Saving for a brainy sort of pay

June 27, 1997

TRADITIONALLY, there have been three ways of financing higher education: through tuition fees, state support, or private charitable contributions. But I would like to propose a fourth option - the creation of an asset market for human capital.

The existing methods of funding have a number of advantages and disadvantages. In the United States and a few other countries, tuition fees have been heavily relied upon. In past decades, however, the costs of higher education have exploded. The traditional argument that tuition fees will create incentives for young students to work harder is increasingly falling apart. Soon, the best universities will have reached price levels where only those on scholarships and those with wealthy families will be able to attend.

As universities increasingly need to generate revenue, the number of scholarships will decline. Many talented and hard-working young people might find themselves excluded from top colleges and universities for the wrong reasons. The system will tend to create the wrong incentives - it will favour the well-to-do instead of the hard working. This problem can only partially be solved by the state-supported school-loan systems. The indebtedness and risk for students will continue to grow disproportionately.

State financing has been the preferred mode of higher education financing in most of continental Europe and the developing world. It is certainly a solution that allows students from all economic backgrounds to compete on an equal level. State-financed systems, however, have reached their limit, in Europe, Africa and elsewhere. Prices have exploded, the productivity of the system has declined and state coffers are strained.

Governments worldwide will have to scale down their investments. This method, therefore, cannot offer a solution, especially in light of the challenges the globe will face in the next century.

To some extent, private donations have made up the shortfall in state financing and the ever-increasing costs of higher education. But how long can this trend continue in traditionally donation-friendly environments? And will it be possible to generate private donations in systems where citizens are not used to this kind of support? In the US, which has the most active support market, a slowdown in the growth of private support is imminent. In Germany, which has been used to a state-financed free provision of education, it is difficult to convince wealthy donors that they should give money to universities. Private donations are a welcome addition to higher education finance, but they cannot provide all the revenue that is needed to maintain the system.

Well worth considering is the creation of asset markets for human capital. Today, capital is chasing around the globe in search of good investments in ever-increasing amounts. Asset markets have emerged for all forms of investment; witness the explosion of interest in stocks, bonds, real estate, wine, art and collectors' cars. Why should it not be possible to interest investors in human capital? The World Bank has already recognised the importance of human capital and is increasingly channelling its funds into social areas such as education and public health.

Asset markets for human capital would be relatively easy to achieve. A university could issue stocks or bonds for any year or subject. These stocks or bonds would pay for the education of that year. The terms of the offer would be made public well in advance. For example, there could be a 1998 Cambridge stock issue. You could own percentages of the earning power of the hu-man capital represented by that intake. An investment bank would assess the terms of the initial public offering and assume responsibility for making the stock offer "fly". Participants would pay 5 per cent of their initial annual income to the shareholders. The obligation would be perpetual. By 2005, the issue might prove to be the hottest item on the academic investors' market. A new class of investors could emerge. Well-known vintages such as Princeton, Harvard, Yale, Cambridge and Oxford might capture the eye of the public, but a connoisseur might also invest in a 1998 Mount Holyoke College for its out-standing potential.

Given that investors spend millions on wine and art and even Hollywood memorabilia, why should there not be a market for the most exciting investment of them all - human assets?

Of course, there will be many questions to address. A stock issue would need a minimum size to be economically viable. The costs covered by, say, a 1998 Cambridge or Oxford issue, would amount to a few thousand students multiplied by Pounds 50,000 (the unit cost of educating each student), giving up to Pounds 150 million. The valuation of the issue would depend on investors' assessment of prospects.

Smaller colleges might not have the same opportunities. If, for example, only 200 students were graduating each year at a total cost of Pounds 30,000, this would entail an issue of only Pounds 6 million. But why not create professionally managed funds for small colleges? The funds could concentrate on delivering value for money.

Issues could be made for individual subjects. There could be a 1999 Harvard Business School issue. And it should be the universities' own discretionary decision as to how to distribute the funds generated among different subjects. Some schools might concentrate on professional fields, others might cross-subsidise less well- performing subjects. Checks and balances would exist, but not sacrifice institutional discretion.

I prefer equity financing to debt. Human capital is like venture capital, characterised by high potential returns as well as high risks. This investment structure is best captured by stocks. If there were to be a bond market, it would have to be a junk bond market, with high interest rates and high risks of default or renegotiation.

Asset markets for human capital have a number of advantages over state-supported school loans or outright education subsidies. They would make an investment in the future a tradable asset, with a fair market valuation - which would reflect expected rates of return. There would presumably be less over-investment in human or physical capital, as each type of investment would compete. Asset markets would allow comparison of institutions' relative market value.

Governments would still have play a role to play. They would address information asymmetry in the market, and enforce fair rules. Through tax credits, they might even support issues in years with weak market conditions.

Max Otte is the global higher education specialist for Arthur D. Little International Inc.

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