HECS-style loans during the crisis is a bad idea

Sydney Harbour Bridge with cruise ship in the foreground

By Rohan Pitchford and Rabee Tourky

The spread COVID-19 inevitably means that people will isolate themselves at home, perhaps over several waves of infection, as the spread is managed. This may happen for a few, or many, months. The change in people’s behaviour means that the economy is faced with a large fall in demand in certain sectors.

Public health experts have concluded that people being isolated is the best way to slow this very serious disease — to our minds this is more important at the moment than any immediate economic priority. But it comes with a large human cost: affected businesses will find themselves without the flow of revenue necessary to cover the wages they pay to employees, the rents they pay for buildings and equipment, and the repayments they make for bank loans. Without any relief, business with excellent future prospects will close and unemployment will spike.

The key question is, what form of relief should be given? Our colleagues Professors Chapman and McKibbin have suggested that HECS-style government-backed income contingent loans be granted to workers and revenue contingent loans to business. We disagree with this prescription.

The HECS system was designed to address a very specific problem with capital markets — the inability of a student to borrow privately while they acquires education (i.e. `human capital’). There is around a three-year lag for students until they are able to earn substantive income. Further, students obviously cannot provide their potential human capital as collateral for private banks! HECS effectively allows students to pledge their future income through the tax system when it rises above a certain threshold.

Income-contingent schemes are not appropriate for workers affected by a downturn in demand. Workers who have lost their jobs are not acquiring human capital over several years, but are temporarily without income due to a downwards demand shock. They require immediate relief without the the incentive-dampening burden that future repayments impose. This is what unemployment insurance is designed to provide. If current benefits are insufficient or too broadly targeted, then the government can provide a special COVID relief form of unemployment benefits aimed specifically at productive people who have been laid off.

There are much bigger problems with revenue-contingent loans for businesses (shared by income-contingent loans to workers). To begin with, the Australian government has no specific expertise in evaluating the commercial viability of such loans. Such expertise resides in the private banking system. This problem does not go away if the government uses the banking sector to make the loan and provides the funds and the infrastructure for repayment. Banks, not bearing the risk of bad loans have no incentive to be prudent. The USA has had experience with backing home loans through ‘Fannie Mae and Freddie Mac’, quasi government/private entities that accumulated years of experience in backing loans, yet still were implicated as an antecedent to the great financial crisis.

The issue of bad loans is compounded by the fact that government is subject to direct political pressure through the electoral cycle. Consider a situation where contingent loans are extended to a sector in a marginal electorate. Foreseeing the requirement to repay as demand recovers, local businesses and workers have an incentive to lobby their local member for further relief, for example, raising the threshold for repayment, reducing the rate of interest or otherwise relaxing the terms of the contingent-loan.

We argue that the Australian government should not become an equity-holder in private loans, which is what government-backed contingent-loans will do. To do so risks future liability of tax-payers, through the extension of bad loans and the risk of forgiveness via political pressure.

What then, is the best way to address the problems that businesses face? No solution is perfect, but some are better than others. The RBA has responded quickly to make borrowing rates very low. 

Our suggestion is that the government facilitates the transmission of low rates by doing whatever it can to encourage renegotiation of loans and credit lines and debt forgiveness by private banks. In short, let the banking sector prudently absorb the risk to businesses, they are in the position to do so and have the expertise to do so. There has been a lot of distrust of the private banking system in Australia. However, they also have an incentive to ensure that businesses with a viable future are not dismantled in haste. Banks, after all, make their money from loan repayments and their own future depends on taking a short-term loss for future gain.

Rabee Tourky is the Director of the Research School of Economics at the Australian National University and The Trevor Swan Distinguished Professor of Economics. His interest has been the operations of markets and market incompleteness.

Rohan Pitchford, is a Professor of Economics in the Research School of Economics, he works on financial stability and securitisation. He has published papers on default, securitistion, and contracts in the leading journals in Economics. He is a graduate from MIT.