What’s the Difference Between Financial and Economic Strategies, and Why Does It Matter?

If we compartmentalize financial actions, we ignore the very powerful economic factors that influence financial health

At CFI we often talk about financial health as if it is a crisp, free-standing concept. Moreover, by connecting financial health to financial inclusion we imply – and hope – that we can affect financial health by offering the right kind of financial services and/or developing a person’s financial capabilities. However, while there is truth to this view, it is sometimes easy to overestimate the power of financial services. We need to think about how both financial and economic factors intertwine to create outcomes. If we compartmentalize financial actions, we ignore the very powerful economic factors that influence financial health.

As defined by the Center for Financial Services Innovation (CFSI) – and embraced by us at CFI – three elements must all be present to declare a person, family or microenterprise to be financially healthy:

  • Balanced day-to-day money management – outflows balanced with incomes over time.
  • Protection from shocks – ability to draw down, borrow or call upon resources to lessen the blow when bad things happen.
  • Pursuit of goals – ability to accumulate resources for medium to long-term purposes, whether personal or productive.

In speaking with low income people around the world, we find that many people intuitively define financial health in these terms, and nearly everyone tries to pursue financial health in their own lives. But achieving these three elements is not just a financial task. It requires both economic and financial actions. (It also hinges on personal choices and capabilities, but we will set these aside for now.)

No one lives exclusively on the basis of their financial strategies. In fact, financial and economic functions are so interconnected that it is often hard to distinguish them when we look at real life examples. For the most part, financial strategies supplement and facilitate economic strategies. Before you can even consider financial health, there must be an economic strategy that is at least minimally effective at generating inflows; from that base, financial strategies can amplify or leverage the economic strategy or compensate for some of its weaknesses.

The ascendancy of economic factors is illustrated clearly in the recently published The Financial Diaries, as it was in CFI’s research on financial health with CFSI and Dalberg’s Design Impact Group in India and Kenya. In Diaries, Jonathan Morduch and Rachel Schneider introduced a family experiencing month-to-month income volatility because the main breadwinner’s pay was commission-based, fluctuating significantly between peak and low periods (an increasingly common reality among Americans). It was hard for the family to manage their financial flows under these circumstances. While they used various financial tools and tactics to meet their needs, their most effective strategy turned out to be an economic action: a different job that provided a fixed, though slightly lower, salary. Financial strategies enabled the family to make the best of a difficult situation, but the economic strategy trumped (shall we say) the financial.

In Kenya we observed a young man responding to the vulnerability of his unlicensed pool hall business (which he explained could be shut down by the police) by developing a farm and other businesses. In both the U.S. and Kenyan examples, the objective was increasing the reliability of income, and the strategy for achieving this mainly involved changing income sources – clearly economic more than financial actions. In our work together, Dalberg referred to this as ‘shaping income’. Some of these shifts in income actually served partly financial functions (volatility smoothing in the U.S. and risk diversification in Kenya), illustrating that people often use economic activities to solve what might appear to be financial problems, and vice versa.

So, what is the difference between a financial action and an economic action, and why make such a fuss about it?

We can think of economic actions as those that directly involve the ‘real economy’. On the income side economic actions involve supplying labor or capital to productive activities (i.e. getting a job or investing). On the expenditure side economic actions involve managing consumption and expenses. Buying and selling services and things are economic strategies.

As usually defined, financial actions involve the manipulation of financial resources across time and space in order to make those resources more useful. Financial actions also include managing risk – the aim is to create risk exposure levels in keeping with risk appetite and return expectations. So, actions that move money (or other resources) across time and space or change risk exposure are primarily financial.

These categories are not neatly separated, however, especially for people who use few formal financial services, like our respondents in Kenya and India. We often observe economic moves being made for financial management purposes. For example, saving in cash or in a bank is clearly financial, but saving in gold bangles is also financial, because the bangles act as a store of value. Another frequent form of savings – in construction materials – could easily be mistaken for an economic strategy, but it is often a means to store value for later use, and so it, too, is fundamentally financial.

We might think of food deprivation as purely an economic necessity, but in fact, it can act somewhat like a financial strategy. Many people scrimp on food when they want to put money aside for an important objective. At the very low end of the economic spectrum, some Kenyan families reported coping with income volatility by skipping meals. Even well-off Americans may resolve to forego Starbucks in the morning and save the $4 a day they would have spent on coffee.

If the boundaries between economic and financial strategies are porous, why bother trying to distinguish them?

We considered the interaction between financial and economic actions carefully during our research on financial health in Kenya and India, ultimately deciding to focus the financial health framework on financial actions while noting the influence of economic circumstances as a context factor. This was a practical but not fully satisfying solution.

A principal reason for keeping the conceptual distinction in mind is to avoid considering only financial solutions to problems that fundamentally need economic ones. Another is to recognize the extent to which people use economic solutions in seemingly financial ways. If we are alert to both potential financial and economic actions and the interventions needed to support them we will consider a much broader range of solutions. Frequently, these solutions may not even be carried out by the same groups of actors.

In Diaries, the policy prescriptions Morduch and Schneider make to assist Americans struggling with volatile incomes are primarily economic: their top recommendation is to improve the quality of employment, with specific ideas like mandating more predictability in work scheduling and raising the minimum wage for workers who receive tips. They also recommend adjustments to government benefit programs that would give people steadier incomes. After all, if the problem is income volatility, the most obvious solution is less volatile income. Their financial-side recommendations are somewhat more specific: consumer protection, real-time payments, and savings products that combine discipline with flexibility. These recommendations all involve making financial services perform their important but modest functions as well as possible.

In Kenya and India strong policy levers on the economic side may not be available. The scarcity of resources for tackling economic problems is part of the very definition of underdevelopment. The private sector remains small relative to the number of potential job seekers, and the government can only offer very minimal income support. In such circumstances, financial strategies appear as more relevant levers partly because they can be made available. Certainly for the self-employed, financial tools are often needed to help them pursue their most important economic strategy – investing in their businesses.

As we work to understand the financial – and economic – lives of the poor, we in the financial inclusion community must strive to offer lower income households the best possible financial tools for coping with and overcoming the shortcomings of their available economic solutions.

Image credit: World Bank

Have you read?

Accion’s Financial Health – Results of a Survey

Dollar by Dollar or Goat by Goat: How Financial Health Translates Across Oceans

Seeking Happiness and Financial Health in Bhutan

 

Join the Conversation

Stay informed. Subscribe to our newsletter.