A Better Way to Fix the U.K.'s Student Debt Problem

(Bloomberg View) -- Tuition fees have become one of the hot-button issues of British politics again and Chancellor of the Exchequer Philip Hammond is expected to confirm the Tory pledge to freeze tuition fees when he issues his budget today. The Labour Party wants to abolish them entirely, endearing itself to younger voters. But so far neither Conservative nor Labour approaches get at the real problem.

University fees were introduced across the U.K. in 1998 and, while still far below many U.S. universities, have been going up ever since to their current rate of around 9,000 pounds ($11,907). They are largely financed by publicly subsidized loans, taken by 79 percent of students, though three quarters will fail to fully pay it back.

In the next two decades, student loans are expected to add 10 percent of GDP to the U.K. public debt with a write-off that could reach 45 percent. The high debt levels -- still much lower than those in the U.S. -- may be tolerable if university graduates were going on to fulfilling careers. But that is not the case. In the U.K., which currently enjoys a strong labor market, about a third of young graduates will be either unemployed in the two years following graduation or taking jobs that don't require a university education. According to a survey by McKinsey, 61 percent of U.K. education providers say they are "confident that their graduates were prepared for work," but only 40 percent of students and 36 percent of employers agreed.

The Labour Party's idea of abolishing tuition fees not only would create unbearable costs -- 11 billion pounds per year, according to the Institute for Fiscal Studies -- but it would also starve universities of much-needed funding and exacerbate the core problem of a mismatch between university offerings and labor-market demand. The Tory fee cap might be popular, but it too fundamentally misunderstands why there is so much angst around university costs.

The current student loan system means that higher education providers (which have no liabilities for the defaults) have little incentive to limit students, orient them towards vocational training or even teach to the long-term needs of the marketplace in order to limit debt defaults. Indeed, second-tier establishments or departments have much to lose in refusing or limiting the number of candidates, even if they know a high percentage will be unable to repay the loans that finance these programs.

According to the McKinsey study, only 30 percent of U.K. students say they knew, when choosing their course, what the graduate placement rates is for that course or have an idea of average wages or possible job openings in areas related to what they are studying. The lack of information on outcomes, a disregard for vocational training, and misaligned financial incentives all contribute to the increasingly high student loan default rate.

Instead of fiddling with fee caps, education providers need to be incentivized to provide students with long-term marketable skills, and courses adapted to their abilities. To that end, Milton Friedman once suggested "human capital contracts" between students and universities. It's an idea worth reviving. The principle is straightforward: Investors pay for the education costs in exchange for a share of the student's future income above a certain threshold for a number of years.

In such a system, education providers would become financially incentivized to push students to acquire the long-term skills needed by the marketplace. They would also benefit from a string of future income linked to their students' real-world abilities. They could then sell these contracts in portfolios to capital markets, being rewarded, or sanctioned, according to the value they create. Market prices would signal to both students and universities alike which skills are in demand and which universities provide the most long-term value-added education.

Of course, not all degrees worthy of acquiring are immediately translatable into market value; nobody wants a society limited to, say, coders and accountants. And not all highly valuable skills (teaching, for example) are amply rewarded. Society as a whole has an interest in having a wide range of academic fields; universities also see their mission as the development of intellectual inquiry or cultural preservation. In recognition of this, government will have to continue to subsidize certain educational provisions to reap these benefits. But the incentive for students and universities to think pragmatically would be much stronger -- and defaults much less frequent -- through such a system.

Vocational training, currently hugely undervalued in the U.K., would also become more prized as training institutions and prospective students alike would be able to see the value-added of this sector. Internet education providers could be expanded, finally applying mainstream technology to reduce the cost of providing education. Continuous education programs maintaining the skill levels of graduates facing continuous innovation during their career could become a new norm.

For the time being, the political debate is a long way from such enlightened thinking; it is stuck in a battle over capping or scrapping fees. That is likely to lead to higher levels of government expenditure, but not necessarily better opportunities for young people or a trained workforce for companies.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Jean-Michel Paul is founder and Chief Executive of Acheron Capital in London.

To contact the author of this story: Jean-Michel Paul at JPaul@acheroncapital.com.

To contact the editor responsible for this story: Therese Raphael at traphael4@bloomberg.net.

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