Two approaches to American governance–The case of higher education financing

Hillary Clinton deserves credit for setting out her positions on individual policy issues so that we can have an intelligent discussion of their pros and cons. She is nothing if not a tireless policy wonk. Think of her exhaustive but failed effort to “fix the provision of health care in America” during her husband’s presidency. While the Clinton’s are Democratic Party centrist, they still embrace a top down government/regulatory approach to dealing with many of societies challenges/problems. Mrs. Clinton’s plans to make college affordable provide a recent example of this approach. It is thoughtful and balanced from a left of center, regulatory approach perspective. I prefer a difference, right of center, more market oriented approach.

I have not read Mrs. Clinton’s detailed proposal and rely completely on the following Washington Post summary: http://www.washingtonpost.com/news/wonkblog/wp/2015/08/10/clinton-proposes-a-350-billion-plan-to-make-college-affordable/

Background

Americans believe in equality of opportunity rather than equality of outcomes. We are not egalitarians. There is nothing we can do about the fact that each person is born with different predispositions and capabilities. But it has been a long-standing, broadly shared principle that everyone should have access to the education she is capable of. We have lived up to this goal very imperfectly. Tuition vouchers and school choice are moving us closer to this goal for K-12 by making the state’s financial contribution to education more equal for each student and subjecting schools to greater competition in producing good results. Unlike primary and secondary education, however, which in the United States is financed by the states (generally by municipalities), college is not for everyone. An important public policy issue is who should pay for higher education for those who do go.

When the government began to supplement private universities and colleges with state run, public ones, it generally funded the cost from tax payers charging only nominal tuitions, if any, to those attending. Milton Friedman and others pointed out that this resulted in a perverse redistribution of income from lower to higher income people. University graduates enjoy incomes two or three times the average of non-college graduates. In response to this criticism, state colleges and universities in recent decades have raised their tuitions in order to finance more of the cost of the education by its beneficiaries.

It is desirable for those from low-income families with the intelligence and desire to pursue careers requiring a college education to have that opportunity. This accords with our belief in providing an equal opportunity to all and increases our individual and national wealth by facilitating the maximum productivity of every citizen. But how can we best accomplish this goal without perversely redistributing taxpayers’ money to the better off? Along with higher tuitions, many universities offer financial assistance to such students in order to attract and graduate the best students. Having the best graduates enhances their reputations. A number of private organizations provide fellowship to promising low-income students. America is renowned for its extensive private charities. Many companies do the same, generally for the children of their employees. These have the substantial advantage over government bureaucrats of being closer to the beneficiaries of their largesse and thus better able to determine who in their communities will benefit the most from such assistance.

Determined students often work while studying and/or borrow from their families and friends (this was my approach). In business, future benefits from current investments are normally financed with borrowed money or by giving investors a stake in the outcome (selling shares in the hoped for profits). Unless they are family or friends, lending to someone with potential future human capital as collateral (i.e. lending to a student based on the expectation that she can repay out of higher future income) is a riskier proposition than, say lending to someone with a job to buy a car or a house (both of which can be use as collateral). So bank lending to college students was rather limited and expensive (interest rates high enough to cover the higher risks to the lender) until the government began to guarantee such loans.

Solutions

To address this problem, and building on the experience with financing college for veterans of World War II in the “GI Bill” of 1944, Congress adopted what became known as Pell Grants, financial aid to low-income students in undergraduate college programs, in the Higher Education Act of 1965. This Act also provided limited government loans, which over time expanded in various ways to include students from middle-income families (Middle Income Student Assistance Act of 1978) and studies at graduate and professional schools. Over time the scope and terms of government assistance continued to expand. Grad PLUS was added by that spend thrift George W Bush in 2006 to help finance graduate education. “For the first time, it gave professional and graduate-school students unlimited access to below-market-rate loans from the government, which, of course, borrows the money to begin with.”[1]

This has enabled more American’s to go to college– a potentially good thing. The increased demand for places in colleges is likely to increase the cost of supplying more (higher salaries for college professors in order to attract more into teaching), but hardly justifies what has happened. According to The Economist “Tuition fees have doubled in real terms in the past 20 years. Student debt has trebled in the past decade, to $1.2 trillion.” Seventeen percent of these loans are now in default or seriously delinquent. Many of these students have dropped out of school or not found the jobs they were trained for.

The government (Secretary of Education Arne Duncan) has established a number of programs to help and Hilary Clinton “proposes capping the repayment of college loans at a maximum of 10% of income over 20 years. If a loan is not paid off by then the government will pick up the tab. The estimated bill for her scheme…, comes to $350 billion over ten years.”[2] This may be sensible within the context of government aid. But this top down government approach suffers from a number of weaknesses. One is the propensity for such programs to grow as different special interests succeed in getting added to the list: “Despite all the talk about the government’s $1.1 trillion student loan portfolio, and the burden it represents for college students, some 40 percent of the money is owed by graduate and professional school students — who make up only 16 percent of all student-loan borrowers.”[3] Another is the inferior ability of government bureaucrats, with no financial stake in the outcome, to evaluate the appropriateness of each individual loan or grant. A third is the limited incentive for government to find new innovative ways to deal with the problems that invariably arise.

