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MAPPING FINANCIAL LITERACY: COGNITION AND THE ENVIRONMENT

Mapping financial literacy: cognition and the environment by Gordon L. Clark

CLARK, G. L. (2013): ‘Mapping financial literacy: cognition and the environment’, Geografiska Annaler: Series B, Human Geography 95 (2): 131–145. ABSTRACT. Recent research suggests that regions can be char acterized according to their (more or less) financial literacy. One implication is that there may be regional ecologies of finance nest ed within national institutions and global markets. This article be gins by situating behaviour in time and space, linking behaviour to the interaction between cognition and the environment. This is fol lowed by a substantive account of the geographical scale of the “en vironment” working from the global to the local and in return from the local to the global. By implication, maps of financial literacy re flect the skills and expertise of resident populations, affecting how they sort amongst the relevant information to make effective de cisions (which have a material effect on their long-term welfare). Explaining how and why this is the case is one goal of the article. It is also acknowledged that representing the relationship between be haviour and the environment is conceptually and empirically chal lenging. Reference is made to new findings about the ways in which people “sample” the world around them, suggesting that cognition and the environment are intertwined in ways that may reinforce ex isting urban and regional inequalities. In conclusion, implications are drawn for the design and implementation of pension and retire ment saving policies. Keywords: behaviour, cognition, environment, financial literacy

Introduction Many years ago, Simon (1956) suggested that be haviour is produced at the intersection between cog nition and the environment – as symbolized by the blades of a pair of scissors. If useful for represent ing the context of behaviour, more often than not the environment is treated as “given” albeit signif icant (witness Oaksford and Chater 2007). Going beyond the scissors metaphor, March (1997, pp. 24– 25) argues that ‘decision-making is embedded in a social context that is itself simultaneously shaped by decision-making’. With reference to organiza tion theory, he argues for an ‘ecological vision of decision-making, a vision that considers how the structure of relationships among individual units interacts with the behaviour of these units to pro duce systemic properties not easily attributed to individual behaviour alone’. March seeks an “ac tive” environment of interaction, symbiosis, and mutual adaptation; his empiricism and theoretical

predisposition fit well with contemporary economic geography (see Bathelt and Glückler 2011; Pike and Pollard 2010). To illustrate, Leyshon et al. (2004, 2006) com pared the financial ecologies of poor UK neigh bourhoods with middle-class suburbs, arguing that market fundamentalism hides the realities of de pendence and vulnerability. In their work, it is sup posed that these ecologies can be coercive and (in effect) exploitative. Recognizing that local norms and conventions may not be benign, Leyshon et al. (2006) use terms such as “parasitism” and “symbi otic mutualism” to conceptualize the relationship between consumers and moneylenders in UK urban centres. They contend that this kind of relationship is produced by those who stand to gain from geo graphical asymmetries of knowledge and informa tion and consumers’ inability to understand the ways in which they may be vulnerable to doorstep market ing. Equally, they may have little choice in the mat ter; maps of financial literacy provide the financial services industry opportunities to exploit ignorance and lack of judgement (French et al. 2011).1 This article does not present new empiri cal research, or new ways of testing the financial competence of decision-makers by region or by socio-demographic characteristics. Rather, I refer to Leyshon et al. (2004, 2006) (UK), Fornero and Monticone (2011) and Klapper and Panos (2011) (Europe), and Bumcrot et al. (2011) (USA) who show there are distinctive geographical patterns or maps of financial literacy which demand explana tion. Elsewhere, I consider in some detail the logic and the ways in which the financial literacy of con sumers is tested and evaluated (Clark 2013). There are reasons to suppose that the formal conception of financial literacy, which underpins the research programme initiated by Lusardi and Mitchell (2007; Mitchell and Lusardi 2011), may not capture the range of possible environments. In some settings, low levels of (general) literacy combined with dis crimination and poverty (Fuller and Mellor 2008) may effectively exclude people from what Scott

© The author 2013 Geografiska Annaler: Series B © 2013 Swedish Society for Anthropology and Geography

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(2008, 2010) and others have referred to as “cog nitive capitalism”. Formal tests of financial literacy may be tangential, at best, for many individuals and their communities. In Clark (2013), it is noted that tests of financial literacy that rely upon puzzles or problems that re late to theoretical principles of financial decisionmaking are, unfortunately, more consistent with higher levels of formal education than the lived ex periences of many people. While a significant por tion of the population of a developed nation and its regions may perform reasonably well on these tests, the abstract nature of these tests of financial knowl edge and understanding may effectively exclude segments of the population and even whole regions. This does not mean that those unable or unwilling to engage in formal tests of knowledge and reason ing do not appreciate the significance of financial literacy when conceived in terms relevant to their everyday lives. The use of formal tests of reasoning based upon quantitative measures of performance, including probabilistic measures of risk and return, means that the average respondent is typically una ble to make sense of the underlying issues (a com mon trait, noted by Baron 2008). Even so, it is apparent that there are discernible patterns in successful test “performance” relating to socio-demographic status and regions of residence. In this article, the focus is upon how we might con ceptualize maps of financial literacy and behav iour, relying in part upon recent findings from the financial literacy research programme and related research in the UK and Germany (Burger 2011; Burger and Clark 2011). Throughout, I am con cerned with what people know, how people make choices between various options, and the role of the environment in framing or prompting individual be haviour.2 As such, the article is a bridge between re cent work on financial decision-making, the project on financialization, and the re-invigorated behav iouralism in economic geography (see Clark et al. 2012; French et al. 2011; and Pike and Pollard 2010; and McCormick and Schwanen 2012, Pykett forth coming, and Strauss 2008; respectively). At issue is how to make good on Simon’s scissors and March’s and Leyshon et al.’s ecological models of decisionmaking while being sensitive to how people actu ally make decisions in specific environments as opposed to those who favour a form of “universal” behaviouralism.3 In the first instance, the relationship between the environment and behaviour is conceptualized 132

