Mike Konczal

Roosevelt Institute Fellow

Recent Posts by Mike Konczal

  • Human Capital Contracts Could Increase Dropouts

    Sep 4, 2015Mike Konczal

    One last note, following up on previous posts about human capital contracts (ISAs) and higher education. The first is about a NY Fed report that I believe argues ISAs would increase education costs. The second is that the features of ISAs that are meant to mitigate higher education costs aren't likely to do so.

    I've received pushback from Andrew P. Kelly and others on the right on twitter arguing that human capital contracts (ISAs) would help increase graduation rates, and that my arguments and evidence doesn't capture this. Schools have varying completion rates, and reducing dropouts is an important priority. ISA creditors would have an incentive to make sure college students graduate, so they can receive more upside income. How can ISAs help? By offering better terms for colleges that have lower dropout rates, aligning the profit motive of financial capital with the goals of a better, more just, education system.

    Why would we assume they do this? I want to post a toy model showing there's a reasonable story where they won't. (This is how the quants would approach it. The big difference is that we are taking the future salaries for granted, but that's what would need to be modeled.)

    There’s Mike. He’s 18 and could attend one of two colleges that costs the same, School A and School B. Let's say he signs an ISA promising 10% of his income until he hits 30 in order to attend either one. He doesn’t make any money while in college, and the ISA has a discount rate of 8% (probably low given the downside adverse selection risk it has to hold).

    In one world, Mike attends School A and drops out after two years because it's a poor quality school. He make $30,000 a year after dropping out with some college. Alternatively, in another world, Mike attends School B, finishing after four years and gets to make 30% more, for a yearly income of $39,000. That’s a big premium! Obviously the ISA would prefer the world where Mike attends School B and he graduates, right?
     
    No. The ISA would prefer he drops out and start paying out earlier to maximize profits. Excel:

    When it comes to the present value (PV) of the ISA, two extra years of payments earlier more than compensate for higher earnings later.
     
    This difference is increasing in the discount rate, dropout income and equity rate, decreasing in the length of payments and education premium. It’s not juked - if anything that discount rate feels low, and this is robust to different ways of setting up the terms. Even if it was just 10 payments each, a higher discount rate and lower premium does the same thing. (Again, it's tough to model an imaginary market that won't exist without extensive government intervention because of profound adverse selection problems.)
     
    Here's the kicker: since the present value of the ISA when Mike attends the bad school and drops out is higher, the quants would be able to offer him better terms to attend that school. (Better terms here is a lower rate of equity payments.) You would receive a better rate to attend the worse school. The price mechanism of the ISA could easily, as demonstrated in this toy model, lead to a world where people are encouraged to attend a worse school option. This contradicts the idea that the ISA would necessarily, through the profit motive, offer better terms to better schools, especially ones with higher completion rates.
     
    Will this happen? I don't know. Neither does anyone else. But this shows the problem with assuming that this ISA financial instrument seeks to maximize school quality, rather than the actual goal of maximizing expected earnings. We should take the profit-motive as what it is - designed to extract profits ruthlessly and completely. We shouldn’t assume it lines up with the social outcomes that we want.
     
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    One last note, following up on previous posts about human capital contracts (ISAs) and higher education. The first is about a NY Fed report that I believe argues ISAs would increase education costs. The second is that the features of ISAs that are meant to mitigate higher education costs aren't likely to do so.

    I've received pushback from Andrew P. Kelly and others on the right on twitter arguing that human capital contracts (ISAs) would help increase graduation rates, and that my arguments and evidence doesn't capture this. Schools have varying completion rates, and reducing dropouts is an important priority. ISA creditors would have an incentive to make sure college students graduate, so they can receive more upside income. How can ISAs help? By offering better terms for colleges that have lower dropout rates, aligning the profit motive of financial capital with the goals of a better, more just, education system.

    Why would we assume they do this? I want to post a toy model showing there's a reasonable story where they won't. (This is how the quants would approach it. The big difference is that we are taking the future salaries for granted, but that's what would need to be modeled.)

    There’s Mike. He’s 18 and could attend one of two colleges that costs the same, School A and School B. Let's say he signs an ISA promising 10% of his income until he hits 30 in order to attend either one. He doesn’t make any money while in college, and the ISA has a discount rate of 8% (probably low given the downside adverse selection risk it has to hold).

    In one world, Mike attends School A and drops out after two years because it's a poor quality school. He make $30,000 a year after dropping out with some college. Alternatively, in another world, Mike attends School B, finishing after four years and gets to make 30% more, for a yearly income of $39,000. That’s a big premium! Obviously the ISA would prefer the world where Mike attends School B and he graduates, right?
     
    No. The ISA would prefer he drops out and start paying out earlier to maximize profits. Excel:

    When it comes to the present value (PV) of the ISA, two extra years of payments earlier more than compensate for higher earnings later.
     
    This difference is increasing in the discount rate, dropout income and equity rate, decreasing in the length of payments and education premium. It’s not juked - if anything that discount rate feels low, and this is robust to different ways of setting up the terms. Even if it was just 10 payments each, a higher discount rate and lower premium does the same thing. (Again, it's tough to model an imaginary market that won't exist without extensive government intervention because of profound adverse selection problems.)
     
    Here's the kicker: since the present value of the ISA when Mike attends the bad school and drops out is higher, the quants would be able to offer him better terms to attend that school. (Better terms here is a lower rate of equity payments.) You would receive a better rate to attend the worse school. The price mechanism of the ISA could easily, as demonstrated in this toy model, lead to a world where people are encouraged to attend a worse school option. This contradicts the idea that the ISA would necessarily, through the profit motive, offer better terms to better schools, especially ones with higher completion rates.
     
    Will this happen? I don't know. Neither does anyone else. But this shows the problem with assuming that this ISA financial instrument seeks to maximize school quality, rather than the actual goal of maximizing expected earnings. We should take the profit-motive as what it is - designed to extract profits ruthlessly and completely. We shouldn’t assume it lines up with the social outcomes that we want.
     
