Wednesday, October 12, 2011

In praise of "slavery" or Why education should be equity financed

As an avowed free market libertarian, I am, in general, opposed to Government intervention in the economy. Conceptually, an intervention can be justified only if the nature of the problem is a "market failure" , or if a "public good" has to be provided. Even in such cases, the intervention is justified if and only if the proposed intervention solves the identified problem without inducing unintended collateral damage.

Hence whenever any Government intervention is proposed the tests that I use are a) Is there a market failure? b) If not, are there gaps in financial markets that prevent the market from functioning and then c) Is the cost-benefit evaluation of the intervention better than laissez faire?

The reason I think about financial markets separately is that a well functioning financial market is an unstated assumption in free market theory. Markets for "real goods" can be hampered if people are not able to make intertemporal trade-offs (e.g., borrow money to start a company and then repay it later) or manage risk (e.g., insurance for different "states of the world"- investments may dry up if people think that a single event can wipe out their money)

Having laid out the conceptual framework let me get to a specific example: Recently when I contested the case for Government intervention in education by a friend, he asked me how I would view the problem? Without Government intervention (either by being the provider of free/subsidized education or being the payor by schemes such as school vouchers or Government mandated low interest rate education loans), wouldn't the market for education just collapse- perpetuating poverty since the poor will not have access to education?

The argument seems sound: While education is not a public good in the economic sense (since it is definitely excludable, though it is somewhat non-rival), for a poor person, the benefits of being educated are clear, but how would he ever raise the money to pay the fee?

Is there a gap in financial markets to provide the same? Why have student loans not solved the problem?

For that take a project finance view to education (that is, consider that educating a person is a project. An applicant comes to you (a financier) and asks you for money to finance his education. How would you view this proposal in purely financial terms?). What are the characteristics of this project in financial terms:

1. The payoff is real, but variable: Education definitely leads to an increased economic payoff to the beneficiary (i.e. the applicant). However the degree of benefit is highly variable (see the high distribution of income among all people that you attended school with). Hence the financial requirement is for risk capital, since the financier has to be willing to live with variable payoffs.

2. The payoff is deferred: The returns to education typically accrue after a time gap (for school education the gap is considerable- maybe as high as 15-25 years). Hence the financial requirement is for patient capital, the financier should be willing to defer his expectation on when his money would be returned

Hence from a project finance standpoint, the financier needs to provide patient risk capital. In finance, the capital that has this characteristic is not debt (that is loans) but equity. Equity implies taking a risk, and being content with getting the payback much later. But in equity, when the investment does payoff, you get a much higher return (unlike debt where the returns are fixed)

The missing gap in financial markets is that you cannot buy equity in people (such contracts are generally not allowed in law). If I could sell a part of myself (in financial terms) I may be able to raise the money needed for education.

Markets would arise where we could trade shares in people. Just as in financial markets for companies you have equity investors at various stages of financing, based on their own risk appetites and expertise (for example, angel investors for startups, venture capitalists for fledgling companies, private equity firms for different stages of growth, and the capital markets for more mature companies) we would have various investor profiles for investing in people too.

For example I may make a bet that out of 500 schoolchildren in a village in Bihar,my assessment is that at least 2-3 people may end up as high income earners. If I invest by taking a stake (say 50%) in each of them and pay for their school fees, they will owe me 50% of their income in perpetuity.

The crucial point here is that many investments may fail, but the successes could be so huge so as to justify the investments across the entire portfolio (just as VC and PE firms do with companies).

Such an investor, would at a later stage, offload some of his stake in specific people, to later stage investors. Financial aggregators would warehouse risk across multiple investments (for example, I will create a scrip tha is an aggregation across 10,000 IIT students which I will trade; this may raise the money to finance their MS/MBA in the US in top schools), just as mutual funds and other funds do for companies.

In industries of a "superstar" nature, such contracts actually exist! In an industry like book publishing, or music, the distribution of incomes is very high- successful people earn huge amounts (like  Lady Gaga or a writer like J.K. Rowling), unsuccessful ones end up with no money. Music companies or book publishers typically take up "rights", that is a percentage of the revenue from the sales of the book/ album. This is a equity like contract.

But such a contract would not be possible for the person's earnings as a whole- which is why they don;t exist for other industries.

Look forward to the day when such an innovation would be allowed!


Visitor said...

Very interesting. Although I think structuring repayments on the debt to give it an equity-like flavor should be possible no? So for instance repayments can begin at different times on the basis of the person in question. Also, the percentage to be repaid increases with increased earnings and the time you take to begin repayment?

Seems like a workable solution can be thought through?

Anonymous said...

There are two functions of education. One of them is learning, and learning is something that becomes very specialised as students progress. There are plenty of systems that effectively enslave the labourer from the time they are seeking a job during professional school until death. Think the partner track in major law firms and consultancies. High performers take loans and then they are repaid by companies. Salary tracks and potential rewards make it hard for people to leave. This system is well developed for the most sought after talent.

However, there is another purpose for education from the perspective of the community. The community is more productive and provides a better platform for businesses to operate when there is a basic level of education (and health and roads, etc,). This is not about learning as much as socialisation. English, math, knowledge or the law, and much more is less about individual earning potential than about unlocking a network effect that the community can use to be a better platform to business.

Businesses want to go where there is a higher level of labor available per rupee of cost. Many of us who vote in communities also value this. We have a sense that life will be better when we can all talk to each other, when people can count, when there is some knowledge about each others cultures and religions.

I'd agree with you that learning should be funded by equity, but socialisation is also a part of the equation and is better funded in a different manner than you suggest.