Sheila Bair and Preston Cooper:

In a 1955 essay, economist Milton Friedman highlighted a market failure in the finance of higher education: unlike most types of debt, such as mortgages or auto loans, education debt gives the borrower no physical asset to put up as collateral. This lack of security for the lender, combined with wide variation in the fortunes of indi- vidual students, would require usurious interest rates on education loans despite high returns to schooling, he observed, leading to widespread underinvestment in higher education and untapped potential among America’s youth.1
Politicians over the following decades heeded Friedman’s warning and created the federal student loan program, which has existed in one form or another since 1958.2 While the design of the program has evolved, a consis- tent theme has been a large role for the federal government in ensuring the continued provision of low-interest student loans. Today the federal government originates nearly 90% of the $106 billion in student loans disbursed annually.3

But boosters of a federal student loan program to counter this market failure have ignored the second part of Friedman’s analysis—that debt is an inappropriate instrument to finance education, regardless of whether the government or the private market originates the loans. Policymakers should turn instead to the standard instru- ment to finance risky ventures that has long served the interests of investors as well as those in need of financing: equity.

Friedman argued that the education-finance market could benefit from an analogue to equity. He proposed that an investor could “advance [a student] the funds needed to finance his training on condition that he agree to pay the lender a specified fraction of his future earnings.” Rather than fixing payments at a set amount every month, an individual would repay more of his obligation if he were financially successful and less if not, just as shareholders in a corporation receive larger returns when the company does well. Today, we call this concept an “income-share agreement” (ISA).
In recent years, ISAs have gained popularity as a means to finance education. Major universities such as Purdue have created ISA programs for their students, while new educational models, such as short-term coding acade- mies, look to ISAs as a financing tool. The idea has proved popular with students and parents, too: in contrast to a fixed debt obligation, the borrower is guaranteed a flexible, affordable payment. If the borrower’s income drops because of recession or personal circumstance, so does his ISA payment; if the borrower’s income increases, the reverse is true. Lawmakers from both parties have sponsored legislation to speed the introduction of ISAs into the private market, while policy experts have proposed replacing the federal student loan program with a gov- ernment-run ISA.