The Financial Crisis and Colleges: Part 3

By Richard Vedder

As the financial crisis has deepened considerably and the signs of economic decline mount, it is worth extending our analysis of what this means for colleges in the near term.

PRIVATE FOUR YEAR COLLEGES

The elite, wealthy schools are going to get hurt, but in different ways than others. Let's look at endowments under three scenarios. The first scenario is a relatively optimistic one, where the Dow stops falling shortly, bank failures are minimal, only a few big corporations go broke, and the Dow ends the college fiscal year (next June 30) around 10,000. The most fortunate rich schools should show maybe no nominal change in their endowment size, assuming payoffs from endowments roughly equal new contributions. Adjusting for inflation, the result is a modest decline. More realistically, most schools will suffer at least a 10 percent decline in endowments, which eventually for most rich schools, will force perhaps a two percent budget reduction. Under an intermediate scenario, the Dow falls more, the negative consequences continue, but we begin to pull out by the end of the fiscal year, with the Dow between 8,000 and 9,000. Everyone suffers some loss in endowment size, with a typical private school losing maybe 15-20 percent. At the richer schools, that translates eventually into a 3 to 6 percent reduction in budgets because of lower endowment returns. In a worse case scenario, the econmy continues to implode, with no recovery this fiscal year, with the Dow dropping below 8,000, and losses in endowment at a typical school of at least 20 percent, and the elites forced to cut budgets significantly (maybe 8 to 10 percent at Harvard for example, a noticeable reduction).

The elites in the Great Depression sought more rich kids who could pay full tuition, and I suspect that could happen again, the rhetoric of recent years notwithstanding. I wonder if the allegedly super bright investment gurus running endowment funds who have done well by investing in hedge funds and other risky investments at the Yales and Harvards of the world are going to take a huge fall, with their endowments declining as much or more than those of the colleges that have pursued a less daring investment strategy. Time will tell.

The less elite and wealthy private schools are in worse shape, maybe the worst of the various types of institutions. They are heavily tuition-driven, and students hunting for bargains may head for cheaper public institutions (they, too, will suffer some on the endowment side, and in declining annual contributions). A few of them might be toast. Some could face budget cuts in the 5 to 10 percent range, with more forthcoming. Uncertainties about student loan funding aggravates the problem.

PUBLIC FOUR YEAR UNIVERSITIES

Public appropriations will take a hit, hurting public schools. The ability to make up for this by increasing tuition fees is difficult on both economic and political grounds, so growing austerity is likely. This might have some modest positive impacts, such as leading to the elimination of some costly programs that are not terribly productive, and possibly some inter-institutional cooperation to consolidate offerings. Enrollment effects are hard to gauge --some publics have actually had enrollment gains in bad times, as students switch to them from higher cost privates and/or draw in students who are unemployed and thus do not face the huge loss of income when they attend school as they usually would. On the whole, however, I expect the net effect of the falling economy on enrollments to be negative, and for these schools to have budgets for next year that are typically several percentage points below this year in real terms. Obviously, the exact decline will depend on the extent of the general decline in the economy.

TWO YEAR PUBLIC COLLEGES

This category stands to gain enrollments, I suspect, because of substitution effects (people switching to lower cost alternatives). Yet these schools depend a lot on state funding, which is likely to decline. So these schools face the worst of all possible outcomes - rising enrollments and falling budgets. This could lead to legislatures reducing the subsidy reductions for these schools relative to four year universities.

Economists are hopeless at important predictions, and I am no exception. Who would have said six months ago that the Dow on October 10 would be around 8,500? Who would have predicted the demise of Bear Stearns, Lehman Brothers, Wachovia or Chrysler? Panic can have devastating effects, as anyone who has studied the Panics of 1819, 1937, 1893, 1907 or 1929-33 knows. If people lose complete faith in government and the Fed, all bets are off, and higher education will suffer big time across the board.

I am of the opinion that government should now actually back off some, and let market forces work. Buffet's financial infusions, the Wells Fargo purchase of Wachovia (taking the FDIC off the hook), and the GM purchase of Chrysler are good examples of private solutions to problems (not all of these efforts may succeed, to be sure). The decline in oil prices and its positive effect is one example of how the self-correcting mechanisms of the market work. Let us not try to mute those positive market forces.