Higher Education – Enough Already

My exposure to the higher education market was positive – thanks to incredibly generous financial aid offices, I received my BA at Northwestern owing just $5k, and graduated debt free with my MBA from Duke.  However, as I’ve spent more time in the labor market, and as the cost of higher education has defied gravity, I’ve become increasingly doubtful about the economic value of a college degree.  My goal with today’s post is to shed light on what I see as a flawed assumption:  That a college degree is invariably a wise investment.

There are strong similarities between the housing bubble and what we see today in the higher education market.  For starters, both saw a rapid rise in prices.  Between 1997 and 2006, home prices more than tripled.  In higher education, since 1988, tuition and fees have increased more than 300%.  Both run-ups were fueled by cheap loans made possible by an artificially low interest rate environment, lax or non-existent lending standards, Principal-Agent problems (originators of the loans bear little risk from non-payment and hence have low incentives to make good loans and high incentives for making more loans), and the mistaken belief that value (prices of homes, return on education) will always increase.  And lastly, in both markets the government decreed that more was always better, and created and adjusted policies to support this aim.

In the housing market, the last few years were fueled in part by the sub-prime market – having run out of even marginally qualified loan applicants, originators went to the bottom of the barrel – and when these loans defaulted, the market collapsed (The economy collapsed because of massively leveraged bankers gamblers).  Does the recent growth of for-profit colleges, largely unqualified to educate but very adept at siphoning taxpayer-financed loans, signify that the irrational exuberance in the education market approaches a reckoning?

There’s a vicious cycle that appears to be driving the runaway costs.  Starting with a policy of increasing college attendance, the government makes subsidized loans available, increasing the amount that students can pay for school.  Recognizing this, schools are able to increase tuition and fees, which over time prices many students out of the education market.  The government and private lenders respond by increasing financial aid available and the escalation continues.  To break this cycle, just one assumption needs to be proven false.  The one I’m interested in is the assumption by students and parents that taking on ever higher levels of debt to achieve a degree is a profit-maximizing decision.

So let’s see why everyone is convinced we are better off with more college graduates.  First let’s look at trends in costs over the past 30 years, compared to the ability to pay.

It’s clear from this chart that costs have dramatically outpaced the median family income and overall rate of inflation.  But costs, of course, are only one part of the equation.  How do salaries compare across the different levels of degrees?

Comparing after-tax earnings, we see that there’s a significant rise in earnings as a student goes progressively higher into the education field.  This seems to make sense – a degree signifies competence, which is then rewarded in the labor market with a higher income.

Now the last thing to understand is the actual return to the degree.  During the time a student is working towards a degree, not only are many racking up debt that may take years to repay, but they’re sacrificing money they could have made if they had immediately entered the workforce instead of attending school.  The chart below incorporates both higher earnings as well as direct and opportunity costs associated with education.  It is created from public sources of data as well as from my own calculations and assumptions.

Along the bottom is the highest degree attained, ranging from a high school diploma to a professional degree (MBA, JD, etc.)  The columns signify how much more money the person earns compared to holders of the degree immediately to the left.  So for instance, a high school diploma earns you $300k more than not getting a diploma, while attending some college earns you $100k more than someone just with a high school diploma.  Finally, the number on top of each column is the age at which that degree holder has accumulated more earnings than the degree to the left (except for professional degrees; these are compared to a bachelor’s degree).  For instance, after earning a bachelor’s degree, it won’t be until you’re 33 that your cumulative earnings exceed the cumulative earnings of someone earning a degree at a community college.  This is due to direct costs (i.e., debt) and opportunity costs (out of the workforce for several more years).

Currently, about 35% of adults have some sort of college degree.  President Obama has indicated that he’d like to see this number hit 60%.  The Gates Foundation has an even loftier target:  80%.  Based on the previous chart, it’s understandable that people think more is better.  According to this logic, we could increase worker pay across the entire economy if those with only high school diplomas all went back to school to get their undergrad degrees.  Assuming that these workers returned to the workforce and spent their higher incomes, GDP would more than double.  Magic!!  Of course, this fantastical result shows the faulty logic underlying the more-education-is-always-better argument.

