Monday, March 27, 2006

Want to buy a pound of flesh?

In The Merchant of Venice Shylock, a Jewish usurer, enters a contract with a young lover's friend stipulating that if his friend fails to pay back a loan then he can claim a pound of his flesh. Since both parties entered the agreement voluntarily presumably it increased their ex ante welfare.

Arguing along similar lines, the latest Policy magazine leads with a proposal, by Joseph Clark, that there should be more opportunities to sell a portion of oneself. (Unfortunately the article is not available online.)

The basic idea is that I could sell someone the right to a percentage of my future income. Say, for example, I'm studying and expect larger income in the future, I could offer someone 5 per cent of my total earnings for the first 10 years out of uni. The value of this contract will be the net present value of the expected payments, further discounted by the expected risk that my income might not meet expectations. Effectively, it allows students to issue equity instead of just debt to finance their studies.

As Joe points out, such a new financial instrument would:
  • allow people to smooth consumption;
  • facilitate the financing of degrees that are more costly than current government subsidies provide for (if they deliver large returns); and
  • provide clear signals on the potential financial payoffs of degrees ('better' degrees would attract less onerous terms).
Such benefits are also available in debt markets (for example less lucrative professions would presumably attract higher rates of interest). Yet, most debt markets are not fully developed because they are crowded out by government involvement. Why get a loan (on which you have to pay interest) when you get an income-contingent HECS loan only indexed to CPI? As a result, many of the claimed benefits of this instrument would largely come from simply reducing government intervention and allowing for the emergence of more mature debt instruments.

That said, equity does allow for a greater transfer of risk. A student taking out a loan takes on much of the risk that their future income may not meet expectations (collateral can be repossessed). Whereas the owners of equity, having no power to repossess assets, essentially take on the risk that incomes are sub par. Considering that investors would probably be able to diversify with such instruments, and hold a lower amount of average risk than any individual student, this is likely to increase welfare.

However, the transfer of this risk also lets the moral hazard genie out of the bottle. Once the equity issuer has less of an incentive to earn more, they will most likely sub to activities that have a lower income (but a greater level of net happiness).

Whether or not this problem will be fatal to personal equity issuance is an empirical question. Joe argues that such problems can be solved through contract design, limiting the amount of equity one can issue and perhaps including conditions that if you don't score so well at uni, you have to pay more.

I'm more skeptical. Contracts are difficult to cover all potentialities and may not be effective in this inherently uncertain case. (In this regard, it's important to note that Shylock failed to take his pound of flesh when a lawyer argued that the contract did not allow for bleeding and hence the flesh would have to be taken with no loss of blood. I can't recall, in this pre-Law and Economics world, whether the judge accounted for the dampening effect that such a literal interpretation would have on future flesh trades.)

Plus, there are already some methods to buy personal equity in a student. A firm could fund a degree on the proviso that the recipient takes a job with them. But, again, such contracts are usually hard to enforce and don't seem to be overly popular. Perhaps widespread equity issues would allow investors to more readily diversify risks and make them more attractive than these 'one-on-one' contracts.

However, opportunities to diversify risk would require there to be a large amount of students wanting to issue equity, from those of varying interests and ability. I am not convinced that the market is this deep. There is a substitute for the issuing of debt or equity: the use of retained earnings.

In the States most students, in the face of lower government assistance, appear to survive through inter-generational transfers from parents. This has the benefit of removing adverse selection (parents tend to know their kids quite well) and moral hazard (future costs won't be contingent on income). It also improves governance arrangements - parents tend to make a quite effective board of directors.

Overall though shares in people is a thought-provoking idea. It could probably serve at least a niche market and should at least be given a chance. Current government policies, not to mention 16th century Italian law, effectively mandate such innovations stillborn.


David said...

Ok idea in theory,
but I think that you're going to run into problems into calculating this return on equity and how will it be enforced.
If I make 100k in a year and I 5% of my equity is sold, I should the investor 5k. But what if 60K was from the occupation that I was studying for, 20K for a job at my parents farm and 20K return on investments.
How much should they get? What if instead of holding financial assets I moved the money into a house so that the investor couldnt' get their hands on those returns. What if I started a company to hide my real income. I could defer all personal income (most of the 100K), put it into the business and recieve dividends and capital gains later down the track. It's not hard and it does happen. You only have to see how much si actually paid back on HECS to realise that shenanigans go on.

Matt Canavan said...

In the article Joe points out that ATO declarations could be used to verify gross income. Note that your deferral scheme would only work if you also were able to avoid tax by misreporting income. When you buy a house you are deferring consumption not income. Although this is a further risk, I don't think it is fatal to the scheme.

Anonymous said...

buying a house is consumption

Anonymous said...

The author said:
'I could offer someone 5 per cent of my total earnings for the first 10 years out of uni.'

What is stopping someone from deferring their income for ten years. It can be done, Sometimes it is called a trust, sometimes a company. I could even negatively gear to buggery to reduce my net income.

In the real world, people defer income all the time. I know countless men that do it to reduce the amount that they pay their ex-wives in child payments.

Besides, what is stopping me from leaving the country for ten years.
What if I marry, have kids and not earn much official income for ten years?

The idea is stupid, not necessary and detracts from real economic reform. If it's not stupid, well then put your money where your mouth is and set up the scheme. If it suceeds, then I'll be the first to admit that I'm wrong. Till then, it's stupid.

Matt Canavan said...

To both the anon's:

1. Buying a house is consumption but as a durable asset the consumption is deferred over the life of the house.

2. I would imagine the contract would stipulate 5 per cent of gross not net income. Thus negatively gearing or putting income in trust/company won't reduce your liability.

3. Sure people could skip the country but unless they go to Brazil/Spain/etc there are ways to collect the debt. This also gets back to the point that if it is only a small part of your income, are really going to leave the country for the sake of a few thousand?

Matt Canavan said...

Another problem I see with this scheme is that it would not be as lucrative for women. There is a risk that a women would simply have kids rather than take a job and thus the returns on female equity would/should be lower. Although there is noting inefficient about such discrimination, it would raise political difficulties.

Anonymous said...

To both the Matt Canavans:

The idea is stupid, not necessary and detracts from real economic reform. If it's not stupid, well then put your money where your mouth is and set up the scheme. If it suceeds, then I'll be the first to admit that I'm wrong. Till then, it's stupid.

Matt Canavan said...

Anon, I don't think the idea is stupid but, as I said in the post, I do think it is impractical. Hence, I won't be setting up a scheme anytime soon. But, it is the sort of idea that is worthwhile thinking about, and as you say both you and I could be wrong. I'm sure there would have been a lot of people in the 70s who thought, "this derivatives stuff will never take off."

Anonymous said...

fair enough.

Anonymous said...

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Anonymous said...

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