Even the pros could benefit from Finance 101

The economic slump has roots in faulty logic and unwise moves by the financial elite, analysts say. Congress has designated April as Financial Literacy Month.

By Mark Trumbull | Staff writer of The Christian Science Monitor

from the April 30, 2008 edition

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When Congress designated April to be Financial Literacy Month a few years ago, the goal was to address a dearth of money smarts among the general population. But a funny thing happened on the road to financial enlightenment: It turns out that even the pros have a lot to learn.

"Illiteracy" isn't quite the word for it, but some analysts say that America's current economic slowdown has important roots in flawed logic and unwise behavior among the financial elite.

In short, America is getting some unplanned financial education this year that extends to boardrooms as well as schoolrooms. The hard lessons will probably weigh upon the credit and housing markets for several years.

But how well will those lessons be learned? It's an open question whether banking is destined to remain a source of instability in the economy, or whether leaders in business and government can learn to better manage financial risk.

"The reality is that finance is a complex business," says Peter Morici, a University of Maryland economist at College Park. "There has been no monopoly on foolish behavior."

In some cases, the lessons for financial sophisticates are the same ones that some programs for schoolchildren have been teaching this month: Be careful how much you borrow; if the return on an investment is higher than average, then its risk is probably higher than average, too.

A few examples of where the professionals have gone astray recently:

•Mortgage companies popularized loans where the buyer put no money down, a risky practice that helped fuel a housing boom – and now a bust.

•Wall Street banks relied on complex mathematical models to gauge the value of their investments, but they misjudged how far those values could plunge when times got tough.

•Regulatory agencies, critics say, put too much faith in the ability of financial institutions to safeguard their own interests. Now, those regulators have to clean up damage such as an expected rise in bank failures.

A central problem is the cyclicality of lending and real estate activity. In the euphoria of a boom, professionals successfully reap big profits, but they also tend to commit lapses that set the stage for a bust. They forget basic principles or push into new activities they don't comprehend.

"In many cases, they didn't understand the risks they were taking," Mr. Morici says.

And their mistakes can have big repercussions. Although many factors are at work, financial-industry missteps are one reason for an economic downturn that may be turning into an outright recession.

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