I suggest that what we need is more jobs requiring a college education, not more graduates.  There’s no hidden reservoir of millions of high-paying, college-level jobs just waiting for qualified applicants to fill them (nor were there prior to the recession).  In countries like Korea, where 80% of high school graduates enter college, fewer than half can find full-time jobs, and fewer than one third believe their jobs require a college degree.  How can anyone believe this is really the model we want to follow?  The promise of a better life that leads many people to pursue higher education is betrayed when a significant share of degree holders work in jobs for which a degree was unnecessary.  Just because the job description says ‘degree required’ doesn’t make it so.  Public policy appears focused on creating more college graduates without a clear understanding of what those folks will do and where they will work.

One of the problems with taking the charts above at face value is that they confuse average with marginal.  Generally speaking, efficient investment continues until the marginal benefit equals the marginal cost.  In this case, think of marginal benefit as lifetime earnings and marginal cost the expense students/society incurs to realize that benefit.  Unfortunately, like in many markets, as more of something happens, the marginal benefit decreases.  So when we see the historical average returns of a college degree, we are wrong to assume that those returns will remain positive today and in the future.The reality is that as we add more and more ‘sub-prime’ students and provide them ‘sub-prime’ educations at a premium cost, we can expect to see less and less return.  Another way to think of this:  Suppose a company offers the first 10 shoppers $200, then charges the next 10 shoppers $100.  Stating that the average shopper receives $50 free, while technically true, disguises the fact that half the population would have been better off not shopping at all.

Our failure to distinguish differences on the margin is resulting in a massive distortion in the market for credentials.  At the same time, the cost associated with supplying the marginal student an education is higher than average (generally because they require more loans).  As we expand the proportion of students attending college, the marginal benefit diminishes rapidly while the marginal cost increases.  This is a poor recipe for positive return, and I’ve graphed this below.

But wait, there’s more!  Because as we add more degree holders to the job market, unless we’ve added the requisite number of jobs needing a degree, we’ve watered down the value of everyone’s degree.  This results in a downward shift of the marginal benefit curve.  Concurrently, because of ever spiraling costs, the associated debt burden, and resultant increase in delinquencies and defaults, the more students we add to the higher education market, the more ‘education’ costs for everyone.  This results in an upward shift of the marginal cost curve.  Taken together, this shifting massively expands the loss associated with the over-consumption of education.

Most folks would agree that the higher education market is, at best, inefficient.  Others would argue that it’s broken.  So whatever view you take, there’s room for improvement.  There are 4 main actors on the stage, and I’d like to focus on each of them:  Schools, Government, Business, and Students.

The schools clearly play a major role in creating and sustaining the problem.  However, for several reasons it seems unlikely that they will contribute directly to a solution.  For one thing, outside of government bureaucracy, there may be no more opposed-to-change culture than academics.  Second, and more important, asking schools to focus on efficiency and profit/loss ignores the basic business model they use.  That many schools turn a profit doesn’t mean that that is what they look to optimize.  Instead, their focus is on higher rankings, exclusivity, etc. – what they’d refer to as their brand, and a prestigious one at that.

I do think that schools have a point – the power of the brand is important.  I’ve done my share of job interviews and by and large what gets me in the door is the power of my personal brands:  Northwestern, Duke, Apple, McKinsey.  During the interviews, it’s rare that I actually discuss what I learned – it’s like the brands themselves define my worth, independent of what the brands added to my worth.  From this perspective, schools are being completely rationale when they focus on ways to increase their brand equity:  Always higher prices, greater selectivity, renowned professors who rarely teach, and world-class facilities

Like the housing market mess, well-intentioned government policies sometimes create and often exacerbate problems in the marketplace.  As we’ve already seen, the government does this in the market for higher education by advocating a college degree at all cost, by distorting demand via artificially low interest rates, and by increasing prices through loan guarantees and raising borrowing limits in lockstep with tuition increases.

