Human capital bonds

After last week's post on the relative benefits of renting versus buying a home, Ryan Decker sent me to his earlier post on the subject. In it Ryan mentions an interesting concept I'd never heard of before; lifecycle investing.  Developed by Ian Aryes and Barry Nalebuff (pdf), the idea is that investors in their twenties can reduce risk and improve returns not only by investing all their savings in the stock market, but by going one step further and taking out a loan to buy stock.

Odd advice, right? But there are good reasons for this. Aryes and Nalebuff's thesis begins with the idea that we all own something called a "human capital bond." This is the present value of our lifetime stream of saved wages. Imagine a young investor with an average tolerance for risk who has just entered the labour force. He/she possesses a human capital bond that is currently worth, say, $500,000. Let's assume that this bond is expected to be quite stable in value, maybe because the young investor has just taken on a unionized government job. It make senses for our investor to reduce their allocation to this low-risk human capital bond in order to get exposure to an appropriate amount of riskier equity, thus boosting overall returns. Say the ideal equity share is around 50%, or $250,000. Waiting for the paychecks to roll in is far too slow a way to build a $250,000 stake in equities. Far quicker to sell half the human capital bond right now—or $250,000—and use it to buy the stake in equities outright.

The problem is that our investor can't simply sell away $250,000 worth of human capital. A spot market for human capital bonds doesn't exist. Absent the appropriate market, Aryes and Nalebuff believe that the way to approximate the ideal ratio is to use debt. By leveraging their meagre savings at a ratio of 2:1, a young investor with (say) $5,000 in savings in the first year of employment can get exposure to  $10,000 worth of stock, thus getting twice as close to the ideal amount of diversification. Ayres and Nalebuff refer to this as time diversification. Rather than waiting till mid age to have accumulated an appropriately diversified portfolio, do so as early as possible.

I think that it makes a lot of sense to imagine ourselves as if we held a Ayres/Nalebuff human capital bond and make our best effort to diversify around this asset. However, what if our bond is risky rather than safe? Maybe we make ends meet via a series of freelance jobs rather than perpetual government employment, or maybe we get by on commission income which can vary dramatically year-over-year. If so, the asset that represents our capitalized savings should probably be conceived not as a bond, but as a relatively volatile human capital "share." Instead of levering up to buy even more shares, a freelancer or salesperson seeking to diversify across time should borrow and acquire a stable asset with low drift, say like a mortgaged home.*

Liquidity is another facet worth considering. To own a human capital bond (or share) means to be terribly illiquid. Unlike a regular bond (or share), these instruments can't be rapidly swapped for other assets.

Owning an illiquid portfolio comes at large emotional cost. Consider that we are mere specks of dust being tossed around by currents far too large and complex to control, let alone understand. Against this awful uncertainty, extremely liquid financial assets, specifically instruments like deposits and banknotes, are our best lines of defence. When the universe suddenly knocks us down, liquid assets can be deployed to cope. When it throws us a bone, they can help us seize the moment. So while deposits and cash provide little in the form of a financial return (they are expected to steadily inflate away in value), they compensate by providing huge non-pecuniary flows of convenience, relief, and confidence.

When a young investor is advised to lever up and invest in either stocks or real estate, both of which are more liquid than a human bond but still not terribly liquid, they are being asked to bear some of the burdens of uncertainty. After all, leverage means running down inventories of cash and deploying back up lines of credit. Too much leverage and our investor loses their only hedge against the unknown. This lack of liquidity could subject them to enormous emotional costs when the proverbial shit hits the fan (or an unforeseen life changing opportunity must be passed up).

So young investors need to be careful that they take on an appropriate amount of debt (too little may be as bad as too much) and acquire suitable assets. To begin with, they must do their best to estimate the present value and riskiness of their largest asset, their Aryes/Nalebuff human capital bond. Only then can they determine the merits of borrowing to diversify across time; some assets promise significant returns (like shares) and some of them don't (like houses), the best option depending on the nature of the individual's capital bond. They also need to ask themselves a philosophical question: to what degree can the world be understand and controlled and to what degree is their fate governed by random and unpredictable forces? The more chaos our young investor sees, the more they should keep themselves liquid; the more order they see, the less liquid. There is no one-size fits all solution here, no trustworthy rule of thumb. But I'm sure you'll figure it out.

