Here's a little test. You buy a new £1,000 computer, but you need to take on some debt to finance it. You have two options: pay in 12 instalments, £100 a month for a year; or borrow at an interest rate of 20 per cent and pay back £1,200 at the end of the year. Which is the better offer?* Or are they both the same?
Take your time. Annamaria Lusardi, an Italian economics professor now based at Dartmouth College in the United States, has been asking a lot of people this question. Only seven per cent of Americans get the answer right. Even simpler multiple choice questions about interest rates and minimum payments on credit cards baffle the majority of people.
Lusardi believes that financial illiteracy is a major problem in the US and many other countries, rich and poor. It contributed to the credit crunch because too many Americans were ripe to be mis-sold subprime mortgages. It has severe daily costs for people who resort to usurious payday loans and other forms of short-term credit, or older people about to retire on an inadequate pension.
Lusardi is particularly worried that the poor, the elderly, ethnic minorities and women are less likely to be financially competent, and she wants something to be done.
But what? Lusardi argues for introducing financial education into the school curriculum. And perhaps that would work, although the evidence is a little slim. We can have some confidence that financial literacy - the ability to answer Lusardi's questions correctly - leads to better financial decisions in life. But it is far less clear that taking classes at school do much to help improve financial literacy itself.
That is why new research conducted with entrepreneurs in the Dominican Republic caught my attention. Three economists called Alejandro Drexler, Greg Fischer and Antoinette Schoar conducted a controlled experiment in which small business owners were given classes in how to manage their business cash flow.
Four hundred business owners were given a brief but comprehensive course in business accounting; another 400 received no training at all; the final 400 were given a course consisting of rules of thumb. These quick tips were intended to show how to keep business cash and personal cash separate, and how to use simple reckoners to figure out how profitable a business is.
The results were a triumph for rules of thumb. The business owners taught these simple maxims had better control of their accounts, saved more and seemed to manage cash flow better in hard times. The accounting training, by contrast, didn't help at all.
So perhaps rules of thumb are an answer to financial incompetence. Here's one: never buy a computer in instalments.
*Answer: Borrowing at 20 per cent is a much better offer. Either way, you pay back £1,200 in total, but the monthly instalments require you to start paying back the loan almost immediately. The implicit interest rate of the monthly instalment deal is closer to 30 per cent than 20 per cent. That's a very large difference.
Tim Harford's new book, Dear Undercover Economist
, is now out in paperback
BUY IT HERE Dear Undercover Economist: The Very Best Letters from the "Dear Economist" Column
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