A four (to five) year vacation: Why the market for higher education is too perfect in the U.S.

I have always envied Europe's little to no cost higher education systems. While I envied it, however, it always amazed me that such a system was sustainable. With recent tuition hikes in the UK and the ensuing protests, it shows that nothing good lasts forever.

So which system is better? One where education is funded by taxpayers or one where students pay their own way? Because of my current circumstances I’d be inclined to want taxpayers to pay off my debt, but this is unsustainable and most importantly inefficient.

I have little knowledge of comparative higher education systems, but can’t help myself from attempting to answer this question.

Let’s start with full disclosure. Under the American system, I have easily been able to obtain loans to pay for my extremely high education costs. I was lucky enough that my parents were able to pay for my first two years as an undergraduate, while I took out personal loans to pay for the last two years and my year of graduate school. This has totaled to somewhere around $100,000, half provided privately and half by the government.

$100,000! This is an amount of debt that I can hardly comprehend and honestly seems surreal. But, it is not all that uncommon and many of my friends have incurred similar levels of debt. We are trying to pay off a mortgage before we have a house.

A typical European will incur nowhere near this amount of debt and in countries like Sweden higher education is practically free of costs. 

To examine this question I'll call on, quite possibly my favorite book, The Undercover Economist by Tim Harford whose lessons in economics can easily be applied to higher education. The first is that a free market reveals the truth.

Privatization of higher education in the U.S. has revealed student preferences perfectly. So perfectly that universities have moved away from their original mission of education provision to provision of other services. The increase in recreational facilities, football stadiums and cafeterias that rival four star restaurants clearly shows that students prefer these goods/services over education.

How do we know this? Because universities compete amongst each other to enroll the best students and to attract the best they must respond to student demands. And what we have been demanding is more of a Club Med experience rather than modest facilities filled with the best professors money can buy.

This brings us to our first problem: excessive-signaling or advertising by colleges and universities. Karsten Mause (2009) reviews the academic literature and remarks on this concept determining that effective tools to measure the effect excessive-signaling has on social welfare have yet to be developed. 

I fell victim to signaling. The picturesque campus of my university sold me. I was still unsure what I was going to major in, but couldn't resist the thought of spending four years on such a beautiful campus and ignored looking into universities that held the highest reputation for what I was interested in studying. I am not saying that everyone is as gullible as me and likely to succumb to signaling as I am, but it without a doubt plays a factor. I also value my education and experience at my university very highly, whether or not I value it at $100,000 is yet to be seen.

Onto other problems. Harford points out three market failures that afflict healthcare that also hold true for higher education: scarcity power, externalities, and adverse selection caused by asymmetric information.

Scarcity power is not that troubling. Potential students have so many choices when it comes to selecting a college or university that it is overwhelming. The rise of online institutions has made competition even fiercer, providing yet another option.

To make competition perfect, the accreditation system could be removed. This would affect the marginal price as institutions could offer lower quality, cheaper education outside accredited colleges and universities, increasing supply. It would be then up to employers to recognize and investigate the value of a student's education if they attended one of these marginal institutions.

Next let’s look at how externalities impact higher education. When a person obtains a degree they create a positive externality for society as a whole by increasing human capital. Externalities and public goods (see older post) are not properly priced in an open market, so government intervention is needed. Negative externalities, such as the traffic that a new football stadium brings to a town, should be taxed, while positive externalities should receive a subsidy, evident when a person studies immunology and helps develop HIV/AIDS treatments. 

How much of a subsidy should be given to a person that invests in their human capital? This is the most difficult question to answer. European states have chosen to subsidize this cost much like the U.S. does for primary and secondary education. The U.S. subsidizes higher education differently. Both public and private higher education institutions exist and receive a fair amount of federal and state funding, but this funding is then redistributed on a need basis. The most common subsidy comes in the form of low fixed rate loans, the type of aid I received. 

The question of how much to subsidize investment in human capital is closely linked with the third market failure, adverse selection.

