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Frances, despite the crash, I'm sure equities will still return more over 18 years. Don't forget that in the mean time, bond yields have fallen to nearly 0.

Have you heard of the marshmallow test for success. Four year olds were told that they could have one marshmallow now or two marshmallows if they waited some min. Most broke down before the alloted time. But about 30 percent were able to wait it out and get the larger treat. This was done in the late 60's and the children have been followed. Those who delayed gratification have been significantly more successful. Now I get to my point. It is not what you know, but what you do with it that counts. I think almost everyone knows that not paying off credit cards is financially stupid, but do they have the self control not to run them up?

I think almost everyone knows that not paying off credit cards is financially stupid, but do they have the self control not to run them up?

Self control isn't the only thing required. In this day and age you also need a certain degree of immunity to the corporate consumer propaganda you're bombarded with every day from birth as well.

Frances: While debtor households may not be adept at arithmetic, one would expect their creditors to be. If debtors are pushed off the edge, it is the creditors who stand to lose. (Unless they're bailed out, on behalf of the general taxpayer...for the good of society, of course.)

Andrew F:  How sure are you?  The Nikkei has returned a rockin' -74% (plus some dividends) over the past 20 years.  Yen bonds have been pretty spectacular in that period.  If we get some deflation the real return on those treasuries might look pretty good in 18 years.

On a more theoretical note, I am starting to doubt the idea of equity risk premium, and the premises of CAPM in general.  With no risk free asset (i.e. there's inflation risk) we are left with the zero-beta CAPM.  And in that world, who's to say that we prefer the risk of the zero beta portfolio over the market portfolio?  Personally, I might prefer a portfolio that preserves my rank in the economy rather than one with uncorrelated (but still undiversifiable) risk.

And on the topic of financial education, I completely agree.  What passes for information is nothing more than brokerage industry marketing literature.  Did anyone watch the round table on The National last night discussing how people should be allocating their income?  Turns out we should 1) save more cause we have too much debt, 2) keep spending cause the economy needs us.  Nodding smiling heads all around.  Also, Patti Croft (head economist at RBC securities who explained back in March 2000 why we should all buy tech stocks) says we shouldn't worry too much about debt to income since, you know, it's backed by housing.

Rachel, yup, unless financial literacy programs in high school can somehow teach people how to resist the temptation of marshmallows (or, worse yet, potato chips)?

There are ways to trick ourselves into overcoming this weakness of will - if I store homemade cookies in a glass container on the kitchen counter, I can't walk through the kitchen without grabbing one. But if I put the cookies in an opaque tin where I can't see them, it's much much easier to resist. Unfortunately this kind of economic psychology isn't a big part of financial literacy programs - though it should be.

Andrew F - sure, stocks might recover. However if Sara and Joshua have a few thousand dollars (or less) to invest, they can't possibly get any diversification without going into mutual funds, and management fees on even i-funds held in a discount brokerage account will eat up a significant portion of the difference between stocks and bonds, especially if the stocks were bought at the height of the market. So there is a very good case for saying that the correct answer is "it depends."

Robert McClelland - and financial institutions tend to be fairly enthusiastic about financial literacy programs, perhaps because it shifts the responsibility for making good choices onto consumers.

K: "On a more theoretical note, I am starting to doubt the idea of equity risk premium" - yes, I'm glad someone is saying this.

I tend to agree with Rachel, but; I keep hearing anecdotes about young people who think things like they only have to pay interest on credit cards if they don't make the minimum monthly payment.

Actually one of my favourite questions on the 2008 US Jump$tart survey is this one:

Don and Bill work together in the finance department of the same company and earn the
same pay. Bill spends his free time taking work-related classes to improve his computer
skills; while Don spends his free time socializing with friends and working out at a fitness
center. After five years, what is likely to be true?
a) Don will make more because he is more social.
b) Don will make more because Bill is likely to be laid off.
c) Bill will make more money because he is more valuable to his company.*
d) Don and Bill will continue to make the same money.

Not at all obvious to me that (c) is the right answer.

Frances:  Yeah, cause the manipulative sociopaths never go anywhere and the most technically competent always rise straight to the top.  Who writes this crap???

People who have never worked in the real world.

By is it that many people in general, and Baby Boomers in particular can't grasp that business in the real world is as capricious, illogical, greedy, short-sighted and outright dumb as often as it is brilliant, efficient, profitable and far-seeing?

Frances: It's about 10%, yes?

