Aligning Compensation Incentives in Higher Education: Is Higher Education Debt or Equity?

Desperate times call for desperate creative fantasizing … isn’t one of the problems of our higher education bubble the poorly aligned incentives for the universities providing the eduction?  They provide a service for a couple of years as an expert agent to poorly informed principals, charging them for the service upfront, whereas the outcomes are not known for years and years down the road.  You might almost say that universities are a securitization shop, though let’s not get too enthused about abusing metaphors.

The situation is compounded given that the present purchasers of the service are borrowing money on a long term basis to finance it and, in effect, give the universities their payout today.  I don’t think that one can hope to solve the problem on the front end, not really, by insisting that people study only fields that we determine today to have job getting potential down the road; the information uncertainties are too great – no one knows where jobs, the economy, technology, services, etc., will move in the future.

At this point, however, one might say that the university, paid its fee upfront, without any obligation or knowledge of what a student’s outcome will be, has monetized the value of the education in the present, paid for by student loans.  The lender – effectively the US government, whether directly or through guarantees – has taken a super-secured interest in the student (so super-secured that it can’t be discharged in bankruptcy).  The interest is a debt interest, and creates harsh outcomes for students given a fixed borrowing cost that must be repaid no matter what the student does or is able to do.

In Europe, that harshness – and more than harshness, irrationality, given all the unknowns involved in the risk of accepting the loan – is solved by the government taking an equity, not a debt, interest in the student – or more precisely the student’s contingent future earnings.  This is done because the student repays not a loan at fixed principle and interest, but as a contingent profit interest in the form of taxes of one kind or another. Those taxes are generally either income or consumption taxes; they serve as a proxy of the student’s success in life.  The European governments, which provide free university education, and pays for it with taxes, is closer to the nature of the transaction – equity, not debt – than the American model of lending in which the student bears the risk of the fixed lending amount.

The  (far from only) problem with the European solution is that although it is correct to regard the financing as best understood as equity, because it accepts the contingent profit nature of the return in any particular student’s case, the separation of the equity investor (the government) from the student means that there is very little incentive for the actual provider of the service to take account of the actual service provided.  Suppose, then, that the university were to become an equity investor as well – not 100%, but in large part.  Meaning that the university pays the upfront cost of the education.  But in return, it takes a specified percentage in the life-long earnings of the student.  A small percentage, to make gaming it not very worthwhile – but one that lasts a lifetime.  It more accurately characterizes the nature of the student’s return on investment and ability to repay as a contingency rather than a fixed mechanism.  But it also moves the incentive to provide a good service to the actual service provider, rather than to the government, if the government were to do the same but take its equity return as taxes.

I’m just thinking aloud here.  I understand that there are going to be big problems with this model in terms of the incentives it might provide to the university … but work with me.  Criticism about why the idea is terrible is fine, but I’d also be interested to know how, if possible, it might be tweaked to provide incentives for the university to provide an education not just in narrow technical SMET, but also in the humanities properly understood.  Times are soon to be desperate in higher ed; desperate times invite creative thinking about the business model.  Think away.

Meanwhile, thanks to everyone who offered advice on my Rice University post a few days ago.  Tomorrow is graduation day here, and for many other high school students around the country, so congratulations to all the grads and their families.