Tuesday, December 04, 2007

A Tuition Bubble? Part 4 of 4

By Andrew Gillen

This is the fourth in a four part series that will explore the similarities between the housing bubble and rapidly increasing tuition. A study that explores these issues in greater detail will be available at the conclusion of the series.
Part 1 is available here.
Part 2 is available here.
Part 3 is available here.

A working paper that addresses this issue in greater detail is available from our website.

Conclusion

The previous post showed how because schools are prestige rather than profit maximizers, and because a lack of any measure of their output precludes normal price competition, widely available government subsidies will contribute to higher tuition rates.

Government guarantees for student loans contribute to artificially low interest rates and lax lending standards, which were two of the driving forces of the housing bubble. Of course, the bubbles themselves are driven by other causes (speculators in the housing market and market characteristics in higher education), but artificially low interest rates and lax lending standards enable these culprits to exert greater influence. Thus it should come as no surprise that we witness tuition increasing at an unsustainable rate, just as housing prices were until 2007. They are both driven, at least partially, by the same phenomena, artificially low interest rates and a lack of lending standards.

If it took a rise in interest rates to pop the housing bubble, do interest rates need to rise to pop the tuition bubble? If so, current policies like The College Cost Reduction Act of 2007, which is seeking to expand the availability of loans and to lower interest rates even more, will accomplish little other than allowing schools to raise their tuition.

Public policy should cease guaranteeing student loans for so many students. The characteristics of the market for higher education ensure that when the ability of the typical student to pay is increased, schools will simply raise tuition. Restricting loans to low income students would make it harder for schools to raise tuition. Besides, grants are a better method of funding the education of low income students because they do not lead to some of the other problems associated with loans.

The main lesson to draw from the housing bubble (when it comes to higher education at least) is that guarantees for student loans result in artificially low interest rates and lax lending standards. When these subsidies are too widely available, they increase the ability of the typical student to pay for schooling, which encourages schools to raise tuition more than they otherwise could.

1 comment:

TC said...

Andrew, I read your full report and I think you illustrated the problem with tuition costs well. However I have some issues with a few things you say in your report. After reading the full report, I'm left wondering what the solution is.

A few things that I would consider debatable are as follows:

You cite low interest rates and the subsequent increase in rates as one of the reasons for the housing collapse – which I agree with, but with more specificity. Further in your report you say, "In fact, I would argue that the primary responsibility for the housing 'bubble' lies with the speculators (who were of course enabled by the banks).”

Regarding the former, a very large part of the collapse was due to predatory lending practices in subprime mortgages. These loans had low introductory interest rates or “teaser rates” that expired one to two years into the loans. A lot of people were still paying the introductory rates as the Fed raised rates. When the introductory rates expired, mortgage payments increased more than the mortgagees could afford and they defaulted. That and ARM's were the biggest contributors to the housing collapse. Personally, I consider “The Bankruptcy Reform Act of 2005” as part of the problem due to the fact that it makes it damn near impossible to restructure debt before borrowers default or even before they realize they are in deep trouble.

With regard to the latter, "speculators", or investors are only guilty of making stupid investments in mortgage pools via Collateralized Mortgage Obligations (CMO’s), Commercial Mortgage Backed Securities (CMBS’s), Mortgage Real Estate Investment Trusts (Mortgage REIT’s), and Real Estate Mortgage Investment Conduits (REMICS), etc. And most of all, Hedge Funds that do not include the average Joe investor.

Also, I am wondering where the substantiation is for claiming that loan guarantees cause “lax lending standards and artificially low interest rates”. Large percentages (60%?) of SBA loans are guaranteed by the government and I don’t see low interest rates there – or lax lending standards. So I presume this conclusion is based on observation.

If interest rates on student loans were, say, doubled and demand for higher education dropped proportionately; would tuition costs come down, go up, or stay the same? My guess is that tuition would remain the same and colleges would start “trimming fat” – in the short term.

Finally, from all the reading I have done on CCAP’s blog and CCAP’s reports – along with a little research I have done on my own, I believe a college’s weak spot is their endowment funds. I also am inclined to believe donations to college endowments are part of the problem. Maybe the answer is that donors need to stop donating until colleges reduce tuition. This is where I see colleges most sensitive and vulnerable.