Colleges and the Financial Crisis of 2008

By Richard Vedder

First, let me state at the outset that I think government tinkering in financial markets is bad, and that the current financial mess is about two-thirds the consequence of government mistakes. First, the Federal Reserve pursued an excessively loose monetary policy in the 2002-07 period. Interest rates were pushed well below their "natural" rate (to use a term coined by Swedish economist Knut Wicksell roughly a century ago), which tends to lead to what Austrian economists call "malinvestment" --over spending on capital goods. One byproduct of that was a run-up in housing prices. Second, following from this, bankers made many imprudent and overly large loans at low interest rates to persons with very dubious credit histories. These persons were forced into foreclosure by the fall in real estate prices and inadequate cash flows. Third, government regulators did nothing to stop the lending foolishness. In a sense, calling on the government to solve the resulting problem is a bit like putting Charlie Manson in charge of Children Protective Services, or making Lorena Bobbitt the Surgeon General.

At the same time, however, a crisis born out of boneheaded decisions by the central bank and others has turned now into a crisis of confidence, which can be devastating in a fractional reserve system where even sound banks only keep 10 cents or so of each dollar in deposit liabilities in the form of cash or near-cash liquid assets. If asset values held by banks fall 10 percent or more, there will be thousands of banks thrown into bankruptcy. The impact of that on the economy would be sizable.

Accordingly, a bailout makes some perverse sense. At the minimum, Congress should use this crisis to fix some clear wrongs, for example removing the special role that Fannie Mae and Freddie Mac have (because of bribes of Congressmen by those companies in the form of "campaign contributions", that is not going to happen). And Congress must be sure that any solution allows those making stupid decisions pay a high financial cost (actually, I would extend that to the Federal Reserve Board too, but that is politically infeasible). The moral hazard problem here is absolutely huge.

Last week, the system came close to a meltdown. The LIBOR spiked 300 basis points on September 16 as potential bank borrowers found no bank lenders because of plunging confidence. The money interest rate on T bills briefly turned negative --an unprecedented happening. Two major money market funds "broke the buck", meaning they did not have an ability to pay holders of their assets at par. People are very, very edgy.

What does all this mean for colleges? Here are four real possiblities:

1) The bailout crimps federal budgets, so dreamed/planned increases in federal assistance become unlikely --for example the College Board's proposed reform of student financial aid which has a multi-billion dollar price tag on it;

2) Endowment returns are more likely to fall than rise, although there will be exceptions (e.g., bond rich funds). The sharp decline in Harvard's 2008 rate of return is the beginning of a series of similar reports from others, suggesting the days of endowment-funded spending increase by rich schools may be over, actually lessening the academic arms race as other schools try to stay competitive;

3)Private student lending will largely dry up except under full federal guarantee, and maybe even that will not induce private lenders to make loans;

4)If this all induces a further downturn in the economy, state appropriations for universities will be reduced.

The day of reckoning to the economy as a whole from monetary-fiscal recklessness is coming home to roost on college campuses across the land. The Ivory Tower is not immune to happenings in the Real World.