Monday, July 11, 2011

The Higher Education Bubble

I was golfing with a college friend of mine the other day and he mentioned a fund-raising event he went to at our Alma Mater. There, the president of the school projected that tuition would continue to rise at a rate of 8.5% annually. Perhaps this doesn't sound too awful, but compounding the increases is a bitch...

2011-12 tuition: $40,000
12-13: $43,400
13-14: $47,089
14-15: $51,091
15-16: $55,434
16-17: $60,146
17-18: $65,259
18-19: $70,805
19-20: $76,824
20-21: $83,354
21-22: $90,439
22-23: $98,127
23-24: $106,467
24-25: $115,517
25-26: $125,336
26-27: $135,989
27-28: $147,548
28-29: $160,090

For a child born today, entering college at age 18:
29-30: $173,698
30-31: $188,462
31-32: $204,482
32-33: $221,863

Total: $788,805

Keep in mind that this is for tuition only and does not include living expenses or various other "fees" that colleges like to tack on to the bill.

My friend noted that he was trying to put together a savings plan for his one year-old son. To which I replied, "What's the point?" How much money do you reasonably have save each year to save for both college tuition and retirement? And is it at all responsible to pay for college over saving for retirement? And if you have multiple children, what percentage of people are going to have $1.5 million saved for their children's colleges? Finally, what entity (in the post-financial crisis world) would be crazy enough to lend a college student upwards of half a million dollars to get a bachelors degree?

Honestly, I tried answering these questions until I got dizzy and decided to consider the ramifications of home-schooling my future children through medical school.

Unless wages rise dramatically over the next decade (and there's little reason to believe that will happen), we can expect to see dramatic changes in the behavior of American students at some point in the next 15 years.

It is my belief (and a google search of "higher education bubble" will show I'm not alone in this belief) that America's higher education- colleges & grad schools- are a bubble that will eventually burst. I can't say when this will happen, but as the above tuition chart shows, it may come sooner rather than later.

Look at the parallels between higher education and the housing market bubble:

1. Belief that the item has an almost mythical value. (See: American dream of home-ownership vs. America's dream of a college education)
2. Irrational belief that the items value will always increase. (See: "Historically, housing has never gone down in value." vs. "College educations pay for themselves many times over in a lifetime")
3. Tax treatment that inflates the affordability of the item. (See: Deductible home loan interest payments vs. student loan interest deduction)
4. Easy credit to purchase the item. (See: Housing Loans of 2004-2007 vs. student loans backed up by the government, ability to defer interest until graduation, and availability of federal loans at a low fixed rate- which are admittedly not that low right now)
5. A rapid increase in cost that dramatically outpaces average incomes (See: Historical housing prices vs. 8.5% annual increases in tuition)

The housing bubble burst when banks became unable to sell the loans that were on their books and stopped offering refinancing on adjustable rate mortgages. Homeowners, who were relying on refinancing to avoid the increased payments, began defaulting on their mortgages. This threw into doubt the ideas that housing always goes up in value and that housing is a 100% safe investment. Suddenly, people who were overextended on their debts were no longer able to rely on the banks to prop them up. New home buyers couldn't get loans to buy homes, a glut of foreclosed homes and houses bought for investment flooded the market, and the deteriorating employment picture kept most other home buyers on the sidelines. Housing prices got crushed and are finally starting to stabilize after price drops of well over 50% in some areas.

This is the final major characteristic of all bubbles. Once they burst, things unravel very quickly.

I see two scenarios for the bursting of the higher education bubble. Let's tackle them like an episode of 'Mega-Disasters':

Scenario 1: The short wait-list.

It's a warm spring day in Chesterfieldtownport, Connecticut. The dean of admissions for a small liberal arts school is downloading the applications of candidates to start in the fall of 2018. The college has had a minor drop of in applications the previous two years, but nothing drastic. Tuition is $72k a year and the average salary for graduates is hovering about $41,000 a year with 55% finding work within 6 months of graduation.

Something seems off. There's only 2300 applicants for a class of 1850 students. She tries to redownload the applications. She calls her IT department. The IT department contacts the digital application hub. The number is correct. Only 48 paper applications are in-hand. The admissions board moves quickly through the applicants. Only 1100 students merit acceptance based on the prior year's standards. The entire wait list from early applications is accepted. After much argument, the standards are relaxed. 1500 are accepted under the new standards.

