Thoughts on Human Capital Contracts

Okay folks, back from a break and ready for at least one good substantive post this week.

A while back I promised my thoughts on the benefits and drawbacks of human capital contracts (HCCs). Richard Vedder, the first serious HCC advocate in higher education (I suspect it’d work even better far better for professional education, which is a later post), came up with two: (1) Unenforceability and (2) Adverse selection.

Unenforceability refers to the fundamental problem that human capital investments can’t be securitized, which is the ultimate source of all higher education’s problems. The solution, such as it is, that the government found was to give out loans, eventually make ‘em nondischargeable in bankruptcy (with no real basis beyond pure mistrust of graduates), and allow the creditors to hunt down the debtors when they defaulted.

As for adverse selection: an HCC system would not work so well if the only people to use it were those who planned to go into low-paying occupations to begin with, e.g. social work. Obviously, this isn’t a problem for the loan system: once you take on the debt, you must pay it regardless of your major’s value, which is another problem we’re seeing. The natural solution is to individualize/underwrite the contracts and risk-pool them.

I should note two things about Vedder: first, he prefers a progressive higher education voucher system in which every potential college student gets a $5,000 grant to attend college. It’d be adjustable depending on performance, and those of wealthier backgrounds would be ineligible for them. Secondly, and more significantly for my following thought exercise, Vedder is through with government-funded higher education. The only advocate of anything resembling publicly-funded HCCs I know of is former Labor Secretary Robert Reich. Sherman Dorn believes that a combination of public funding and HCCs would work because anyone who went to college more than a few years after high school would be considered a much higher risk than someone who immediately went to college with good grades. Public investment also creates an intangible “public good” in an educated populace. Unlike private goods (stuff we can buy for ourselves), public goods are vastly more difficult to quantify. [i]

So, as promised, here’s a rough thought experiment on the pros and cons of HCCs, both private (ala Vedder) and public (the Reich model). I try to match up the pros and cons between both tables.

Private HCCs

PROs	CONs
Sponsors have an incentive to underwrite majors accurately to limit higher education adverse selection. You won’t be able to take out six figures in debt for a humanities degree.	Whither the liberal arts? Seriously. The meta-point of all these higher education financing discussions is that education IS a free lunch. Some aspects of education don’t give a direct economic return—something Charles Murray, who advocates against mass higher education, is heavily criticized for.  Also, it’s hard to invest in people when you don’t know what their major is, but this wouldn’t be a problem for professional education.
Sponsors are incentivized to find work for their graduates, even during economic downturns or if they’re returning to the workforce. This is a vast improvement over current college career services offices.	Enforcement Issues:  (1)  If the grad bails or refuses to work, the sponsor gets nothing. The sleeper problem here is sex-discriminatory sponsorship because women often leave the workforce to raise children. For example, Slate reviewed a book in which the author encourages women with MBAs to remain in the workforce after having children, even though half of these women never return to the workforce.[ii] With student loans, they pay debt on an education they probably didn’t need; with HCCs, rational sponsors would avoid investing in women, or at least they’d demand higher returns than they would with men. As far as law is concerned, consider an anecdote from the After the JD study, which reported on one 2000 UW Madison graduate’s outcome. By 2007, she’d retired to raise five kids, though she’d worked only a few years full time. If she’d gone to law school on a 10-year HCC, her sponsors would’ve received far less than their investment. (2)  Sponsors may interfere in grads’ lives, encouraging them to work where it’s profitable rather than where the graduate wants to work, e.g. Dr. Joel Fleishman from Northern Exposure. Bet you’d forgotten about that show. These problems could lead to litigation where in the student loan context there should be bankruptcy: sponsors may sue graduates, on contract grounds, to move or take jobs where it’s convenient for them. Solutions: Sponsors can buy human capital contract insurance. The insurance company would pool the risks. Sponsors can place options in their human capital contracts that allow them to be converted to student loans. Then we’re back to the bankruptcy dischargeability problem.
Possibility that sponsors will invest in their own human capital. I like this option quite a bit, and it allows for a more decentralized education system. For example, a law firm might send a good paralegal to law school.  The benefit is that if the sponsor’s business fails, the graduate still has the degree à Graduate windfall. The benefit to a limited HCC repayment period, e.g. 10 years, is that people could move on to public interest work or start their own businesses.	A sponsor’s windfall (sponsor gets more productivity than the education cost) disserves workers and their families, though not as badly as a malfunctioning student loan system. It could be more profitable for workers to remain in their current positions or move to different occupations if they don’t have the right information. This is more a market problem, though, so we’d expect it to be minimal.  Might lead to more difficult HCC contract issues down the line, such as competition covenants. Might lead to a reverse-amakudari problem: highly-trained business experts become government bureaucrats tasked to regulate their former employers.
Sponsors become an interest group that favors cheap, efficient education.	Sponsors’ demands on education institutions may compromise quality.  There’s also the possibility of a vertical monopoly disserving workers. A business could own the schools that it sends its workers to, which could create a conflict of interest leading to substandard worker education if the worker wants to work elsewhere. Asymmetry of information could cause a “miner’s scrip”-style sponsor windfall if the sponsor promised more post-graduate income than it delivered, or a sponsor creates its own certification/degree of little value outside the firm. I doubt this’d be a problem though. For instance, large law firms already hold their own in-house CLEs and train summer associates in “classes”. It wouldn’t be too hard for these practices to evolve into a new kind of decentralized law school. Do we want businesses to consolidate this much, like, into American keiretsu?
	Sponsors still have to get their money from somewhere, and they may end up borrowing it from banks. I’m wary of more unsecured education-related debt.
Might lead to graduate windfalls for breakthrough innovators, e.g. an author who publishes a widely distributed novel. The intellectual property belongs to the author and not the sponsor.	What happens if a graduate gets blacklisted, e.g. fired for-cause because of sexual harassment (legit or not)? Sponsors wouldn’t like this and would want to mitigate it somehow.