The policy challenge in my view is to bring more effective competitive pressure on colleges and universities to deliver more for less, to facilitate more careful and better informed decisions by potential students of what education they need and will benefit from and the best place for them to get it, and insuring at the same time that initial poverty does not prevent them from getting it.

Leaving the GI Bill aside as a special case, the arrangements for financing college and advanced degrees that existed prior to the Federal government’s involvement worked pretty well. Those of us needing financial assistance paid a great deal of attention to the cost and value of the educations we sought. We were also more careful about whether and what sort of higher education would benefit us. I have no doubt that the incipient revolution of on-line courses, perhaps supplemented with class room discussions, will dramatically reduce the cost of higher education without significantly sacrificing its quality. Everyone’s professors can be the best that exist. Universities will be forced by such competition to exploit these new technological tools to dramatically reduce the costs of their offerings. The very best students will still pay the premium to attend the University of Chicago’s of the world (pardon my bias). Hopefully they will be the best and not just the wealthiest.

Market based financing innovations are also more likely to come from basically private funding of education. The suggestion made by Milton Friedman in 1955[4] and repeated in Capitalism and Freedom in 1962 for sharing the risk of investing in higher education between the borrowing student and the lender is now being explored in the private sector. “Enter income-share agreements ( ISAs ), which are essentially equity instruments for human capital. Investors finance a student’s college education in return for a percentage of their future income over a fixed period. ISAs are not loans and there is no outstanding balance. If students earn more than expected, they will pay more, but they also will pay less—or nothing—if their earnings do not materialize.”[5] Sharing the risk in this way insures a financial interest by both borrowers and lenders that collage choices maximize the expected return to both. A lender, (especially loans made or guaranteed by the government) is not well placed to determine the career intentions of the borrower leading to what economists call adverse selection. Income sharing agreements overcome this problem because the student being financed has a large stake in making the best choices.

Government always has an important role to play. This issue is what the nature of that role should be. Private contracts such as loans or the ISAs described above require a legal framework of enforcement. Such framework for ISAs is currently rather unclear. Sen. Marco Rubio (R., Fla.) and Rep. Tom Petri (R., Wis.) recently introduced the Investing in Student Success Act, which would set basic standards for ISA contracts. In addition their bill would provide for the collection and publishing of information on the cost and average earnings of graduates of different colleges and fields, which would help students choose where and how to invest in their futures.

Clinton’s and Rubio’s approaches represent very different concepts of how government can most constructively contribute to our flourishing. I prefer the approach of a more limited, legal framework role for government.

[1] Charles Lane, Washington Post Aug 26, 2015 https://www.washingtonpost.com/opinions/how-student-loans-help-keep-expensive-schools-in-business/2015/08/26/e7d7f83a-4c11-11e5-902f-39e9219e574b_story.html

[2] The Economist, August 22, 2015.

[3] Charles Lane op. cit.

[4] Milton Friedman, “The Role of Government

in Education,” in Economics and the Public Interest ,

  1. Robert Solo, (Rutgers: Rutgers University

Press, 1955).

[5]   Miguel Palacios And Andrew P. Kelly, “A Better Way to Finance That College Degree” WSJ April 13, 2015, http://www.wsj.com/news/articles/SB10001424052702303456104579485801253355622

About wcoats

Dr. Warren L. Coats specializes in advising central banks on monetary policy, and in the development of their capacity to formulate and implement monetary policy. He is retired from the International Monetary Fund, where, as Assistant Director of the Monetary and Financial Systems Department, he led missions to over twenty countries. Before then, he served as Visiting Economist to the Board of Governors of the Federal Reserve System, and to the World Bank, and was Assistant Prof of Economics at the Univ. of Virginia from 1970-75. Most recently he was Senior Monetary Policy Advisor to the Central Bank of Iraq; an IMF consultant to the central banks of Afghanistan, Kenya and Zimbabwe; and a Deloitte/USAID advisor to the Government of South Sudan. He is currently a member of the Editorial Board of the Cayman Financial Review and until the end of 2013 was a member of the IMF program team for Afghanistan. His most recent book is entitled "One Currency for Bosnia: Creating the Central Bank of Bosnia and Herzegovina."
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One Response to Two approaches to American governance–The case of higher education financing

  1. Sergio Pombo says:

    Warren, this is food for thought. ISAs, while not the silver bullet, seem to be an innovative tool for financing higher education. Being an equity investor myself (private equity specifically), i fail to see the mechanics and legalities of how this equity investment would work, the required intermediaries, the high risk-return profile, the governance and representation for investors. Also who would make the decision of investing in a student on a cost afficient way and ongoing monitoring. I am delighted to discuss further.

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