims. We also urgently need proper financial education. [Emphasis added].

For more, see Greater Fools by James Surowiecki, July 5, 2010, at The New Yorker.