Are Student Loans Causing College Tuitions to Skyrocket?

Do student loans help students or colleges? A new paper published by the New York Federal Reserve makes a clear, and depressing assertion: Federal student loans and grants are often simply gobbled up by schools through tuition inflation, leaving the students no better off.

More dollars chasing the fewer goods cause prices to rise. That’s both a standard economics principle and an often obvious, but punishing reality. During the housing bubble years, the more banks lent potential home buyers, the more prices rose, as consumers with bigger and bigger borrowing power bid up prices. Larger loans weren’t the only factor, but they were a big one.

The new paper, called “Credit Supply and the Rise in College Tuition,” posed an intriguing question: Is this same phenomenon happening in college? Has a dramatic widening of college aid programs during the past decade, chiefly through loans, done more harm than good by simply fueling college tuition inflation? It’s a depressing possibility, the idea that wider availability of student loans haven’t helped students, they merely helped colleges — something called the “passthrough effect.”

“From a finance perspective, the market for postsecondary education has shared several features with the housing market in the past few decades…. resembling the twin house price and mortgage balance booms,” the authors write.

Here are the basics, according to the paper: Yearly student loan originations grew from $53 billion to $120 billion between 2001 and 2012. Meanwhile, average sticker tuition rose 46% in constant 2012 dollars between 2001 and 2012, from $6,950 to $10,200.

That’s a pretty compelling parallel, though as is often the case in economics, it’s not quite so simple. There’s the correlation/causation problem. Did more loans cause higher prices, or did the higher prices come first, or is this just a coincidence? And then there’s the macro/micro problem. Tuition sticker price hasn’t grown uniformly across public, private and community colleges, muddying the analysis. Sticker price is also a rough measure to use, as so many students use a complex mixture of aid to pay for school that sticker price can be almost meaningless.

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Finally, the parallel between housing and college markets is inexact. Slots at colleges aren’t limited in supply the same way that houses are. So we’re not really talking about more dollars chasing “fewer” goods.

Still, that doesn’t mean the laws of economics are suspended, and the more money made available to college consumers, the easier it is for colleges to raise prices. And through a number-crunching formula designed to tease out these effects, the Fed comes up with this depressing conclusion: Pell Grants and subsidized loans create a passthrough effect of about 55-65 cents on the dollar. That means for every additional $100 the federal government gives or loans a student, colleges raise tuition $55-$65.

Tax dollars flowing right to colleges, funneled through (mostly) borrowing students.

“From a welfare perspective, these estimates suggest that, while one would expect a student aid expansion to benefit its recipients, the subsidized loan expansion could have been to their detriment, on net, because of the sizable and offsetting tuition effect,” the authors conclude.

The idea that aid helps colleges more than students is not new. Back in the 1980s, then-Education Secretary Bill Bennett warned about the problem, saying, “increases in financial aid in recent years have enabled colleges and universities blithely to raise their tuitions, confident that Federal loan subsidies would help cushion the increase.” His statement is now known as the Bennett Hypothesis, which this paper seems to confirm.

But there are a lot of caveats in the findings. Plenty of other factors put price pressure on colleges during the time span studied. Here’s just one: When the housing bubble burst, newly unemployed workers flocked to colleges, particularly community colleges. That created “fewer goods,” and likely contributed to higher prices.

The authors tried to deal with these issues, but of course any such study will be inexact – and it’s important to note the paper does not represent the views of Federal Reserve, just the paper’s authors. The bulk of the paper explains how the authors tried to isolate the effects of tuition increases. They did so essentially by identifying which schools gained the most from increases in aid eligibility during the time studied, and looking for corresponding tuition changes at those schools. For example, the maximum subsidized federal loan amount for freshmen rose in the 2007-08 academic year from $2,625 to $3,500, which benefitted students at some schools more than others.

That led to a bit of fine-tuning in the results. Passthrough of unsubsidized students loans was only 30%, the study found. And the biggest benefactors from the passthrough effect were pricey private colleges with average academic reputations.

“We find that the passthrough of subsidized loan aid to tuition is highest among relatively expensive, mostly private, four-year institutions with relatively high-income students but with average selectivity, as measured by their admittance rates,” the authors say.

The paper makes no recommendation on what to do about this effect. Less aid wouldn’t translate into lower prices, at least not right away (prices fall much more slowly than they rise), and that would be a terrible burden to impost on today’s students. The real sad news is that increases in student aid might not help either, as colleges seem to “correct” for the greater dollars available to them very efficiently.

When student loans come due, they have a major impact on the credit scores of millions of Americans — some seeing their scores rise from consistent on-time payments, and others experiencing a major credit score dive if they can’t pay or won’t pay. You can see whether your student loan debt is hurting or helping your credit scores for free on Credit.com.