From this I have two conclusions:

(1)  Private human capital contracts would be more complex than student loan documents because it’s easier for one debtor to file for bankruptcy than it is for an investor to order someone to work.

(2)  Private HCCs could greatly benefit large efficient businesses over smaller firms. We may see a decentralization and privatization of higher/professional education.

Public HCCs—The Robert Reich Model

PROs	CONs
More likely to support liberal arts at a nominal loss. Still no massive debt though.	Won’t encourage as efficient underwriting for majors/professions.
Easier to enforce because the government can always find its graduates (hint, your Social Security gets garnished), and less need to force people to work. Friendlier to families.  Less meddling by the investors in people’s lives Risk is pooled by the government, and it’s probably cheaper to manage. Less of a need for complex agreements and creation of equity to debt conversion options.	Doesn’t have the job assistance incentive that private HCCs provide, especially during economic downturns. Might lead to greater deficit problems during periods of high unemployment.  The government’s return might not be that great. Then again, that’s not the point of education. It’s considered a public good in this context.
Government may still invest in its own human capital.	Might lead to amakudari?
No more student debt bubbles!  Lesser likelihood of non-standardized credentials.	Perhaps there’d be another way to scam the government, similar to Pell Grant fraud: people take the money and then drop out. Could use escrows or other mechanisms to prevent it. Although, universities don’t like teaching someone and then not getting paid for it.  Also, would this really prevent the Title IV Trap we’re in? We’re back to the Direct loans + Grad Plus loans + Income-Based Repayment = taxpayer rip-off. Universities could still charge whatever they want for tuition and the government would still pay. After all, the government doesn’t care much about the growing mass of higher education debt now; arguably, what does guaranteeing people’s education solve?
	Left hand/right hand problem: the government (legislature) must adequately invest in the public education system (administrative agency) for this to work.
Very easy for people to move into public interest positions from the traditional college model.	Government takes the loss. (Or does it?)
Money comes directly from taxpayers	Money comes directly from taxpayers, and if we’ve learned anything about how education is financed in the US, we know public education is the first thing that’s cut in recessions.

My two brief conclusions:

(1)  Public HCC documents will be less complicated and more diverse.

(2)  Public funding for education benefits the public more broadly, and public HCCs are probably easier to enforce.

Later I’ll go into what assumptions we can change about how higher education (and legal education) works to see if there is a better model.

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[i] As an editorial aside, I think how we value public goods to complement private goods is rapidly becoming one of the most contested societal problems in contemporary American politics.

[ii] Note no one is reporting whether it’s a good idea to invest in an MBA generally, or whether there’s a business school tuition bubble—just that women with children don’t see much use for the degree.