Category Archives: Debt

Time to Rethink the Fed – Mauldin Economics

John Mauldin  2/4/2022

“In many important ways, the financial crash of 2008 had never ended. It was a long crash that crippled the economy for years. The problems that caused it went almost entirely unsolved. And this financial crash was compounded by a long crash in the strength of America’s democratic institutions. When America relied on the Federal Reserve to address its economic problems, it relied on a deeply flawed tool. All the Fed’s money only widened the distance between America’s winners and losers and laid the foundation for more instability. This fragile financial system was wrecked by the pandemic and in response the Fed created yet more new money, amplifying the earlier distortions.”

—Christopher Leonard, The Lords of Easy Money (2022) (h/t Michael Lewitt)

One of the hardest leadership challenges is knowing when to change plans. Is what you could do better than what you are doing? Certainty is impossible.

At some point, though, good leaders recognize their plans aren’t going well and start looking for better ones. I believe the Federal Reserve is there. I don’t mean the Fed’s current policy dilemma. I mean the Fed itself; its very existence, structure, and goals. They need a complete restructuring, because the Fed isn’t accomplishing what we all need it to. Worse, it is causing problems we could do without.

I believe Fed officials are largely responsible for the cycles of bubbles, booms, and busts over the last 30 years. Further, they share some of the blame (clearly not all) for the growing divisions and tribalism in our society. Much of it springs from the wealth disparity they aided and abetted.

I’ve talked before about how the Fed has painted itself into a corner. All the options are bad and getting worse. The reasons it is in this position are no mystery. Indeed, this is all inherent in the Federal Reserve system’s design. It is trying to do things it shouldn’t be attempting. The only real solution is a wholesale redesign and reconstruction. What we have today isn’t working and the time has come to amend the Federal Reserve Act and change its purposes and authorities.

I realize these are bold words. I fully acknowledge the gravity of what I’m proposing here. And I am totally open to ideas of what a new and better Fed would look like. I know any transition from here to there will be tricky, too.

It also will take time. I do not expect anything to happen of any substance until we get to The Great Reset, where we will be forced to think and do many things now unthinkable in the current environment. In the meantime, I fully expect the current Federal Reserve will increasingly inject itself into the economy and make things worse. Its leaders will do so with the best of intentions, because they believe their own dogma. In their view, this is just what they do.

We need to have this conversation and it has to start somewhere. So today I’ll start it.

Who Needs Central Banks?

We should first ask why the Federal Reserve (or any other central bank) is even necessary. Answering that leads quickly to much deeper questions, like what is “money” and who should create/control its value. Many libertarians and Austrian-school economists argue governments should have no role at all.

I probably would’ve been sympathetic to that in the late 19th century and early 20th century. I will now no longer argue for the Fed’s full dissolution. We need central banks with limited capabilities, just like young children need training wheels. My goal is to improve the present system and reduce its harmful side effects.

Modern central banking is fairly new. Until the 19th century private banks commonly issued their own currency notes, sometimes linked to gold but not always. Wars and political machinations created instability, with periodic panics and bank runs. Banking was not a “system” as we know it today. Banks did their own thing, and if yours had trouble it was your problem, too.

Let’s stop here and make an important distinction. Today we associate central banks with “fiat money” without independent backing like gold. That’s not always the case. You can have both a gold standard and a central bank at the same time. A central bank standing behind individual banks helps maintain stability, thereby promoting the confidence that attracts deposits. This would be important even in a 100% reserve system.

In the 1870s the Bank of England pioneered the “lender of last resort” concept. British writer Walter Bagehot (a co-founder of The Economist magazine) famously summarized the central banks’ job as averting panic by “lending freely, to solvent firms, against good collateral, and at high rates.”

That isn’t what today’s Federal Reserve does. In particular, it doesn’t follow the “high rates” part of Bagehot’s advice. This, I think, is key to many of our problems.

