Unit 9 Lenders and borrowers and differences in wealth

9.13 Application: Policies to reduce risk exposure of less well off people

The vicious circle that results in the poverty trap perpetuation of Julia’s lack of wealth might have been disrupted if there had been some way to limit the risks that she faced, for example, the riskiness of owning a home not knowing what the price would be in the future, or giving up a job to finish one’s education not knowing if the degree would pay off.

Home value insurance: Reducing risk exposure, encouraging innovation by less well off people

For most families (excepting the very wealthy) the largest component of their wealth, as shown in Figure 9.2, is the value of their home if they are fortunate enough to own where they live. Home prices often reflect the nature of the dwelling, for example, its size, condition, location, and amenities. The owner can affect the price, and therefore value of the home, by maintaining it well and devoting time and energy to ensuring that the surrounding neighbourhood is a pleasant place to live, for example, by seeking to improve the local schools. But independently of anything that the owner does, home prices can fluctuate dramatically with bubbles and crashes occurring from time to time. When house prices crash, the wealth of a family can be dramatically reduced in a matter of a year or so.

Fluctuations in the price of housing have these effects:

• They expose families to great uncertainty about how much wealth they will have in the future; the resulting insecurity deters families from taking risks such as studying to learn an entirely new skill, going into business rather than remaining an employee, or moving to a different region of the country or world to find a better job match.
• In severe house price downturns, households with limited wealth are likely to be forced to part with their assets on unfavourable terms, and so volatility in house values can increase inequality.

In short, as a result of house price volatility, the economy is more unequal, more volatile, and less dynamic than it would be if housing price shocks were moderated. There would be significant advantages if families could be insulated—at least partially—from the fluctuations in the price of their homes. One way of doing this would be to insure homeowners against changes in the price of their homes.

moral hazard, hidden actions

If there is a conflict of interest between a principal and an agent over the agent taking some action that cannot be observed or cannot be verified by a court, then the principal faces a problem of hidden actions; also known as moral hazard.

But devising such a home price insurance policy is a challenge: if the homeowner were to receive an insurance payout when the price of their home falls, then they would be less motivated to maintain the house and neighbourhood in good condition. But there is a way to avoid this moral hazard problem: insure the owner against a price fall not of their own house, but of the average house price in the city or region where the house is located.

To understand how this works, suppose the family lives in Milan, Italy. If house prices in Milan fall, then the family receives a payment from the insurance provider even if their own home price did not fall.

The ‘even if’ is important because this means that the owner’s incentive to maintain the value of the house is unaffected by the house price insurance. If they plant a beautiful garden and, as a result, the home is more valuable to others, then they will benefit 100% from the home price increase. The key idea is that the insurance is based on a piece of information that is both:

• easily observed by both the home owner and the insurer (the average house price in Milan), and
• not something that the homeowner themself can influence (unlike the value of their own home).

An even better design would be to let the homeowner pay for the insurance based on the house prices in their city. If Milan experienced a house price boom, then they would pay more into the insurance fund; and this would finance the insurance payouts to homeowners in cities with depressed prices.

If house price insurance is such a good idea, why do we not have it? The answer seems to be that private insurers would be unable to insure on such a huge scale, and would run the risk of their own bankruptcy were the entire housing market to be depressed for a year or so. Governments, however, could provide this insurance, and their insurance payouts during periods of depressed housing markets would contribute to the aggregate demand expansion that would most likely be an appropriate policy at those times.

How to finance a risky investment in yourself: Higher education

Investing in yourself by pursuing higher education or technical/professional training is risky with substantial and certain costs up front and uncertain benefits often far in the future. When you make choices in this, you typically do not have very clear answers to some basic questions, such as:

• Will the institution where I choose to study provide the education that I want?
• How much will the knowledge, skills, and credentials I obtain help me get a good job when I graduate?
• Will I be a good student and graduate?

Given the costs and uncertainties, without some kind of government support, most people would not continue education after secondary school. To encourage more people to continue their education, governments set aside tax revenues to fund higher education. Methods of funding vary greatly around the world. Let’s think about six ways of financing higher education from the standpoint of efficiency and fairness.

1. The entirely private funding of higher education by the families of students: Many consider this to be unfair. It violates elementary principles of equality of opportunity. As a result of this funding system, the children of the high-paid and well educated also tend to be highly paid and well educated, which contributes to the perpetuation of income differences across families from generation to generation. It is inefficient because it restricts high-quality education to a small group, not all of whom are capable of benefiting, while denying higher education to the talented children of the less well off.
2. The no-fees option: This goes to the other extreme, motivating even those who expect to benefit very little from higher education to attend, at considerable cost to taxpayers. Also, many consider this option to be unfair because the students enrolled in higher education tend to come from families who have more experience of and information about universities and graduate jobs. Such families have much higher incomes than those without children in university, so the no-fees option is a free government service that is used disproportionately by well off people.
3. Higher education financed by private credit: This is an option, but has never been a major source of funding. The reason is that unlike borrowing to purchase a home or a car, the borrower does not acquire an asset that can be used as collateral (insuring the lender against losses if the borrower cannot repay). The assets acquired are the skills embodied in the person themself, and (because slavery is illegal) that person cannot sign over ownership of themself and their skills to the lender.
4. Funding by government agencies or companies in return for long-term commitment to work for the funder: Student fees and maintenance are paid for and the graduate works for the agency or company after completing the course. Such schemes are often referred to as ‘bonds’—the student is bonded to the funder for a number of years.
5. A government-backed student loan option: By making loans available to families who otherwise would be excluded from borrowing sufficient funds from private lenders, this increases educational opportunity for less well off students without subsidizing the educational expenses of higher-income families.
6. Free tuition with an income-contingent tax for graduates: This is a proposal under which attending university would be free, but students would incur an additional ‘graduate tax’ obligation (later in life), the total revenues of which would fund higher education (either fully, or more plausibly, partially). The amount of tax paid would depend on (be contingent on) the income earned. An effect would be to reduce the pressure that students who take out loans feel to study ‘high-earning subjects’ (like engineering) so as to be able to pay off their loans: low-earning subjects (like literature) would lead to jobs with lower graduate taxes.

Advocates say that free tuition with an income-contingent graduate tax obligation addresses most of the shortcomings of the other systems, depending on how these tax obligations are designed. For example, suppose policymakers or the electorate wanted to aggressively promote equal access to higher education without expanding the amount of public resources used. They could combine the free tuition option with a graduate tax that rises steeply with income. Those who receive high incomes following graduation would then pay more than their education cost, while those with low incomes would pay less. The result would be to reduce some of the uncertainties facing people considering continuing their education by reducing differences in income (after taxation) between those who end up with high wages or salaries, and those who work in lower-paid jobs after graduation.