    Follow or contact the Rortybomb blog:
     
      

     

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  • Human Capital Contracts Will Do Nothing To Contain College Costs

    Sep 4, 2015Mike Konczal

    Andrew Kelly and Kevin James, higher education researchers at the American Enterprise Institute and prominent defenders of human capital contracts (ISAs), take issue with my earlier post on that topic, arguing that I “miss the mark.” They argue that ISAs, or selling off a future percentage of your income to pay for college now, would not cause higher education prices to increase because these contracts are significantly different from student loans. They have better incentives for the borrowers and lenders, and private market underwriting is designed to guide students to the best programs.

    I didn’t find this convincing when I wrote the first post, but after engaging these arguments more fully I’m absolutely confident that there’s no way ISAs would function the way the authors say they would. There’s no incentive to control costs, the underwriting would be dominated by factors far different than the marginal school choice, and they would disincentivize cost control for students. These would all have consequences.

    It’s tough to debate an imaginary private market that will never exist at scale without significant government action because of profound adverse selection issues, but I’ll try to make my arguments generalizable to whatever specific forms this could take—though I’m presuming that the ISA is a profit-seeking, private entity, and I’m only looking at the issue of cost control rather than fairness, opportunity, etc.

    It might be good to refresh yourself with the original argument, but to recap: my argument about the New York Federal Reserve paper is that, if borrowing against future income drives higher price inflation, that is a serious problem for attempts to tackle higher education costs that involve making markets more complete. A more complete market involves moving money forward, and whether taking future money and spending it now takes the form of loans or equity doesn’t matter for this effect. Creating a legal infrastructure for ISAs to thrive, moving more money forward, would cause tuition prices to increase.

    Now of course student loans and selling human equity isn’t identical. In particular, the distribution of risk and rewards is shared differently among debtors/creditors. The AEI authors are arguing that what makes ISAs unique would actually check costs, or at least not make them any worse. I don’t believe this pans out.

    ISAs Have No Incentive to Contain Costs

    AEI makes a big point of arguing that ISAs have an incentive to lend to the best schools because schools that add the most value in terms of future income will make them more money. Let’s concede this point for a second.

    What they certainly do not have is an incentive to contain costs. Let’s imagine School A and School B, which are identical in terms of their value-add, but A costs $30,000 and B costs $40,000. Let’s say an ISA runs the numbers and decides it will charge you 6 percent of your income to attend A and 8 percent of your income to attend B. At this point the ISA doesn’t care either way.

    Remember that the whole point of having the equity rate adjust is to make the ISA indifferent about the choice between School A or School B. The ISA has no incentive to nudge the student away from B. It’ll all fall on the student, as it currently does.

    And while it’s tough to imagine how the second-order effects play out, inasmuch as an ISA business model swings for the fences, or wants to capture the upside of extremely high earners in our unequal society, there would be a bias for seeking a higher percentage. This would mean moving more money forward, which would lead to cost inflation.

    You Underwrite Income, Not Colleges

    Kelly and James put a lot of emphasis on underwriting. Student loans, they argue, do “not underwrite based on the expected value of postsecondary programs, while [an ISA] does.” Because a more valuable program increases the upside, and thus lowers the cost of the ISA, an ISA “channels funding and people toward valuable programs.”

    This is not right. An ISA would underwrite based on the expected value of future income, full stop. Differences in postsecondary programs are a determinant of future income, but they are only a minor one. Family income, occupation, race, and gender are going to be much more important to the calculation. Pricing an ISA isn’t about finding the best school; it’s about the overall income package.

    Note this graphic from Pew via Matt Bruenig:

    It’s complicated to read, but those born in the top 20 percent who don’t have a college degree are two and a half times more likely to end up in the top 20 percent than people born in the bottom 20 percent who do have a college degree. More to the point, the median person born rich without a college degree is around the top 40th percentile of income, while the median person born poor with a college degree is around the 60th.

    Which is to say it is very likely when the quants put together the pricing model that a white male born rich who attends a bad school will get significantly better equity pricing than a woman of color born poor who attends a better school, because the former will have a higher expected future income. This expectation of future income is exactly what the contract is meant to price.

    We don’t even have to be hypothetical. As a Department of Education report once put it, “Overall, the net contribution of college characteristics to variance in men’s earnings was [...] somewhat less than the net effect of background characteristics on earnings.” Men’s family background matters more to expected future incomes than the schools they choose.

    This is a major problem for the idea that ISAs would reward the best schools overall. The raw amount of capital wouldn’t be channeled from ISA creditors based on school characteristics, but instead on other individual predictors of future income, especially ones we are born with, that will dominate the price signal.

    Marginal School Choice Isn’t a Major Determinant of Future Income

    Students themselves might be able to discern between schools because they can compare the rates they’ll get. This isn’t the choice between Harvard and a state college, which is obvious; it’s the choice between, say, two similar state colleges. Wouldn’t a person gravitate to the school that offers the best reward? But there’s genuinely little evidence that the marginal school choice is a major determinant of future incomes, certainly not enough for the quants to measure.

    There’s an interesting finding, argued by Stacy Dale and Alan Krueger, that which school you go to matters less than which schools accepted you. This means that equity prices won’t be capable of doing the kind of granular sorting of schools at the margins that the ISA proponents argue they will. If you got accepted to schools A and B that are similar in selectiveness, the expected value of your future income won’t vary enough to change incentives.

    Now we do know that selectivity makes a difference. (Jordan Weissmann summarized this literature.) But do we need to create a giant financial market to tell us that it is better to go to an Ivy League school than a state college for future earnings? And, for our narrow question of cost control, to the extent that people don’t know this—and many do not—wouldn’t this additional information cause them to move more money forward?

    Occupation is also an important determinant, and ISAs could fund majors associated with more profitable occupations.[1] But there you’d have such an adverse selection problem I have difficulty seeing it work. Why not major in business or engineering if you want to do social work, so you can lock in a cheaper rate and then go do a low-paying job? Many people don’t do the work their degrees are associated with, and that doesn’t seem like a societal problem.