A Benchmark for Everything

As lender of last resort, a central bank stands ready to always loan a commercial bank enough cash to repay depositors. This doesn’t always mean the bank is in trouble. Money flows in and out every day and sometimes gets unbalanced. In the US, “federal funds” are available overnight to fill these gaps, for which banks pay interest at the federal funds rate, the amount of which is set by the Federal Open Market Committee (FOMC).

This rate has grown far beyond the limited purpose of simply enhancing bank liquidity. It has become the benchmark for everything. The entire global economy now hinges on a price subjectively determined by a committee of a) politically appointed Governors and b) regional Fed presidents selected by boards who represent their region’s commercial banks. Unlike other prices, it isn’t a function of supply and demand. The rate can be as high or as low as the committee wants. The FOMC members set the rate at whatever they think will achieve what they believe are good economic goals. But that has economic consequences.

It all seems so logical when they explain it. But the reality is that we have been through multiple bubbles brought about by ever-lower interest rates in an effort to avoid recessions and improve employment (laudable goals to be sure) and in recent years a new tool: quantitative easing (QE).

The Federal Reserve Act gives the Fed a “dual mandate.” It is required to promote both full employment and price stability. Unfortunately, its monetary policy tools have at best a distant influence on employment. Creating the conditions that let businesses create jobs is really a fiscal and regulatory function. Congress and the president should be doing that part. The Fed should focus on price stability.

Fed proponents point to a correlation between Federal Reserve efforts and unemployment. I would argue that this is correlation without causation. Jobs are created when entrepreneurs recognize business opportunities and need workers to achieve them.

As for price stability, the Fed defines “stability” as inflation averaging 2% yearly. That’s not stability. A 2% inflation rate will, over a typical worker’s lifetime, consume a large part of the buying power of their savings and leave them anything but “stable.”

Moreover, the Fed hasn’t produced consistent price stability despite its many tools. Inflation was well below target for most of the last decade (based on the Fed’s own benchmarks, though consumers certainly saw higher inflation in their living costs). Now inflation is far above their target. The Fed’s choice to keep rates low and continue massive QE is having serious side effects.

This Can’t Continue

As you know, there are interest rates and “real” interest rates (nominal interest rates minus the inflation rate), which account for the fact the currency with which a borrower repays may have changed value before repayment was due. The Fed is now taking this to extremes, as former Morgan Stanley Asia chair Stephen Roach explained in a recent Project Syndicate piece. Quoting (emphasis mine):

“Consider the math: The inflation rate as measured by the Consumer Price Index reached 7% in December 2021. With the nominal federal funds rate effectively at zero, that translates into a real funds rate (the preferred metric for assessing the efficacy of monetary policy) of -7%.

“That is a record low.

“Only twice before in modern history, in early 1975 and again in mid-1980, did the Fed allow the real funds rate to plunge to -5%. Those two instances bookended the Great Inflation, when, over a five-year-plus period, the CPI rose at an 8.6% average annual rate.

“Of course, no one thinks we are facing a sequel. I have been worried about inflation for longer than most, but even I don’t entertain that possibility. Most forecasters expect inflation to moderate over the course of this year. As supply-chain bottlenecks ease and markets become more balanced, that is a reasonable presumption.

“But only to a point. The forward-looking Fed still faces a critical tactical question: What federal funds rate should it target to address the most likely inflation rate 12–18 months from now?

“No one has a clue, including the Fed and the financial markets.”

A -7% real interest rate is simply bizarre. It means anyone who can borrow at the fed funds rate, or close to it, is effectively being paid to take on more debt. And not just paid but paid well, plus whatever return they can generate with the borrowed money. This is partly why so many asset prices are so bubble-like today.

Now, real rates may moderate somewhat in 2022 as inflation eases and/or the Fed raises rates. But even the most hawkish scenarios would only bring it back to the 0% range, which is still not normal.

