Can you get something for nothing?

There is no question that higher education in 2020 is facing serious problems.  The proximate cause is the current Pandemic recession, which will lead to significant cutbacks in state support for public colleges & universities, and also serious decreases in demand for higher education by students.  The latter is in part due to losses in family income due to layoffs and pay cuts, and in part due to students questioning whether it’s worth going away to college campuses in light of social distancing and large-scale shifts to online courses. Either way, schools are facing dramatic budget shortfalls.  Higher education is also confronting longer term problems with inflation in tuition and fees significantly greater than the rate of inflation of prices in general, and with a decline in the number of traditional college-age students.  The closure of colleges, especially those outside of urban areas, threatens the economic survival of surrounding communities.   

The above open letter, which as an economist I was asked to address, appears to be a response to this problem.  The proposal in the letter is quite complex and this post, without going too deeply, represents my initial thoughts.  All quotes are from the open letter.

“Mid-Sized Regional Public University (MSRPU) announces its plan to issue 150 million (or more) of its own Unis, which it guarantees to accept for all university payments — from tuition and fees to rent — across all university-owned real estate and every university cafeteria.”

The basic idea is for schools to issue debt, called “Unis,” to cover budget shortfalls.  The Unis would be redeemable in the future as payments students would alternatively make to attend the institution.  In other words, the schools would borrow for operating expenses today, promising to repay in the form of free education at a future date for Uni-holders.

Suppose a school estimates it needs $100 million (or $100 million in excess of expected revenues) to operate for the year.  It offers $100 million worth of Unis for sale.  Who would purchase these? 

First, would be people planning to attend the school in the future, and who wanted to prepay, like a lay-away plan to purchase from a department store.  In this respect, the plan would be similar to a state’s prepaid college plan (e.g. Virginia 529 Prepaid plan).  Note that the Uni plan would be more effective if Unis were redeemable at multiple universities (like Virginia’s prepaid college plan).  This would require collective action, since the more schools that participated, the more useful the Unis would be.  This would then require all participating schools to charge the same price for Unis, since otherwise purchasers could arbitrage—purchasing from the school with the cheaper price to redeem at a school charging more.  This could be problematic the greater the diversity in tuition & fees across participating schools.  But could this put a pressure on higher cost schools to reduce their costs to those of other participating schools? How does the Virginia 529 Prepaid plan deal with this now?  Something to explore.

The open letter implies that people with wealth (or financial institutions) would purchase Unis as an investment, i.e. when they have no plans to use them to pay for school. Would they?  That would depend on their rate of return and risk, compared to alternative investments.  The value of a Uni would be the price of a semester in college when they mature, i.e. when a person would be able to redeem them. Assuming that tuition & fees continue to rise over time, Unis would increase in value at the rate of college cost inflation, which has exceeded general inflation.  If school cost inflation declined to match the general inflation rate, this would diminish the value of Unis as an investment asset.  How does this rate of return compare with that of alternative investment assets?  How would the risk compare?  One could look at data from the past for an estimate.

Open Question #1: What if the Unis don’t all sell?  For example, what if our sample school above only sells $80 million worth of Unis, when it needs to sell $100 million worth? Presumably, like bonds, schools would have to discount the price to sell the additional Unis to cover the complete need. This would increase the return on investment to purchasers making them more attractive as an investment. It would imply offering one semester of tuition & fees at a time in the future for less $ than it is estimated to cost the scholl, which would make the financing problem worse down the road.  If the discrepancy is small, the school could squeeze the extra students in, making classes larger and putting more students into the same number of dormitory rooms.

If Unis are perceived as desirable investments, they might sell at a premium since at the nominal price (i.e. par), the demand would exceed the amount supplied.  This would provide additional revenue to the schools, and would be the flip side of the shortfall problem in the last paragraph. What would make these desirable investments?  More on that below.

What could go wrong with this plan?  Let’s return to our lay-away purchase metaphor.  The way a lay-away purchase is supposed to work is an individual wishes to purchase a big ticket item (e.g. a sofa, a refrigerator, a bedroom suite) that they don’t currently have the money to afford.  So they enter into a lay-away plan with the department store, which is essentially a plan to finance the purchase by making payments in advance until one has invested enough cash to pay for the item.  The department store promises to hold the item (say it’s a sofa) until the lay-away is completed.  The purchaser can see the sofa if they visit the store.  Note that this is an excellent investment for the seller.  They hold the sofa, and they also hold the accumulating payments.  There is no apparent risk to this financing plan for the store.  Suppose the store is not doing very well and needs money to make its payroll, so they sell the sofa to another customer for cash.  The sofa goes home with the customer.  It’s no longer available for the lay-away purchaser.  The end of the lay-away plan is coming up and the store needs to come up with another sofa.  How do they come up with the cash to purchase it from the manufacturer?  The answer is they need to find another lay-away customer to put their money upfront. 

I think this is essentially how the Uni plan works.  It is a mechanism by which the school can move expected future revenue to the present.  But then it needs to provide the education in the future.  The education has a cost to the school, which they need to cover by selling more Unis.