by relying upon a standard Bayesian signal–re sponse formulation. This leads to discussion about the nature and scope of the environment, which is an explicit geographical conception separate and dif ferent from time. In the time domain, it is noted that behavioural psychology discounts the realism of Bayesian models of information processing. When we introduce space it becomes even harder to sus tain the empirical validity of signal–response mod els of cognition and the environment. It is contended that experience is almost always local, albeit linked to higher tiers of the spatial hierarchy via the threads of personal networks that are more or less robust in the face of spatial differentiation. The article notes the existence of distinctive and well defined maps of financial literacy. Accounting for the significance and persistence of these maps of literacy is shown to rely, in part, upon behavioural traits such as status quo bias and fealty to sunk costs. Recent research is cited showing that people sample the environment and that the sampling frame is, more often than not, systematically biased in favour of the local over the global (Stewart et al. 2006). Environment and behaviour Standard treatments of the relationship between environment and behaviour distinguish between the unit of behaviour, the individual, and the envi ronment or arena in which behaviour takes place. Assuming agents have well defined utility functions, seek to realize their interests, and do so in a logi cal and consistent manner, the environment can be treated as an opportunity set or the parameters cir cumscribing the relevant action-space. Whether or not agents are self-conscious about their interests and the means by which they seek to realize goals and objectives is less important than the assump tion that humans, like other animals, process sig nals from the environment mediated by pre-existing commitments (Hurley 2008). By this account, the environment can significantly affect behaviour, es pecially if it provides rewards and sanctions for different types of behaviour (individually and col lectively) (see Smith and Easterlow 2005). In its simplest form, this signal–response model of environment and behaviour can be applied to any number of situations (Rachlin 2000). Notice, though, the degree to which people understand and adapt to the environment will determine the success or oth erwise of their decisions. By convention, environ mental “signals” are treated as “information” such



that the latter must be processed in order to inform decision-making and hence determine behaviour. In this respect, the quality and quantity of informa tion representing the environment is fundamental to decision-making. But, of course, in modern econ omies information is hardly ever a free good. The Internet notwithstanding, searching for the requisite quality and quantity of information can be a costly affair: discrimination between alternate sources of information requires judgement and expertise. More prosaically, given budget constraints, it seems inev itable people trade off the expected benefits of ad ditional information against processing and search costs (Grossman et al. 1977). Social scientists cling to the signal–response model of the relationship between the environment and behaviour, supposing it provides a reasonable benchmark against which to evaluate observed be haviour (Pettit 2002, part II, ch. 2). Even so, assump tions made about the coherence of agents’ interests and intentions and their decision-making skills have been heavily contested. See, for example, Ainslie (2001) on the significance and consequences of weakness of will for the assumption that people con sistently seek to realize their interests over time. In a related vein, the behavioural revolution spawned by Kahneman and Tversky (1979) challenges the plau sibility of these assumptions in the context of risk and uncertainty (characteristic of financial markets). Most people appear unable to cope with this type of environment. Not all theories of decision-making and behav iour are sensitive to the environment (Alvarez 2010). In fact, some theorists are hostile to treating the en vironment as anything more than the action-space or stage for human beliefs and desires (Jackson and Pettit 2004). By contrast, Bayesian theorists assume that humans adapt to the environment and that process ing information from the environment is an essential cognitive response to that evolutionary imperative. In its strongest form, human information processing is tailored to the environment precisely because inade quate processing would discount individual welfare and ultimately collective survival (Anderson 1991). This is a large claim, and difficult to refute. Further, it exists at a level of abstraction which is quite in sensitive to time and place and, indeed, particular economic and institutional formations (Greif 2006). Nonetheless, it serves to emphasize that information processing is important. The issue is, however, how do people process information? One answer is that they do so in a Bayesian manner.

Bayesian reasoning links individuals’ pre- existing models of the world with acquired data such that expectations incrementally adapt in response to new information. The underlying probability dis tribution of possible outcomes anchors expecta tions about the future which evolve in response to changing information calibrated against that which is inherited from the past. Specifying the probabil ity distribution is very challenging, not least because it requires individuals to sort through the available information in a deliberate and systematic manner looking for patterns. As well, carrying forward the distribution of possible outcomes as the reference point for processing new information assumes that the process or processes producing the distribution of possible outcomes are stable (Kahneman 2011). Perhaps more problematic is the assumption that the relevant information is reliable, or at least that its er ror rate can be reliably estimated (see Tversky and Kahneman 1982), an issue of great significance for financial markets (Clark 2011). Most importantly, there are cognitive limits to information processing (Rachlin 2000). It is not sur prising behavioural research has found that many people are not effective Bayesian decision-makers (Clark et al. 2006). Even so, these objections do not necessarily void the idea that Bayesian reasoning is a standard by which to judge the adequacy or other wise of individuals’ information-processing compe tence (Jones and Love 2011a, 2011b). In this respect, it is apparent people use various techniques or meth ods of information processing in ways that are use ful, if not ideal. If it is important to select among the available information, sort its relevance, and use it in a constructive manner, people typically use fil ters or heuristics to manage information processing (Gigerenzer et al. 1999). One such filter may be the nature of the decision problem, its inherited char acteristics, and the limits that might be imposed to determine relevant information. So, for example, rather than treating decision problems as generic, people may be better off if they treat them as differ ent by type, requiring different kinds of information and domain-specific tools of assessment. Herein lies the significance of Lusardi and Mitchell’s (2008; Mitchell and Lusardi 2011) pro ject on financial literacy. Their emphasis on the cru cial concepts underpinning individual financial decision-making suggests that these concepts rep resent a type of filter that allows those with domain- specific knowledge and understanding to cut through the cacophony of information to the most