Maybe I'm making harder than it needs to be but it wasn't all that easy to figure out:

m is monthly payment,
p is principle
i is monthly interest rate (annual rate / 12).
n is the number of periods (months in this case).

Using the simple formula for monthly payment:

m = p*i / (1 - (1+i)^-n)

Say m1 is the payment at 3%, m2 the payment at 4%. Ignoring changes in principle:

% change = m2 - m1 / m1

Skipping some algebra:

% change = (i2 * x1) - (i1 * x2) / i1 * x2

where :

x1 = 1 - (1 + i1)^-n
x2 = 1 - (1 + i2)^-n

Maybe it could simplified more, but my algebra is pretty rusty. Plug-in 4% and 3% over 25 years and I get about 11%. Checking against the online CMHC mortgage calculator I get the same thing.

On the Jump$tart thing: In the world I live on (c) is the suckers answer. The right answer is (a), provided Don is playing golf with his boss and is better looking because he works out. Unfortunately for me, I don't play golf ;)

K, Determinant - it's tricky because, yes, some of these financial literacy questions (and, one can infer, the curriculum students are being taught)do seem slightly bogus. But as my original post, and Nick's comment, points out, there (probably) are many people who are seriously unaware of how precarious their financial situation is. So there's a problem, and a proposed solution, but I'm not convinced that the proposed solution solves the problem. And part of it is that the people who write the financial literacy curriculum are, one suspects, people who work in the financial services sector, and they make their money by selling a set of products - hence the number of times you will read financial advice suggesting that people borrow money to invest in an RRSP.

Patrick,

I can't work out this stuff out either (hence I added "e", none of the above, in case none of the options I'd put down were correct - almost always do this these days when I'm writing a multiple choice exam).

But as you suggested, I went on-line and used CMHC's on-line mortgage calculator. A $100,000 mortgage, amortized over 25 years, with monthly payments and an interest rate of 3%, will incur a total of interest payments of $41,973 over the life of the mortgage. Same assumptions, 4% interest rate, and the total interest payments are $57,806. So that's an increase of 37%.

In the first version of the post, I wasn't clear that the payments that I was talking about were the interest payments - perhaps that's why we get different answers.

Fixed or variable rate? If he has a fixed rate loan, then the real interest component goes down as the nominal rate for new mortgages goes up.

Matt: the typical Canadian mortgage has a fixed rate that re-sets every few (1,2,3,4,or 5) years.

US mortgages are very weird from our perspective. The so-called 30 year "fixed rate" US mortgage doesn't exist in Canada. It's what we would call an "open" mortgage, because the borrower has the option to switch to a cheaper mortgage at any time. Our open mortgages only last one or two years.

"Not at all obvious to me that (c) is the right answer."

I had thought that "(e) both Don and Bill will be laid off and their job outsourced to India" would have been a credible answer.

"I'm glad someone is saying this."

Well, people have been saying this, and more, for a long time now. I'm too lazy to fish up the references for you, but here is a recent paper on the financial consequences of the non-existence of a risk-free asset: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1648164.

DAMN! I did what I always did as a student and didn't read the question carefully. I calculated the % increase in the monthly payment, not the % increase in the interest component of the payment. That would be harder to calculate.

"I think almost everyone knows that not paying off credit cards is financially stupid, but do they have the self control not to run them up?"

Again, I don't have the reference handy, but my recollection is that quantifying the degree of stupidity influences behavior. In particular, the claim that I am think of was that if the implied repayment period is printed next to the minimum payment amount, then both A) the percentage of card-holders making the minimum payment decreased, and B) the average payment, relative to balance, increased.

As is often the case with multiple choice questions, "not enough information" is likely the correct answer, since the right answer likely depends on the terms and exact numbers involved in the mortgage. I'd agree 33% would be a close estimate, but it depends, mostly, one whether you increase your payment to maintain the amount going to principle.

I think the proposed solution (better financial literacy education) is a good one, but coming to an agreement about what better financial literacy entails will never be agreed upon. The financial industry has its profitable axes to grind. The government bureaucrats who determine curricula are unlikely to be particularly qualified in this area either. Us accountants tend to think that it's not understanding, but information that most people are lacking, and therefore simply tracking income and expenditures will fill that information gap and let people make rational choices.

The advice to save nothing for retirement if income is low is no longer correct. The Tax-Free Savings Account (TFSA) allows up to $5,000 per yeqr to be contributed from after-tax income. The earnings on the account are not taxable and prioceeds are not taxable when taken down. Funds withdrawn for other purposes (e.g., an emergency) can be contributed again without penalty, without affecing new conributions.