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Related post: Labour Shares™: Beating capital at its own game

*Could housing booms be a function of forces that make human capital bonds increasingly risky, say like increased contract work and the demise of the traditional promise of lifetime employment offered by corporations? To offset the growing risk of the standard human capital bond, everyone may simultaneously try to offset by purchasing a home, traditionally a low return asset.

Labour Shares™: Beating capital at its own game

We all carry a variety of media of exchange in our portfolios, some more liquid than others. Deposits are pretty high on the liquidity scale, stocks and bonds a little less so, and our household's furniture is even less movable. The most sizable medium of exchange in our portfolios also happens to be our least liquid one: labor. Our capacity to use our brains and bodies to work is the primary currency that each of us own, although it isn't a particularly mobile one. Might things be different? Could labor be converted into a more effective medium of exchange that is capable of competing with highly fluid financial assets for preferred liquidity status?

Much of our lives are spent trying to make marginal improvements to the liquidity of our labour. We may choose to learn more skills so that we can participate in multiple markets, the more markets being open to us on any given day the more saleable our labour. Alternatively we may choose to learn one thing very well. While this leaves us with only one market in which to sell our labor, the quality of our work should differentiate itself enough such that the liquidity we enjoy within that one market outweighs the liquidity we choose to forgo by not participating in other labour markets.

Even with these liquidity enhancing strategies, labor remains a relatively hard sell compared to other media of exchange. This is problematic. Insofar as liquid media are the best hedges against an uncertain future—they can be rapidly mobilized to help plug leaks and patch holes—this means that labour, our largest medium of exchange, does a pretty bad job of protecting us from unpredictable events. It takes too much time and effort to sell the damn stuff. Amongst media of exchange, labour is the slow moving Titanic.

Which is why we fashion contractual crutches to convert illiquid labour into a more vendible product. Rather than go out into the marketplace each morning to find a new person who'll buy our labour, we usually make long term deals with buyers that require them to repeatedly purchase our services over a period of time. Having secured a repeated buyer of our services, we've converted a bad hedge against uncertainty into a better one, at least as long as the contract is in effect.

But there are ways to make labor even more liquid. To do so, we need to overcome the physical characteristics of labour that prevent it from being as good of a medium of exchange as, say, gold. Gold is divisible, portable, uniform, and durable. An ounce can be divided into smaller bits without any loss of value, it can be used by successive individuals without depreciating in quality, and it passes easily across time and space. Labor, on the other hand, can't be bottled up and stored, nor can it be passed on from buyer to buyer. Once expended on some task, labour is dissipated and ceases to be a conveyable medium. Labour is like an ice cream cone, it doesn't last very long.

A time-honoured way to encourage the liquidity of something is to securitize it. Take an illiquid mortgage, combine it along with others into a pool and splice that pool up into easily tradeable mortgage-backed securities. Or convert a sole proprietorship into a corporation, create shares that represent ownership, and list those shares on a marketplace, thereby converting illiquid ownership into liquid ownership. Exporting these ideas to the labour front, if people are capable of toiling away for fifty years, then why not create a series of claims on that labour and allow those claims to be sold off? In this science fiction world, these claims might be called 'labour shares'. While physical labour itself cannot be resold, the non-physical representation of that labour—labor shares—can be passed around indefinitely along long monetary chains.

This solves the resaleability problem that has historically impeded the liquidity of labour. After an employer has bought some of our labour shares and put us to work, should they have no further need for us they can trade away our shares to another employer rather than just firing us. Middle men might buy our shares and sell them on to other middle men, with the odd speculator jumping into the fray when they think they can buy low sell high. Financial engineers might combine our shares together with those of other similar workers, creating large pools of labour that can be bought all in one fell swoop by large employers. Our labour, once the Titanic of exchange media, has become a nimble instrument.

In this science fiction world, labour "does" more for its purchaser than in times past. As before it provides anyone who has bought it with a real pecuniary return (a labour share can be converted into work), but now it also provides an extra non-pecuniary return. Specifically, labor shares act as a stock of liquid media of exchange on par with an inventory of cash. A buyer of our labour, say a firm, now finds itself owning a fairly decent uncertainty hedge—should it be blindsided by some unforeseen event, the firm's owners can rest well knowing that the firm's managers can sell off either its cash or its accumulated labour shares, or some combination of the two, in order to help acquire the resources necessary to resolve the crisis.