Negative rates were increasingly normal even before the current inflation. I wrote a long letter about it back in August 2016: Six Ways NIRP Is Economically Negative. I showed how the Fed and other central banks were ignoring even their demigod, Lord John Maynard Keynes. Following a long Keynes quote I said this:

To paraphrase, Keynes is saying here that a lower interest rate won’t help employment (i.e., stimulate demand for labor) if the interest rate is set too low. Interest rates must account for the various costs he outlines. The lender must make enough to offset taxes and “cover his risk and uncertainty.” Zero won’t do it, and negative certainly won’t.

The footnote in the second paragraph is important, too. Keynes refers to “the nineteenth-century saying, quoted by Bagehot, that ‘John Bull can stand many things, but he cannot stand 2 per cent.’”

Is Keynes saying 2% is some kind of interest rate floor? Not necessarily, but he says there is a floor, and it’s obviously somewhere above zero. Cutting rates gets less effective as you get closer to zero. At some point it becomes counterproductive.

The Bagehot that Keynes mentions is Walter Bagehot, 19th-century British economist and journalist. His father-in-law, James Wilson, founded The Economist magazine that still exists today. Bagehot was its editor from 1860–1877. (Incidentally, if you want to sound very British and sophisticated, mention Bagehot and pronounce it as they do, “badge-it.” I don’t know where they get that from the spelling of his name. That’s an even more unlikely pronunciation than the one they apply to Worcestershire.)

Bagehot wrote an influential 1873 book called Lombard Street: A Description of the Money Market. In it he describes the “lender of last resort” function the Bank of England provided, a model embraced by the Fed and other central banks. He said that when necessary, the BoE should lend freely, at a high rate of interest, with good collateral.

Sound familiar? It was to Keynes, clearly, since he cited it in the General Theory. Yet today’s central bankers follow only the “lend freely” part of this advice. Bagehot said last-resort loans should impose a “heavy fine on unreasonable timidity” and deter borrowing by institutions that did not really need to borrow. Propping up the shareholders of banks by lending low-interest money essentially paid for by the public when management has made bad decisions is not what Bagehot meant when he said that the Bank of England should lend freely.

How did the Fed act in 2008? In exact opposition to Bagehot’s rule. They sprayed money in all directions, charged practically nothing for it, and accepted almost anything as collateral. Not surprisingly, the banks took to this largesse like bees to honey. Taking it away from them has proved very difficult. We now find ourselves in an era of speculation about what will happen when interest rates are raised.

A few months after that letter, the Fed embarked on a two-year tightening phase that took rates about two percentage points higher. Even that small, slow change was more than markets could handle. The Fed gave up and resumed cutting in mid-2019. Then COVID hit and here we are, in a mess with no good way out.

This can’t continue. The Federal Reserve and its peers need to get back to boring, Bagehot-style central banking and stop trying to micromanage the entire economy. The mere attempt generates yet more problems. The free (or better than free) money environment they’ve created makes every other challenge worse.

How Then Should We Change the Fed?

So what can we do? I think we abolish the dual mandate and have the Fed focus squarely on inflation. That will be easier if full employment isn’t on their plate, too. As noted above, the link between low interest rates and employment is tenuous, if it exists at all.

Further, 2% inflation should be seen as high. The Fed should be leaning into inflation (tightening monetary policy) at 2% inflation and ease policy when inflation is at 1% or lower. Period. It goes without saying that we need better inflation tracking tools, too.

The Federal Reserve should not be this all-powerful “manager” of the economy. The Fed has taken on a third unwritten mandate, that of “financial stability,” which really means stock market stability. The low rates that keep the stock market happy also financialized the entire economy. It is now cheaper to buy your competition than to actually compete. Private equity has evolved the way it has because low rates make it possible to buy good businesses, add cheap leverage, and over time generally produce well-above-market returns. None of it is available to the bottom 80% of the population, meaning the rich get richer. The financialization of the economy has been one of the greatest ills brought about by a loose monetary policy.