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relevant information. Put slightly differently, under pinning their project is a supposition that knowing these concepts is a cost-effective way of processing information from the environment. Instead of col lecting the available information on financial mar kets and products, financial literacy is a lens through which to determine the crucial information for mak ing financial decisions, and what might be deemed irrelevant or less important aspects of the environ ment. In this respect, financial literacy provides a template for those who must judge the relevance of existing information and search for more informa tion. Domain-specific concepts allow sophisticates to discount noise and the enormous flows of more or less relevant information (Wagner 2002). Scope of the environment The environment can be represented in a variety of ways. From the global to the national, from the national to the regional, and then to the local, each level in the spatial hierarchy is presumably a com ponent part of the total environment faced by indi viduals. With respect to financial markets, La Porta et al.’s (1997, 1998) ambition was to explain the map of stock market liquidity, the relative signifi cance of market intermediation, and apparent differ ences between countries in terms of the reliance of domiciled corporations upon stock markets for capi tal. Coming after more than 25 years of rapid growth in Anglo-American stock markets, but before the apogee of the neoclassical theory of finance owed to Merton and Bodie (2005) amongst others, their ac count supposed that Anglo-American market insti tutions would ultimately dominate their continental European rivals. La Porta et al.’s explanation of the hegemony of Anglo-American financial institutions emphasized the historical legacies or traditions of whole blocs of countries. They argued that English common law and the principles and practices associated with fi duciary duty have provided countries reliant upon that tradition a more effective means of switching capital between industries and regions on the basis of relative risk and return than found in countries whose legal traditions are not so adaptive or pliant to commercial interests. Importantly, the principles and practices associated with trust law are believed to have been based upon private interests before sovereign interests; the evolution and elaboration of trust law can be read as an expression of March’s (1997, p. 24) comment that ‘the development of 134

beliefs, rules, and expectations in one organization is intertwined with the development in others’ (see also Mackenzie 2008). While La Porta et al. did not reference path dependence, the implication is clear. Their account resonates with Arthur (1994) amongst others. In their geography of finance, nation-states are treated as organic wholes wherein private agents are assumed to be representative of their nation of or igin. Being one step below global capital markets and institutions, nation-states are crucial component parts of an evolving complex interplay of agents, in stitutions, and markets. The Euro crisis exemplifies March’s (1997, p. 24) observation that ‘competition, cooperation, and imitation lead organizations to shape each other’s decisions and decision-making’. As such, global markets have challenged nationstates to be effective decision-making units in cir cumstances where national interests are contested by those who stand to gain and lose from financial markets. Bauer et al. (2008) have shown that large European corporations have adapted their invest ment strategies so as to be consistent with the expec tations of global financial markets while abiding by national rules and regulations. Social scientists typically privilege the nationstate over its provinces and regions – a rank or der that is assumed to represent modernity (Miller 2000). And yet, in the European case, many nationstates are probably better understood as alliances of regions and industries rather than integrated wholes (Crouch et al. 2009). Agnew’s (2002) Italy is a set of regions whose relationship to the nation-state is tenuous at best. His political geography of Italy is simultaneously economic and cultural, discount ing holistic conceptions of national identity and functional integration. Equally, Clark and Wójcik (2007) argue that the German economic system is best understood by reference to regions’ financial cultures and their quite different traditions with re gard to the structure and market-facing propensities of inherited systems of corporate governance. There remain, quite obviously, significant differences be tween Germany and Italy, notwithstanding the sig nificance of their regions. Global economic success has provided the German nation-state with the re sources necessary to sustain economic and politi cal integration. As the Euro crisis has shown, some European nation-states could dissemble to their con stituent regions. Where the nation-state provides the formal le gal structure and its regions provide the norms and



conventions by which people make plans for the fu ture, behaviour is presumably formed at the inter section between institutional structure and social practice (Storper 2009). To the extent that there is a recognized relationship between the two, where na tional institutions provide a space for regional norms and conventions, that relationship may be constitu tive of the expected nature and likely scope of indi vidual options and behaviour. But, of course, there need not be stasis. The relationship between institu tional form and social practice may be heavily con tested within and without threatening, at every turn, to pull apart the social-cum-geographical construc tion of the nation-state. Further, conflict over the proper relationship between institutional form and social practice may be exacerbated by incentives to defect from one or the other or both – the rewards of participating in global networks may put stress on already stressed relationships between nation-states and their regions (as in Italy and Spain). In these ways, the environment is a multi-scalar phenomenon. Evidently, the trajectory of the “local” is bound up with its history as well as its intersection with processes operating at higher tiers in the spa tial hierarchy. If we assume, as Simon, March, and many others do, that the environment is essential to understanding observed behaviour this “world” could be, for many people, virtually unbounded. Environmental signals are likely to come from all di rections (horizontally and vertically). Just as infor mation must be managed according to its relevance in the time domain, individuals must also filter infor mation from different tiers of the spatial hierarchy. Intuitively, the filter of “relevance” should be suffi cient to prioritize the various spatial sources of in formation (Hogarth 2001). Experience and learning by doing can augment tests of relevance so as to fil ter information from near and far, on a case-by-case basis (Gertler 2003). However, it appears that expe rience and learning by doing are likely, on average, to prioritize the local over the global. While many people rely upon networks integrating the local with the global, the focus of their everyday activity re mains local.4 The contrast drawn here is between extensive networks of information and intensive networks of information. An important finding of the behavioural revolu tion is that most people, most of the time, are time– space myopic. People cope with the cacophony of information by eliminating that with which they are not familiar, reinforced by the observed behav iour of others who are part of their social networks