The application numbers are leaked to the press, becoming national news within hours. Other colleges are revealed to be suffering the same drop-off in applications. The public universities reap the windfall, as in-state applicants double across the country. The state schools (with in-state tuition about half that of private schools) become extremely competitive and become harder to get into than all but the most prestigious private universities.

The small liberal arts college takes a massive reputation hit. Only 950 students send in deposits for the 2018 school year. Many sophomores and juniors decide not to return to school. The school lays off staff and non-tenured professors. Classes jump in size, the school's ranking plummets. By 2022, the college is closed.

Scenario 2: Don't send us your poor.

It's the late summer of 2019. At the south's Big Private University, orientations are being planned, dorms painted and the basketball court polished. Over 3400 freshman are expected to arrive in the coming weeks.

Suddenly, the financial aid office's telephones start ringing. By the late afternoon, the office has left a voicemail message to contact them by e-mail. Over 5000 e-mails arrive that day. Sallie Mae, citing a huge number of student loan defaults, is suspending its loan program. The company is owed $9 billion in delinquent loan repayments and may need government intervention to continue operations. Citibank soon suspends their loan program, citing concerns about delinquencies and the need for an 'internal audit' to assess the risk they're taking on these loans.

All students receiving financial aid are notified that their loan money is not going to arrive in time for the fall semester. Big Private allows these students to withdraw for a semester without academic penalty due to financial hardship. Over 5500 students take this option. No one at the school will say it, but there's no guarantee this loan money will ever return.

Once the belief system of college as an American birthright and as an unrivaled investment ceases to hold consumers (and that's what college students are- consumers) captive, the entire system will need to be reanalyzed. Like with housing, college will again begin to be assessed like any other major purchase. Schools will need to focus on supplying value and on showing that to potential students.

After the bubble bursts, the gap in education may be filled by private companies, who cherry-pick the most talented students to start 'apprenticeships' at their companies. Likewise, on-line colleges will likely become more of a mainstream option and more accepted as a reasoned alternative to traditional colleges. Finally, colleges may start allowing for public service to count for school credit. In this way, students can gain life skills, help their community, and reduce the cost of tuition by replacing classroom work with service.

Friday, July 8, 2011

On inflation...

Future historians will look back at the last few years of economic upheaval with great interest. Whether it's historically known as the Great Recession (as some pundits are trying to coin it), or some other moderately clever name, it will serve as a great example of how very large social systems are not immune to catastrophic meltdowns.

In this post, I'd like to focus on the idea of inflation and specifically how governments are using inflation as a tool to address the stumbling economy.

What is inflation?

To most Americans over a certain age, "inflation" is a scary word. It is associated with price spikes, as in the recent fluctuations in gas prices, and is universally used as an explanation for any increase in prices (regardless of whether or not such price increase has anything to do with systematic inflation).

In actuality, inflation is an economic term used to refer to a broad increase in prices of goods. This is usually calculated by assessing the prices of a certain basket of commodities (fuel, wheat, coffee, produce, metals, etc.) over the passage of time.

How does this play out?

Another way to look at inflation is to think of it in terms of cash. If you have $1,000 under your mattress, you can take the money out from under your mattress, go to ShopRite and buy $1,000 worth of goods. If you wait a year (keeping the $1,000 under the mattress) and go to ShopRite then, a positive inflation rate will mean that you can buy less than you could had you gone the year before. In other words, you're $1,000 is worth less than it was a year earlier.

With this in mind, the kneejerk reaction is to decide that inflation is a bad thing and that the best result for individuals would be if the price of those goods had gone down (in effect, making that $1,000 worth more money after sitting under the mattress for a year).

However, while there may be satisfaction in walking out of the store with the same amount or more goods than the year before (as a reward for you saving that money for an extra year), the negative effect of the decrease will likely outweigh any benefits.

For example: let's say you have a student loan to repay. You have the loan at a fixed rate of interest and pay $200 every month. If, after a year, inflation has made your dollar worth less money, the fixed loan payment is essentially discounted. Whereas a year ago, that $200 could have bought you 25 pounds of coffee at WholeFoods, you can only buy only 22 pounds today. So, instead of paying back your lender a value of 25 pounds of Whole Foods coffee, you're now only paying them the equivalent of 22 pounds of coffee.