Jeremy Grantham said in his recent piece:

“Perhaps the most important longer-term negative of these three bubbles, compressed into 25 years, has been a sustained pressure increasing inequality: to participate in the upside of an asset bubble you need to own some assets and the poorer quarter of the public owns almost nothing. The top 1%, in contrast, own more than one-third of all assets. And we can measure the rapid increase in inequality since 1997, which has left the U.S. as the least equal of all rich countries and, even more shockingly, with the lowest level of economic mobility, even worse than that of the U.K., at whom we used to laugh a few decades back for its social and economic rigidity.

“This increase in inequality directly subtracts from broad-based consumption because, on the margin, rich people getting richer will spend little to nothing of the increment where the poorest quartile would spend almost all of it. So, here we are again. This time with world-record stimulus from the housing bust days, followed up by ineffably massive stimulus for COVID. (Some of it of course necessary—just how much to be revealed at a later date.) But everything has consequences and the consequences this time may or may not include some intractable inflation.”

The economy can manage itself (with a few rules, of course). We just need stable money, a stable economic environment, and an honest, reliable banking system. A great deal of the Fed’s activity has nothing to do with what should be its core mission. As bureaucracies do, it has grown too powerful and invented new reasons to justify its existence.

That’s not any one person’s fault, nor is it a partisan political thing. Getting us into this mess was a long-term bipartisan comedy of well-intentioned errors. Finding a solution is more important than pinning blame. We have to start somewhere and now is the time.

A few final thoughts:

  1. As I keep saying, we will eventually come to a financial reckoning I call The Great Reset. It will require us to rationalize debt, reduce government spending, and increase taxes. Otherwise we will fall into very difficult economic times. Not the end of the world, but still difficult.
  2. The Fed will continue doing what it does, up to the moment of actual crisis, helping bring it about, and then offer to put out the fire it helped create. Failure to reform the Fed will let it continue to create bubbles and distort the economy.
  3. Starting this conversation now will help us have proposals ready when the time is right. There are others far more knowledgeable than I am who can provide better ideas and insight. I am simply observing a pattern that has developed over 25 years of loose monetary policy beginning with the Greenspan Fed, which is responsible for many ills.

This is a serendipitous time to begin this discussion, with pushback against authorities across the spectrum “speaking down” to the hoi polloi. We live in a time of dueling experts, with one group of experts wanting to censor others or drown out alternative, competing ideas.

The Fed is part of that system, led by a group of people who believe they know better how to manage a $20 trillion economy than businesses and consumers themselves. They have created all sorts of unintended consequences, none of which they assume responsibility for, because their theories tell them that what they are doing is correct and those consequences are caused by something else. They are like Plato’s philosopher kings. “Trust us, we know how to run your lives.”

The Federal Reserve is just one of many institutions that need rethinking. But while we do it, let’s make sure we take care of the Fed. We need a properly managed Fed for crises like we saw in early 2020, but it must have limits.


The subsidies keep coming!

Don’t expect anything that looks intelligent for a few years yet… mrossol

The WSJ. 2/24/2021 

We’ve been telling readers about the progressive policy priorities hitching a ride on Congress’s “Covid relief” bill. That includes shoveling billions into the Affordable Care Act, with the goal of making government insurance a middle-class entitlement on the way to Medicare for All.

Provisions of the $1.9 trillion bill moving through the House make Affordable Care Act subsidies more generous and available even to the affluent. Buying an ObamaCare policy makes sense if a subsidy shields you from fearsome premiums and out-of-pocket costs; more than 85% of enrollees receive such a subsidy. But those who earn too much to qualify for government subsidies have been fleeing the exchanges. The Centers for Medicare and Medicaid Servicessaid last fall that unsubsidized enrollment dropped 45% between 2016 and 2019.


Instead of making the underlying product better or less expensive, Democrats now want to pass more of the cost onto taxpayers. More low-income buyers would pay little to nothing for insurance. Democrats would also remove the income cap for receiving subsidies, which is 400% of the poverty line, and reduce a person’s maximum contribution to 8.5% of income from 10%.