and reference groups or embody their aspirations (see Schultz et al. 2007; Ungemach et al. 2009). The cognitive difficulties of making judgements about the significance of current events in relation to future prospects and the significance of local cir cumstances with respect to global prospects are well known. In the face of market risk and uncer tainty, people retreat to that which they know best (Clark 2012a). This does not mean that most peo ple, most of the time, cannot look beyond imme diate circumstances and events to future prospects and other geographies (Doherty 2003). Gigerenzer et al. (1999) have shown that people can be trained to manage myopia, especially if the issues they face are framed in ways that are familiar while, at the same time, containing cues for effective decision- making. Nonetheless, people are not Bayesian in time or space. They rely, rightly or wrongly, upon local signals even if they recognize their experience is partial. This explanation of the status of the local over the global is consistent with theories of information processing and economic behaviour (see Coval and Moskowitz 2001).5 If the crucial processes affect ing the local come from the global, those affected need to understand the relationship between the lo cal and the global so as to collect the relevant in formation. But if they rely upon experience and learning by doing, they may be misled by local in formation because they lack the resources needed to test whether, in fact, that information is consistent with processes located higher up the spatial hierar chy. In this respect, financial literacy may assume greater importance than is often recognized: being a means of filtering information according to rele vance, it may also serve as a model of the way the world works by linking behaviour at the local level to expectations as to the structure and performance of the local in relation to global financial markets. In this way, forming expectations about local inflation requires a model of the local economy as well as its relationship to global financial markets. This is a striking conclusion, re-introducing a distinction noted above between the prevalence of informal modes of reasoning that are used by peo ple to simply get by and the more formal modes of reasoning that are organized around principles or structured sets of propositions that frame reasoning in ways that conform to the axioms of standard ne oclassical microeconomics. Both types of reason ing can be effective, especially in situations where expectations and plans for the future are realized in


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predictable ways. The former may not be optimal but good enough. However, the financial literacy programme makes the point that shallow or incon sistent understanding of financial principles can lead to mistakes in judgement and behaviour that result in significant losses of welfare (individually and col lectively) over the long term (Mitchell et al. 2010). Whether either mode of reasoning is robust in the face of market turmoil and systemic risk remains to be determined (empirically). Over-confidence in the robustness of formal models of the economy and fi nancial markets can have significant costs, perhaps more so than naïve responses that reinforce risk aversion (Clark 2012a). Mapping financial literacy The research programme initiated by Lusardi and Mitchell (2007) on financial literacy has brought into the open remarkable differences amongst US residents as to their financial sophistication with evidence to the effect that these differences can be correlated with socio-demographic character istics such as age, education, income, and gender. Lusardi and Mitchell’s test regime assumes that fi nancial decision-making is an issue of knowledge and understanding, not rationality per se. Their ap proach shares with behavioural psychology the use of puzzles or problems, which respondents are asked to solve. They test whether respondents know and understand basic principles of financial decision- making, including the effects of compounding, infla tion, and risk diversification on household investing. They are particularly concerned about whether re spondents are systematic in their knowledge and un derstanding of these principles. The implication is that knowledge of these principles is a fair test of in dividuals’ financial sophistication. Lusardi and Mitchell’s framework has been used in other countries, in part sponsored by the World Bank (see Miller et al. 2009). A study based upon the Bank of Italy’s survey of household income and wealth demonstrated that ‘most individuals lack knowledge of basic financial concepts’ (Fornero and Monticone 2011, p. 548). It was also found that gen der and education were correlated with poor per formance on tests of financial literacy. Importantly, they found significant regional patterns in finan cial literacy, such that respondents from northern Italy were more likely than respondents from south ern Italy to demonstrate knowledge of basic finan cial concepts. The authors were also able to produce 136

maps showing differential levels of financial liter acy across Italy. A similar study for Russia showed that for a national representative sample, taking into account administrative regions and the seven federal regions, low average levels of financial literacy were mediated by younger individuals with higher edu cation. Klapper and Panos (2011) also showed that financial literacy was highly correlated with urban ization, with a systematic regional bias in favour of the major urban centres of western Russia. One implication from these studies is that av erage levels of financial literacy and the regional spread of financial literacy are correlated with coun tries’ economic development (Rutledge 2010). As such, market integration could be thought to carry forward the geographical spread of financial knowl edge and understanding (consistent with Barro and Sala-i-Martin 1995). More subtly, however, re gional differentiation within and between countries can persist and reinforce financial literacy in some places versus other places because of their distinc tive paths of economic development. It is notable that the highest levels of Italian financial literacy were found in the Third Italy, regions of northern Italy dominated by small and medium enterprises reliant upon the economies of scope rather than scale. These enterprises and their regions are linked to the global economy through mutually beneficial networks of exchange and communication (Storper 1995). In effect, these networks bypass the nation in favour of the global economy, reinforcing extensive alliances rather than regional and national politi cal alliances, thereby deepening reciprocal relation ships and shared strategies that ameliorate market risk and uncertainty (Scott 2008). What is the origin of these types of environ ments? Here, we could refer to history and geogra phy in the sense that there may be inherited regional “cultures” which are consistent with the measured attributes of financial literacy. Financial literacy can be thought to be “produced” in certain types of cen tres and not others; financial literacy can be thought to be an endogenous attribute of certain economic, geographical, and institutional formations. Asheim (2000, pp. 420–421) goes further, contending that cooperation and mutual learning form the basis of long-term regional success. While there is less re search about the formation and management of the learning process per se, it is widely believed that this type of learning is based upon shared experi ence and expertise – in effect, the geographical shar ing of tacit knowledge (Gertler 2003). Emphasis on



