The Paradox of Subsidies

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President Obama has responded to the spiraling cost of higher education with a proposal that might sound familiar: create a centralized federal bureaucracy to control everything. That's the upshot of his proposal to create a federal ratings system for universities and steer more federal money to schools that perform well on the ratings. So every school will be homogenized to fit the model preferred by federal bureaucrats.

And Obama's plan is likely to make the problem worse. As Richard Vedder explains, Obama's proposal to cap student loan payments to a percentage of the borrower's income "simply raises incentives for future students to borrow more money, if they know their obligation to pay it back is capped. That, in turn, allows colleges to keep raising costs."

If all of this sounds like a parallel to ObamaCare--a huge expansion of federal control, a menu of choices dictated from Washington, and no actual impact on controlling costs--that's not a coincidence. In citing the Obama proposals as an example of the government saying "no" to rising costs--when has that ever happened, exactly?--Ezra Klein explains that what health care and education have in common is that they are special kinds of goods and services that are just, well, different from everything else. So the laws of economics don't apply to them, and only government intervention can restrain costs.

"Health care and education pose the same basic threat to the economy: How do you keep costs down for a product that consumers must purchase?

"Saying 'no,' after all, is how consumers typically restrain costs. If Best Buy Co. wants to charge you too much for a television, you can walk out. You might want a television, but you don't actually need one. That gives you the upper hand. When push comes to shove, producers need to meet the demands of consumers.

"But you can't walk out on medical care for your spouse or education for your child. In the case of medical care, your spouse might die. In the case of college, you're just throwing away your kid's future (or so goes the conventional wisdom). Consequently, medical care and higher education are the two purchases that families will mortgage everything to make. They need to find a way to say 'yes.' In these markets, when push comes to shove, consumers meet the demands of producers.

"The result, in both cases, is similar: skyrocketing costs for a product of uncertain quality."

Where to start? Well, Megan McArdle points out the obvious: you can't say "no" to food, either.

"Food and water are far more vital than health care, let alone higher education, which the human race managed to do without for a few hundred thousands of years. You can go quite a while without blood pressure medication or even insulin-much longer than most people could go without fuel for heating or cooking. Clothing and some sort of shelter would also rank higher on the list of imminent necessities than health care and education. Yet none of these goods displays health care and education's pattern of above-inflation cost increases. It's true that demand for education and health care is what economists call inelastic-meaning that the demand doesn't decrease very much even when the price rises-but that doesn't explain why the prices of these two inelastic services, and no others, has risen faster than inflation for decades."

Back to Richard Vedder, who explains what really makes higher education (and, I would add, health care) different: massive government subsidies.

"Obama proposes to ignore or worsen the root cause of much of the explosion in student costs: the federal financial assistance programs that encourage schools to raise costs and that haven't achieved their goals of providing college access to low-income Americans.

"Two recent studies highlight the problem. First, the National Center for Education Statistics released data suggesting that federal college financing is growing rapidly. Now 84 percent of full-time undergraduate students get some aid. Average grant assistance for dependent full-time undergraduate students (unmarried, younger than 24) was $10,600 in 2011-12, up 34 percent in just four years-four times the inflation rate.

"Middle-class kids who were previously denied Pell grant aid are now increasingly getting it: In 2011, 17.5 percent of dependent students from families with $60,000 to $80,000 in annual income received Pells, compared with a mere 1.6 percent just four years earlier. A number of federal aid programs-for example, tuition tax credits and the PLUS loan program-now disproportionately serve students from relatively affluent families. According to College Board data, total federal student financial assistance programs totaled $56.8 billion in 2001-2002, compared with $173.8 billion a decade later, an astonishing compounded annual rate of increase of 11.7 percent.

"A new study by Dennis Epple, Richard Romano, Sinan Sarpca and Holger Sieg for the National Bureau of Economic Research suggests that the impact of these aid programs is clearly different from what federal policy makers intended. 'We show that private colleges game the federal financial aid system,' they conclude. Every dollar in new financial aid to students leads to about 40 cents less spent by the colleges on institutional financial aid-so students benefit far less than federal policy makers intended."

We can expand this observation to draw a wider principle, something that is, or ought to be, Free-Market Economics 101. Call it the Paradox of Subsidies. Why do you subsidize something? To make it cheaper. What is the actual effect? To make it more expensive.

The greater the subsidy, the more money flowing in to the sellers of a product or service, the less incentive they have to reduce costs--as we can see in all those universities taking in federal loan and grant money and using it to decrease the tuition breaks they would otherwise offer to students. To go back to Klein's Best Buy example, if you offer a national subsidy for flat-screen televisions, that reduces Best Buy's incentive to offers special sales and discounts. It increases their incentive to offer bigger and more lavish TVs, which people might not have purchased before, but which they can afford now that they are subsidized. As for the buyer, he becomes less demanding about prices when he's not paying all of the cost, either because of grants or because of easy financing.

Hence the treadmill effect created by the Paradox of Subsidies. The more the government subsidizes something, the more expensive it gets--which requires higher subsidies to get the same results, which increases the costs even more--which requires still higher subsidies, and so on. And then some myopic observer like Klein comes along to declare that the free market is broken and government needs to take over.

The traditional free-market economist's explanation would be to chalk this up to the Law of Unintended Consequences. But I'm an advocate of the Law of Intended Consequences, and from that perspective, I ask: What was the actual intention of the subsidy? The actual intention was not to make higher education cheaper. The intention was to hide its cost from the consumer. The intention was to tell the consumer he can buy as much of it as he wants without regard for cost.

This is what explains the paradox, because in shielding the consumer from considerations of cost, subsidies shut down the mechanisms that would actually, in fact, make something cheaper.

Let's go to the Best Buy example. What drives down the cost of flat-screen televisions is not the fact that you can go without a television. For better or worse, very few of us actually do so. In fact, we have more and bigger televisions than ever, at lower prices. No, what drives falling prices is the fact that you can buy a television from someone else, which means that you can reward the company that finds a way to make a cheaper television or to sell them with a lower markup. What drives down prices in the rest of the economy, outside of government-subsidized bubbles like higher education and health care, is innovation spurred forward by competition. All of that happens because producers and consumers are responding to price signals. But when customers are insulated from prices, they have less incentive to reward the innovator who disrupts the status quo.

If you're one of the producers of higher education--a tenured professor or overpaid administrator living inside the posh, subsidized bubble of the ivory tower--that just might be the consequence you intended.


Robert Tracinski is senior writer for The Federalist and editor of The Tracinski Letter.

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