When applying to colleges and universities there are many different people and organizations that have to act as actuaries and attempt to determine risk, including you. First, you have to evaluate the riskiness of taking out a loan, choosing the right school, etc. and try to determine if this going to pay off through increased job opportunities. The school admissions office also has to look into the material you submit with your application: high school transcripts, SAT scores, essays, etc. and evaluate whether you are going to be an academic flop or star and increase the school’s prestige. Lastly, there are financial organizations that decide whether you eligible for federal aid based on need. If not, and you decide to apply for private loans, banks must try to predict the future and determine whether or not you will be able pay off the money they are lending you.

Adverse selection occurs because we lack an important technology, crystal balls. The private sector will underinvest in human capital because it cannot be sure, especially since most potential students are unsure of what they want to major in, that the person will be able to repay their debt.

Complete private financing of higher education will lead to discrimination against some disciplines. Mine, political science, will likely go the way of the dinosaurs under such a system; banks simply won’t finance disciplines that don’t lead to the most profitable careers. Students who choose engineering, medicine, and other “hard” sciences will receive the most financing.

Exploring some possible solutions...

1. Excessive-signaling

This is difficult to solve since there is no effective way to measure the impact signaling has on social welfare. A cap could be set on expenses that aren’t directly related to increasing teaching and research capacity. The government could also compel institutions to spend an equal on signaling and those that  add value to education. In both cases, a large increase in spending that adds value to education would occur as institutions competed with one another. It would be more difficult for the institutions to compete by buying commercials or recruiting a star basketball player because of the caps.  The only place left to compete would be on teaching.

Its also hard to determine what expense are signaling and what are adding value to education. Does a state of the art dorm facility, that makes living conditions more comfortable, increase the productivity of students?

2. Externalities

It’s difficult, but not impossible (see average earnings for persons with degrees) to evaluate how much a degree should cost. Harford points out we shouldn’t subsidize something that the market can regulate. People will continue to seek college degrees because of the increased income they will receive. People who otherwise wouldn’t seek an education require a subsidy to push them into the market, since this will increase social welfare by raising human capital. This is how the system currently works, on a need basis. While the poor are largely left out, this is a poverty problem, not a problem with the system.  

3. Adverse selection

Under a completely private financing scheme, some disciplines will lose, and the less privileged will find it difficult, if not impossible, to find financing. Banks, with no knowledge of your future, will be less inclined to invest in human capital, which will lead to under investment, a fact of the U.S. system (Jacobs et al., 2006). Jacobs et al. (2006) suggest a graduate tax. This would act exactly like an income tax, and be used to fund higher education. A radical change I cannot see coming to fruition in the U.S. or Europe.  With more and more people attending higher education institutions, it would also be unsustainable.

Which system better deals with these issues? U.S. institutions consistently dominate world rankings. Whether this is because of the way the system is structured or our overall wealth will be revealed as the developing world catches up and it becomes easier to study abroad. But, the more market based approach in the U.S. leads to a highly competitive, and as we’ve seen probably too competitive, market that will push colleges and universities to offer the best services, education or other, at the lowest cost.  The European system, on the other hand, looks as if it is going to shift closer to the American way, as a shrinking population cannot afford the huge subsidies that colleges and universities receive.

While it has flaws, the U.S. is the clear victor.

For now the focus should be on determining the effect that signaling has on social welfare. I have a feeling (intuition, no empirical evidence) that the massive inflation of higher education costs has a lot to do with excessive signaling. If this can be measured, it can be fixed, and the other, more difficult problems can be dealt with accordingly.  

References

Jacobs, Bas and Sweder van Wijnbergen. 2006.”Capital-Market Failure, Adverse Selection and Equity Financing of Higher Education.” Public Finance Analysis 63 (1): 1-32.

Mause, Karsten. 2009. “Too Much Competition in Higher Education? Some Conceptual Remarks on the Excessive-Signaling Hypothesis.” American Journal of Economics & Sociology 68(5): 1107-1133.

