Commentary

We shouldn't rely on debt to finance our investment in human capital

by Chris Farrell, Marketplace

Chris Farrell is economics editor of American Public Media's Marketplace Money and author of "The New Frugality: How to Consume Less, Save More and Live Better."

Over the years reporters for American RadioWorks, the documentary producer at American Public Media, have spent time in low-income communities around the country. It's striking how parents from areas as diverse as rural Appalachia, public housing projects in Chicago and working-poor neighborhoods in Muncie all know that the way for their children to get ahead is to get some form of postsecondary education — from a certificate earned at a community college to a masters degree at a public university.

The educated person lies at the core of our complex, high-tech, globalized economy. Postsecondary education is the entrance exam for applying to good jobs and careers, the kind of work that comes with retirement and healthcare benefits. A postsecondary degree is what philosophers call a necessary but not sufficient condition.

At the same time, college is increasingly contentious, partly because the stakes are so high. Cultural critics fight over curriculum and standards. University presidents at independent private colleges publically wring their hands about the high cost of a degree and quietly boost next year's price tag. Governors and legislators have balanced their budgets by cutting deep into higher education spending, especially in recent years.

Still, the epicenter of college controversy can be illustrated with one number: $112 billion.

That figure represents inflation-adjusted borrowing by parents and their students, having more than doubled over the course of a decade, according to the College Board. Parents and their students are borrowing huge sums to pay for college. As recently as the early 1990s, hardly anyone took out student loans. Over the past decade, the percentage of students who borrowed went from 47 percent to 53 percent.

To be sure, the investment in postsecondary education will eventually pay off for most people. The issue isn't postsecondary education. It's relying on debt to finance the investment in human capital. We know from economic history that too much leverage on an investment ends up being financially burdensome for most and destructive for too many (think housing). The real worry is the student loan trend line.

There are disturbing and multiplying signs of strain. For example, a recent study by economists at the Federal Reserve Bank of New York found that, in the third quarter of 2011, some 27 percent of the 37 million borrowers in its database had past-due balances. The proportion of outstanding student loan balances that were delinquent was 21 percent.

Many recent college graduates are squeezed between high debts and anemic earnings. The inflation-adjusted earnings of full-time male workers, ages 25-34 with only a bachelor's degree, are down 19 percent since peaking in 2000. The comparable figure for women college grads is down 16 percent since 2003, according to Michael Mandel, chief economic strategist for the Progressive Policy Institute in Washington, D.C. Borrowers who drop out are four times more likely to default on their loans, according to the Education Sector, a Washington think tank.

The capital markets offer a key insight for reform. Earning a postsecondary certificate — especially the classic four-year undergraduate degree — is an inherently risky enterprise. It's in the nature of the beast. How many of the millions of freshman about to enter college in the fall have a real clue about what they want to do when they graduate? Many parents encourage them to explore, to learn and to take risks. Your son or daughter may like the idea of becoming an electrical engineer or a biophysicist, yet embrace the humanities after an inspiring course on 19th century Latin American history or modern European literature.

Students might graduate when the economy is strong. Bravo. Then again, the business cycle could have taken a turn for the worse right around the time they get their student loan repayment book. (I'm well acquainted with bad timing, since I graduated from college during one recession and graduate school during another.)

The riskiness in the postsecondary enterprise suggests an alternative approach: Equity-based financing instead of debt financing. It's an approach advocated in 1955 by Milton Friedman, the late Nobel laureate. "Such an investment necessarily involves much risk," he wrote about going to college. "The average expected return may be high, but there is wide variation about the average."

Debt is too risky for start-ups. (Think venture capital.) "The counterpart for education would be to 'buy' a share in an individual's earning prospects: to advance him the funds needed to finance his training on condition that he agree to pay the lender a specified fraction of his future earnings," wrote Friedman. "In this way, a lender would get back more than his initial investment from relatively successful individuals, which would compensate for the failure to recoup his original investment from the unsuccessful."

Variations of the basic idea already exist. For example, Australia offers a program where students don't pay university tuition up front, but meet the bill for their education through a progressive tax system once their income reaches a certain threshold. The United States offers students the option of repaying their student loans through an income-contingent program and the income-based repayment program.

In essence, the government would invest in a student's education, and the return on investment would come from the student's future earnings. The repayments could come through the progressive income tax system. Grants could be targeted at low-income students. There wouldn't be any need for parents to fill out financial aid forms and students to apply for loan forbearance. The private student loan business — really a consumer loan with a different label — would disappear.

The idea is far from radical. It's similar to the current income-based repayment student loan option.

Here is a radical thought, though. How about reforming the financing for our postsecondary education system before the debt burden truly grows into monstrous proportions? We had a chance to prick the housing market bubble long before it reached into the trillions of dollars. Let's learn from the past rather than repeat it.