Tuesday, October 27, 2015

Educational Loans: Dare We Ask Who Benefits from the Subsidy?

Sometimes it pays to ask the right question.

This will be the first of a few postings with the same general theme.  The theme is that often the solution to a problem that policy makers are addressing is totally dependent upon how they couch the question.   


The US will never get the right level of investment in education and a justified public subsidy to post-secondary education until we eliminate the problem of the free rider. When addressing subsidies for post-secondary education policy makers should first compare who benefits from post-secondary educational loans to who bears the risk of those loans.  If they did, they would realize that analyzing who benefits is a prerequisite to addressing the appropriate level of expenditures for education and the appropriate participation of the public sector.  They would also realize that it is clear that the educational establishment should be bearing some of the risk.

Think Out-Of-The-Box

In many instances we seem to have no problem understanding that loan guarantees represent a subsidy.  For example, during the financial crisis much was made of the subsidy to banks from the implicit guarantee involved in too-big-to-fail.  So, analyses of the subsidy implied by loan guarantees are quite common in political and policy debates. Yet, we seem to be totally unable to view student loans in the same light.  But, that's not the worst of it.

We also know that the benefits of loan subsidies do not all flow to only one of the parties involved.   For example, right now the Republican Party is split on the issue of the import-export bank.  Some libertarian-leaning Republicans are offended by the implicit subsidy to large employers and refer to it as corporate welfare.  The import-export bank finances and guarantees that a purchaser’s debt will be paid.  It is the purchaser’s borrowing that is subsidized, but there is little doubt that the manufactures benefits from being able to sell to a purchaser who might not be able to purchase without the subsidy.  It is the benefit to the producer that results from subsidizing the consumer that we totally ignore when it comes to education.

One does not need to go to policy issues to find evidence that producers benefit from making credit readily available to consumers.  We have numerous examples of large corporations making it quite apparent that they believe they received benefit from loans to customers.  We have no problem understanding that an automaker may choose to loan money to the auto purchaser because of the benefits to the auto company.  Similarly, many large corporations make it a normal practice to loan money to their customers.  General Electric's finance division originally started out with that focus and grew into a totally separate product line.  General Electric is not alone in doing it.  Many other companies from industrial firms (e.g., Boeing and Westinghouse) to consumer products companies (e.g., auto manufacturers and now even Apple) have financial operations designed to finance the purchases of their customers.   We seem to be totally incapable of even asking whether to some extent we should be applying the same logic to higher education. 

Focus on the Complete Problem

Right now there are numerous proposals for how to address the growing levels of student debt.  Every candidate has a proposal; some of which are totally absurd.  Others very successfully address the problem as that particular politician sees it.  Unfortunately, most politicians see the issue in terms of the votes they might be able to gather from different proposals.  If the academic institutions or their unions are strong supporters, the politicians have an incentive to overlook the subsidies’ benefit to producers.  But even if the politicians are not suffering from a conflict of interest, they do not bother to think about what the problem is they are trying to solve. 

The issue of how to fund education gets broad coverage.  The coverage often ignores the issue of who is getting the benefit of the subsidy involved in government loan guarantees.  Even BARON’S magazine in a 9/14/2015 editorial chimed in.  Not surprisingly, the editorial advocated a market solution, “Monetizing HigherEducation: Can Investors Replace Government Lenders?”  The editorial, at least, articulates what it sees as the problem which it summarizes as: “…there’s too much easy federal money floating through the education economy to tempt many students.”  However, as close as that comes to addressing the issue, the thrust of the editorial is not aligning the subsidy with the beneficiaries.  Rather, it just focuses on substituting private-sector money for public-sector funding.

There is some merit to trying to make educational funding more dependent upon voluntary actions instead of the forced contributions of taxpayers.  However, as long as there is any logic for subsidizing education, the market cannot solely support educational funding.  It does not take a lot to undo whatever benefit the market might yield.  For example, the Wall Street Journal on 9/24/2015 in an article entitled “Debt Relief for Students Snarls Market for Their Loans,” reports how thoroughly markets can be sabotaged even by efforts that are designed to have a minimum impact.  It reports that even subsidies restricted to need-based repayment schedules have short-circuited the bond market for student loan-backed securities.  One does not need a vivid imagination to realize that a general subsidy for education could result in even more sub-optimal market performance.

What most people addressing the issue failed to distinguish is whether they are concerned about the amount being spent on education versus who is financing the education.  They are two different issues.  

Consider All the Possibilities

With each possibility (i.e., spending too much or spending too little on education) there are possibilities of some individuals spending too much or spending too little.  Consequently, there are four possible scenarios:

First, we could have a situation where not enough is spent on education, yet those paying for it are paying more than is justified.  Put differently, there is a free rider who is benefiting from education but not paying for any of it.  For example, students and/or the public sector may be contributing more to post-secondary education than is justified by the benefits they receive.  At the same time, the total amount spent on post-secondary education may be less than optimal.

Second, we could be not spending enough on education because no one is spending as much as would be justified.  The benefits from education materialize in a different time frame from the cost.  If there is no mechanism for financing that mismatch in time, education may be underfunded regardless of the magnitude of the benefits.  The BARRON'S piece referenced above addressed the issue of this mismatch in timing by proposing an alternative to public-sector financing.