This Account is seen as a way to ovecome the high margianl tax rates on low income people receiving GIS, who face a 50%$ clawaback rate.

Mike - great to see you join the comments!

Yes, TFSAs are a big help for low income people who wish to save.

I was thinking more in terms of the replacement rate issue, as opposed to the marginal tax rate issue - thinking about my aunt in Scarborough, who found that she was better off after she retired that she'd ever been during her years working as a waitress at Simpsons.

The income required to maintain one's current standard of living upon retirement depends upon the life stage one is at.

A recent report by Keith Horner, that I discuss here: http://worthwhile.typepad.com/worthwhile_canadian_initi/2010/07/is-there-any-point-in-saving.html suggests that for anyone with children earning under $40k a year the replacement rate offered by GIS, OAS, CPP etc is enough that there's not really a need to save.

Mike: so money in a TSFA, or withdrawn from a TSFA, doesn't count against GIS, but money in an RSP, or withdrawn from and RSP, does? Interesting. I didn't know that.

The interest proportion of a mortgage rises from .03 to .04 or 33%. The confusion seems to arise from one person using the payment (a blend of interest and principal(sic))while Frances Woolley was asking about the interest component. If the payment was on a one-year mortgage, then the annual payment would rise from 1.03 to 1.04 per dollar of principal.
The interest portion would rise by 33% but the principal paid would be the same. The payment is the sum of these two components and it would rise by a small percentrage (1.04/1.03) or 0.97%.

Well, actually you should save even at low income.

The future real value of public pension programmes cannot be taken for granted by a rational economic actor. Even if the programme nominally survives, for example, its real value may be significantly depleted by the deliberate undercalculation of inflation rates.

Savings offer a hedge against political risk.

Roland, yes, political risks are very real, but the question is: what is the rational response to those risks?

In Cuba I once met someone who wouldn't save any money in a bank account because of the political risks - one could never be sure that the government wouldn't just turn around and seize one's assets. He saved by investing in auto parts (true story).

If you save and then the government introduces asset tests for programs aimed at poor individuals, then you could end up being worse off as a result of savings.

Investing everything in one's kids, staying healthy enough to keep working and maintaining a strong social network - like Don in the financial literacy test - might be the best strategy.

@Nick - The TFSA is currently not counted as income for any purpose. However, there's a significant risk that these rules may change before many people retire.

@Mike - The question asks about the proportion of monthly payments going to interest. Since a change in interest rate inevitably changes the repayment plan, the increased interest cost is only exactly 33% for the first payment. Over the course of the mortgage, the increased total interest payment (and thus the average paid on each monthly payment) will not be exactly 33%. Unless, I suppose, you have an interest-only mortgage.

Given what we know of general levels of financial literacy (ie many people, including smart ones, can't seem to understand basic concepts), I always read with a degree of wonder WCI discussions of fiscal policy. While in theory notions like marginal tax rates matter, I don't know anyone who can do the assessments discussed on WCI, like whether poor people should save for retirement, how their pay raise might make them poorer (if they fall into one of those 110% marginal tax traps) and so on. Not saying those discussions are not interesting and important, but let's not assume that they apply in real life. Even something as simple as the optimal rate of reimbursement of an HBP is beyond most people.

Perhaps finacial literacy courses should be very practical and show the consequences of the most common issues that people face ("quantifying stupidity" as Phil said), and not get into explaining how and why it is so - they can learn more if they want, but most would rather not. Make people calculate their mortgage payments at various interest rates, make them think what they'll have to cut (weekly restaurant outing?) to face the increase, and so on. The total price of the house (after 25 years) is more meaningful to most of us than the interest component of the mortgage payment.

Rule of thumb: financial literacy courses should not be written by finance or economics specialists...

I'd say Rachel and Robert have it about right between them in that some people can avoid hyperbolic discounting without any help, but most people do better if the environment is supportive.

I re-iterate my comment from a previous discussion of this topic here.

Frances, the Bank of Canada Financial System Review triggered a lot of media coverage on rising and excessive household debt in Canada. I was hoping you might shed some light on this issue. I did not find the article in the Globe that you cite very impressive.

Is there really a problem here? With unemployment relatively high, wouldn't one expect some Canadians to draw on the large equity in their homes, and thus increase total household debt? And doesn't this make sense when interest rates are low and debt service ratios low? Aren't the aggregate numbers quite reassuring, e.g. debt to asset ratio of about 19%, about what it was in 1990 (see Statistics Canada Financial Indicators)?