Who you gonna call? Ashton..Barroso…Van Rompuy…Merkel?

You would be hard pressed to find anyone in Europe who has anything to do with the EU that hasn’t heard this quote:

          "Who do I call if I want to call Europe?"—Henry Kissinger

My education in Europe afforded me the opportunity to meet with many EU officials, interest representation organizations, and academics. I am not exaggerating when I say that almost every person brought up this question posed by Kissinger.

A leaked diplomatic cable available on WikiLeaks and reported on by the EUObserver here, highlights why Europeans have an obsession with this question. In a cable reporting on a meeting between the U.S. and former external relations Commissioner Chris Patten from the UK, Patten states that the EU will never be a real power because it is not willing to unilaterally implement policy that the rest of the world considers unwise, like the U.S.

The Lisbon treaty was Europe’s attempt to solve the Kissinger question. What it accomplished, however, was increased confusion. The treaty created a new Council president, Herman Van Rompuy was chosen for this post, and a High Representative for Foreign Affairs and Security Policy, Catherine Ashton holds this post. The treaty did not do away with the rotating Council presidency in which a member state holds this post for six months.

The treaty effectively created more phone numbers to dial when trying to call Europe. The Commission President was a clear supranational leader pre-Lisbon. Now who should the U.S. call? Ashton, Van Rompuy, Barrosso, Belgium (who holds the rotating presidency), or just negotiate bilaterally through member states?

Without a clear foreign policy leader, as is the case with the president in the U.S., the EU will never be a “real” power as Patten describes because member states will negotiate their own foreign policies. When you want to negotiate with the United States, it is clear who to contact. It is unnecessary to contact all branches of the government or individual states. When you want to negotiate with Europe, why go through the hassle of figuring out who to call, when you can just dial the individual member states whose leaders are clear.

Many have been quick to criticize the appointment of Van Rompuy as a “straw man” who can be controlled by the member states. In a recent rant by Member of Parliament Nigel Farage, he stated Van Rompuy has the “charisma of a damp rag” and “the appearance of a low-grade bank clear.” While this is an overstatement, he clearly isn’t a charismatic figure who is willing to further a European foreign policy agenda, Farage, a Euroskeptic should appreciate this.

It comes down to the fact that to pass foreign policy legislation, voting in the Council requires unanimity. This is something that has not changed with the Lisbon treaty. Lisbon moved many Justice and Home affairs issues to the “community method”( which only requires a qualified majority in the Council) and extended the Parliament the power of codecision in all areas but foreign policy. Extended codecision has made the legislative process similar to a bicameral legislature. While this is a large generalization the Council now operates like the Senate and Parliament as the House of Representatives.

Lisbon also created the European External Action Service (EEAS), a diplomatic corps to serve European goals. Ashton will be in charge of this new service. How the EEAS will look is still not clear. They are set to move into their new headquarters in Brussels shortly.

Will we see European delegations replace those of the member states? I don’t imagine this will happen anytime soon. But, if I were a German or UK citizen in these tough economic times, I wouldn’t mind seeing my embassy in Ulaanbaatar shut down in lieu of an EEAS office that would handle the affairs of all Europeans. Currently an EU citizen can use the services of another member state (an Estonian can use a German consulate) in countries where they have no diplomatic presence. This offsets huge costs for small member states like Malta and Estonia, who just can’t afford to have the world wide diplomatic presence that the UK and Germany have.

There is no doubt that there would be benefits if the EU could establish an effective foreign policy. This is most evident in the WTO where it negotiates as a single entity making it an extremely powerful player because of the bloc’s combined trade. The EEAS can also help to offset the large cost of maintaining a global diplomatic presence for both large and small member states. Will foreign policy ever fall under the community method? This is hard to say, but before this happens, fiscal union is needed to save the bloc first.

With threat of euro collapse, remember what European integration has achieved

Every news source over the last few weeks has published articles on the Irish bailout and the eminent demise of the euro. For the first time, I am also becoming skeptical that the single currency will weather the next few years.

