The College Bubble and the Austrian Business Cycle

America’s malinvestment in higher ed

Bernie Sanders has enjoyed enormous popularity among college-aged voters in part thanks to his proposal to make college affordable for all. Earlier this year, Sanders released his six-step plan to make college “debt free.” The plan involves making public colleges and universities tuition free, having the federal government greatly expand grants and student lending, and significantly lowering interest rates on all student loans.

Sanders’s popularity shouldn’t come as a surprise. College students are notoriously suckers for a free lunch. But as popular and presumably well-intentioned as “free college” might sound, there are some strong economic reasons to suspect that this is one meal we ought to skip.

In recent years, people like famed tech entrepreneur Peter Thiel and University of Tennessee law professor Glenn Reynolds have argued that higher education — just like the housing sector in the early 2000s — is a “bubble.”

Much of the rhetoric surrounding the “free college” movement bears an uncanny resemblance to the rhetoric that surrounded the federal government’s effort in the 1990s and early 2000s to expand home ownership by making “the American dream” affordable for everyone. The numbers also show some striking similarities.

The cost of college has risen much faster than inflation in recent decades. According to the Federal Reserve Bank of New York, outstanding student loan debt in the United States has grown much faster than auto, credit card, and other major types of debt, paralleling the massive run up in mortgage debt that preceded the bursting of the housing bubble. As of 2014 Q4, outstanding student loan debt exceeded $1.16 trillion; the vast majority of this debt stems from federal student loans. The Institute for College Access and Success reports that more than two-thirds of seniors in the class of 2014 graduated with some student loan debt — an average of roughly $30,000 per graduate.

There are a number of factors that explain this phenomena. The demand amongst employers for high-skilled, college-educated workers has increased over time. Sluggish employment growth has also driven more students into college and graduate school. But arguably the biggest factor has been the recent explosion of federal spending and lending going towards higher education.

What can economics tell us about the unintended consequences that might result from this massive influx of financial and intellectual resources into higher education? One common expectation is that this increased demand — stemming both from higher market demand for college and greater subsidies — will result in spiraling prices, making college increasingly unaffordable.

Although these basic economic insights are valid, there is another compelling way to think about the unintended consequences of these policies, derived from a more heterodox theory: the Austrian theory of the business cycle.

Austrian business cycle theory (ABCT) maintains that the boom-bust cycles arises when central banks print too much money, artificially lowering interest rates below their equilibrium, or “natural,” rates. This cheap credit induces investors and businesses to engage in more investment projects — particularly longer lasting ones that tend to be more interest-sensitive like housing construction or building capital-intensive plants. The boom turns to bust once investors realize that there are not enough real savings to sustain all of these longer lasting projects. As a result, some of their projects — or “malinvestments” — must be liquidated.

This “bust” stage represents the recession. The economy temporarily slows as entrepreneurs try to reallocate labor and capital back in line with underlying consumer preferences. This readjustment process can take time. But this short-term pain is necessary for the economy to return to sustainable long run growth.

Although it is primarily a story about how monetary distortions adversely affect interest rates and the production of physical capital, the theory has some profound implications for thinking about federal higher education policy. Just as government policies distorted the structure of relative prices and interest rates in the real estate market during the housing boom, they have also disrupted relative prices and interest rates in the market for higher education.

The federal government has drastically increased its student loan programs by offering larger loans and keeping their interest rates well below private market rates. As a recent Pew study indicates, the federal government is “by far the nation’s largest student lender.” It issued a record $103 billion in student loans in 2013 through the Stafford and PLUS loan programs. Federal loans grew 376 percent in inflation-adjusted terms from 1990 to 2013.

The federal government has also artificially stimulated investments in higher education through a variety of grants, subsidies, and tax deductions. The same Pew study shows that Pell grants have more than doubled from $15 billion to $35 billion between 2009 and 2013. The federal government also provided a record $31 billion in special tax credits, deductions, and exemptions for higher education in 2013. Thanks to these programs and state budget cuts, federal spending on higher education ($75.6 billion) recently eclipsed state spending ($72 billion) for the first time.

There are other parallels. Economists often talk about the importance of higher education for enhancing students’ knowledge and skills, allowing them to become more productive workers. They refer to this as an investment in “human capital” — a direct parallel for labor to the concept of physical capital. What they often times neglect is that human capital can be malinvested just like physical capital.

It ultimately doesn’t matter if the artificially cheap credit is coming from the Federal Reserve or the taxpayers; the effects of this cheap credit on human capital are very similar to the effects on physical capital.

By making college artificially cheap via grants and subsidized loans, the government distorts the relative price signals that guide current and prospective students. On the margin, these false price signals can induce too many students to enter college and embark on unprofitable investments in degrees that employers don’t demand. The human capital structure of production is thereby “lengthened,” as more students engage in these time-consuming investments in their human capital that all often don’t pan out.

It is unsurprising that an increasing number of these human capital investments have proven to be outright malinvestments. Graduation rates have steadily declined since 2005, even as critics argue grade inflation has made college increasingly easier; today, nearly half of college enrollees will either drop out or not complete their degree within six years. Although it has declined a bit recently as the economy has recovered, the default rate on student has climbed over time to 11.7 percent — making higher education a far riskier investment than many care to admit.

Malinvestments can show up in other ways, too. Many graduates have been unable to find a job in their area of study. According to the Federal Reserve Bank of St. Louis, the unemployment rate for workers with a bachelor’s degree or higher doubled from 2.0 to 5.5 percent during the Great Recession and has remained persistently high. The left-leaning Economic Policy Institute has also reported that the underemployment rate for these workers climbed from 3.9 percent to 8.5 percent between 2008 and 2011 and has remained above trend.

This mismatch between the skills that employers demand and the skills workers actually have is precisely the “skills gap” that economists worry about. Other students have had to change majors, go back to school, or enroll in graduate programs to retool their skills to what employers really want. As with physical capital, this readjustment process can be painful and time-consuming. However, liquidating these malinvestments is absolutely necessary if graduates want to land sustainable jobs. 

ABCT might not illuminate every aspect of the complex higher ed bubble. But its core insights regarding the importance of relative prices in guiding investment can help explain how the student debt crisis arose and what its likely effects will be.

The basic lesson is simple: nothing is quite as unaffordable as a free lunch.

Further Reading