incremental adaptation to an evolving world im plies, though, that Bayesian reasoning underpins the learning process. Regions with high levels of finan cial literacy are likely to be unusual and not easily produced elsewhere. Lusardi and Mitchell’s conception of financial literacy is particularly relevant to environments where people need a certain level of financial knowl edge and understanding to realize their aspirations. However, even in developed economies with long traditions of private retirement saving, there appear to be systematic and significant differences in finan cial literacy according to socio-demographic status. Socio-demographic variables, including age, gen der, income, and education are significant correlates of whether people are sophisticated or naïve con sumers of pension products (Clark et al. 2012, ch. 5). For example, Lusardi and Mitchell (2009) found that having had a college education has a positive effect on respondents’ financial literacy. More im portantly, they also found that ‘exposure to econom ics in (high) school makes respondents more likely to locate in the top quartiles of sophisticated finan cial literacy’ (Lusardi and Mitchell 2009, p. 15). As such, financial literacy can be “produced” by public policy: to the extent school districts and states vary in the provision of this type of education, the surface of financial literacy may be systematically uneven (see Bumcrot et al.’s 2011 study of financial literacy by US states).6 Liberal democracies such as the UK and the US share many legal traditions as well as a cul tural presumption in favour of individual respon sibility. This is, of course, consistent with La Porta et al.’s global map of financial institutions and mar ket liquidity. Even so, the widespread adoption of policy frameworks favouring individual responsi bility, notwithstanding inherited traditions of col lective responsibility, is readily apparent in Europe and elsewhere (Clark 2003). The diffusion of these frameworks can be explained by reference to shared solutions to common problems, such as the increas ing fiscal burdens associated with population ageing. The World Bank’s (1994) policy favouring the intro duction of a three-pillar approach to pension provi sion sought to discount reliance on state-provided social security in favour of self-reliance. With the involvement of the OECD in promoting policy di alogue and institutional innovation on these issues, there is evidence of contagion effects promoting the adoption of these frameworks, especially amongst neighbouring European countries.

Another possibility is that the adoption of pol icy frameworks favouring individual responsibility is coercive in the sense that they demand certain lev els of knowledge and understanding that only some groups and some regions have at hand. There may be interaction effects between individuals’ age, ed ucation, and incomes and the environment in which those attributes consistent with financial knowledge and understanding are monetized (Langley 2008). In this respect, the level of regional development may be a necessary condition for producing high levels of individual education and income, which, in turn, drives individuals’ financial sophistication. This may help explain the western, urban bias in Russia in favour of financial literacy found by Klapper and Panos (2011). Continuity and commitment There are reasons, however, to be cautious of the reach of Lusardi and Mitchell’s findings on the correlates of financial literacy and the implication drawn that knowledge and understanding is suf ficient for effective financial decision-making. It may be that knowledge and understanding is really about the necessary but not the sufficient conditions for skilled financial decision-making. For instance, Kahneman and Tversky (1979) emphasize the skills necessary to deal with risk and uncertainty charac teristic of financial markets rather than knowledge and understanding per se. By their account, the rel evant tests of sophisticated decision-making might include whether individuals can apply probabilis tic reasoning, integrate events with underlying pat terns, and can discriminate between the framing of problems and their underlying common properties (see Clark et al. 2007). It is possible that financial lit eracy is a means of processing information within an accepted framework rather than the means of making financial decisions. To illustrate, we begin with a simple model of decision-making and complicate its logic by refer ence to status quo bias, sunk costs, and imitation (see also Brown et al. 2011). Status quo bias refers to the preference of many people for ‘things as they are’ (Baron 2008, p. 297), reinforced by Kahneman and Tversky’s (1979) demonstration that people are loss averse (preferring to avoid loss notwithstanding possible gain). In their seminal paper, Samuelson and Zeckhauser (1988) demonstrated that many par ticipants in defined contribution or money purchase pension schemes tend not to act when they would


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benefit from rebalancing their retirement portfolios in the face of changing circumstances. Status quo bias and sunk costs are related in that people tend to honour past commitments, even reinforce those commitments notwithstanding the expected benefits of a change in strategy (Baron 2008, p. 305). Taking the analysis a step further, we ask whether leading and lagging “ecologies of reasoning” can be brought together through networks of relationships that ena ble the diffusion of knowledge and understanding. Spatial differentiation Assume our representative agents use a standard de cision framework consisting of ‘three basic com ponents: the alternatives available to the decision maker; events or contingencies that relate actions to outcomes as well as their associated probabilities; and the values associated with the outcomes’ (Payne et al. 1990, p. 131). Also assume that there are two agents, residents of a European country. One is lo cated in Region A, which has a rich culture of finan cial knowledge and understanding, while the other is located in Region B, which is underdeveloped in terms of its financial culture. Region A is function ally integrated with national and global financial markets whereas Region B is not. We assume that a region’s embeddedness in financial markets spills over to affect residents’ experience and expectations in a manner suggested by Harvey (2012). To com plicate the discussion, let us also assume that the na tional government has introduced a new retirement savings policy framework designed to discount the future costs of social security, encourage private (in dividual) retirement saving through tax incentives, and broaden the scope of the country’s financial ser vices industry (as in continental European countries; see Clark 2003). If agents recognize the implications of the new policy framework for their long-term welfare, they must choose a savings product (and provider) so as to realize retirement income aspirations. To the extent that financial knowledge and understanding frames this decision, we suggest our agent located in Region A would seek out a variety of options distinguished by product characteristics and prospects, whereas our agent located in Region B might only respond via a fairly simple choice between that which they know (e.g. property) and that which appears quite abstract and unfamiliar (retail investment products). To the extent that Lusardi and Mitchell’s tests of fi nancial literacy represent agents’ scope of financial 138