It was the Greeks in May, the Irish now, and Portugal and Spain in the near future that have/will require an EU-IMF bailout. This year has been an “I told you so” moment for many economists, a lot of whom are American.

For those not familiar with the issue, the crux of the problem lies in the PIIGS (Portugal, Ireland, Italy, Greece, Spain) inability to devalue their currency (see Paul Krugman’s article) Devaluation is a practice that the U.S., UK and what China has effectively been doing for over a decade, engage in to make their exports more competitive. If New Jersey had its own currency, say the Lire (to serve stereotypes) it could devalue the Lire relative to other state currencies instead of enacting the tough budget cuts that it is currently imposing. The PIIGS must implement even tougher austerity measures to cut their debt and save the euro.

Austerity is a problem form both an economic and political standpoint. Cutting spending when it is needed the most (to spur the growth needed to climb out of the crisis) can lead to a downward spiral of no growth or contraction that will eventually result in countries defaulting on their debt. This is something many economists are predicting will happen in Europe. Politically, this will cause many politicians to question the value of the Euro as the public protests budget slashing, as seen in Greece.

Fiscal union could save the euro. Supranational control over member states’ budgets would allow the EU to function like the U.S. Greece and Portugal would become as much of a threat to the euro as New Jersey is to the dollar. This will not happen. Germany is terrified of its wealth being transferred to these fiscally “irresponsible” states and the fire that drove integration up to this point has fizzled out with Euroskeptics becoming increasingly powerful domestically and in the European Parliament.

The end of the euro will come with a series of protests: Protests against austerity measures in the PIIGS and German protests against taxpayer money saving the PIIGS from default.  

What implications will this have for the EU? I can only hope the integration project will not unravel and in this time of crisis it is important to remember all the EU has accomplished.

All the benefits of the single market aside, let’s not forget the original purpose of the European Coal and Steel Community (ECSC), the predecessor of the EU. The ECSC, formally established in 1951 by the Treaty of Paris, created a common market for coal and steel, the two main resources needed to conduct war. France, Germany, Italy, Belgium, Luxembourg and the Netherlands were all party to the treaty. A supranational institution, the High Authority, was created to oversee the market. With the means to make war under the control of the ECSC’s High Authority, war between the six states became impossible.

My generation takes this for granted. We have the luxury of being born after wars tore apart Europe, and as all living veterans slowly pass on, so does the first hand memory of the horror that was World War II.

However, out of this horror sprung something truly remarkable in the ECSC. Like WWII this is a historical precedent that we must not forget. The ECSC took two countries that had a primordial hatred, a continent that was ripping itself apart through brutal wars of the likes the world had never seen, and brought them so close that in less than 50 years war in Western Europe was and is unimaginable.

I find this feat of peace to be a more important lesson than the devastation of world war.

I look to the EU as a microcosm for what world governance could eventually look like; I do not think this is some sort of utopian dream. The close relationship that is now shared between Germany and France can only be compared to a union in 50 years between India and Pakistan, or Iraq and Iran. Although there were a unique set of circumstances that allowed for the formation of the ECSC, that are not present in these hypothetical examples, the history of war between European states is often overlooked, and the ECSC is short changed in the history books.

The EU has reached the limits of integration and adopting a single currency before fiscal union has been a mistake. Like WWII and the ECSC, the single currency now serves as a lesson as the world inevitably becomes more integrated and competencies that were once at the state level creep upward into institutions like the WTO and the UN. I believe that future generations (not near future) will look back on the WTO and conclude that it was world economic integration that eradicated interstate war, just like the ECSC did for Europe. European integration is a political experiment and just because it was too bold and may fail in establishing a single currency in no way means it is a failure.

What is the future of the EU if the euro collapses? I don’t have the answer and the future of the Union is more uncertain than it ever was. But let’s stop for a minute, put the bickering about the future aside, and remember that it could be worse. The French and Germans could still be killing each other.