And then there is the Bank's stress test under a negative labour shock of 11% unemployment. I'm not sure the moral of the story should be that Canadians deserve to be upbraided over their debt levels. More like: don't lose your job! If you keep your job, your debts are manageable. If you lose your job, your previous excessive borrowing still might be in your favour if you happened to have done it to acquire a home that is now much more valuable than one you could have more easily afforded. It's not clear that Canadians need a lecture from the Bank on this subject at all.

So...

"You earn $20,000 per year in a minimum wage job. Each year you should plan to save:"

GrossIncome    $20,000.00	
PersonalDeduct $10,382.00	
NetIncome       $9,618.00	
FederalTax      $1,442.70 @15.00%
OntarioTax        $485.71 @5.05%
TotalTax        $1,928.41	
NetIncome      $18,071.59	
ExpensesPerYear (per month)
RentWithUtils   $9,000.00 ($750)
Transport       $1,920.00 ($160) TTC pass, 2 taxi rides
Food            $2,400.00 ($200) 6$/day?
Clothing        $1,200.00 ($100) Save for a suit?
TV/Phone        $1,200.00 ($100) Landline+basic cable
Entertainment   $1,200.00 ($100) Movies,books
SundryPerYear     $240.00 ($20) Coffee occasionally
Vacation          $500.00 (Don't go far...)
Gifts             $300.00(Christmas and birthdays)
TotalExpense   $17,960.00	
Savings(NetIncome-TotalExpense)	$111.59
SavingRate $111.59/$20000 = 0.56%
0.56% is closest to "Nothing". I might *prefer* 5%, but given that I used a fairly minimal list of expenses in the first place, it's not clear where that other 4.44% is coming from.

In the interests of transparency, I provided my calculations. Feel free to disagree, plus or minus.

My strongest impression? Anyone successfully living on $20000 per year is probably more financially literate than the average!

Chris S - You raise a good point with these calculations. On an income of $20,000/year any savings are reducing consumption at a point where the marginal value of additional consumption is pretty high - and the future benefits of saving are uncertain.

Gregory - when I see a question like yours my first thought is "I hope one of the macro guys will jump in and answer it." Honestly, I don't know. Not having anything intelligent to say on the subject, I'll just repeat David Andolfatto's point from earlier:

"If debtors are pushed off the edge, it is the creditors who stand to lose. (Unless they're bailed out, on behalf of the general taxpayer...for the good of society, of course.)"

To some extent, if people can't afford to pay their mortgages - so what? The demand for houses will decrease, the price of housing will fall, some people will walk away from their mortgages, but their houses will still be there. As long as we can avoid destruction of the housing stock, isn't it basically a bunch of lump-sum transfers - some people gain, some people lose?

The big if, of course, is "as long as we can avoid destruction of the housing stock." That's one of the things that I find really painful about the US crisis = the sheer mindboggling degree of waste resulting from the destruction of perfectly good homes.

Carney's speech (available at http://www.bankofcanada.ca/en/speeches/2010/sp131210.html -- and well worth a read) is a useful and practical warning to those who have not lived through a credit tightening or have not studied financial history -- a valuable public service, in my view.

I think sound "financial literacy" is equivalent to the wisdom of our grand-parents -- be true to yourself, don't try to keep up with the Jones', don't buy what you can't afford (cable on $20k a year springs to mind, along with $1200 suits!), saving up for things makes you appreciate them more when you have them, life's a marathon and not a sprint and living below your means will make you happiest in the long run.

FW - Indeed there is physical loss and waste in the US housing meltdown, but I must confess that it does not pain me in the least when put beside the kids who are struggling to go to school while living in shelters, tents, cars or on the street after their parents' losing their homes.

To tie all that together - for the fiscal policy-makers, the role of stagnant median after-tax family incomes in our increasing debtload should be clear. The importance of ensuring that the present generation of kids are able to live in decent comfort and invest in their education cannot be exaggerated -- hopefully they'll be able to use their education to manage things better than our generations have!

Barnaby: "when put beside the kids who are struggling to go to school while living in shelters, tents, cars or on the street after their parents' losing their homes"

- precisely, it's the madness of people living on the streets while homes stand empty - or are gutted by people looking to make a buck or two from salvaged copper piping.