Third, we could be spending too much on education, yet have some of those who benefit from education not paying what would be justified.  This situation would imply that those not benefiting from education are subsidizing those who do.  The third scenario would imply that an elite that benefits from post-secondary education is forcing the general population and students to over spend on education despite a lack of benefits commensurate with the return.

Fourth, we could be spending too much on education because everyone involved is paying more than is justified.  This would imply broad-based irrational behavior on the part of everyone involved in higher education.  While not inconceivable, it is a very unlikely scenario.

Define the Problem

In order to consider which of these possibilities may exist, one has to establish a definition of what is a justified expenditure for education.  It seems reasonable to say an expenditure is justified if it will return benefits as great or greater than the expenditure.  However, at the individual level, the expenditure is justified only if the return is to the individual or institution making the expenditure.  For example, a student’s expenditures should be roughly equivalent to the benefit the student derives from the education.  Therein lies the rub. 

It is generally agreed that education has what economists refer to as externalities.  Translating the jargon, that means that education has benefits for people other than the individual receiving the education.  For example, there are general benefits to having an educated population.  So, clearly a government subsidy is appropriate.  Almost all societies recognize that benefit and strive to provide universal elementary and, in most instances, secondary education.  To some degree, that same argument regarding general benefits applies to college and postgraduate education.  However, much more of the benefit of post-secondary and graduate-level education is captured by the individuals involved in the process.   So, anyone addressing financing a post-secondary and graduate education needs to look closely at who are the principal beneficiaries.

Prioritize the Issues

When one approaches post-secondary and graduate education from the perspective of the potential beneficiaries, it raises two important questions.  First, are the public-sector subsidies (loans, loan guarantees, grants, and budgetary expenditures) appropriate given the amount of general benefit to society?  After all, we all participate in providing the public-sector subsidies. 

The second question is: are all parties who benefit from the subsidies sharing in the cost of the subsidy to an extent appropriate given the benefit they derive?  While the second question may seem like one of the equity, it is much more important than that.  If there are constituencies which derive substantial benefit from public-sector subsidies without experiencing a commensurate amount of the cost, it will always be in the interest of those constituencies to cloud the issue.  They have a strong vested interest in arguing that the public-sector subsidies are not sufficient. 

It is also worth noting that when there is a participant in the educational process who is receiving benefit beyond their contribution to the subsidy, it introduces an inherent contradiction.  If there is a free rider benefiting from the subsidies, then either less will be spent on education than is justified by its benefits (because the free rider is not paying for the benefits received) or the public-sector subsidies will be inflated beyond what is justified by the social benefit of education (because somebody has to pick up the cost that results in the free benefits received by the free rider).   

Thus, it is fruitless to try to address either the level of educational expenditures or the amount of public-sector money that should be dedicated to post-secondary education without first addressing the issue of how the benefits of the subsidies are distributed.  It helps to set aside the equity issue.  Setting aside equity does not mean that one can ignore the issue associated with having someone who barely got through high school and is struggling to make ends meet pay taxes to subsidize a highly paid professors and the graduate education of someone who will likely have a much higher income. Rather the point of avoiding the equity issue is to focus on the fact that getting the subsidy right is a precondition to simultaneously achieving both the right level of subsidy from the public sector and the right level of total expenditures on post-secondary education.

Not All Subsidies Are Created Equal

Subsidies for post-secondary education can be structured in many different ways.  In fact, the government pursues a number of different subsidy strategies.  In terms of understanding the implications of different subsidy strategies, one should differentiate between subsidizing demand versus subsidizing supply.  Ultimately, the form the subsidy takes will determine who receives benefits.  But, to understand the distribution of benefits, one should first analyze the differences in the impact of the two different strategies.

In a competitive market, if one subsidizes supply and production is allowed to increase, it will increase the quantity available and/or reduce the price.  The relative influence on quantity and price depends upon the elasticity of demand for the product.  In other words, it depends upon whether purchases of the good are sensitive to its price.  With a subsidy of supply, the amount produced is the driving variable with price changes being a response to the increased amount produced.  In a post-secondary education market public subsidies are generally done in order to achieve both objectives (i.e., increase the availability and lower the price of post-secondary education). 

The ability of the educational establishment to constrain supply is the only limitation on the ability of supply subsidies to both increase the amount of education while reducing its price.  Thus, supply subsidies have to be structured in ways that avoid promoting supply constraining institutions.  Accreditors or College Certification Boards, unions, grants based upon inappropriate criteria (e.g., research activities, faculty qualifications, student/faculty ratios) need to be carefully examined, and subsidies should be structured to avoid encouraging them.  In fact, as an alternative to increasing subsidies to education, public policy directed at eliminating supply constraints created by the educational establishment should be considered.

