Author’s Note: This was my winning entry for a HeroX challenge to find the root causes of financial illiteracy and propose a solution. I’ve reposted it here to gauge interest in me moving forward with the idea by developing it into a personal finance course. Visit BiteSizedFinance.com to join the email list and show your support for an entirely new way to think about financial literacy.
Note that the essay was written and submitted in spring 2016, so some of the statistics like unemployment data might be a bit outdated, but the general point of the article is still valid.
What is money? Almost everyone thinks they know the answer to this question, but usually they are wrong. The truth is, the majority of people don’t truly grasp the concept of money at a basic, fundamental level. To most people, money is just something you use to buy stuff, whether it is food, housing, or a new car. They don’t realize that money is something more abstract than that. This misunderstanding about money is the root cause of financial illiteracy, which is a problem of great importance in the United States and globally. But to fully analyze the extent and implications of this problem, it is worth backing up to define what is meant by the term “financial literacy.”
Financial literacy is often defined in terms of basic personal finance skills like budgeting, saving, and diversification. Thus, the usual advice to solve the problem of financial illiteracy almost always consists of teaching those skills to people at an early age so that they can “start while they are young” in order to have a reasonable shot at retiring some day. But while teaching those skills is important, it does not impart true financial literacy.
True financial literacy is an ability to increase one’s net worth regardless of the economic climate. With that definition, it starts to become clear why those basic skills mentioned earlier are not sufficient. Saving, budgeting, and diversifying are only useful to the extent that you actually have money to save, budget, and diversify. It does not address the issue of how to create that money in the first place. That piece of the puzzle requires a deeper understanding of money.
At an abstract level, money is just a carrier of value. If a plumber fixes my water heater, he has created value for me by doing something I don’t know how to do. In exchange, I give him some money that he can exchange elsewhere for other valuable goods and services. Money is a way to simplify the exchange of value throughout a very complicated network of individuals, businesses, and governments. But despite the complexity of the overall network, every single connection consists of a very simple exchange of value. Thus, the process of making money can be summed up into two words: find value.
In practical terms, that means money can be acquired by one of three primary methods:
Get a job – By helping a business make money, you have created value for them. In exchange, you get money.
Invest – By noticing price discrepancies between various forms of value, you get a bargain price on your exchange, resulting in profit.
Own a business – You deliver a valuable product or service in exchange for money.
Of these three basic methods of income creation, the first two have shortcomings. A job is a very reactive approach to generating income. Of the three methods, it is the one most subject to economic fluctuations. In addition, it is limited by the amount of time in a day. When working for an hourly wage, even if you could work every hour of every day, there is an upper limit to how much you can make.
Investing also has problems of its own. Specifically, to make any substantial amount of money from investing requires either a lot of money up front or decades of patience. This is a great way to grow wealth, but not a very realistic way of creating wealth.
This leads us to the third option: owning a business. By starting a business, you are building a machine that creates value for others in exchange for payment, and that machine continues to become more valuable over time as the product improves and it develops stronger relationships with customers. In addition, the initial startup cost can be greatly reduced by leveraging your existing skill set, reaching out to your network, and structuring creative deals that aren’t reliant on money. This makes it more effective than jobs and investing as a means to create initial wealth.
These facts are supported by evidence. By looking at the most recent list of people on the Forbes list of the 400 richest Americans, we can see how the most successful and financially literate people in America go about creating wealth.
Of the top 10 people on the list, six of them built their fortunes from starting businesses, while one person did so by investing and three inherited their wealth. Of those who inherited it, all of them inherited from their parents who themselves created businesses. So of the 10 richest people in America, nine of them are rich as a result of entrepreneurship.
A common counter argument to this is that those people created their fortunes decades ago when the economy was much different than it is today. That is true, but further data shows that to be irrelevant. Of all the people on the list, 17 of them are under the age of 40. By looking at only those young people, we can see how people have created vast wealth in more recent decades.
By looking at that subset, the argument still holds up. Of the 17 billionaires under the age of 40, 13 of them built businesses. The remaining four all inherited their wealth from parents who built businesses. (Note that Mark Zuckerberg was on both the top 10 list and the under-40 list, so there is some overlap). Not a single person on either list built their fortune from having a job, and only one (Warren Buffett) became rich primarily as a result of investing.
The data clearly indicates the power of entrepreneurship to build wealth. But what has not been shown is the distinct lack of any organized effort to teach entrepreneurship in schools. To demonstrate that problem, we have to look no further than the levels of unemployment around the world.
Presented in table 1 is a chart showing the unemployment rates of over 200 countries. Of the 200 countries included in the chart, nearly half of them (45%) have unemployment rates of at least 10%, while over two thirds (69%) have unemployment rates over 5%. Currently, the U.S. unemployment rate is about 5%. However, the most recent Gallup poll shows that the underemployment rate is a more discouraging 14%. The implications of this data become even more startling when viewed in light of the student debt crisis.
Currently, student debt in the United States alone is over $1 trillion. That debt is not removed by bankruptcy and it damages the financial growth of young people for the rest of their lives. Even worse, that money is being borrowed by young people in the hopes of improving their job prospects. But as the unemployment data demonstrates, those jobs simply aren’t there. There are too many people looking for jobs because they don’t know any other way to create income. The data clearly illustrates the need for a complete change in what we teach kids about money. By looking at the data, we can develop an entirely new paradigm of financial education. That new approach to teaching would involve a few key components.
First, let’s teach young people about the basic fundamentals of how money works. By teaching them the most basic concepts of money, they will understand the need to be creators of value. This will be the “why” of entrepreneurship.
Second, we need to teach them the skills required to start businesses. It is not enough to teach them why they should start businesses. They also need to learn the technical skills required to generate income, such as product design, sales, and marketing. This would be the “how” of entrepreneurship.
Third, this new way of teaching should come at an early age, ideally before high school. On one hand, we need to encourage young people to stop defaulting to the same recipe of going to college to get a job, which only results in an imbalance of value consumers vs. value creators. But at the same time, college will still be the right choice for some people. Thus, this change needs to occur at early grade levels so young people have at least a few years to decide whether or not college is appropriate.
Financial illiteracy is the result of not understanding money at a fundamental level. By teaching those basic concepts of money with a focus on entrepreneurship, we can get young people to create new value and generate income while giving them the confidence to skip college altogether. The outcome of this would be an end to the student debt problem and the unemployment problem in one fell swoop. That would be a truly revolutionary approach to financial education.