    Students Already Have This Now, With a More Salient Measure

    Either way, it falls to the student to handle cost control. But it already falls to the student to handle this, and they are unable to do it. AEI makes a big deal of the fact that student loans don’t adjust the interest rate based on risks, and that students could adjust their decisions based on the equity rate of ISAs.

    But students are already adjusting one of the most important parts of their student loan package: the balance. Many people don’t go to the most expensive school they could in order to hold down student loan balances and minimize their risks of financial distress.

    Quick: How much would you sell 5 percent of your future earnings for? I… have no idea. And I used to do a lot wacky financial modeling. I could guess, but it would be just that, a guess.[2] It is easier (though perhaps not easy) to figure out if I could afford a $30,000 loan. Whenever I’ve talked with people about student debt, they will, if they trust me, share the loan balance. What they can’t usually do is tell me their interest rates. It’s not a salient feature of the loan.

    Note that it’s this salience of a feature of debt that generally causes people to act, and replacing loans with ISAs would likely reduce the salience that can control costs. A loan balance is scary in a way 5 percent vs. 10 percent of future earnings is not. This cuts in several different directions. If people feel the student loan balance as a constraint in a way they wouldn’t with an equivalent equity percentage, that means they would move more money forward with ISAs. Inasmuch as children are bad at predicting future outcomes, they could easily sell a higher rate of equity than is reasonable, which would lead to moving more money forward. What happens when a dumb kid sells 60 percent of his or her equity to a predatory program?[3]

    The Downside Risk Contains Costs

    Let me spell that out more bluntly: There’s a lot of talk about aligning incentives, but what we are really doing is shuffling incentives, moving the downside from students to private markets. And right now students facing the downside is a major factor in limiting the amount of money being moved forward.

    The idea that students should be borrowing more if it means completing their education comes up quite often in these debates. It’s why we should feel sorry about those with too little debt, as a recent New York Times piece put it. The threat of financial stress is a major pressure on aggregate borrowing. Removing it by insulating students from downside risk will cause students to move more money forward. Indeed, these credit constraints on student loans are part of the critique of student loans that ISA literature brings up. This isn’t a value judgment either way (I’m not a fan of the implications), but just an acknowledgment that widespread acceptance of ISAs would reduce students’ incentive to contain school costs, and the ISAs don’t have one.

    If college as a whole is underfunded due to credit market imperfections, ISAs will cause prices to rise. All the talk of information and incentives do not change this. There needs to be a more serious plan to control costs, and using public education as a public option is a much better solution than giving more resources to the already rich and selective.

    [1] Sometimes people suggest student loans should be priced by majors, e.g. this paper. But isn’t the point of having a labor market to channel this information through salaries? Why do we assume it is failing, and why do we think the government or hedge fund quants can better guess the labor demand decades out using central planner-style modeling?

    [2] For all the endless hype, are there a lot of examples of people actually executing an ISA? I’d love to see a contract to see how they handle what is included in income. Is a percentage of capital market income claimed by an ISA? Business ownership income? Inheritances? EITC?

    [3] You’ll be happy to note that Kelly is against any kind of usury regulation and bankruptcy protections for ISAs. That would interfere with the market. The thing where he describes building a joint government–creditor surveillance state, where the IRS uses its extensive power to consistently feed all of your personal information to debt collectors in real time to assess the earnings they need to collect? That’s just normal for markets.

    Andrew Kelly and Kevin James, higher education researchers at the American Enterprise Institute and prominent defenders of human capital contracts (ISAs), take issue with my earlier post on that topic, arguing that I “miss the mark.” They argue that ISAs, or selling off a future percentage of your income to pay for college now, would not cause higher education prices to increase because these contracts are significantly different from student loans. They have better incentives for the borrowers and lenders, and private market underwriting is designed to guide students to the best programs.

    I didn’t find this convincing when I wrote the first post, but after engaging these arguments more fully I’m absolutely confident that there’s no way ISAs would function the way the authors say they would. There’s no incentive to control costs, the underwriting would be dominated by factors far different than the marginal school choice, and they would disincentivize cost control for students. These would all have consequences.

    It’s tough to debate an imaginary private market that will never exist at scale without significant government action because of profound adverse selection issues, but I’ll try to make my arguments generalizable to whatever specific forms this could take—though I’m presuming that the ISA is a profit-seeking, private entity, and I’m only looking at the issue of cost control rather than fairness, opportunity, etc.

    It might be good to refresh yourself with the original argument, but to recap: my argument about the New York Federal Reserve paper is that, if borrowing against future income drives higher price inflation, that is a serious problem for attempts to tackle higher education costs that involve making markets more complete. A more complete market involves moving money forward, and whether taking future money and spending it now takes the form of loans or equity doesn’t matter for this effect. Creating a legal infrastructure for ISAs to thrive, moving more money forward, would cause tuition prices to increase.

    Now of course student loans and selling human equity isn’t identical. In particular, the distribution of risk and rewards is shared differently among debtors/creditors. The AEI authors are arguing that what makes ISAs unique would actually check costs, or at least not make them any worse. I don’t believe this pans out.

    ISAs Have No Incentive to Contain Costs

    AEI makes a big point of arguing that ISAs have an incentive to lend to the best schools because schools that add the most value in terms of future income will make them more money. Let’s concede this point for a second.

    What they certainly do not have is an incentive to contain costs. Let’s imagine School A and School B, which are identical in terms of their value-add, but A costs $30,000 and B costs $40,000. Let’s say an ISA runs the numbers and decides it will charge you 6 percent of your income to attend A and 8 percent of your income to attend B. At this point the ISA doesn’t care either way.

    Remember that the whole point of having the equity rate adjust is to make the ISA indifferent about the choice between School A or School B. The ISA has no incentive to nudge the student away from B. It’ll all fall on the student, as it currently does.

    And while it’s tough to imagine how the second-order effects play out, inasmuch as an ISA business model swings for the fences, or wants to capture the upside of extremely high earners in our unequal society, there would be a bias for seeking a higher percentage. This would mean moving more money forward, which would lead to cost inflation.