The ObamaCare “subsidy cliff” is poor policy that punishes Americans for working and earning more, but now government will spend scarce resources on those who don’t need help. Brian Blase of the Galen Institute has pointed out that a family of four headed by a 60-year-old earning $240,000 could qualify for a nearly $9,000 subsidy. These are not the folks hit hard by the pandemic, many of whom are eligible for Medicaid.

The supersized subsidies would cost $34 billion over two years but that is merely the beginning. The politics are such that the benefit will never be revoked. The more generous subsidies will be captured by insurers, who will continue to raise premiums, and the specter of high costs will push lawmakers to intervene again. Rinse, repeat. Smaller businesses may move their workers onto the exchanges instead of offering their own insurance.

The House bill also offers a temporary five-percentage-point increase in federal funding to states that decide to expand Medicaid to childless, prime-age adults above the poverty line. This has nothing to do with Covid relief.

Texas, Florida and 10 other states declined to expand Medicaid as part of the Affordable Care Act, and that decision looks smart in retrospect. States have spent more money on more enrolleeswithout improving emergency room visit rates or other health outcomes, while burning a hole in state budgets. State legislators will have to tie themselves to the mast amid interest-group demands to take advantage of “free” money from the feds.

Oh, and would you like to pay more at the counter for your prescription drugs? Democrats have you covered. Here’s how: Drug manufacturers are required to offer steep discounts to Medicaid, and these discounts are capped at 100% of the average manufacturer price of the drug. House Democrats would remove that cap.

Some companies could end up paying state Medicaid programs to take their drugs. The cost of such Medicaid dysfunction is spread across commercial markets, raising drug prices elsewhere, and it is one reason some diabetics pay too much for insulin.

Democrats will talk all of this up as merely helping struggling Americans get health coverage. The true plan is to continue to chip away at private health insurance, creating more market dysfunction that they will later claim to solve with more government insurance.


Escaping the Student-Debt Trap

We need more national debate on this issue of student debt. Not just how to solve, but if it is the right solution to education at all.
Kate Bachelder – June 13, 2014 6:41 p.m. ET

Student debt in the U.S. now tops $1.2 trillion, spread among 37 million borrowers, 5.4 million of whom have already defaulted. Washington took notice this week, rolling out the usual non-solutions: On Monday, President Obama expanded a federal program that allows students to repay debt based on what they earn, eventually forgiving the balance. Taxpayers pay the rest. On Wednesday, Sen. Elizabeth Warren’s idea to tax millionaires to pay for broad student-loan refinancing stalled in the Senate.

But there’s one way to slow student-loan debt that didn’t make Washington’s agenda. What if a tool could help any student pay for college without a loan or government subsidy? If that sounds impossible, ask Miguel Palacios, assistant professor of finance at Vanderbilt University’s Owen School of Management. He’s the creative force behind income-share agreements.

“College is on average a good investment, but it’s a risky investment,” Mr. Palacios says. More than 40% of college students don’t finish in six years, and in 2012 45% of those who did graduate had jobs that didn’t require a degree, according to Federal Reserve data.

Here’s his solution in a nutshell: Suppose an industrious young person wants to get a degree at a top university but needs about $50,000. Under an income-share agreement, the student promises an investor a certain percent of his income over a fixed period in exchange for cash. The agreements are not loans, and there is no outstanding balance. Students who earn more pay more, and students who earn less pay less.

Mr. Palacios has seen these income-share agreements in action and thinks they can revolutionize higher education. The startup he co-founded in 2002 with entrepreneur Felipe Vergara, called Lumni, has funded nearly 5,000 students in five countries. In April Sen. Marco Rubio and Rep. Tom Petri, both Republicans, introduced legislation that would give income-share agreements the legal and regulatory clarity to flourish in the U.S.

At first handshake, Mr. Palacios seems easily typecast as an academic. He’s poring over spread sheets when I arrive at his Vanderbilt office. A dry-erase board behind him is scribbled with graphs and values of “x,” and the bookshelves are stocked with finance textbooks. Even the décor is industry-specific: On white walls hang two pieces of contemporary art, both using outmoded currency notes as a medium.

