Tag Archives: crowding out

Free Education!

Should college be free?

Photo: Kelly Martin. Source: Wikipedia

There is a move, politically, to make college less expensive. And with tuition and fees at private institutions running $60-70 thousand per year, it’s understandable why people get concerned: most of us don’t have half a million dollars just lying around to pay for our kids’ college. Moreover, tuitions that high make the idea of “working your way through school” seem ridiculous. Twenty hours per week at a work-study job pays for less than 20% of a private school.

The college’s usually respond by saying that no one really pays full freight – most of their students get some kind of financial aid. But that often works out to be one more progressive income tax and a penalty on prudence. In the “Expected Family Contribution” formula that financial aid offices use, they calculate that every penny of a student’s accumulated savings will go towards their school’s expenses. And when the schools evaluate the parent’s income, they don’t use taxable income. They use our adjust gross income – line 37 on Form 1040. No deductions are allowed when colleges come calling.

Source: St. Louis Fed

One approach to all this expense and complexity is to chuck the whole thing out, and make college free for everyone – or at least, expand public funding to middle-class families. That’s what New York is doing with its Excelsior Scholarship, which can pay up to $26,000 of tuition per year for public college – if the student stays in New York after graduating. Families that earn less than $100,000 per year are eligible.

This is a bad idea. It layers more complexity onto an already Byzantine system. Completing the FAFSA every year – for families that have students in college – ranks right up there with doing taxes as an unpleasant, tooth-pulling experience. But unlike taxes, the FAFSA calculations are shrouded in secrecy. Presumably, the Excelsior Scholarship will rely on FAFSA forms to determine eligibility.

Also, this approach creates perverse incentives. State schools will now receive applications from more and more students, making them more selective. That may help them in the US News college rankings, but it won’t help poorer students, who are often less well-prepared. They usually can’t afford SAT tutoring services. In addition, mid-range private colleges will now have to compete with “free” public schools. This can push them into a “death spiral” of higher tuition and lower enrollment. We know where that ends: bankruptcy and fewer educational choices. Public funding ends up crowding out private educational diversity.

Really? Source: US News

In addition, there is an endowment effect in education. Not the school’s endowments: we’d all like to have a large asset base to pay some of our operating expenses! No, kids have an endowment effect when they pay to go to school. Students who work to pay even a small percentage of their college expenses are more likely to work hard at their studies and graduate. As the cost of attending college falls to zero, so does the perceived cost of dropping out. But when you put your own cash into your own education, you’re more likely to finish that degree. People value what they pay for.

There’s a network effect where we all benefit from a better-educated populace. But the folks who receive an advanced education benefit the most, in the form or higher lifetime earnings. Why shouldn’t they have some skin in the game?

Douglas R. Tengdin, CFA

The Great Wall of Debt

What effect does China’s debt have on its economy?

Photo: Severin Stadler. Source: Wikipedia

The Great Wall of China was built over the course of several centuries to protect the Chinese Empire from invasion by mostly northern nomadic tribes. It stretches about 1,500 miles, although with all the extensions and branches, there are over 20,000 miles of fortifications. In the short run, the Great Wall served to discourage raiders and helped rulers manage trade. In the long run, however, it became economically unsustainable—absorbing labor and resources that were better used elsewhere.

Is China’s debt serving the same function? During the financial crisis China responded with a massive amount of borrowing—over $500 billion, in an economy of only $4 trillion—about 12% of the economy. This kept their economy growing, and helped establish China’s position as a major player in global trade. Moreover, since most of this debt has been issued by local governments in local currency, they “owe it to themselves.” China won’t have to send cash back to foreign creditors as they service their debt.

Source: VoxEU

But what are the longer-term effects? It turns out that the massive local borrowing has had a negative effect on the formation of private manufacturing firms. It’s harder for smaller button factories and shoe-makers to get access to capital and workers. Those are being absorbed by the state-owned companies, which have better political connections and more stable credit foundations. In short, the state-owned companies are crowding out the private firms.

But the private firms have much higher levels of productivity. They’re more flexible: able to relocate to better facilities when new highways are completed or new electricity-generating utilities come on-line. They can respond more readily to new market conditions. By supporting state-owned factories during the crisis, China may have reduced its long-run growth—not to mention, saddling its banks with a lot of local government debt, potentially increasing its systemic financial risk.

Government debt is neither a blessing nor a curse. It is financial tool that has to be used wisely. If it ceases to be productive, it may become a legacy asset—a curiosity—like the original Great Wall itself.

Douglas R. Tengdin, CFA

Chief Investment Officer