    You Underwrite Income, Not Colleges

    Kelly and James put a lot of emphasis on underwriting. Student loans, they argue, do “not underwrite based on the expected value of postsecondary programs, while [an ISA] does.” Because a more valuable program increases the upside, and thus lowers the cost of the ISA, an ISA “channels funding and people toward valuable programs.”

    This is not right. An ISA would underwrite based on the expected value of future income, full stop. Differences in postsecondary programs are a determinant of future income, but they are only a minor one. Family income, occupation, race, and gender are going to be much more important to the calculation. Pricing an ISA isn’t about finding the best school; it’s about the overall income package.

    Note this graphic from Pew via Matt Bruenig:

    It’s complicated to read, but those born in the top 20 percent who don’t have a college degree are two and a half times more likely to end up in the top 20 percent than people born in the bottom 20 percent who do have a college degree. More to the point, the median person born rich without a college degree is around the top 40th percentile of income, while the median person born poor with a college degree is around the 60th.

    Which is to say it is very likely when the quants put together the pricing model that a white male born rich who attends a bad school will get significantly better equity pricing than a woman of color born poor who attends a better school, because the former will have a higher expected future income. This expectation of future income is exactly what the contract is meant to price.

    We don’t even have to be hypothetical. As a Department of Education report once put it, “Overall, the net contribution of college characteristics to variance in men’s earnings was [...] somewhat less than the net effect of background characteristics on earnings.” Men’s family background matters more to expected future incomes than the schools they choose.

    This is a major problem for the idea that ISAs would reward the best schools overall. The raw amount of capital wouldn’t be channeled from ISA creditors based on school characteristics, but instead on other individual predictors of future income, especially ones we are born with, that will dominate the price signal.

    Marginal School Choice Isn’t a Major Determinant of Future Income

    Students themselves might be able to discern between schools because they can compare the rates they’ll get. This isn’t the choice between Harvard and a state college, which is obvious; it’s the choice between, say, two similar state colleges. Wouldn’t a person gravitate to the school that offers the best reward? But there’s genuinely little evidence that the marginal school choice is a major determinant of future incomes, certainly not enough for the quants to measure.

    There’s an interesting finding, argued by Stacy Dale and Alan Krueger, that which school you go to matters less than which schools accepted you. This means that equity prices won’t be capable of doing the kind of granular sorting of schools at the margins that the ISA proponents argue they will. If you got accepted to schools A and B that are similar in selectiveness, the expected value of your future income won’t vary enough to change incentives.

    Now we do know that selectivity makes a difference. (Jordan Weissmann summarized this literature.) But do we need to create a giant financial market to tell us that it is better to go to an Ivy League school than a state college for future earnings? And, for our narrow question of cost control, to the extent that people don’t know this—and many do not—wouldn’t this additional information cause them to move more money forward?

    Occupation is also an important determinant, and ISAs could fund majors associated with more profitable occupations.[1] But there you’d have such an adverse selection problem I have difficulty seeing it work. Why not major in business or engineering if you want to do social work, so you can lock in a cheaper rate and then go do a low-paying job? Many people don’t do the work their degrees are associated with, and that doesn’t seem like a societal problem.

    Students Already Have This Now, With a More Salient Measure

    Either way, it falls to the student to handle cost control. But it already falls to the student to handle this, and they are unable to do it. AEI makes a big deal of the fact that student loans don’t adjust the interest rate based on risks, and that students could adjust their decisions based on the equity rate of ISAs.

    But students are already adjusting one of the most important parts of their student loan package: the balance. Many people don’t go to the most expensive school they could in order to hold down student loan balances and minimize their risks of financial distress.

    Quick: How much would you sell 5 percent of your future earnings for? I… have no idea. And I used to do a lot wacky financial modeling. I could guess, but it would be just that, a guess.[2] It is easier (though perhaps not easy) to figure out if I could afford a $30,000 loan. Whenever I’ve talked with people about student debt, they will, if they trust me, share the loan balance. What they can’t usually do is tell me their interest rates. It’s not a salient feature of the loan.

    Note that it’s this salience of a feature of debt that generally causes people to act, and replacing loans with ISAs would likely reduce the salience that can control costs. A loan balance is scary in a way 5 percent vs. 10 percent of future earnings is not. This cuts in several different directions. If people feel the student loan balance as a constraint in a way they wouldn’t with an equivalent equity percentage, that means they would move more money forward with ISAs. Inasmuch as children are bad at predicting future outcomes, they could easily sell a higher rate of equity than is reasonable, which would lead to moving more money forward. What happens when a dumb kid sells 60 percent of his or her equity to a predatory program?[3]

    The Downside Risk Contains Costs

    Let me spell that out more bluntly: There’s a lot of talk about aligning incentives, but what we are really doing is shuffling incentives, moving the downside from students to private markets. And right now students facing the downside is a major factor in limiting the amount of money being moved forward.

    The idea that students should be borrowing more if it means completing their education comes up quite often in these debates. It’s why we should feel sorry about those with too little debt, as a recent New York Times piece put it. The threat of financial stress is a major pressure on aggregate borrowing. Removing it by insulating students from downside risk will cause students to move more money forward. Indeed, these credit constraints on student loans are part of the critique of student loans that ISA literature brings up. This isn’t a value judgment either way (I’m not a fan of the implications), but just an acknowledgment that widespread acceptance of ISAs would reduce students’ incentive to contain school costs, and the ISAs don’t have one.

    If college as a whole is underfunded due to credit market imperfections, ISAs will cause prices to rise. All the talk of information and incentives do not change this. There needs to be a more serious plan to control costs, and using public education as a public option is a much better solution than giving more resources to the already rich and selective.

    [1] Sometimes people suggest student loans should be priced by majors, e.g. this paper. But isn’t the point of having a labor market to channel this information through salaries? Why do we assume it is failing, and why do we think the government or hedge fund quants can better guess the labor demand decades out using central planner-style modeling?

