Monday, June 28, 2010

Student Financial-Aid Reform: It's All in a Footnote

by Richard Vedder

Someone once told me that the theory of imperfect competition, usually considered one of the major theoretical advances in economics dating from the 1930s, was actually pretty much laid out two generations earlier in a footnote in Alfred Marshall's Principles of Economics. I was reminded of that reading a superb paper by my former student and Center for College Affordability and Productivity employee, Matthew Denhart. It seems that two giants in economics, Milton Friedman and Simon Kuznets, both winners of the Nobel Prize, wrote a footnote on page 90 of a 1945 monograph for the National Bureau of Economic Research that contains an alternative way to finance college education.

Friedman (better known in educational-reform circles as the founder of the voucher financing idea in K-12 education) and Kuznets (better known as the father of national income accounting) thought it was peculiar that people borrow money to finance their education. They noted that when investments carry inherently high risks, usually they are financed by the issuance of equity (common stock).  Individuals borrowing money face a fixed financial obligation upon graduation. But if they sell stock in themselves—say a right to 10 percent of their earnings for a decade or two after graduation—the financial burden varies with economic circumstances. Purchasers in equity interests in such persons make big profits on those who succeed well, and perhaps lose money on those who fail to live up to expectations.

As an economic historian, I have to say the Friedman-Kuznets proposal was not completely new even in 1945. Nearly three centuries earlier, at a time when major finanical institutions like the Bank of England or London Stock Exchange did not even exist (much less commercial banks), migrants to the New World could finance the very high costs of passage (about equal, relative to the average income, to what the costs of four years at a private college are today) by becoming indentured servants—agreeing to work for subsistence (below market) wages in America for a period of several years (usually not more than seven) in return for having the ocean voyage to America financed. The system worked well in bringing many of our founding ancestors to our shores.

Would a similar idea be a good idea today? There are lots of issues that need to be dealt with to make the idea viable—issues relating to the nature of the human-capital contract, as it might be called. How do companies decide on the percent of a person's income it must take, and for how long? While, on average, college graduates earn more because of their higher education, there are exceptions—students who fail to graduate, ones who fail to get very remunerative jobs, those who become drug addicts, etc. The percent of income payback required of fine-arts majors and historians would be less than that of business majors and engineers, for example. This, no doubt, would put some people into a dither. There has been at least one abortive effort to start such a scheme, but it succumbed as a byproduct of the 2008 financial crisis. A back of the envelope calculation tells me Harvard could probably finance the cost of attendance of all undergraduate students beyond existing financial aid for about 2 percent of its endowment—maybe investing in its own students would be a good use of endowment funds.

One person whose financial acumen I greatly respect, Charles Miller (who chaired the Spellings Commission and once also chaired the Board of Regents of the University of Texas) tells me that this is not a great idea. But if I were an aspiring presidential candidate wanting to break out of the mold and propose something different regarding higher education, I would at least explore the idea pretty intensely.

Mentioning politicians leads me to add: I don't think this should be a federal government activity. The Feds have pretty badly scrwed up our Byzantine current student financial aid system that has been accompanied by a decline in the portion of college students from lower income groups. The government would politicize it—we have too much government intervention in the economy as it is. Besides, the Feds don't have the money, and borrowing money from, say, the Chinese to finance student loans—what we are doing now—strikes me as highly dubious economic policy. But there are entrepreneurs like Michael Clifford or Randy Best out there who might see the potential in such a scheme.

I discuss this idea with some of the CCAP staff in this CCAP YouTube video.

2 comments:

Steve said...

One big problem with contracting for a portion of someone's income is that it disincentivizing working. If you have to pay 10% of your income to someone that will have the same supply-side effect as a 10% marginal tax hike.

Milind said...

I think the indentured servant arrangement of a few centuries ago represented a degree of servitude, and possibly a view of human nature, that would not be viable today in reinstating.Saying that however, what is being proposed here about restructuring financial aid should be explored and pilot programs developed to test it. Students paying back from the income they earn after graduating from college for the equity those investors put in their education sounds to me like a responsible approach in which everyone benefits. I am sure there will be challenges in implementing such a system, but pilot programs can work these challenges out. Ultimately I do not believe that such a financial aid system should be a large part of financial aid, but should have a place in financial aid and would probably stimulate other innovations in financial aid. It is the matter of finding those institutions willingly to take on pilot programs to make it a workable approach.