Sara and Joshua just had a baby. They received money as baby gifts and want to put it away for the baby's education.
This was a US survey? The first mistake is saving anything for college if you think your child will go to a top 50 school.

Base-line financial aid is doled out like this, roughly:
Cost of Education Per Year (all inclusive: tuition, fees, housing, food, travel, books, supplies)
-0.20*(Students Assets)
-0.12*(Liquid parents assets excluding home, retirement accounts, and 52K "savings protection")
-0.33*(Parents Income net of taxes excluding 24K "income protection")

Private universities are more generous. It escapes me why anyone would make the boneheaded move of saving for college at all--or worse savings in the child's name.

Retirement accounts permit you to give yourself a loan for education costs or during a qualifying event such as unemployment or illness.

Consequently the only rational course of action is 0) make sure your kid is bankrupt, 1) put your money into your house (or family farm), and 2) stock the rest away in your retirement account, and 3) keep no more than 52K in liquid assets--more than adequate to cover a year of the median household income. Spend the rest, buy nice stuff!!!

Frances Woolley said: "To some extent, if people can't afford to pay their mortgages - so what? The demand for houses will decrease, the price of housing will fall, some people will walk away from their mortgages, but their houses will still be there. As long as we can avoid destruction of the housing stock, isn't it basically a bunch of lump-sum transfers - some people gain, some people lose?"

What happens if the banks don't have enough capital set aside for the losses?

Phil Koop: That was a pretty bad paper you linked to.  Basically they review Markowitz and *nothing* after.  Then they pontificate on the consequences of no risk free asset, like it had never been considered before.  No math.  No reference to href="http://www.mef.unina.it/download/finanza/Black_JB_72.pdf">Black 1972. Not a single citation in the whole paper.  No mention of inflation risk:  they seem to assume that default is the only thing that makes government bonds risky.  And they claim that default free zero coupon government bonds are risk free (no rate risk???), but that for coupon bonds you can't reinvest your coupon at a predetermined rate and that this is a source of risk.  Utter nonsense.

Most of the paper is dedicated to discussing the consequences of increased risk premium.  But as far as I can tell there is no logical support for the premise that risk premium ought to be increased.  And premium over what?  There is no risk free asset, yet no discussion of a zero-beta or other reference portfolio.

The point that I was making was very specific: In an economy where two fund separation applies but with no risk-free asset, it is not clear to me that the zero-beta portfolios will lie below the market portfolio.  Perhaps this is nonsense, but if not, I'm pretty sure it must have been considered over the past 40 years.  

Chris S: Unless I'm missing something, EI and CPP 'contributions' need to be considered as well.

I find it hypocritical when the governing classes chatter about "too much debt" and "living paycheque to paycheque". It's simply unrealistic to assume that everyone can save six months living expenses on their own, especially the young.

Furthermore the generation that is now in charge was raised during the post-war Keynesian consensus. It was government policy that there should be full employment. If you are employed, these debt levels aren't so bad. But since the 1980's we've got rid of the full employment at any costs policy. We have chronic high unemployment, private sector DB pension coverage is declining and job security doesn't exist anymore. Why are we shocked when we have debt problems given the lack of job security?

Determinant - There's a difference between the normative: "you're a bad person to have debt" and the positive: "you're going to be ****ed if interest rates rise."


I would see both "you're a bad person to have debt" and "bad things are going to happen to you if interest rates rise" as normative. Both hinge on definitions of "bad". I knew someone who lived very well for 25 years on borrowing against rising house prices. When they fell, he went bankrupt. But - as he pointed out - he had had 25 years of living very well, as had his kids.

The poor spend more on gambling than the rich. They know that saving is pointless - small shifts in matters beyond their control (illness, outsourcing) will leave them ****ed anyway. But a big win offers the possibility of escape, which saving can never do.

Whether poverty is rough or genteel is socially determined rather more than a matter of individual rational calculation.


I would add that attitudes to both debt and saving vary significantly over generations. In earlier times, climbing to wealth and status was often a matter of generations, with moves such as marriages, education and location plotted decades ahead. Small continuous savings made sense, since they mounted up over long periods. But the individual was not planning for him/her self, but for their children or grandchildren - for their lineage. Likewise, sometimes debt has made sense - you owe money, but you garner relationships. At some times, these are more valuable.

Does the current situation owe something to a clash between attitudes and changing possibilities? When there is a strong expectation that upward mobility will be the norm, low savings might be expected. When mobility lessens, there would be a strong temptation to go into debt rather than adjust to a diminished future.

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