Is There An Education Bubble?

Instapundit and many others certainly think so.  Anecdotally, it certainly seems like there could be one given the prices that many colleges are charging.  Instead of thinking about it in terms of what people say, let’s look at some math.  Numbers sometimes bring clarity to a situation.

If you pull some free market logic from Finance and apply it to the education market, you might frame things differently.  Eugene Fama from the University of Chicago says that there are no such things as “bubbles” in financial markets.  If there are, you ought to be able to predict them and act accordingly.  He correctly points out that all publicly known information is incorporated into the price of an asset.  Are asset bubbles in financial markets directly comparable to intangible assets?  Probably not, but Fama’s theory on efficient markets should at least give us a touchstone to think about.

In this case, our asset is a college education.  The asset is not physical like a stock or a piece of real estate, but intangible.  Hence, there are properties to that asset that are subjective.  For example, what is the real value of the Coca-Cola brand name?  In turn, what is the real value of a college education-and within the finite range of colleges, what’s the individual value?

Here is the hypothesis:  We will assume that there is an education bubble.

What is our evidence?  The two forces that combined to create the housing crisis are doing the very same thing in education.  Cheap, easy money by the Federal Reserve, and a Federal Government that guarantees the entire loan system.

But, it’s not enough to say that it’s just expensive.  When did it become expensive, or in a “bubble”?

Here is the annual Fed Funds rate from 1955-2010.  The average Fed Funds rate from 1990-2010 is 3.866. You can see the high inflation of the late 1970′s-early 1980′s reflected in the rate.

The Prime rate is usually a point over the Fed Funds rate. But, because of default risk and other factors, college loans are taken out at higher rates. The average interest rate on a student loan is not so simple. Imagine that, something with a lot of government interference is not clear! There are subsidized and unsubsidized loans. The market is so murky, many sights tell people to assume that the interest rate will be 8%. But after doing a couple of searches at Edulender, a 10% rate is a better implied rate.

Now that we at least have a firm foundation on borrowing costs, we can look at what we will spend the money on.

It’s funny, when I speak with men and women about college costs, they speak different languages. Men almost always quote “all in” costs, tuition, room and board, books, etc. Women break it up. To a man, Harvard costs 50 grand, to a women it’s 35k for tuition, and 12k for room and board, but I know that I can save some money on food! Men know that you gotta eat-plus pay for a little beer too. That 12k can grow in a hurry!

For our purposes, we will make the women happy and just look at tuition. The average tuition rate at four year public colleges nationwide last year was $7,605 for in state students. Private colleges charge an average tuition of $27,293. Private is almost four times as much as public. In 1990, the average public rate was $2,035, and average private was $10,348. Twenty years ago, private college was five times more expensive than public. Annual inflation as measured by the Consumer Price Index (CPI) from 1990-2009 (2010 not out yet) was 2.79%. If tuition rates rose by the inflation rate, you would expect the public number to be $3,528.
The private number would be $17,942

Yowza. By that measure there may be an education bubble!

However, there is much more to the analysis of the problem than that. It pays to look at salaries. Here is a chart of median weekly earnings based on degree, and the corresponding unemployment figures.

This chart is more dramatic, because it charts the growth of income with a degree over time

The real interesting facet of this chart is looking at income, and what was going on in the underlying economy. In 1986, the slope of the graduate degree line started to increase. In 1990, the high school degree line started to decrease. This can be explained by our economy transitioning from a manufacturing based economy, to a knowledge based service economy. Over a person’s lifetime, a college grad will earn 75% more than an non-college grad.  College matters.

Researchers have also tried to delve into the subject of which college matters. Ivy League schools supposedly carry more “respect” among the populace, so demand for top tier institutions exceeds demand at other schools. While all schools have raised tuition significantly, many of the top tier schools are able to raise it more.

These underlying economic changes changed the demand curve for college. Tangible evidence could be physically seen with standards of living and income. Additionally, communism fell in eastern Europe in 1989, allowing a new crop of foreign students access to US schools. This combined with Deng Xiaoping liberalizing force in China, and a large influx of immigrant students from India has also moved out demand for a US college education, especially graduate school.

Supply is constant. No new colleges have been built. Here is a graphical explanation of what happens to price(tuition) when supply is held constant and demand is increased.

Then comes the US government trying to “do good”. What does the US government do? It increases subsidies to education. What happens when you subsidize a market? You get more of whatever it is you are subsidizing. In this case, because supply cannot increase, it puts upward pressure on price (tuition). President Jimmy Carter created the Department of Education. Since it’s inception, we now spend 30 billion dollars a year on higher education in subsidies.

This puts upward price pressure on tuition.  Along with that, the cost of the subsidies are not borne by the beneficiaries.  This causes economic imbalances.  In a nutshell, blue collar workers are subsidizing the college education of future higher income workers.  Also, the students in college don’t pay for the true cost of the subsidy, since they have access to grants, loans and tax credits.

Increased demand from more people, increased subsidies, no new supply and boom, significantly higher prices. But the increase can almost be entirely explained by government intervention!

One can look at average cost data to see the inflationary effect of rising student aid. From 1987 to 2007, there was a strong upward trend in average per-student costs of private and public universities (tuition, fees, and room and board). However, if you subtract from those costs federal grants, loans, and tax benefits, there has been only a modest increase over two decades.

Consider four-year private colleges and universities. The average real cost (in 2006 dollars) per student rose from $18,122 in 1986 to $30,497 in 2006, a 68 percent increase. But students didn’t bear that large increase because of grants, loans, and tax benefits. After these benefits, the cost grew from $10,943 to $14,158, a much more modest 29 percent increase. A similar pattern holds for price increases and public institutions.

Salaries earned are so variable, it’s tough to tease out statistics that are meaningful.  Here are two examples.

The median salary lawyers earned in 2008 was $110,590 per year.  Law school between private/public schools average about $150,000.  If you borrow the entire amount, which a lot of students do, it takes quite a bit of effort to pay of your loans, but still it’s worth it over the course of an entire lifetime.   You will have to payback about $350,000.

Average salary for a person with an MBA in 2008 was $104,000.  The average cost of tuition at an elite school in 2008 was more than that, around $125,000.  But, over a person’s lifetime, the payback was still worth it, even assuming small raises of 3% a year (or the rate of inflation)  The highest payback using Edulender was $292,000.

Both scenarios put a flutter in your gut.  But, under each there is always the potential to do better than the average.  Plus, the argument is the knowledge learned will cause you to think differently, and able to take advantage of unique opportunities that other people less educated will not see.  That supposition is highly variable.

It has been found at many institutions all across the country that colleges have used government dollars not to increase options and improve facilities, but to increase headcount among staff. All of this extra overhead adds to the fixed cost of college. The cost is not just in salary, but guaranteed pension benefits that accrue to the staff members no matter what.

In summary, the college market is efficient. Supply has not increased, but demand has. Subsidies have increased. This has put extraordinary upward pressure on the price of college.

There are two ways out of the problem, and we ought to do both.

First, build more colleges. This increases the supply and tempers demand, dropping prices. At the same time, remove the stigma of going to a community college. Going to a two year school will also relieve demand pressure on four year colleges, allowing prices to stagnate.

The second solution sounds cold hearted. But in order to make college more affordable for everyone, government ought to get out of the higher education subsidy business altogether. Blue collar workers will thank them for removing this hidden tax burden. Colleges will run leaner, and the federal budget deficit will drop.

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