What would a failure of the Uni plan look like?  It would involve a failure by a school to be able to cover its future liabilities.  That is, the inability in some future year to sell enough Unis to cover current expenses.  Let’s explore this in more detail.  While I’m not an expert on state prepaid plans, I imagine the way they work is to invest the funds in assets whose return covers the cost of education in the future.  The problem with the Uni plan is that, since the proceeds are used to cover current costs, there would be no funds to invest for the future.  Every year’s (excess) expenses would have to be funded by a new issue of Unis.  This is not without precedent: It is how the U.S. Social Security system works. The FICA deductions from your paycheck are not invested in an account with your name on it.  Rather, current deductions are spent on checks to current retirees.  Social Security has an advantage the Uni plan lacks—it can force people to participate, but schools can’t force people to buy (or invest in) Unis.  When the Social Security Trust Fund starts to run out of money, which happens from time to time but with plenty of advance warning since people typically work 40+ years before they are eligible, the Social Security Administration can either cut benefits or raise FICA contributions.  Working people have no recourse but to accept the changes.

Suppose the number of people attending college in the future declines, reducing the demand for Unis in the future.  This would be analogous to another problem the U.S. is facing with the large number of Baby-Boomers retiring to be supported by smaller demographic cohorts of workers.  Doesn’t this mean that schools will run out of money for operating expenses before hand, since they need to cover the cost of educating the current large class with the funds provided in advance by a smaller class.  This would be true even if college costs do not increase over time.  How would the difference be paid for?  Schools could increase the price of Unis above their future expected costs, but that would reduce the current demand for Unis further since it would imply asking people to pay more today than they would pay in the future.  Alternatively, schools could sell longer term unis—that is to fund one year’s students’ education in the present, they would have to trade more than one year’s students’ education in the future.  This seems problematic.  At some point, would a school decline to honor its Unis?  If so, their ability to sell more would immediately dry up.  Students could possibly then apply to other schools to redeem their Unis, causing the problem to spread.  If Uni-holders were unable to redeem them for education, they wouldn’t be able to sell them at face value either.  The market value of Unis would crash.

“Finally, to clinch the Uni’s universal acceptability, MSRPU petitions the Federal Reserve to backstop its credit with full purchasing support for Unis in accordance with its already existing statutory authority.”

This leads to the second major part of the Uni proposal. Participating Uni schools ask the Federal Reserve to guarantee Unis, making them risk-free investments. The authors argue for this stating:

“Just as the Federal Reserve Act’s Sections 13(3) and 14(2)b opened up its balance sheet to banks, insurance companies, and a host of other institutions, these same legal arrangements are designed to free a wide array of educational institutions from fiscal crises. “

This claim isn’t quite right.  The legal arrangements were not “designed” for this purpose, though they could perhaps be used that way.   This is slippery wording of their argument.

“Should the Fed resist, institutions of higher ed still can and should proceed to issue Unis anyway.”

If the Fed declined to back Unis, they would be much less desirable (and perceived as more risky) for investment purposes.  This would make it harder to float an issue (that is, sell all the Unis needed in a given year.

Would the Fed be willing to back Unis?  A Fed backstop would have to involve a procedure by which Uni-holders could redeem Unis at face value. The Fed has the ability to do this by “printing” new money.  But should it?  There are two reasons to question why, but first we need to introduce one more element.

Open Question #2: Is this Uni plan intended to be temporary or permanent?  The Fed’s interest in supporting state & local governments and small business financing is to provide temporary support during the Pandemic recession. I suspect the Uni plan is intended to provide permanent financing, which the Fed is less likely to support.

Let’s sum up. The Uni plan has three elements.  The first is to use debt to borrow for current spending.  This makes sense to get through the Pandemic Recession.  If the state desires to support higher education, but the loss of tax revenue makes that difficult to do right now, it would make sense to borrow as a bridge back to non-recessionary times.  It makes less sense as a permanent solution for schools that can’t cover their budgets. The second element is to make the debt attractive to investors, which is a stretch.  If the Fed were persuaded to guarantee the debt, that would make this part of the plan more feasible.  But as long as higher education faces long term headwinds, Unis aren’t a viable solution unless the Fed begins to monetize the debt, i.e. print money to redeem Unis from investors who can’t get their purchase price back.  This would almost certainly occur.

Such a backstop would essentially nationalize (the opposite of privatize) higher education, making it a liability of the Fed.  Why should the Fed do this and not something similar for housing or healthcare or hunger or other worthy expenditures?  This would require a fairly radical change in culture and practice, not just by the Fed, but in the nation politically speaking.

Under what circumstances should the Fed support ordinary businesses who can’t make a profit, that is, where demand for their products is not sufficient to cover their costs.  Would you be willing to do this indefinitely with your tax dollars?  Why those businesses and not others? 

Clearly there would be a cost to Americans in doing this.

The only way this would make sense is if redeeming the Unis didn’t cause inflation.  According to a new school in economics, the Modern Monetary Theorists, the Fed can create an infinite amount of money without inflation occurring.  You can make a good case for increasing the amount of money in circulation during recessions when there are unemployed resources going wasting.  The increased money can stimulate demand and put people back to work.  But over the long term, once an economy achieves full employment, it can’t produce any more goods and services.  Additional spending on the same number of products would just drive up prices.

This isn’t just my idea—it’s supported by centuries of economic theory and research.  Do you believe everyone can get something for nothing?

The Modern Monetary Theorists think that if the Fed provided the money, the cost would disappear.  Mainstream economists believe that the cost would be diffused in the form of inflation—higher prices for the goods and services consumers buy, but it would still be there.  Who is right?  We may find out sooner than you think.  Whether or not the Uni plan goes forward, during the Covid Pandemic recession by running historically-large federal budget deficits, we are engaged in an experiment to test Modern Monetary theory. Is it possible to create real wealth by merely printing money?  I have a hard time believing it.  We’ll see.

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