    [2] For all the endless hype, are there a lot of examples of people actually executing an ISA? I’d love to see a contract to see how they handle what is included in income. Is a percentage of capital market income claimed by an ISA? Business ownership income? Inheritances? EITC?

    [3] You’ll be happy to note that Kelly is against any kind of usury regulation and bankruptcy protections for ISAs. That would interfere with the market. The thing where he describes building a joint government–creditor surveillance state, where the IRS uses its extensive power to consistently feed all of your personal information to debt collectors in real time to assess the earnings they need to collect? That’s just normal for markets.

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  • NY Fed Study Should Redefine How We Think About Student Loans and College Costs

    Sep 2, 2015Mike Konczal

    Sometimes you hear something that sounds so much like common sense that you end up missing how it overturns everything you were actually thinking, and points in a far more interesting and disturbing direction. That’s how I’m feeling about the coverage of a recent paper on student loans and college tuition coming out of the New York Federal Reserve, “Credit Supply and the Rise in College Tuition: Evidence from the Expansion in Federal Student Aid Programs,” by David Lucca, Taylor Nadauld, and Karen Shen.

    They find that “institutions more exposed to changes in the subsidized federal loan program increased their tuition,” or for every dollar in increased student loan availability colleges increased the sticker price of their tuition 65 cents. Crucially, they find that the effect is stronger for subsidized student loans than for Pell Grants. When they go further and control for additional variables, Pell Grants lose their significance in the study, while student loans become more important.

    There’s been a lot of debate over this research, with Libby Nelson at Vox providing a strong summary. I want to talk about the theory of the paper. People have been covering this as a normal debate about whether subsidizing college leads to higher tuition, but this is a far different story. It actually overturns a lot of what we believe about higher education funding, and means that the conservative solution to higher education costs, going back to Milton Friedman, will send tuition skyrocketing. And it ends up providing more evidence of the importance of free higher education.

    To start, it’s essential to understand the difference between Pell Grants and student loans in economic terms. Pell Grants are a subsidy. They provide money that isn’t paid back and that goes entirely to aid the purchasing of more education. Student loans are a form of increasing credit supply for higher education. They allow students to borrow against future income to fund their education right now.

    There’s a large debate over whether and how much student loans are subsidized and what that would even mean. Some people who think they are really subsidized might say that their value consists of a 10–20 percent subsidy. Others, following current data, argue that they have a slight negative subsidy (the government makes a profit on them). Either way, that’s obviously nothing compared to a Pell Grant, which is a 100 percent subsidy.

    With this important difference in mind, let’s reexamine the conclusion of the New York Fed paper: Changes in the credit supply, in the form of student loans, are far more of a driver of higher education costs than subsidies, in the form of Pell Grants. That’s why the title has “credit supply" in the title. The deeper the study digs, the stronger this difference becomes. Virtually no coverage is catching this difference, grouping everything under a subsidy. (Here's an example of such a piece.) But this difference changes everything we should think about the topic.

    What’s Economics 101?

    David Boaz at the Cato Institute has a snarky post in response to the study, saying that “[u]nderstanding basic economics” would have predicted it. This is false, because economics 101 would have predicted the opposite. Economists fight a lot about this [1], but the simple economics story is clear. According to actual economics 101, letting students borrow against future earnings should have no effect on prices.

    This derives from something called the Modigliani-Miller Theorem (MM), the frustrating staple of corporate finance 101 courses. A quick way of understanding MM is that how much you value an asset or investment, be it a factory or higher education, should be independent of how you finance it. Whether you pay cash, a loan, your future equity, a complicated financial product, or some other means that doesn’t even exist yet, you ultimately value the asset by how profitable and productive it is. In this story, which requires abstract and complete markets, expanding credit supply won’t drive tuition higher.

    Now what would change your valuation, according to this theorem, is getting subsidies, say in the form of Pell Grants. This would make you willing to buy more and pay a higher price. This is one of the reasons why so much of the economics research focuses on Pell Grants instead of student loans: the story about what is happening is clearer. But, again, extensions of the credit supply, not subsidies, are doing the work here.

    Sorry Milton Friedman…..

    But this result isn’t an abstract debate. It overturns everything conservatives are currently proposing in regard to higher education.

    Ever since Milton Friedman’s Capitalism and Freedom, the proposed solution to higher college funding has been to increase the credit supply by allowing students to borrow against future earnings by selling equity in themselves. This is what Marco Rubio is proposing. Reform conservatives have gotten behind the idea that we should roll back government student loans and expand private “Income Share Agreements” (human capital contracts) instead.

    It’s funny to imagine describing such efforts as “small government” or involving “civil society” when you see what they require [2]. For our purposes, it’s enough to note that these efforts would send tuition skyrocketing because, while they involve private market actors, they are fundamentally about expanding the credit supply and making it easier to borrow against future earnings. There’s no first-order difference between human capital contracts and student loans when it comes to an expansion of the credit supply and the ability to borrow against future earnings. This type of borrowing is exactly what is driving the results in this New York Fed study, not government subsidies.

    Whether or not it would be fairer or better to reorient our student funding system toward students selling equity in themselves, we should conclude that it would do nothing to contain the costs of higher education. In fact, it would likely send them spiraling.

    You Complete Me

    Note that it isn’t clear why students borrowing more against their future is driving increases in tuition they’ll pay. It could be “rational” under arcane definitions of that word. It could be that in a winner-take-all economy, in which those at the top do fantastically and those who don’t make it do not make it at all, leveraging up and swinging for the fences is a smart play. It could be that liquidity and credit are important determinants of the economy as a whole rather than a neutral veil over real resources. It could be as simple as the fact that 18-year-olds aren’t highly calculating supercomputers solving thousands of Euler equations of their future earnings into an infinite future, but instead a bunch of kids jacked up on hormones doing the best they can with the world adults provide them.

    But no matter the cause, the conclusion of this research points in an interesting, complicated, and scary direction. I read this research as implicitly concluding that the cost of higher education is low relative to where it would be if markets were “complete.” By complete I mean a situation in which students have perfect access to borrow against future outcomes. Students can’t do this now due to financial market imperfections, which is why the government provides student lending. But as finance does a better job of providing students with these options, or the government reworks markets to create these conditions, say in the form of human capital contracts, we are talking about a widespread increase in tuition.

