Last week, I a lot of fun discussing the de rigueur issue of bank capital requirements with various people. I especially thank Miles Kimball and Josh Hendricksen. Today, by chance, I come across this blog, written by someone who calls themselves squarelyrooted. One post in particular caught my eye:
Of course, since we haven’t invented time travel (and even if we had if giving money to your past self changes the future we might trap ourselves in an infinite loop) you are assisted in this process by an outside lender, usually a bank or bankish institution, who assess you a fee for borrowing this money. However, a fee doesn’t quite solve the big inherent problem in this model, which is “what if you don’t give the lender the money back” which is why we invented collateral, which in addition to being an excellent movie is the formal name for “if you can’t pay the bill the bank takes your [thing you borrowed the money to buy]” and assuming your legal system functions sufficiently well then you’ve got yourself a financial system.
However, education poses two major problems to this model. Firstly, there’s no collateral – once educated, your education cannot be reclaimed or clawed back. Secondly, there are massive positive externalities to education – a more educated workforce is more productive, more innovative, and produces higher quality goods and services for everyone to consume. And the big problem is that these mitigate in opposite directions, the former against having an education loan market at all even though the latter makes widespread education hugely desireable.
It seems to me we need to repurpose an idea from the old days for modernity. And by old days, I mean the idea was the common form of education during the Middle Ages — it was an industrial organization tool used to protect proprietary information. The tool is still used today, though much more limited in scope. I’m talking, of course, about apprenticeship. Apprenticeship is a system by which a tradesman takes an equity stake (by providing time and resources) in training a pupil, and then captures a reward in the form of excess profits while the apprentice performs work under the tutelage of the “master”. The system doesn’t work exactly that way today, but it does still exist for skilled trades (often through unions).
As noted above, debt is not a particularly smart way of funding investments in education. This is because debt financing affixes a fixed payment schedule to a highly variable income stream. Absent the generous subsidies we’ve hobbled together, this arrangement would be largely untenable for most lenders, except at an interest rate that most borrowers would find unacceptable. In short, the market would be tiny. Students should instead finance education out of cash and equity.
This is actually surprisingly easy to do, given that state governments run a rather large public education infrastructure. A Federal cash grant that was based on a weighted average of tuitions at state universities would act as a price anchor, in the public system. Students would be free to spend the cash grant at any university they please — from the cheapest state university, where it may cover the entire bill, to a top-tier university. The point is that the grant would be automatically available for poor and middle class students enrolling each year in any university. All the government would need to do is set the initial rate and then tie it to inflation. The cash grant need not be large — university education is currently well overpriced due to the subsidies for student debt financing.
Finally, for the portion of education that is not covered by the cash grant (and not even every public university would be, UCLA is a more popular destination that UNO, after all!), investors could finance equity stakes in students, as Luigi Zingales lays out here:
The best way to fix this inefficiency is to address the root of the problem: most bright students do not have any collateral and cannot easily pledge their future income. Yet the venture-capital industry has shown that the private sector can do a good job at financing new ventures with no collateral. So why can’t they finance bright students?
Investors could finance students’ education with equity rather than debt. In exchange for their capital, the investors would receive a fraction of a student’s future income — or, even better, a fraction of the increase in her income that derives from college attendance. (This increase can be easily calculated as the difference between the actual income and the average income of high school graduates in the same area.)
Kevin Drum thought at the time of writing that investors wouldn’t take equity from students under the top 50 universities…but that ignores the fact that prices (and yields) would adjust to equilirbiate supply and demand for equity at all levels of education. But say there is still an unfortunate cohort that would be locked out of equity markets. If people in that cohort are dead set on attending Harvard, just have the government take an equity stake at a marginally punitive dividend yield (discouraging government as first equity partner).
Under this system, I think that the vast majority of students that attend college could do so solely on cash grants and savings.