Since labour now provides potential owners with a greater range of services than before it will command a premium over its previous price, or a liquidity premium. Anyone who provides labour will receive that premium, thereby earning more than they did before.

There are some ugly aspects to this science fiction world. It is certainly dehumanizing, treating humans like any other vendible commodity or asset. A market for labour shares might breed a highly itinerant workforce the members of which, much like Federal Reserve notes, would be constantly recycled from one side of the globe to the other. It also raises moral questions of personal agency. If we no longer want to toil for the employer who owns our labour shares, must we repurchase those shares—and our freedom—back from them?

The positive aspect of a world with liquidity shares is that in rendering itself more liquid, labor earns a greater share of the pie. Why should capital, after all, be rewarded the entire range of liquidity premia that society has to offer? Over the last few decades, financial engineers have made houses, equities, bonds, and all sorts of other assets ever more liquid. As a result the prices of these assets have steadily appreciated, a higher price being the market's reward for any asset that throws off growing quantities of liquidity services. That's great for the 0.01% who's wealth is primarily comprised of these assets; they enjoy ever growing capital gains (see chart below) and a larger slice of society's wealth. However, the majority of the world whose wealth is largely comprised of relatively illiquid labour potential has been left eating dirt.

The wealthiest 0.01% of society now owns 11% of society's wealth, up from just 2% in the 1970s.
Saez and Zucman, March 2014. [pdf]

Speed up the exchangeability of labor, on the other hand, and the reverse happens—labour grabs a larger liquidity premium for itself, thus appreciating in price and henceforth earning a larger share of society's total wealth.

Another advantage to a labour share scheme is that workers reduce their exposure to the discomforts of uncertainty. A worker's labour, represented by the full lifetime stock of liquidity shares in their portfolio, is more marketable than before, which means that they can more easily sell their labour to deal with potential disasters. This renders the future a little less frightening, the reduced contingency planning this entails allowing workers more time to enjoy the present.

Alternatively, rather than speeding up the liquidity of labour, maybe we should be slowing down the liquidity of all other things. That way labour, in the name of keeping up with the Joneses, never has to go down the somewhat ghoulish path of ever-accelerating liquidity. Various policies including a Tobin tax, the slowing down of equity markets in order to weed out HFTs, Glass Steagall style banking restrictions, and trade protectionism are all ways to help clog up the liquidity passageways. Enact these policies and mobile assets like stock and bonds lose their liquidity premia. The 0.01% who previously benefited from capital gains on rising housing, stock, and bond prices now suffer capital losses, and the labouring 90% will enjoy relative wealth gains.

The problem with these policies is that in constricting liquidity, we'd end up losing a major bulwark against felt uncertainty. Fretting and brow furrowing would increase, our lives worse off than before. The retort here is that perhaps liquidity should never have become our most important uncertainty hedge. In times past, self sufficiency, communities, families, and tribes were the institutions that we relied on to cope with a cloudy future. What made one's labour a great hedge against uncertain events, say a flood, was not that it could be rapidly sold off, but rather that together with other members of the community, our toil, sweat, and tears could be mobilized to plug dikes or rebuild houses. Implement policies like a Tobin tax and we may move back towards this world.

That may be true, by we've gone so many centuries down the liquidity path that its probably too late to reverse course. Labour shares, or something like it, might not just be science fiction; they could be the next step in the great liquidity race, especially if labour wants a larger share of resources. Perhaps the best way to cope with the ugliness created by an institution like labour shares, still very much in the imaginative stages, would be to innovate more humane ways to securitize labour. No-trade clauses or limited-movement clauses, for instance, might allow individuals to have some say in determining the destination to which they are dispatched. Unions may have a role to play in designing standards for labour shares that ensure that we don't bargain too much of our humanity away.

There is probably some upper limit to how liquid you can make something. Until that plateau is reached, financial engineers will keep making capital more liquid, and owners of capital will continuously enjoy the resulting price gains. Unless labour decides to liquidate itself, it could be facing many years of deteriorating wealth relative to the top 0.01%.