knowledge and understanding, it is likely that the uptake of retail investment products would vary considerably by region. Recognizing this possibil ity, the retail investment industry may well concen trate their sales efforts on Region A (which appears to be the case in Germany; see Burger 2011; Burger and Clark 2011). By this logic, our agent in Region B retreats to that which he or she knows. Status quo bias becomes the default option and he or she does not progress beyond the first element in the decision framework. What of our agent in Region A? This would appear to be a more complex situation in that our agent faces a number of plausible options (stage one), must evaluate the probable trajectories of those op tions (stage two), and must attribute value to those various options, combining the expected probabil ity of realizing planned outcomes with the expected value of those options (stage three). If there are time constraints on decision-making, if there are a num ber of alternatives, and if it is clear that some op tions are more risky than others, then the only way financial knowledge and understanding can affect decision-making is if one option or a small subset of options provides a high level of certainty. But, this is not likely. As recent events demonstrate, even gov ernment bonds with a “guaranteed” coupon value over a specified time horizon are subject to the risks of default. Our agents must manage the nature and scope of the decision problem before they can make a deci sion. With time constraints on the assessment of the available options, one obvious strategy would be to begin with those options that are well known and then extend the search for other options until the search budget is exhausted. If there are a large number of options, the available time can be used as a sorting mechanism to reduce options augmented by tests of relevance or salience that are cued against desirable product attributes (Tversky 1972). Inevitably, these types of heuristics embody status quo bias: our rep resentative agents are unlikely to come to these deci sions shorn of past commitments. Their experience, if any, in purchasing other types of financial prod ucts may lead to the same vendors or indeed similar products. When combined with ongoing commit ments, fealty to sunk costs may be a means of econ omizing on the costs of decision-making. Finally, to the extent that our agents can estimate with any con fidence the risks associated with selected options, they will likely prefer certainty over risk and possi ble loss.



Comparison and virtue The argument presented above relies upon the in teraction between cognition and environment, sup posing that “rich” environments versus “poor” environments produce quite different outcomes (Clark 2010). This argument, or more precisely an alytical move, is recognized as such in psychol ogy (Hogarth 2001), human geography (Smith and Easterlow 2005), and economics (Lusardi and Mitchell 2009). In doing so, I show the limits of pol icies designed to improve financial knowledge and understanding in terms of the process whereby in dividuals make decisions. This argument can “ex plain” the coexistence of different levels of financial sophistication by region of residence. It is also able to account for the persistence of spatial differentia tion in financial decision-making consistent with the findings of recent research sponsored by the OECD and the World Bank. But an objection can be regis tered: surely the fact that individuals are utility max imizers means that over the long term, landscapes of financial decision-making become homogeneous (Alchian’s 1950 notion of arbitrage). This objection can be countered by invoking the environmental imperatives that drive individ ual decision-making (by region of residence, etc.). Nonetheless, this counterclaim is rather unsatisfac tory. If the environment is so significant, whether the counterclaim works depends on the circumstances. This counterclaim then collapses into a myriad of stories told about other times and places. More im portantly, recent research in behavioural psychology demonstrates that human beings typically value the expected utility of various options via ‘a series of binary, ordinal comparisons’ (Vlaev et al. 2011). In this sense, it is not just about stories. It is about how human beings value what they have or aspire to have against existing reference points in the environment in which they make decisions. This suggests that cir cumstances and context determine at least the initial process of sampling options and comparing their re spective virtues. As such, the differences between Regions A and B may be very important – their dis tinctive attributes “anchor” the evaluative frame works of our representative agents. These arguments bring to light a larger debate about the significance of the individual in relation to his or her environment. One implication is that we should hold to the conventional model of decision- making as articulated by Payne et al. (1990) and make adjustments as needed by virtue of the role and significance of the environment for different

types or classes of problems. Nonetheless, con ventional models do not pretend to represent how people actually make decisions so much as how peo ple should make decisions. Research on how peo ple evaluate options suggests that cognition is not “compromised” by the environment; in fact, what ever the environment, people appear to sample and compare, rather than consider the absolute virtues of all options. In making a choice they consider the obvious options, based upon salient attributes, and compare the relative virtues of the available options given perceived attributes. This means that cogni tion is profoundly contextual (Vlaev et al. 2011). In this respect, conventional models may encourage quite ineffective policy interventions and regulatory frameworks. The sampling and comparison model of decision- making provides a useful way of “placing” the sig nificance or otherwise of financial knowledge and understanding. In the first instance, the options that people perceive as relevant and for which they have some information by which to characterize their rel ative virtues drive decision-making. Inevitably, they rely on past experience, perhaps presented as for malized decision cues or, more likely, as “fast and frugal” heuristics. Not surprisingly, status quo bias is the default option, just as a commitment to past patterns of behaviour and decision-making may in volve the escalation of commitment to established pathways. In this respect, the value of financial knowledge and understanding depends upon its sali ence against the sampled options. If the sampled op tions only need a modicum of financial knowledge and understanding, it seems reasonable that people would neither value it nor, for that matter, seek to understand its underlying principles. Providing fi nancial knowledge and understanding may have no discernible effect on decision-making, unless it is tailored to people’s perceived options and their cir cumstances (Clark 2012a). Imitation This discussion provides a rationale for why nation- states may be composed of regions with persistent differences in financial literacy. Nonetheless, it car ries with it a presumption that reasoning is always framed by place-specific referencing. This is not en tirely plausible, empirically and theoretically. To il lustrate, let us imagine that Region B is comprised of two sets of residents, one set X being better off fi nancially than the other set Y. With the introduction


