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Financial Literacy and Economic Growth

May 25 , 2013

A few months ago, while developing some new material for the course in international finance that I teach at the University of Maryland, I came across a study produced by

Michael Justin Lee

This astounded me. Since the publication of my first book, “The Chinese Way to Wealth and Prosperity,” I have been invited often to speak about China and Chinese culture. Given the title of my book, it’s not terribly surprising that the one question I have been asked most frequently is how Americans might implement the Chinese way to better manage our finances. You can therefore imagine my surprise at seeing these results. 

Fast forward to this past January when the university’s winter break finally afforded me a chance to delve into the matter. I had no reason to challenge Visa’s conclusions or methodology, but with the support of the McGraw-Hill Research Foundation, I sought to ascertain some possible implications for American economic and educational policy. 

Visa’s overall conclusion about the United States notwithstanding, there was a very disturbing sub-conclusion. On the critical question of whether our college aged people are prepared to manage their own money, the US ranked an unbelievably abysmal twenty-seventh, ahead only of Bosnia! 

This is far more important than the fourth place overall finish. China’s middle of the pack ranking isn’t terrible considering the early state of their financial markets. But I shudder to think what awaits us in the future if our young people can’t do any better than second to last. 

How has it come to this? There couldn’t be any country which has dedicated greater public and private resources to developing financial literacy than the United States. This is what we in the financial profession call a crappy return on investment. 

I contend that our young people’s financial illiteracy is yet another manifestation of our oft-mentioned national deficiency in STEM (Science, Technology, Engineering and Mathematics) competence. The United States inarguably needs a broader STEM foundation. This is quite well known. China has no similar problem. I believe success in that endeavor would already be half of the solution to our American young people’s financial illiteracy. 

For the other half of the solution, I believe we need what I coin Financial Numeracy, a subset of financial literacy. Prosaic numeracy, the ability to use numbers to perform everyday tasks, is a necessary but insufficient step toward the achievement of functional financial literacy. Something else is needed. To see why this is, consider the following scenario. Let’s say you have $200 in a savings account. The account earns 10 percent interest per year. How much would you have in the account at the end of two years? I believe everyone would agree that this calculation should be quite manageable for anyone claiming even low level financial literacy. 

Unfortunately though, Annamaria Lusardi of the Global Center for Financial Literacy at the George Washington University School of Business determined that only 17.8% of surveyed Americans could correctly answer this very question. Here’s the answer: $200 × (1.1)2 = $242 

It requires no more than fifth grade arithmetic. At the time of this writing, my son actually is in the fifth grade. Having asked him to calculate the answer, I’m pleased that he is able to. But what he hasn’t yet been taught (I’m working on it) is the appropriate context into which the arithmetic can be placed. Therefore, he does not yet understand the meaning or significance of compounded interest or more important: why we are performing the calculation in the first place. This is what I call financial numeracy. Our young people need a great deal of this if we’re to rise from the cellar of the financial literacy standings. 

China can do better too but I’m sure their ranking will improve simply with further development of their financial industry. This is because unlike the United States, Chinese young people do not lack for numerical skills. This is no matter of opinion. International test results affirm this repeatedly. I am absolutely convinced that Financial Numeracy will come rather easily to the young Chinese and with it, financial literacy. 

It is very important for me to emphasize that I am not making a self-serving exhortation for more college students to become finance majors. It’d obviously be fine for me if exposure to personal finance encourages some students to study the discipline deeper but that’d just be frosting on the cake. Instead, my intention is to expand the catchment. My position on a university faculty of finance permits me to assure the financially or mathematically fearful that there’s nothing for the basic management of their personal finances that necessitates the study of economics, calculus, statistics or accounting. 

For China and the United States, if we succeed in inculcating Financial Numeracy among our young, I know we’d be a big step closer to the top of the financial literacy rankings. That’d obviously be great for the financial literacy movement and absolutely magnificent for our country’s economy and our young people’s futures. 

Michael Justin Lee, CFA, is a lecturer in the department of finance at the University of Maryland and the author of the white paper entitled, “The Challenge of Financial Numeracy: Requisite Mathematical Reasoning for Financial Literacy” from the McGraw-Hill Research Foundation.

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