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Finance Is So Profitable Because People Are So Financially Incompetent

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Berkeley economist Brad DeLong observed last month that the U.S. finance industry has doubled in size over the past forty years while also claiming we have little positive (and much negative) to show for it. After Kevin Drum pondered why competition has done so little to shrink profit margins in what seems an easy-to-enter industry, finance professor and columnist Noah Smith gave a (by his own words) partial answer for the stubborn profitability of the finance sector: consumer ignorance and the enormous growth in demand for borrowing. I generally agree with these answers and below push a little farther by suggesting that it is the financial illiteracy and desperation of most Americans that have allowed financial service companies to escape the trend of the last few decades towards disintermediation.

While economists are still debating why information technology seems to be falling short of delivering the short of productivity growth long predicted to be a soon-to-arrive benefit of all the investment in computing hardware and software, one place it has clearly delivered efficiency gains is in cutting out middlemen. This disintermediation has given us the ability to buy direct from manufacturers over the internet and even created new verbs as we Google our way to lower search costs and Uber our way to lower transportation costs. 

Disintermediation certainly worked its magic on stock trading where online brokers aggressively discounted trading commissions, greatly lowering the profitability of that financial service. There is some progress along similar lines going on with student lending and financial advising (examples here and here), but those efforts are still in the very early stages. So the question is why have we not seen more of such technology-driven margin squeezing in finance?

First, most people simply don’t understand or want to understand finance. The psychology of investing is such that denial is common, with people loath to look at their 401(k) statements when the market is down. In fact, supposed financial advisors even advise ignoring your statements so you will stick to long-term investment goals. However, not paying attention to your investments means not learning how much you are paying in fees (visible and invisible). null 

Second, people are not educated about finance. Colleges may make students take biology, history, and other classes as general education requirements, but learning anything about saving, investing, and how financial markets work is purely an option. There are plenty of books and online sites where people can learn the basics, but an amazing number of people never even try to understand how finance works. That means they don’t understand the fees they are charged, how credit card interest charges accumulate, how to construct or stick to a budget, and so many more facets of basic money management. 

According to the National Foundation for Credit Counseling’s Consumer Survey of Financial Literacy, only 40 percent of Americans have a budget and track their spending, 29 percent of adults are saving absolutely nothing for retirement, and a staggering 75 percent admit they would benefit from getting financial advice. Yet these survey numbers change little over time. In some sort of Alice in Wonderland world, we know we don’t know something important but do nothing to fix it.

Third, we are really broke and desperate to borrow money on virtually any terms (because we have no bargaining power). As Neal Garber recently wrote, 47 percent of Americans would need to borrow money or sell a possession in order to cover an unexpected $400 bill. While the average American moans about stagnant earnings and a rising cost of living, the sad reality is that most of us live beyond our means. The cost of living is rising not just because of inflation but because we have deemed the latest smartphone, HD television, and trendy clothes to be necessities. 

This is a choice. Google “living frugal” and see how many people manage a much lower cost of living (and then write guides about how we can copy them). If we followed the simple rules of spending less than we make and keeping three to six months expenses saved for emergencies, we could turn down high-fee lending offers and shop for a better deal when we wanted to borrow money. Unfortunately, we too often do not want to borrow, but rather need to borrow. That means the lender has the power and can charge us more, leading to higher profits.

Bureaucracy plays a role, too. Most workers that have a 401(k) or similar retirement plan through a job are restricted in the investment choices offered. That means they may be unable to avoid fees as easily as those with unrestricted funds can by just purchasing a low-cost index fund. Employers are notorious for selecting non-optimal fund managers that cost their employees in fees that translate over the years into a significant loss of wealth. Government financial regulations, especially post-2008 have also been driving up costs and perhaps even creating barriers to entry.

The increasing globalization and the growth in the size of the finance industry should have led to economies of scale that lowered profit margins over time. Information technology should be ideally suited to driving down costs in financial services where so many decisions are driven almost entirely by easily quantified data points. Yet thanks to our financial incompetence, financial services providers are continuing to earn outsized profits. When enough Americans take control of their finances and manage their financial lives more responsibly, we will suddenly see better offers with lower fees. null 

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