It’s quickly evident, though, that the 40-year-old scholar is part economist, part entrepreneur. “When you were starting college, did you know how much money you would make in the first 15 years of your life?” he asks in his crisp Colombian accent. No, and I still don’t.

Federal loan programs “encourage students to pursue any degree regardless of price,” he says. Students can borrow cash directly from the feds through Stafford loans. Parents have an even easier line of credit: Under the federal Parent PLUS program, mom and dad can borrow up to the cost of tuition after a credit check. “People are sometimes mortgaging their homes on what their kids will do,” Mr. Palacios says.

It’s not working. The Consumer Financial Protection Bureau estimated in 2013 that 22% of federal student-loan borrowers who have entered repayment are now in default or forbearance. More than 600,000 borrowers who graduated in 2010 had defaulted by 2012, according to Education Department data.

In response, the Obama administration has taken the “throw money at the problem” approach, as Mr. Palacios puts it, by expanding the Pay As You Earn program, under which students can curb their payments if their earnings don’t keep up. Those programs “do not help students make better choices about where to go and what to study,” Mr. Palacios says. The federal programs forgive loans after 20 years, 10 years if the borrower works in “public service” (government or nonprofit). But how long can the taxpayer bear that expense?

Mr. Palacios says income-share agreements, or ISAs, can mitigate the damage from what he calls the coming student-loan “train wreck.” First, they “send a strong signal about value,” he says. Want to get a peace-studies degree for $100,000? Be prepared to pay a hefty portion of your income for a really long time. ISAs give students much-needed information about which programs are more likely to lead to employment. Over time, colleges would be forced to lower costs and offer better value. Most important, ISAs take away “the risk of financial ruin,” Mr. Palacios says. If you don’t earn any money, you don’t pay any money.

Mr. Palacios explains that economist Milton Friedman floated the notion of buying a “share” in an individual’s earning prospects in the footnote of a 1945 paper and explored it more deeply in 1955 amid debates over financing higher ed. “The idea morphed into an income-contingent loan,” says Mr. Palacios, who calls himself “a liberal in the 19th-century sense,” and “not left or right” but “pro-freedom.”

Yet David Bowie, not Milton Friedman, first inspired Mr. Palacios. In 1997, the rock star announced that he planned to finance his next album by selling shares of future revenues. “I was intrigued.” he recalls. Working in Chile as a financial analyst, the 23-year-old Mr. Palacios thought: Why can’t bright, talented college students do something like the Bowie idea? In college, he saw “very brilliant people who just wouldn’t make it because they didn’t have the right funding.”

In 1999 Mr. Palacios moved to the U.S. to attend the University of Virginia’s business school, where he began researching how to implement human-capital contracts. In 2001 a friend introduced him to fellow Colombian Felipe Vergara, an entrepreneur who liked ISAs and “wanted to do it,” Mr. Palacios recalls. “That’s how Lumni was born.”

Mr. Palacios’s first boss chipped in capital, as did a few other investors. Then they needed students. “We had a spy,” Mr. Palacios confides. Messrs. Palacios and Vergara asked someone they knew attending university in Chile to identify good students who needed financial aid.

In October 2002, Lumni signed contracts with four Chilean university students for one year of funding, later adding two more to the first class. The investment totaled roughly $12,000. The students agreed to pay a small percentage of income—about 3%—for roughly five years. The students thrived: Gonzalo Labbe, for example, met his obligations and now manages corporate accounts for Hewlett-Packard HPQ -0.75% in Chile. The investors did well, too. “We had returns in excess of 10% and on the order of 15%,” Mr. Palacios says.

By 2009 the company had expanded to Colombia, Peru and Mexico and reached more than 1,000 students, funding many in community colleges and vocational programs. Nearly all of Lumni’s students come from low-income backgrounds, and most are the first in their family to attend college.

How has the fund held up? Pretty well. “The returns have been lower, by design,” Mr. Palacios notes. Investors can design the return they want within a certain range, and “many have simply liked the work we do and asked for little or no return.” Lumni has raised about $50 million from individuals, corporations and foundations.