    This makes a lot of cutting-edge reforms more complicated for the issue of controlling tuition costs. Colleges that provide more information on outcomes might provide better education, but that increased information will jack up costs if it means more borrowing. Making sure students who might drop out borrow enough to get to graduation will lead to more cost inflation.

    Public Options

    This effect is virtually nonexistent for public universities, and really driven by non-profit private schools. Though not studied in this specific paper, it’s widely believed that this effect is strongest at for-profit schools, especially the ones expanded under the George W. Bush years in an attempt to push back on accreditation. This means the private market is the most likely to accelerate this trend if given access to an increased credit supply.

    If private education is able to capture Pell Grant subsidies that increase demand, using those resources to increase the supply directly (e.g. provide free public colleges) would drive down tuition overall. This is the logic of public options. If it is also the case that, as the financial markets become more complete, it will send private tuition skyrocketing, that makes the case for a low-cost, high-quality resource to provide an anchor against price inflation even more important. Rather than a vague indictment of government, this paper shows why the logic of free public higher education is even more compelling.

    [1] See the literature over the housing bubble, in which the question of what an increase in credit supply resulting from financial deregulation and financial engineering does to housing prices is empirically rich but theoretically underdeveloped. (This paper is a good example.) The result, if I may be blunt, has been for researchers to throw the best data and techniques at the question and leave the theory aside, hoping the journals simply blink and accept it. That’s a good strategy, and it’s now being extended to student loans.

    [2] There’s something dystopic about invoking “civil society” to describe people having to auction themselves off to hedge funds in order to get a higher education, as if this is just an extension of the town square or the church. If you dig into how these contracts would actually function, they would require a massive expansion of a joint creditor–state surveillance program, as the IRS would have to partner with private debt collectors to share all your data in real time in order for them to consistently verify your income. It’s not clear to me how the state supplying private debt collectors with all your personal information counts as “small government.”

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    Sometimes you hear something that sounds so much like common sense that you end up missing how it overturns everything you were actually thinking, and points in a far more interesting and disturbing direction. That’s how I’m feeling about the coverage of a recent paper on student loans and college tuition coming out of the New York Federal Reserve, “Credit Supply and the Rise in College Tuition: Evidence from the Expansion in Federal Student Aid Programs,” by David Lucca, Taylor Nadauld, and Karen Shen.

    They find that “institutions more exposed to changes in the subsidized federal loan program increased their tuition,” or for every dollar in increased student loan availability colleges increased the sticker price of their tuition 65 cents. Crucially, they find that the effect is stronger for subsidized student loans than for Pell Grants. When they go further and control for additional variables, Pell Grants lose their significance in the study, while student loans become more important.

    There’s been a lot of debate over this research, with Libby Nelson at Vox providing a strong summary. I want to talk about the theory of the paper. People have been covering this as a normal debate about whether subsidizing college leads to higher tuition, but this is a far different story. It actually overturns a lot of what we believe about higher education funding, and means that the conservative solution to higher education costs, going back to Milton Friedman, will send tuition skyrocketing. And it ends up providing more evidence of the importance of free higher education.

    To start, it’s essential to understand the difference between Pell Grants and student loans in economic terms. Pell Grants are a subsidy. They provide money that isn’t paid back and that goes entirely to aid the purchasing of more education. Student loans are a form of increasing credit supply for higher education. They allow students to borrow against future income to fund their education right now.

    There’s a large debate over whether and how much student loans are subsidized and what that would even mean. Some people who think they are really subsidized might say that their value consists of a 10–20 percent subsidy. Others, following current data, argue that they have a slight negative subsidy (the government makes a profit on them). Either way, that’s obviously nothing compared to a Pell Grant, which is a 100 percent subsidy.

    With this important difference in mind, let’s reexamine the conclusion of the New York Fed paper: Changes in the credit supply, in the form of student loans, are far more of a driver of higher education costs than subsidies, in the form of Pell Grants. That’s why the title has “credit supply" in the title. The deeper the study digs, the stronger this difference becomes. Virtually no coverage is catching this difference, grouping everything under a subsidy. (Here's an example of such a piece.) But this difference changes everything we should think about the topic.

    What’s Economics 101?

    David Boaz at the Cato Institute has a snarky post in response to the study, saying that “[u]nderstanding basic economics” would have predicted it. This is false, because economics 101 would have predicted the opposite. Economists fight a lot about this [1], but the simple economics story is clear. According to actual economics 101, letting students borrow against future earnings should have no effect on prices.

    This derives from something called the Modigliani-Miller Theorem (MM), the frustrating staple of corporate finance 101 courses. A quick way of understanding MM is that how much you value an asset or investment, be it a factory or higher education, should be independent of how you finance it. Whether you pay cash, a loan, your future equity, a complicated financial product, or some other means that doesn’t even exist yet, you ultimately value the asset by how profitable and productive it is. In this story, which requires abstract and complete markets, expanding credit supply won’t drive tuition higher.

    Now what would change your valuation, according to this theorem, is getting subsidies, say in the form of Pell Grants. This would make you willing to buy more and pay a higher price. This is one of the reasons why so much of the economics research focuses on Pell Grants instead of student loans: the story about what is happening is clearer. But, again, extensions of the credit supply, not subsidies, are doing the work here.

    Sorry Milton Friedman…..

    But this result isn’t an abstract debate. It overturns everything conservatives are currently proposing in regard to higher education.

    Ever since Milton Friedman’s Capitalism and Freedom, the proposed solution to higher college funding has been to increase the credit supply by allowing students to borrow against future earnings by selling equity in themselves. This is what Marco Rubio is proposing. Reform conservatives have gotten behind the idea that we should roll back government student loans and expand private “Income Share Agreements” (human capital contracts) instead.

