Wednesday, January 2, 2019

Upside Down CAPM: Part 7 - Debt is Ownership

I was reading this piece on debt jubilee (HT: JW) and it occurred to me that this is an issue that gains clarity from the Upside Down CAPM idea. (In short, capital is inherently at risk.  It has a natural long term real rate of return of about 7%, which is basically the return on equity ownership.  Fixed income is a trade between capital owners in which the lenders are the true consumers.  They want to transform risky capital into riskless deferred consumption.  They pay a premium <earning less than 7%> in order to avoid risk.)

I have written skeptically about jubilee before.  The idea is popular because the first order effect is forgiveness of debts.  It is imagined to be a transfer from the powerful to the powerless.  But, that just isn't a very useful way to think of debts, in the aggregate.  We tend to think of debts through the prism of consumer debt, but consumer debt is more of a transactional device.  Most household debt is mortgage debt, which is a clear case of Upside Down CAPM.  The ownership of the house is split between an equity holder who takes responsibility for upkeep and maintenance and takes on the risks of market volatility, and the debt holder who exchanges those risks for a fixed return.  The only reason mortgage financing works is that home equity is, itself, very nearly a fixed income type of ownership, in which most of the return comes from rental value.  (That is one of the core problems with Closed Access housing supply.  It makes home equity less like fixed income and causes a breakdown that makes housing financing less functional.)

Thinking about jubilee from an Upside Down CAPM perspective helps to clarify this.  Modern economies have already incorporated jubilee financing deep into our economic systems.  Capital markets are already dominated by a financial security that automatically forgives the debtor all of their principal when they are unable to pay it.  That security is called shareholder equity.

Sometimes, borrowers (for lack of a better word) opt out of jubilee by selling fixed income securities instead of equity.

Incidentally, I wonder how much overlap there would be on a Venn diagram of people who think debt jubilee would be a great idea and people who think limited liability corporations have been a good idea.

The problem comes from contexts where selling equity is difficult or impossible.  The problem with selling equity as an individual is that this is essentially indentured servitude.  Where that can be managed safely (see, currently, Lambda School, which seems to be a great example of this) it can work, but it is difficult.  So, where jubilee is discussed today, it typically has a focus on things like student debt.

But, student debt is an anomaly.  It probably shouldn't exist in the way that it does, and it only does because it is subsidized by Federal guarantees.  Debt is a service provided by the borrower to the lender - providing risk free deferred consumption.  Students aren't remotely in a position to provide that service.  So, the government steps in to provide that service in their name.  But, since policymakers have not come to terms with the incoherency of this program, the program has been designed to leave many indebted former students in dire straits with unpayable debts that they should never have been in a position to take on.

I hope that developments like Lambda School can help lead us to a new financial technology that better matches funding with students, and creates an equity-like funding mechanism (a jubilee-eligible mechanism, as it were) for school funding.  That probably means being more honest about the demand for education, and the difference between the development of marketable human capital, which is a powerful source of economic equity and betterment, and education that is less vocational and is better viewed as consumption than investment.


  1. Good post!

    Of course, any discussion about education needs to mention Degrees-as-Signalling (like in The Case Against Education).

    1. Thanks.

      Yes. He does seem to have some good points.

  2. Yes, the limited liability partnership is a thing of beauty, no?

    But yes, debt jubilees appeared to be a little far out.

    I wonder if the Federal Reserve, when it conducts QE but maintains the balance sheet, has conducted a type of debt jubilee.

    I keep hoping that labor markets get tight enough, and pay high enough, that our economy dispenses much formal education and substitutes on-the-job training or apprenticeships.

    Jeez,do lawyers really need to go to college for seven years, or could they apprentice for several years, then try to pass a bar exam?

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