By contrast, if one subsidizes demand in a competitive market, the increased demand will drive up prices and, depending upon the responsiveness of supply, increase production.  Since increasing the price of post-secondary education is seldom considered a worthy objective by anyone other than the educational establishment, government subsidies should focus on increasing the supply.  This is a marked contrast from the US emphasis on student loans as a solution to the increased cost of higher education.  The problem is that politicians cannot resist the ability to control who they make post-secondary education available to.  The very fact that control is so prized by politicians is an indicator that deficiencies in demand are not a problem.  By subsidizing additional demand they just ensure that the demand will outstrip supply and increase prices.

The Role of Educational Loans

Given the differences in the impact of subsidizing supply versus subsidizing demand, it would seem appropriate for the government to significantly scale back its subsidies to higher education that take the form of student loans.  At the same time, it is clear that there is a need for a mechanism to finance the difference between when the costs of higher education are incurred and when the benefits are received.  It is not automatically apparent that the public needs to be directly involved in that financial transaction.  It would seem far more appropriate for institutions of higher learning to assume some responsibility for financing the demand for their product. 

A public-sector subsidy is still appropriate to the degree that education benefits the general public to a greater extent than would be financed by the private sector.   If supply subsidies are judged inadequate, the public-sector subsidy could take the form of loans to the institutions of higher learning.  Those loans could be commensurate with the amount the institution of higher learning loans to students.  This approach would meet the financing requirements.  It would also allow the students to assume responsibility for costs that will result in future benefits they will receive. 

At the same time, it would leave responsibility for loss on the loans with the institutions that derive substantial benefit from having demand subsidized.  If the post-secondary education does not result in enough benefit to enable the student to pay back the loan, the institution that provided the education should accept responsibility for its failure.

There might be a concern that some colleges would choose not to participate in the program (i.e., some colleges may choose not to borrow the money).  But all government subsidies designed to increase the supply of education could be made contingent upon participation in the loan program.  It can also be made a requirement for certification from the accrediting organizations and College Certification Board.  Student loans have a role in making post-secondary education available to those who might otherwise not be able to afford it.  For that reason alone, the public sector would be justified in denying any subsidies to institutions that did not participate in the program.

It is worth noting in passing that there is no reason why the government would have to require that student loans from the institution exactly match what they borrow.  A condition of the loan to the institution could be that half of it be used for student loans or could equally feasibly be that two dollars in student loans are required for each dollar of borrowing.  Starting out with the match would seem reasonable, but over time one would expect that the ratio could be fine-tuned.  The very process of fine-tuning would be a way to address the need to simultaneously fund adequate post-secondary education and match the public-sector expenditure to the benefit that the general public derives.  It should be noted that this approach could be tried by any state that has student loan programs. 

The Urgency

This it is not a problem that can be ignored.  First, as is widely reported, there is intense pressure on political candidates to make all sorts of unreasonable promises regarding how they will address the student loan problem.  Not surprisingly, as good candidates, they are making such promises.  The danger is they may try to fulfill those promises.  That politicians want to address the student loan problem would be good if their proposals reflected a thorough understanding of what the problem is, but that is hardly the case.  Their approach seems to be, when something is not working spend more on it. Wall Street Journal investigation that found that in a single year the government sent $16 billion in aid to students at four-year colleges that graduated less than one-third of their students within six years.  The basic structure of student loans needs to be rethought.

Second, as noted in an opinion piece in the Wall Street Journal entitled “Washington’s Revenue Windfall” (8/18/2015), “The Congressional Budget Office … cites a $30 billion, or 51%, spending increase for the Department of Education—‘mostly because of an $18 billion upward revision in the estimated net subsidy costs of student loans and loan guarantees issued in past years.’  The opinion piece’s conclusion is that the government’s “takeover of the student-loan business is costing far more money than advertised, probably due to growing defaults.”  Clearly, there is a budget issue and the risk that the cost of student loans will crowd out other worthy expenditures.

Third, the government is accumulating a huge potential liability that could become a mandated future expenditure. As has been reported in the Wall Street Journal for example in “Duncan Puts Pressure on Colleges” (10/21/2015), “…as student debt has climbed to $1.2 trillion, but graduation rates remain not much better than a “coin toss,” Mr. Duncan has said.  Mr. Duncan is the Education Secretary.  The concern is not the rant of an outsider seeking to undermine education.

Fourth, the misplaced incentives created by the current system are widely recognized.  For example, Mr. Duncan in the article cited above states: “government, at both the federal and state level, along with accreditors and Congress, need to flip the current incentives in higher education,” Mr. Duncan said. “In the current system, only students, their families and taxpayers lose when students do not succeed. That simply doesn’t make sense.”  Currently, about one in every five student loans is in default.  Students, families and taxpayers are being asked to bear burden of debt beyond their financial capabilities.

Finally, and most importantly, the ability of the US to compete in a global market will depend upon it being able to generate an educated, productive labor force.  That can only be done if all participants in the process are contributing appropriately to the success.  It seems to an outsider that the only impediment to achieving that objective is a vested interest of the current free riders benefiting from the subsidies the public-sector must supply to the post-secondary educational industry.  So, it is time for the educational establishment to step up to the plate and recognize that they have to take some responsibility for the value of their product if they expect public-sector subsidies to continue.  Having post-secondary educational institutions accept the risk associated with the return on the investment in post-secondary education would be a good start.

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