Higher Education - Bubble, Closed Society Or Free Market?

By Stephen D. Simpson, CFA | August 30, 2011 AAA
Higher Education - Bubble, Closed Society Or Free Market?

With college costs on a seemingly endless upward march, but salaries and job openings disturbingly flat, there is much talk these days of whether higher education is a bubble due to pop. "Bubble" is arguably an overused word these days and it is debatable whether there's a "greater fool" theory at work in higher education, but clearly something disturbing is happening. Absent some creative thinking and careful planning, college education may once become the domain of the wealthy and create inflexible strata within society. (Bubbles are deceptive and unpredictable, but by studying their history we can prepare to our best ability. See 5 Steps Of A Bubble.)

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The Best Game in Town?
It is difficult to assess the profitability of private schools, but there is no question that colleges, both public and private, have scarcely been shy in putting up prices over the past few decades. Depending upon the source and the time period in question, college tuition has been rising somewhere in the neighborhood of 8% a year for several decades, with room, board and other associated costs basically going along for the ride.

To put 8% a year in perspective, that's roughly triple the inflation rate over the same time. It's also well ahead of the much-maligned increases in healthcare costs (roughly 6% a year) that have incited various calls and attempts by politicians to "do something."

Why are prices high and getting higher? First of all, there's supply and demand. It is largely accepted as a given, that higher education is mandatory to secure a good job and a comfortable life, but there are only so many seats at well-regarded institutions to go around.

Second, schools are in an arms race and if there is anything to be learned from the Cold War, it's that arms races cost a lot of money. Schools like Princeton and Boston University have been mocked for spending large amounts on comfortable and well-appointed dorms. Other schools feel they have to have the best and brightest in athletic, artistic or performance facilities to compete. And do not forget the cost of science labs - it takes tens of millions of dollars to build labs and other facilities that top students and faculty demand.

Personnel plays a role as well. Top PhDs know how valuable they are to schools' rankings and recruiting, and they expect to get paid accordingly. Not only are there ample numbers of school administrators taking home high six-figure paychecks, but schools are getting increasingly generous with benefits (Stanford offers sabbaticals every four years) and cutting down class sizes.

Can't Pay Meets Must Pay
With many private schools costing well in advance of $50,000 a year, it is no surprise that more and more students have to sign on for loans in order to afford their education. A few schools here and there have tried "no loan" guarantees before, but found their endowments shrinking at worrisome rates and ended the programs.

What's more, "needs-based" guarantees set up some interesting puzzles for schools and students. By promising to meet the needs of those who cannot afford to pay (and assuming schools 'need' to charge what they do), it creates a bigger gap in the numbers of those who get aid and those who pay full freight - a situation that ultimately pushes up prices further. Making matters worse, while these schools encourage applicants with the promise of meeting their financial needs, a lot of that "aid" is actually not assistance from the school but just an obligation to go into debt.

The bottom line? Students are graduating with more than $25,000 in debt and much much more from the more expensive private schools. That is all well and good for those moving on to Wall Street or high-end consulting or marketing and so on, but its grim news for those who would like to be scientists (and face another five years of schooling just to make $35,000 as a post-doc). While some will say that this is the market at work and people should thus not spend large sums to study biology at the undergrad level, think a bit about the long-range consequences of discouraging top-level talent from pursuing science education at the best universities.

By the way, that assumes those debt-laden college graduates can even get a job. It is no secret that the job market has been tough for several years now, but wages had started stagnating many years before that. The result? Kids moving back in with parents or struggling to make ends meet in entry-level jobs, taking deferments and seeing student debt pile up.

Is This Sustainable?
There are some who argue that college has become a self-reinforcing "society" - people go to school, rise to positions of authority in companies, and then insist on new hires having college degrees to validate their own decisions and keep the process flowing. That's a bit conspiratorial frankly and presumes more coordination than most people are probably capable of, but there's an element of truth to it - society has by and large bought into the idea that everybody needs a college degree, even though almost everyone reading this has seen people performing jobs that really do not require post secondary education.

The trouble is, what is the alternative? Going the route of Michael Dell or Bill Gates and starting a business is all well and good for those in possession of an entrepreneurial spirit, but that ability does not come by choice or desire. Likewise, manual labor and vocational work is still largely scorned in this culture; going to a community college or technical school is probably a great decision for many people (after all, fixing cars or plumbing is not a job likely to be outsourced to Bangladesh), but there is a lot of social pressure against it.

The bottom line here is that 8% annual tuition growth does not look sustainable if college is going to truly stay open to the masses. Access to debt is ultimately predicated on the ability to repay it (even if banks and nations forget this periodically) and the recent rate of job and wage growth just isn't enough to validate even higher loan balances for an undergraduate degree. What's more, should the mounting pile of student loan debt go bad (a la the housing crisis), lenders may back away from the market.

The Bottom Line
Is higher education a bubble? Well, it certainly has a lot of the characteristics of one - a collective faith in its value, insensitivity to price and a lot of debt underpinning it all. Bubble or no, it is clear that the cost of education is becoming an issue of national concern and its impact on savings, debt, and employment will have long-term implications for the economy. (Overwhelmed by increasing tuition costs for your kids? The U.S. government can help. Check out Investing In Your Child's Education.)

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