Here’s what I think should change.  First, work with businesses to create a post-college accreditation test.  If all college graduates are evaluated objectively, business will possess a powerful gauge of how potential candidates compare.  This would also be an effective way to assess how well academic institutions are preparing their students, and likely lead to academic changes which better focused on results.  High-caliber graduates from less prestigious schools would be less likely to be penalized for having the wrong brand name on their resume, which would serve to also reduce the demand for the most selective (and expensive) colleges.

In response to the fraud being perpetrated by some for-profit colleges like the University of Phoenix (graduation rate of 4%!), where two of three borrowers is delinquent or has defaulted, the government should force those colleges to set aside a significant portion of the $28 billion in federal aid they receive every year, to be used to pay back the government for the inevitable wave of delinquencies and defaults.  These colleges are essentially playing in the sub-prime education market, willing to fleece anyone who can sign an ‘X’ on the application for federal financial aid.  The rare graduate will have $20k+ of debt and a degree that means next to nothing.

Lastly, accept that the education market is not a free market – a higher price will not lead to competition which ultimately reduces prices while increasing supply.  You add fuel to the fire by increasing loan amounts in an inelastic marketplace.  Indeed, recent research has found little evidence that Federal grants and loans do much to increase college enrollment whatsoever; they just raise prices.

The first thing business needs to do is stop the credential inflation.  Over the past 30 years, jobs which used to require a high school diploma now typically require a bachelor’s or even a master’s degree, despite the jobs themselves having undergone little change.

Understanding the skills required for a role and matching that to candidates’ backgrounds and abilities is preferable to assuming a college degree is highly correlated with job performance.  To the extent it is, that’s more likely due to the candidate’s inherent qualities than what they learned in school.  We see students who tip a toe in the labor market, find a lack of demand for their current level of education, and head right back to school to gain an additional degree (and presumably, a competitive edge).  Riding out the storm by adding another degree (and additional debt) makes sense if there’s a perceived value to the degree.  Business can help students make that decision by properly assessing and communicating the true value of education attainment.

Reducing the unnecessary focus on degrees will decrease the incentive for students to pursue degrees that will have little impact on their careers.  Either students will self-select into majors or degrees which correspond with jobs truly needing a degree, or they’ll simply demand less education.

I remain conflicted on the advice I’d provide students/parents:  Do you make an investment which appears rationale, but only because of market irrationalities?  The folks who flipped houses in the 2000 – 2006 timeframe would have a much different answer than folks who got into the housing market at its peak.

Princeton economist Alan Krueger has recently published a working paper (#563) that estimates the return of attending an elite college.  He reports a striking finding:  When student ability is controlled for in the regression, ‘the returns to college selectivity fall substantially and are generally indistinguishable from zero.”  Put another way, very talented students go to very selective colleges, and the future returns that those students experience are due to their talent, not the college.

If these findings can be reproduced with further research, it’s difficult to overstate their implications.  Much is made of the breadth of academics, the outstanding faculty, and the high-value contacts that students can find at elite institutions.  What if for many students, none of that matters?  As a profit-maximizing parent, if your student could have equivalent returns on your $200k investment at Princeton or your $40k investment at your state’s best public university, might that alter your investment decision?  If you’re a business, might you be willing to hire a local state school graduate over a Princeton graduate, if you knew that the state school graduate had been admitted to Princeton?

Based on the data and most recent research, I think students and parents should consider the following when making decisions on higher education.  First, don’t attend college if you’re not sure it’s right for you.  As we’ve seen, dropping out of college means that the student’s cumulative returns don’t exceed a high school graduate’s until they’re almost 50.  Wait a semester, or a year, however long it takes to decide that college is the right choice.  Second, under no circumstances should a freshly-minted high school graduate attend a for-profit university.  Would you trust an institution with a 4% graduation rate and booming growth in profits to provide an effective education for your student?  Third, as a parent, research the majors and degrees where demand is currently or projected to exceed supply, and funnel your students into those areas when appropriately matched with the students interests and abilities.  Understand that a mediocre engineer or computer scientist will have superior employment returns to a world-class history major.  And lastly, understand that while the higher education market is in some ways irrational, until that becomes understood, you need to play by the current rules.  If you can afford to send your student to a selective university, strongly consider doing just that.  At least for now, the power of that brand is more important than your student’s abilities.