NY Fed Study Should Redefine How We Think About Student Loans and College Costs

September 2, 2015

Sometimes you hear something that sounds so much like common sense that you end up missing how it overturns everything you were actually thinking, and points in a far more interesting and disturbing direction. That’s how I’m feeling about the coverage of a recent paper on student loans and college tuition coming out of the New York Federal Reserve, “Credit Supply and the Rise in College Tuition: Evidence from the Expansion in Federal Student Aid Programs,” by David Lucca, Taylor Nadauld, and Karen Shen.

They find that “institutions more exposed to changes in the subsidized federal loan program increased their tuition,” or for every dollar in increased student loan availability colleges increased the sticker price of their tuition 65 cents. Crucially, they find that the effect is stronger for subsidized student loans than for Pell Grants. When they go further and control for additional variables, Pell Grants lose their significance in the study, while student loans become more important.

There’s been a lot of debate over this research, with Libby Nelson at Vox providing a strong summary. I want to talk about the theory of the paper. People have been covering this as a normal debate about whether subsidizing college leads to higher tuition, but this is a far different story. It actually overturns a lot of what we believe about higher education funding, and means that the conservative solution to higher education costs, going back to Milton Friedman, will send tuition skyrocketing. And it ends up providing more evidence of the importance of free higher education.

To start, it’s essential to understand the difference between Pell Grants and student loans in economic terms. Pell Grants are a subsidy. They provide money that isn’t paid back and that goes entirely to aid the purchasing of more education. Student loans are a form of increasing credit supply for higher education. They allow students to borrow against future income to fund their education right now.

There’s a large debate over whether and how much student loans are subsidized and what that would even mean. Some people who think they are really subsidized might say that their value consists of a 10–20 percent subsidy. Others, following current data, argue that they have a slight negative subsidy (the government makes a profit on them). Either way, that’s obviously nothing compared to a Pell Grant, which is a 100 percent subsidy.

With this important difference in mind, let’s reexamine the conclusion of the New York Fed paper: Changes in the credit supply, in the form of student loans, are far more of a driver of higher education costs than subsidies, in the form of Pell Grants. That’s why the title has “credit supply” in the title. The deeper the study digs, the stronger this difference becomes. Virtually no coverage is catching this difference, grouping everything under a subsidy. (Here’s an example of such a piece.) But this difference changes everything we should think about the topic.

What’s Economics 101?

David Boaz at the Cato Institute has a snarky post in response to the study, saying that “[u]nderstanding basic economics” would have predicted it. This is false, because economics 101 would have predicted the opposite. Economists fight a lot about this [1], but the simple economics story is clear. According to actual economics 101, letting students borrow against future earnings should have no effect on prices.

This derives from something called the Modigliani-Miller Theorem (MM), the frustrating staple of corporate finance 101 courses. A quick way of understanding MM is that how much you value an asset or investment, be it a factory or higher education, should be independent of how you finance it. Whether you pay cash, a loan, your future equity, a complicated financial product, or some other means that doesn’t even exist yet, you ultimately value the asset by how profitable and productive it is. In this story, which requires abstract and complete markets, expanding credit supply won’t drive tuition higher.

Now what would change your valuation, according to this theorem, is getting subsidies, say in the form of Pell Grants. This would make you willing to buy more and pay a higher price. This is one of the reasons why so much of the economics research focuses on Pell Grants instead of student loans: the story about what is happening is clearer. But, again, extensions of the credit supply, not subsidies, are doing the work here.

Sorry Milton Friedman…..

But this result isn’t an abstract debate. It overturns everything conservatives are currently proposing in regard to higher education.

Ever since Milton Friedman’s Capitalism and Freedom, the proposed solution to higher college funding has been to increase the credit supply by allowing students to borrow against future earnings by selling equity in themselves. This is what Marco Rubio is proposing. Reform conservatives have gotten behind the idea that we should roll back government student loans and expand private “Income Share Agreements” (human capital contracts) instead.

It’s funny to imagine describing such efforts as “small government” or involving “civil society” when you see what they require [2]. For our purposes, it’s enough to note that these efforts would send tuition skyrocketing because, while they involve private market actors, they are fundamentally about expanding the credit supply and making it easier to borrow against future earnings. There’s no first-order difference between human capital contracts and student loans when it comes to an expansion of the credit supply and the ability to borrow against future earnings. This type of borrowing is exactly what is driving the results in this New York Fed study, not government subsidies.

Whether or not it would be fairer or better to reorient our student funding system toward students selling equity in themselves, we should conclude that it would do nothing to contain the costs of higher education. In fact, it would likely send them spiraling.

You Complete Me

Note that it isn’t clear why students borrowing more against their future is driving increases in tuition they’ll pay. It could be “rational” under arcane definitions of that word. It could be that in a winner-take-all economy, in which those at the top do fantastically and those who don’t make it do not make it at all, leveraging up and swinging for the fences is a smart play. It could be that liquidity and credit are important determinants of the economy as a whole rather than a neutral veil over real resources. It could be as simple as the fact that 18-year-olds aren’t highly calculating supercomputers solving thousands of Euler equations of their future earnings into an infinite future, but instead a bunch of kids jacked up on hormones doing the best they can with the world adults provide them.

But no matter the cause, the conclusion of this research points in an interesting, complicated, and scary direction. I read this research as implicitly concluding that the cost of higher education is low relative to where it would be if markets were “complete.” By complete I mean a situation in which students have perfect access to borrow against future outcomes. Students can’t do this now due to financial market imperfections, which is why the government provides student lending. But as finance does a better job of providing students with these options, or the government reworks markets to create these conditions, say in the form of human capital contracts, we are talking about a widespread increase in tuition.

This makes a lot of cutting-edge reforms more complicated for the issue of controlling tuition costs. Colleges that provide more information on outcomes might provide better education, but that increased information will jack up costs if it means more borrowing. Making sure students who might drop out borrow enough to get to graduation will lead to more cost inflation.

Public Options

This effect is virtually nonexistent for public universities, and really driven by non-profit private schools. Though not studied in this specific paper, it’s widely believed that this effect is strongest at for-profit schools, especially the ones expanded under the George W. Bush years in an attempt to push back on accreditation. This means the private market is the most likely to accelerate this trend if given access to an increased credit supply.

If private education is able to capture Pell Grant subsidies that increase demand, using those resources to increase the supply directly (e.g. provide free public colleges) would drive down tuition overall. This is the logic of public options. If it is also the case that, as the financial markets become more complete, it will send private tuition skyrocketing, that makes the case for a low-cost, high-quality resource to provide an anchor against price inflation even more important. Rather than a vague indictment of government, this paper shows why the logic of free public higher education is even more compelling.

[1] See the literature over the housing bubble, in which the question of what an increase in credit supply resulting from financial deregulation and financial engineering does to housing prices is empirically rich but theoretically underdeveloped. (This paper is a good example.) The result, if I may be blunt, has been for researchers to throw the best data and techniques at the question and leave the theory aside, hoping the journals simply blink and accept it. That’s a good strategy, and it’s now being extended to student loans.
[2] There’s something dystopic about invoking “civil society” to describe people having to auction themselves off to hedge funds in order to get a higher education, as if this is just an extension of the town square or the church. If you dig into how these contracts would actually function, they would require a massive expansion of a joint creditor–state surveillance program, as the IRS would have to partner with private debt collectors to share all your data in real time in order for them to consistently verify your income. It’s not clear to me how the state supplying private debt collectors with all your personal information counts as “small government.”