    It’s funny to imagine describing such efforts as “small government” or involving “civil society” when you see what they require [2]. For our purposes, it’s enough to note that these efforts would send tuition skyrocketing because, while they involve private market actors, they are fundamentally about expanding the credit supply and making it easier to borrow against future earnings. There’s no first-order difference between human capital contracts and student loans when it comes to an expansion of the credit supply and the ability to borrow against future earnings. This type of borrowing is exactly what is driving the results in this New York Fed study, not government subsidies.

    Whether or not it would be fairer or better to reorient our student funding system toward students selling equity in themselves, we should conclude that it would do nothing to contain the costs of higher education. In fact, it would likely send them spiraling.

    You Complete Me

    Note that it isn’t clear why students borrowing more against their future is driving increases in tuition they’ll pay. It could be “rational” under arcane definitions of that word. It could be that in a winner-take-all economy, in which those at the top do fantastically and those who don’t make it do not make it at all, leveraging up and swinging for the fences is a smart play. It could be that liquidity and credit are important determinants of the economy as a whole rather than a neutral veil over real resources. It could be as simple as the fact that 18-year-olds aren’t highly calculating supercomputers solving thousands of Euler equations of their future earnings into an infinite future, but instead a bunch of kids jacked up on hormones doing the best they can with the world adults provide them.

    But no matter the cause, the conclusion of this research points in an interesting, complicated, and scary direction. I read this research as implicitly concluding that the cost of higher education is low relative to where it would be if markets were “complete.” By complete I mean a situation in which students have perfect access to borrow against future outcomes. Students can’t do this now due to financial market imperfections, which is why the government provides student lending. But as finance does a better job of providing students with these options, or the government reworks markets to create these conditions, say in the form of human capital contracts, we are talking about a widespread increase in tuition.

    This makes a lot of cutting-edge reforms more complicated for the issue of controlling tuition costs. Colleges that provide more information on outcomes might provide better education, but that increased information will jack up costs if it means more borrowing. Making sure students who might drop out borrow enough to get to graduation will lead to more cost inflation.

    Public Options

    This effect is virtually nonexistent for public universities, and really driven by non-profit private schools. Though not studied in this specific paper, it’s widely believed that this effect is strongest at for-profit schools, especially the ones expanded under the George W. Bush years in an attempt to push back on accreditation. This means the private market is the most likely to accelerate this trend if given access to an increased credit supply.

    If private education is able to capture Pell Grant subsidies that increase demand, using those resources to increase the supply directly (e.g. provide free public colleges) would drive down tuition overall. This is the logic of public options. If it is also the case that, as the financial markets become more complete, it will send private tuition skyrocketing, that makes the case for a low-cost, high-quality resource to provide an anchor against price inflation even more important. Rather than a vague indictment of government, this paper shows why the logic of free public higher education is even more compelling.

    [1] See the literature over the housing bubble, in which the question of what an increase in credit supply resulting from financial deregulation and financial engineering does to housing prices is empirically rich but theoretically underdeveloped. (This paper is a good example.) The result, if I may be blunt, has been for researchers to throw the best data and techniques at the question and leave the theory aside, hoping the journals simply blink and accept it. That’s a good strategy, and it’s now being extended to student loans.

    [2] There’s something dystopic about invoking “civil society” to describe people having to auction themselves off to hedge funds in order to get a higher education, as if this is just an extension of the town square or the church. If you dig into how these contracts would actually function, they would require a massive expansion of a joint creditor–state surveillance program, as the IRS would have to partner with private debt collectors to share all your data in real time in order for them to consistently verify your income. It’s not clear to me how the state supplying private debt collectors with all your personal information counts as “small government.”

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  • Introducing Our Latest Report: Defining Financialization

    Jul 27, 2015Mike Konczal

    We’re releasing a new report today as part of the Roosevelt Institute’s Financialization Project: Definining Financialization.

    Following the well-received Disgorge The Cash, this is really the foundational paper that outlines a working definition of financialization, some of the leading concerns, worries, and research topics in each area, and a plan for future research and action. Since this is what we are building from, we’d love feedback.

    Prior to this, I couldn’t find a definition of financialization broad enough to account for several different trends and accessible enough for a general, nonacademic audience. So we set out to create our own solid definition of financialization that can serve as the foundation for future research and policy. That definition includes four core elements: savings, power, wealth, and society. Put another way, financialization is the growth of the financial sector, its increased power over the real economy, the explosion in the power of wealth, and the reduction of all of society to the realm of finance.

    Each of these four elements is essential, and together they tell a story about the way the economy has worked, and how it hasn’t, over the past 35 years. This enables us to understand the daunting challenges involved in reforming the financial sector, document the influence of finance over society and the economy as a whole, and clarify how finance has compounded inequality and insecurity while creating an economy that works for fewer people.

    Savings: The financial sector is responsible for taking our savings and putting it toward economically productive uses. However, this sector has grown larger, more profitable, and less efficient over the past 35 years. Its goal of providing needed capital to citizens and businesses has been forgotten amid an explosion of toxic mortgage deals and the predatory pursuit of excessive fees. Beyond wasting financial resources, the sector also draws talent and energy away from more productive fields. These changes constitute the first part of our definition of financialization.

    Power: Perhaps more importantly, financialization is also about the increasing control and power of finance over our productive economy and traditional businesses. The recent intellectual, ideological, and legal revolutions that have pushed CEOs to prioritize the transfer of cash to shareholders over regular, important investment in productive expansion need to be understood as part of the expansion of finance.

    These historically high payouts drain resources away from productive investment. But beyond investment, there are broader worries about firms that are too dominated by the short-term interests of shareholders. These dynamics increase inequality and have a negative impact on innovation. Firms only interested in shareholder returns may be less inclined to take on the long-term, risky investment in innovation that is crucial to growth. This has spillover effects on growth and wages that can create serious long-term problems for our economy. This also makes full employment more difficult to achieve, as the delinking of corporate investment from financing has posed a serious challenge for monetary policy.