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of the national policy promoting private retirement saving, the government initiates a national publicity programme led by a recognized sports star. Knowing something about psychology, government advisors use the sports star to encourage saving suggesting he exemplifies “national” virtues of thrift and selfreliance (Thaler and Sunstein 2008). In effect, the government seeks to “nudge” residents of Regions A and B to imitate the sports star. The geographical literature is replete with studies of the adoption and geographical diffusion of inno vations (new ideas). Early research by Hägerstrand (1967) focused on the spread of ideas from centres of innovation, suggesting that early adopters are located close to the source of innovation and that those at some distance from innovation tend to be late adopters. They note that some people are predis posed to adopt (whatever their location) while others adopt as knowledge and information about innova tions becomes available. If knowledge and informa tion is passed through chains of interaction, then the diffusion of innovation maps onto the chains of inter action. Assuming financial advisors and institutions (located in Region A) have an interest in enrolling higher income people (whatever their region) into new retirement saving products, these organizations have an interest in accelerating the rate of diffusion of these products from Region A to Region B (sub ject to the costs of distribution; see Burger 2011). To complicate matters, let us also assume that set X in Region B have spatially extensive family networks which extend into Region A (more so than set Y). If we assume that family and social networks are more effective than idealized exemplars like sports stars as transmission mechanisms prompting imitation and adoption (see Christakis and Fowler 2007, 2008), then a segment of Region B could be early adopters (like their cousins in Region A).7 But imitation and adoption is more demanding than of ten recognized. For Hurley (2008), imitation can be superficial and inconsistent if it involves simply copying someone else’s observed behaviour (saving for retirement). It may be “affective” behaviour if it is self-consciously adopted and displayed for peer approval. Worse, it may involve parody and playacting (simulation). Hurley (2008) suggests, in fact, that true imitation also involves learning to use and adapting the mechanisms used to “produce” the be haviour sought or deemed worthy of emulation. It is a question of embedding or embodying desired be haviour such that it becomes part of a person’s rep ertoire of behaviour. 140

Four implications follow from this argument. First, social networks can be effective in transcend ing the status quo and broadening sampling frame works in space and time (integrating Region B with Region A). Second, third parties can also play a significant role in facilitating changes in people’s choice and sampling reference points although whether these changes are superficial or not depends on the degree to which such changes are incorpo rated into behaviour. Third, imitation is impor tant and at the heart of the process of adoption. But whether imitation “sticks” may depend on people’s existing skills and expertise and whether the behav iour adopted is consistent with related activities an chored in everyday life. Fourth, where imitation involves adopting decision frames and techniques that are beyond everyday life, formal education and training may be required to make up the difference. In this sense, financial literacy may be a crucial in gredient in translating imitation into systematic be haviour. Otherwise, affectation or simulation may be the response. It is important and underpins human social interaction. It may, however, be ephemeral. Implications and conclusions This article began with the behavioural revolution and Simon’s scissors as a means of conceptualiz ing the interaction between cognition and the envi ronment. In doing so, I have provided an analytical framework whereby behavioural traits interacting with distinctive decision environments, which op erate on at least three different geographical scales, produces highly differentiated maps of financial lit eracy and decision-making. As such, it was noted that human behaviour is more heterogeneous than suggested by simplistic notions of biological or cog nitive determinism. Three implications follow from this analyti cal framework. First, understanding the nature and scope of human behaviour as established by cog nitive science and experimental psychology is an essential first step in providing a meaningful ac count of financial decision-making. It is difficult to see how economics and geography can fall back to strong versions of economic rationality appar ent, for example, in the theory of rational expec tations. Second, placing human predisposition in context is also an empirical project, requiring sensi tivity to the institutions and the various formal and informal codes of practice that frame (in a social and geographical sense) individual decision-making



(Strauss 2008). Third, neither human predisposition nor the environment is an adequate explanation of human behaviour; providing a meaningful account of their interaction is surely the essence of economic geography. These points are developed in some de tail before noting a more challenging implication that derives from recent research on the cognitive foundations of decision-making. For those seeking a rationale for the significance of the environment, Simon’s scissors loom large. His account of the interaction between behaviour and the environment has underwritten a much larger re search programme aimed at determining, for exam ple, the degree to which cognitive predisposition and the environment interact to create context-dependent expectations and preferences. See, for example, Tversky and Simonson (1993). Simon was an institu tional theorist, as well as an experimental psycholo gist with an eye for observed behaviour. Nonetheless, his notion of bounded rationality preserved the pre sumption in favour of human rationality (if not the pure theory of rationality) taking academic debate down a dead-end path towards categorical absolut ism: rationality versus irrationality. If useful when disputing notions of pure rationality (Shiller 2000), it comes at a cost. Researchers are, in effect, forced to choose sides. Unfortunately, many in the social sci ences have ignored the growing list of behavioural biases and anomalies (Kahneman 2003). Simon’s account of the interaction between be haviour and the environment has been developed in a number of ways. For example, environments can be classified as weak or strong, suggesting that some environments are so “disorganized” that their effect on behaviour is inconsistent, whereas other environ ments may have effective institutions and systems of integration such that their effect on behaviour is systematic (Haldane and May 2011). When dis cussing the findings of recent research on the maps of financial literacy by country and region, it was noted that large, metropolitan centres connected with the global economy appear to embody cultures that promote financial knowledge and understand ing consistent with market imperatives. By contrast, environments characterized by low levels of eco nomic development have little in the way of embed ded financial knowledge and understanding through which residents are able to make effective choices. By this logic, maps of financial behaviour can be characterized as maps of behavioural predisposition interacting with the richness or otherwise of resi dents’ environments.

A more convincing explanation for the persis tence of difference can be found in recent research on the nature of decision-making, emphasizing sam pling and selection rather than Bayesian reasoning. Given most people find it difficult (cognitively and practically) to collect the information necessary to characterize whole environments and indeed the place of one part of the environment in relation to other parts, psychologists contend that people cope with these difficulties by sampling. That is, they pick out data from the environment which they believe fairly or at least adequately represent that part of the world which is salient to their beliefs or expecta tions. Whereas some behavioural psychologists be lieve that sampling seeks to characterize the scope of possibilities, it is more likely that sampling is a heuristic, being ‘fast and frugal’ rather than univer sal in scope (Gigerenzer et al. 1999). As such, sam pling will likely over-represent that which is local as opposed to global unless the global is in some way imposed upon the local. Myopia is an ever-present prospect. People may recognize that their sampling frames are biased. But they are likely to economize on the cognitive and resource costs associated with a universal sampling frame that is well beyond their capacity to implement. This much has been realized by informed com mentators, from a variety of analytical and theoreti cal dispositions (see Thaler and Sunstein 2008). One solution mooted is that implied by Leyshon et al. (2004, 2006) and encouraged by the behavioural models suggested by Gabaix and his colleagues (Gabaix et al. 2006): to the extent people are vulner able to risk and uncertainty by reason of their cog nitive abilities and available resources, they should be protected from the predatory behaviour of well positioned market agents. Given the myopic na ture of many people’s decision-making, promoting informed decision-making may do little more than promote the interests of those already predisposed by cognitive ability, social position, education, or lo cation to act effectively on their own behalf. Further, it may simply protect the interests of metropolitan elites who, by reason of social and spatial position, are already integrated into what Scott (2008) termed cognitive capitalism. A second solution might be to encourage private institutions, third-party market agents, and organi zations to act on individuals’ behalf especially in the context of risk and uncertainty. This has been dis cussed at some length in recent public debate about the proper roles and responsibilities of financial