In 2009 Lumni began offering contracts in the U.S., funding 27 students so far. Growth has not happened quickly, and here’s one major reason: There are lingering questions about the legal enforceability of the contracts. It’s also unclear how they’d be taxed or regulated, details that Lumni has mostly worked out in Latin America.

The murkiness has thwarted others interested in ISAs. In the mid-1990s, an entrepreneur named Roy Chapman started Human Capital Resources, seeking to do what Lumni does now. Chapman lobbied Congress for legal and regulatory clarity, and then-Rep. Lindsey Graham introduced a bill in 1999. It went nowhere. In the early 2000s, a firm called My Rich Uncle offered ISAs but soon gave up because, Mr. Palacios thinks, the founders realized that “raising capital for something risky in the regulatory sense is tough.”

Most recently, the lending platforms Upstart and Pave began offering the contracts. That didn’t last long for Upstart. “We’re still huge fans of income-share agreements,” company founder Dave Girouard wrote on Upstart’s website on May 6, but the startup feared it will “likely take many years” to sort out the regulatory issues.

Why so long? In part because ISAs are often portrayed by critics as indentured servitude. “Part of that is fear, and I think it’s completely misplaced,” Mr. Palacios says. “ISAs in no way tell anyone what to do. The contract can’t force anyone to work.” He maintains they are more liberating than student loans: “You have the same freedoms, but you don’t have the same worries.”

Others view ISAs as exploitation. Dave Bergeron, of the left-leaning Center for American Progress, told Reuters in April that ISAs are unfair to students because some would pay back “substantially more” than they borrowed. “That takes a static view of the student,” Mr. Palacios argues, noting some rich ideological inconsistency. “These people who talk about exploiting students have no qualms saying the 1% should pay much more of their income to the federal government. If that student has to pay a lot, it’s because that student became part of the 1%. To them, the right tax rate for the 1% is always just ‘more.’ ”

Do ISAs also encourage students not to work? Mr. Palacios suggests keeping payments as a share of income as low as a state income tax rate so students won’t be tempted “to go to the beach for the rest of their paying-contract lives.”

ISA funds also run the risk of adverse selection, as the best students might see federal loans as a better option. “That’s why we don’t offer everyone the same contract,” Mr. Palacios says. Pricing allows Lumni to be sure it can recoup enough of its investment. The firm also employs psychologists to evaluate whether students are being honest about their career intentions. “The concern that we’re going to end up with a bunch of French literature students who said they wanted to be investment bankers hasn’t panned out,” Mr. Palacios says, adding a playful apology to his wife, who teaches French literature.

The biggest hurdle might be Congress. The Rubio-Petri bill would give ISAs a chance by making them legally enforceable contracts, capping the percentage of income at 15%, setting a maximum repayment period of 30 years, with a repayment exemption for those who earn less than $10,000 a year. Contracts would be required to define what constitutes income, and not permitted to dictate career choices.

The bill may pass the House, but it would be dead on arrival in Harry Reid’s Senate. Mr. Palacios thinks it might fare better if Republicans retake the Senate in the fall, but then it looked that way for ISAs in the 1990s. Still, Mr. Palacios is bullish: “The momentum for ISAs has never been this strong.”

The momentum may reflect the moment. “At this rate,” he says, “student debt could be $2 trillion in five or six years.”

Lumni isn’t waiting around. The organization pledged in 2010 to fund 10,000 students world-wide by 2020, and Mr. Palacios says Lumni is on track to meet the goal. With a little push from Congress, more firms could jump into the market. ISA funds could be run someday by everyone from institutional investors to enthusiastic alumni.

ISAs are “a bright spot in finance,” Mr. Palacios says, because they better the lives of individuals and society. “How could anyone be against that?”

Ms. Bachelder is an assistant editorial features editor at the Journal.

The Weekend Interview: Escaping the Student-Debt Trap – WSJ.