Bubbles, Malinvestment and Higher Education

May 22, 2012

Many commentators are asking whether the next big bubble to burst will be the debt associated with the rising cost of higher education.  College costs have strongly outpaced the inflation rate, and the debt students are racking up is crippling.  The reasons behind this trend are significant and diverse, says Steven Horwitz, the Charles A. Dana Professor of Economics at St. Lawrence University.

First and foremost, government policies regarding student loans have given life to this price bubble.

  • The government currently provides student loans at artificially low interest rates (rates far below what the market would provide in the same circumstances).
  • While this might seem to have the effect of lowering the cost of college and keeping debts low, it has the opposite effect for a number of reasons.
  • By artificially lowering the cost of college, these policies encourage a disproportionate number of people to attend these schools, driving up demand.
  • This has the total impact of producing too many college graduates and too few workers with on-the-job experience for an economy that wants less of the prior and more of the latter.
  • This phenomenon offers a partial explanation to why so many graduates are having trouble finding employment.

Second, in addition to the demand side of this equation, the supply side has also been mangled by bad incentives.  Specifically, schools are responding rationally to the behavior of education consumers by raising tuition and jacking up prices.

  • With more students able to afford college, schools have upped the ante by providing more and better amenities to attract them.
  • These attractions, which can include costly sports programs and state-of-the-art facilities, require increased tuitions and fees in order to pay for them.

An oft-proposed solution to the ills of the debt-burdened college graduate is debt forgiveness.  However, offering sweeping debt assistance could undermine confidence in future loans and discourage private lenders from participating in such markets in the future.

The real solution to this problem comes in two parts.  First, on the demand side, the government needs to stop subsidizing interest rates for student loans.  This would drive down inflationary pressures.  Second, the higher education market needs to be expanded to include non-traditional but nonetheless vital institutions.  This would increase competition and drive down costs.

Source: Steven Horwitz, "Bubbles, Malinvestment and Higher Education," Freeman Online, May 17, 2012.

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