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service providers in the aftermath of the global fi nancial crisis. If framed in terms of fiduciary duty, this issue is more complex than historical accounts of the significance of the doctrine would allow. In economies where there are many agents, overlap ping institutional mandates, and intersecting inter ests that are almost impossible to isolate or separate, it is unlikely that third-party agents could be “exclu sive” agents representing people’s interests. Indeed, the complex interplay of agents and interests com bined with due regard to people’s (limited) cogni tive abilities has given rise to increasing litigation over the nature and meaning of fiduciary duty (Clark et al. 2012). Perhaps the ultimate solution is for governments to provide relatively simple but mandatory decisionmaking frameworks and institutional platforms that deliberately economize on the skills needed to be ef fective decision-makers, emphasizing standardized decision trees and shared default options. This type of solution has become more popular over the past 10–15 years, led by Canada, Denmark, and Sweden and now by the UK. As well, it is arguable that the Australian and Dutch systems of mandatory sup plementary pension scheme participation in large, multi-employer not-for-profit entities have many features in common with public utilities. Notice, however, the idea that a public utility is preferable to individual decision-making (informed or other wise) goes against the process of privatization and deregulation that marked the Thatcher and Reagan years (Clark 2012b). Indeed, it turns on its head the assumption that private agents are more rational, in fact, than governments. Acknowledgements This article draws upon our research programme on financial decision-making with Csaba Burger, Kendra Strauss, Janelle Knox-Hayes, Emiko Caerlewy-Smith, and the late John C. Marshall. Support for research has been provided by the ESRC, Allianz Global Investors, Mercer, Towers Watson, and the National Association of Pension Funds. I also wish to acknowledge a debt of grati tude to Neil Wrigley for his collaboration on issues related to sunk costs, status quo bias, and escalation. Sarah McGill and Ben Webster provided research assistance, Nick Chater, Gordon Brown, Olivia Mitchell, Dane Rook, and Dariusz Wójcik identified sources, and two anonymous referees provided in sightful comments and advice on a previous draft of 142

the paper. Thanks are also due to Najat El Mekkaoui de Freitas of the University of Paris–Dauphine and Netspar for the opportunity to participate in re cent Paris pensions’ workshops. None of the above should be held responsible for any views and opin ions expressed herein. Notes

1. See also Leyshon’s related research on the phenomenon of fi nancial exclusion which considers the causes and consequences of the withdrawal of financial services by financial institutions from certain towns and cities in the UK and USA (see Leyshon and Thrift 1995; Leyshon et al. 2008). 2. In this paper, we leave to one side the issue of household behav iour and how that intersects with other spatial scales, including the local, the regional, and the global. Brief mention is made in the penultimate section of the paper on cross-regional family learning and imitation strategies relevant to financial literacy. See also Clark et al. (2012) on the prevalence of household risk sharing and distribution strategies. 3. March and Simon, along with their colleague Richard Cyert, led a revival of interest in modelling observed behaviour many decades ago. Their work, and that of Hägerstrand, provided a way forward for social scientists including economists, geog raphers, and sociologists to analyse behaviour outside of the rational-actor straightjacket. While they often deployed bi ological analogies when making argument, this was done to illustrate and enlighten rather than hold fast to biological deter minism. This is also the case for Leyshon and his colleagues. More recently, experimental psychology has substantiated the insights of March and Simon if not always the validity of their suppositions. 4. It is revealing that Shafir et al.’s (1997, p. 364) discussion of the effect of inflation on how people judge the value of various options references a vignette introduced by Kahneman et al. (1986) which locates the issue in a ‘community experiencing a recession with substantial unemployment’. The local envi ronment matters a great deal when people are asked to judge the fairness or otherwise of various options (Kahneman et al. 1986). 5. This has significant implications for understanding the nature and scope of home bias in financial markets. See, for example, Hong et al. (2004, 2005) on the composition of mutual fund products by region of origin and Huberman (2001) on geo graphic patterns of investment. 6. Nonetheless, care must be taken not to confuse correlation with causation. The provision of economics in high school may be an indicator of the quality of education, especially significant in US states and municipalities where local taxes underwrite schools. In any event, formal training in economics may sim ply improve respondents’ recognition of the issues rather than prompting effective decision-making (see below). 7. It is arguable that the internet, social media, and related forms of electronic communications that can go “viral” could have the same effect. However, in Clark et al. (2012) we show that when it comes to financial decision-making most people place a large premium on trust – they are more likely to trust immediate family and friends than co-workers or employers; they distrust sources of information that are not validated (informally) by personal relationships. This is not to say that electronic sources of information are irrelevant. It is an issue of relative or com parative valuation (see above).



Gordon L. Clark Smith School of Enterprise and the Environment University of Oxford Hinshelwood Road Oxford OX1 3QY United Kingdom and Faculty of Business and Economics Monash University Caulfield VIC 3142 Australia Email: [email protected] References

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