The College Bubble

Written by Brandon Croarkin

Mark Cuban has recently come out with a very interesting video, which can be found at inc.com (see below), about the student loan bubble, which he says will burst. I found this video to be very interesting and it led me to explore the reality of Cuban’s statements.

I think a good place to start on this is by exploring what a bubble is, how it occurs and then we can delve into comparisons between this student loan bubble and the recent housing bubble.

Economic Bubbles

A bubble is characterized by rapid expansion in a sector followed by a contraction (the popping of the bubble). They are typically started by a paradigm shift in a sector that results in a “boom” where the price of an asset is run-up above a level justifiable by supply and demand.

This boom means an increase in demand, which from basic economics you can see should lead to an increase in quantity supplied. However, textbook models applied to economics cannot always perfectly predict what actually happens in the real world. For example, it can take years to develop new commodities. What this means is that supply lags behind demand (known as a slow supply response – see right hand illustration, above) resulting in higher prices to compensate for the higher demand for a non-changing quantity. Producers respond to this high price and start building, but they typically overproduce because they are seeing this inflated price and seek to profit from it.  With the new higher supply, prices have to fall low enough to clear the market. The bubble eventually bursts when the confidence is lost from seeing the falling prices. Investors sell, the market becomes illiquid, and then full-blown panic begins resulting in plummeting prices.

Collapse of the Housing Market

This was famously seen with the recent collapse of the housing market. Rising home prices exacerbated the long-standing notion that home prices do not fall and led to rampant real estate speculation, fueling excessive consumer spending. Meanwhile, easy money was rampant. Securitization and packaging of multiple mortgages into CDOs spread out risk across a large investor class making these investments seem safer.  This led to a cycle of speculation that became more and more risky with lenders no longer caring whether a borrower could repay, because the originators of mortgages had distributed the repayment risk to others (the broader investor class) while they (the originators) retained all the origination and securitization fees.

However, as we saw above, this upward spiral in prices cannot continue endlessly. People were not able to pay for these mortgages and defaulted in mass numbers, with foreclosures in the United States reaching 6 million by early 2010.  As a result, housing prices began falling and eventually the whole system collapsed.

So how similar is this to the college loan market?

The College Bubble…

Cuban:

“It’s inevitable at some point there will be a cap on student loan guarantees. And when that happens you’re going to see a repeat of what we saw in the housing market: when easy credit for buying or flipping a house disappeared we saw a collapse in the price housing, and we’re going to see that same collapse in the price of student tuition, and that’s going to lead to colleges going out of business.”

In order to be a bubble, people must maintain a high level of confidence in the value of college education and this value must be overpriced. So how true are these two qualifications?

There definitely appears to be a high level of confidence in the value of college education.  People see college as a gateway to coveted careers. There is also a high psycho-social component to college in that people feel pressured into it because they believe it is what is expected from them; yet this varies in degree across the country and in particular across socio-economic status.

However, whether or not college is overpriced remains up for debate. There have been a gratuitous number of studies on the value of education and the debt accrued from it. However, sadly many people who conduct these studies are subject to predetermined biases which lead to subsequent “cherry picking” of data. For instance, the Brookings Institute recently came out with a study stating:

“Despite the widely held belief that circumstances for borrowers with student loan debt are growing worse over time, our findings reveal no evidence in support of this narrative.”

Yet when one analyzes the data used from this study, one can find numerous flaws.

• The report does not include data after 2010, thus neglecting vital information for deciphering information in a rapidly changing environment
• They compiled data on households headed by people between 20 and 40. This is an egregiously faulty methodology for various reasons; it excludes all people living in households headed by their parents (a prime candidate for someone with student debt); and by spreading the data to those up to age 40 this study hardly even depicts debt or recent college graduates.

In reality, it seems that one can draw various conclusions from the same set of data thus making a concrete analysis of the situation hardly dependable. However, here are a few facts that have repeatedly been found to be true:

• College tuition (and consequently college debt) is rising.
• College graduates ages 25 to 32 who are working full time earn more annually than employed young adults holding only a high school diploma.
• Furthermore, evidence is showing that that the disparity between these two are increasing.
• Those born into a higher income household have a higher chance of graduating from a 4-year institution than those born into poverty

…Remains Unpopped

However, despite this, I still do not fully buy into the college bubble argument. Primarily, due to the fact that, despite debate, education still pays. The gap in income between education levels points towards a positive value for college education.  Financial aid and scholarships are available for those who need it, granted less than they should be, making broadcasted tuition prices overstated for the majority of students. I think the main problem stems from the overconfidence in the value of college, which I believe has led to poor financial college decisions.

Although I believe it is unfair (and steps should be taken to make college more affordable to lower income citizens), the truth remains that some people are unable to afford a 4-year private, college education thus making the investment into it much more risky. However, societal pressures to attend these institutions have resulted in students entering without the money needed to complete a degree.  In reality though, there are numerous other more cost-effective options. Two-year colleges and community colleges are always options. A popular money-saving option is to attend a lower-priced community college for the first two years and then to transfer to a more prestigious public or private university for the remainder of his or her studies. Students who expect to pursue careers that are not high paying would be better served by attending lower-priced public colleges.  Lastly, students should consider working part-time to help pay for college as a preferred option instead of student loans.

Conclusion

While I still believe that a bubble of sorts exists in higher education, I think the danger of it is exaggerated.  Higher education is still worth it in America and still safe, if handled correctly.  People of modest means shouldn’t accept the costly dangers of buying a Ferrari when there are numerous cheaper, effective cars available.  Remember that transportation is the objective, not a breathtaking set of wheels.

However, this does not mean that college education is free from criticism. Steps still need to be taken to lower tuition costs and make college more affordable for the lower income citizens in our country. The education of our students should be a top priority; this should start with a larger effort to make it more affordable to the masses.

Sources

• Commodity Prices: Why Do They Shoot Up And Then Collapse (Bill Conerly, Forbes, 26 June 2014)
• The Rising Cost of Not Going To College (Pew Research, 11 February 2014)
• Study: Nearly Half of America’s College Students Drop Out Before Receiving a Degree (Travis Waldron, ThinkProgress, 28 March 2012)
• That Big Study About How the Student Debt Nightmare Is In Your Head? It’s Garbage (Choire Sicha, The Awl, 24 June 2014)
• Our Bubble-Bursting Economy (Jim Tsutsui, 20 February 2013)
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