Yes, there's a piece that's missing. In order for this to benefit individuals, income must rise at the rate of inflation. If that WholeFoods coffee gets more expensive and your income has not risen, you're just going to have to go without that extra three pounds of Arabic Blend. However, if your salary keeps pace with the price of coffee, you've benefited by getting the discounted loan payment.

So, what exactly is the government doing?

The federal government is between a rock and a hard place (as are a lot of Americans and their businesses).

The government needs money to fund both its on-going operations as well as the massive stimulus packages they have funded over the past two years- not to mention the other gazillion dollars of debt it had before. The simple solution (and one that they have been utilizing) is that the federal government can literally print money and introduce more money into the country's money supply. Logically, this should result in inflation. The money supply is guaranteed by the full faith and credit of the US government, so each additional dollar does not increase the overall value of the money supply, it simply dilutes it. The existence of additional currency should lower the value of each dollar in the economy.

Printing money has several benefits. For one thing, the US is in debt (have you heard about this?) and its debt is in American dollars. Ergo, by printing more money, the government is decreasing the value of its debt payments while simultaneously creating dollars to pay back that debt.

For comparison, consider the plight of Greece, who is at risk of defaulting (not being able to pay back) their federal debt. Because Greece uses the Euro and the Euro is used by almost every country in mainland Europe, they lack the power to print Euros or devalue their currency. Other countries that are not in debt and are net creditors (meaning they lend money to other countries), do not want to devalue the currency because it would devalue their savings and devalue the money that it is owed. As a result, the entire Euro area is under strain because of the competing interests of the member countries. The US, by sitting ever-so-firmly in the debtor category, has no such conflict of interest.

Secondly, by devaluing the currency against other currencies, Americans selling their goods abroad benefit. If McDonald's is selling a cheeseburger in Paris for 3 Euros and those 3 Euros are now worth 6 dollars instead of 5, McDonald's is earning an extra dollar on each cheeseburger sale. This allows McDonald's to be more competitive abroad, earn more money and (in theory) allow them to hire more employees and expand their operations.

What are the risks?

The main risk of printing so much additional currency is hyper-inflation. Hyper-inflation is a sudden, significant increase in prices. The easiest way to explain this possibility is to imagine that the world loses faith in the value of the American dollar. Other countries and businesses become nervous that the additional printed US currency will significantly devalue the American dollars that they are receiving for their goods. Suddenly, they begin requesting higher prices for their goods, to cover their risk in holding American dollars. Prices spiral upwards, the American government is forced to pay a large premium to borrow money and this combination of factors causes the whole system to collapse.

Thus far, inflation has remained under control. Investors have seen the US as a "safe-haven" to park their savings, as the history and the size of the United States suggests that the dollar will retain most of its value. To be more accurate, the US dollar is simply the least-bad option. The dollar has fallen in value against certain currencies, notably the Canadian Dollar and the Australian Dollar, but has held its value against the Euro and the British Pound (mostly because those currencies are facing their own challenges).

The problem that has popped up has to do with the lack of increases in wages. A high unemployment rate combined with stagnant wages has decreased the purchasing power of Americans. The savings on your loan payments (because of inflation) are of no benefit when you are making the same or less money than the year before. As a result, people have been cutting back on purchasing and going without, which has hurt the sales of businesses. Businesses, in turn, are not able to expand or hire, since their sales are stagnant or decreasing. Further, the high unemployment rate has put downward pressure on wages, since unemployed workers are willing to take less money to find employment.

As inflation persists (even at moderate levels) the decrease in wages and high unemployment is magnifying the effect of inflation.

What is the opposite of inflation?

Deflation is the opposite of inflation. Again, this may seem like a boon in the short term, but it's extremely problematic.

To use the previous example, imagine if the money you left under your mattress is worth more in a year than it is now simply by virtue of time passing. This creates an incentive is to keep the money under your mattress, as holding cash has become a form of investment. Now, both individuals and companies are inclined to hoard their money, as opposed to either investing or spending it. For a non-profitable company, it would be a realistic option to suspend operations and simply retain their free cash, knowing it will increase in value.

Likewise, those who are in debt will further burdened by their loan payments. Since it's likely that wages will fall in a deflationary environment, these payments will become that much more onerous.

The result could be a "deflationary spiral" where prices decrease, investments decrease, wages decrease and employment decreases. The wage and employment decreases will result in a decrease in purchasing power, which which lowers demand, which lowers prices, which will exacerbate the decrease in wages and employment even further. Thus, a spiral is created.