    Wealth: Wealth inequality has increased dramatically in the past 35 years, and financialization includes the ways in which our laws and regulations have been overhauled to protect and expand the interests of those earning income from their wealth at the expense of everyone else. Together, these factors dramatically redistribute power and wealth upward. They also put the less wealthy at a significant disadvantage.

    More important than simply creating and expanding wealth claims, policy has prioritized wealth claims over competing claims on the economy, from labor to debtors to the public. This isn’t just about increasing the power of wealth; it’s about rewriting the rules of the economy to decrease the power of everyone else.

    Society: Finally, following the business professor Gerald Davis, we focus on how financialization has brought about a “portfolio society,” one in which “entire categories of social life have been securitized, turned into a kind of capital” or an investment to be managed. We now view our education and labor as “human capital,” and we imagine every person as a little corporation set to manage his or her own investments. In this view, public functions and responsibilities are mere services that should be run for profit or privatized, or both.

    This way of thinking results in a radical reworking of society. Social insurance once provided across society is now deemphasized in favor of individual market solutions; for example, students take on an ever-increasing amount of debt to educate themselves. Public functions are increasingly privatized and paid for through fees, creating potential rent-seeking enterprises and further redistributing income and wealth upward. This inequality spiral saps our democracy and our ability to collectively address the nation’s greatest problems.

    We have a lot of future work coming from this set of definitions, including a policy agenda and FAQ on short-termism in the near future. I hope you check this out!

    Follow or contact the Rortybomb blog:
     
      

     

    We’re releasing a new report today as part of the Roosevelt Institute’s Financialization Project: Definining Financialization.

    Following the well-received Disgorge The Cash, this is really the foundational paper that outlines a working definition of financialization, some of the leading concerns, worries, and research topics in each area, and a plan for future research and action. Since this is what we are building from, we’d love feedback.

    Prior to this, I couldn’t find a definition of financialization broad enough to account for several different trends and accessible enough for a general, nonacademic audience. So we set out to create our own solid definition of financialization that can serve as the foundation for future research and policy. That definition includes four core elements: savings, power, wealth, and society. Put another way, financialization is the growth of the financial sector, its increased power over the real economy, the explosion in the power of wealth, and the reduction of all of society to the realm of finance.

    Each of these four elements is essential, and together they tell a story about the way the economy has worked, and how it hasn’t, over the past 35 years. This enables us to understand the daunting challenges involved in reforming the financial sector, document the influence of finance over society and the economy as a whole, and clarify how finance has compounded inequality and insecurity while creating an economy that works for fewer people.

    Savings: The financial sector is responsible for taking our savings and putting it toward economically productive uses. However, this sector has grown larger, more profitable, and less efficient over the past 35 years. Its goal of providing needed capital to citizens and businesses has been forgotten amid an explosion of toxic mortgage deals and the predatory pursuit of excessive fees. Beyond wasting financial resources, the sector also draws talent and energy away from more productive fields. These changes constitute the first part of our definition of financialization.

    Power: Perhaps more importantly, financialization is also about the increasing control and power of finance over our productive economy and traditional businesses. The recent intellectual, ideological, and legal revolutions that have pushed CEOs to prioritize the transfer of cash to shareholders over regular, important investment in productive expansion need to be understood as part of the expansion of finance.

    These historically high payouts drain resources away from productive investment. But beyond investment, there are broader worries about firms that are too dominated by the short-term interests of shareholders. These dynamics increase inequality and have a negative impact on innovation. Firms only interested in shareholder returns may be less inclined to take on the long-term, risky investment in innovation that is crucial to growth. This has spillover effects on growth and wages that can create serious long-term problems for our economy. This also makes full employment more difficult to achieve, as the delinking of corporate investment from financing has posed a serious challenge for monetary policy.

    Wealth: Wealth inequality has increased dramatically in the past 35 years, and financialization includes the ways in which our laws and regulations have been overhauled to protect and expand the interests of those earning income from their wealth at the expense of everyone else. Together, these factors dramatically redistribute power and wealth upward. They also put the less wealthy at a significant disadvantage.

    More important than simply creating and expanding wealth claims, policy has prioritized wealth claims over competing claims on the economy, from labor to debtors to the public. This isn’t just about increasing the power of wealth; it’s about rewriting the rules of the economy to decrease the power of everyone else.

    Society: Finally, following the business professor Gerald Davis, we focus on how financialization has brought about a “portfolio society,” one in which “entire categories of social life have been securitized, turned into a kind of capital” or an investment to be managed. We now view our education and labor as “human capital,” and we imagine every person as a little corporation set to manage his or her own investments. In this view, public functions and responsibilities are mere services that should be run for profit or privatized, or both.

    This way of thinking results in a radical reworking of society. Social insurance once provided across society is now deemphasized in favor of individual market solutions; for example, students take on an ever-increasing amount of debt to educate themselves. Public functions are increasingly privatized and paid for through fees, creating potential rent-seeking enterprises and further redistributing income and wealth upward. This inequality spiral saps our democracy and our ability to collectively address the nation’s greatest problems.

    We have a lot of future work coming from this set of definitions, including a policy agenda and FAQ on short-termism in the near future. I hope you check this out!

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  • At Vox, Dodd-Frank at 5

    Jul 27, 2015Mike Konczal

    In honor of Dodd-Frank's fifth birthday party last week, I wrote a 4,000 word summary of the major accomplishments of the financial reform act. It includes what is working as well as what is stalled, what needs to be amplified and what isn't yet tackled. There's a focus on the CFPB, derivatives, capital, and ending Too Big To Fail. It's aimed at both readers with little background as well as people with some familiarity, so I hope you check it out and share.

    Follow or contact the Rortybomb blog:
     
      

     

    In honor of Dodd-Frank's fifth birthday party last week, I wrote a 4,000 word summary of the major accomplishments of the financial reform act. It includes what is working as well as what is stalled, what needs to be amplified and what isn't yet tackled. There's a focus on the CFPB, derivatives, capital, and ending Too Big To Fail. It's aimed at both readers with little background as well as people with some familiarity, so I hope you check it out and share.

    Follow or contact the Rortybomb blog:
     
      

     

    Share This

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