Tuesday, November 11, 2008

Et in Arcadia Ego

The Dude: "Look, nothing is fucked, here, man."
The Big Lebowski: "Nothing is fucked?! The goddamn plane has crashed into the mountain!!"

— The Big Lebowski

Dealbreaker.com did a nice job yesterday quoting the I-Ching of all earthly wisdom, The Big Lebowski, in its blog post title referring to Drew Faust's November 10th letter to faculty, students, and staff of Harvard University.

In a remarkable and surprisingly realistic appraisal of the Stanford of the East's financial prospects now that the cream of Western Civilization is migrating from Park Avenue and Nob Hill into dingy caves in the West Texas Hill Country lighted only by Sterno, President Faust1 has warned her various constituencies that All Is Not Well:

... we must recognize that Harvard is not invulnerable to the seismic financial shocks in the larger world. Our own economic landscape has been significantly altered. We will need to plan and act in ways that reflect that reality, to assure that we continue to advance our priorities for teaching, research, and service.

Our principal sources of revenue are all likely to be affected by these new economic forces. Consider, first, the endowment. As a result of strong returns and the generosity of our alumni and friends, endowment income has come to fund more than a third of the University’s annual operating budget. Our investments have often outperformed familiar market indexes, thanks to skillful management and broad diversification across asset classes. But given the breadth and the depth of the present downturn, even well-diversified portfolios are experiencing major losses. Moody’s, a leading financial research and ratings service, recently projected a 30 percent decline in the value of college and university endowments in the current fiscal year. While we can hope that markets will improve, we need to be prepared to absorb unprecedented endowment losses and plan for a period of greater financial constraint.

Okay, so Ms Faust obviously didn't receive the memo that Moody's reputation for trustworthiness and probity currently ranks somewhere below that of Adolf Hitler or Caligula, but the rest of her remarks are sound. Losing 30% of an endowment the size of Harvard's—37 billion clams, or bones, or whatever you call them—is going to leave a nasty mark whatever the lighting. If Harvard chooses to maintain the absolute amount of operating support from the endowment at current levels, that will mean cutting into principal even more, and if it maintains the current percentage support, absolute dollars flowing into the university's operating fund will plummet.

Plus, leaving aside how much money Harvard chooses to bleed out of its investment kitty, the tyranny of compound returns—so charming, pleasant, and satisfying on the way up—means that it will take quite some time for the Crimson's rainy day fund to recover its current losses. Should Moody's estimate be correct, Harvard's investment managers will need to book more that 19.5% compound annual returns for the next two years running just to return to the high water mark of 2007. (Forget about growing bigger.) While this is certainly possible, those strike me as rather heroic return assumptions in today's post-bubble market environment, especially for an ocean liner like the Harvard Endowment fund.

President Faust then notes that Harvard's other sugar daddies are unlikely to remain as generous as they have been in the past, either, much less chip in enough to cover the expected shortfall from the endowment:

The economic downturn also puts pressure on other revenues that fuel our annual budgets. Donors and foundations will be harder pressed to support our activities. Federal grants and contracts for sponsored research will be subject to the intensified stress on the federal budget.

Right and right. It can be awkward and uncomfortable to rely on the kindness of strangers, especially when most of those strangers are either tapped out, over-leveraged and desperate themselves, or more focused on paying the mortgage and the grocery bills than buying another Rembrandt etching for the university art museum. Harvard will be lucky indeed if charitable donations do not drop by 50% or more this year, and government grants become a relic of the past. You can bet that Ms Faust and her minions are spinning rapidly into action to forestall the evaporation of millions of dollars in pledges made in happier times and to beat the bushes for those increasingly rare individuals who still have the wherewithal to underwrite the third biochemistry lab on campus. The John Paulson Real Estate Sciences Building, anyone?

But then, predictably, Ms Faust flies off the rails:

Tuition remains an important source of revenue, but in times like these we want to keep increases moderate, mindful that many students and families are facing economic strain.

Keep tuition increases moderate? Oh, President Faust, you were doing so well up until then. Since when have hallucinogenic mushrooms been on the menu at the Faculty Club?

* * *

To be fair to Ms Faust, I suspect that she is not alone among university heads in believing that raising prices in the face of a looming multi-year recession and the ongoing destruction of billions of dollars of net worth among the families which comprise her target consumers is even possible. When viewed in historic context, such apparent mass psychosis might even seem reasonable. After all, the price of a college education in this country has been rising at a compound annual rate over the past quarter of a century that is approximately double that of inflation. Given that this period has encompassed a couple of ruinous wars, the odd stock market boom and bust, general ups and downs in the economy, and several political administrations of varying fiscal rectitude, why shouldn't college administrators believe their target market is as hopelessly price insensitive as your average crack whore?

Sad to say, they have been right so far.

* * *

It is important to note that the very nature of education is such that it is afflicted with Baumol's cost disease. Education is one of those socioeconomic activities which is subject to very little improvement in labor productivity over time: it takes the same number of professor and grad student man-hours to educate little Billy or Sally today that it took to educate Adolphus and Hortense in 1842. Perhaps the content or comprehensiveness of the education delivered today is superior (perhaps), but the core delivery of service is subject to virtually the same constraints in effect when students wore caps and gowns to class.

Because education is so labor intensive, and because its laborers are still delivering the productivity of medieval scholars, the relative cost of education has grown at a pace well in excess of other activities subject to traditional labor productivity growth. This is exactly the case for other activities subject to the same dynamics, such as classical orchestras, for which Professor Baumol and his collaborator William Bowen famously noted "that the same number of musicians are needed to play a Beethoven string quartet today as were needed in the 1800s." As a result, it would cost a lot more Model Ts today to buy a season ticket to the Metropolitan Opera or four years of Ivy League education than it did in 1909.

You can see, then, that educational institutions are faced with constantly escalating labor costs which are effectively out of their control. Harvard does not set the wage for an Assistant Professor of Physics nowadays, Wall Street does (or did until recently). You price the services of a run of the mill Professor of Comparative Literature based on what he or she could earn as an auto assembly worker (okay, perhaps that is another bad example), not on the actual units of education he or she delivers. Harvard and its peers in the private education industry are price takers when it comes to labor inputs, not price setters. That is done elsewhere in our economy.

Unfortunately, a cursory examination of the physical plant or operating budget of a typical private college or preparatory school will quickly disabuse the curious enquirer of the quaint notion that its administrators are otherwise modest, frugal creatures who are only compelled to raise prices against their will by the tyrannical labor markets. In my admittedly limited and anecdotal experience, I have yet to encounter a Manhattan school Headmaster or an Ivy League Dean who would hesitate even one minute before sending the entire English Department on a ten-day "fact-finding" jaunt to China or who would equip the new Freshman Chemistry Lab with standard-issue microscopes when electron microscopes are available at ten times the price.

Last year, on the occasion of a reunion visit to the leafy groves of my own alma mater, I was dismayed to discover that practically all of the verdant green expanses of my salad days (perfect for snoozing over a physics textbook on a sunny day) were no more. There was almost no plot of grassy space left on campus that had not been filled with the hulking form of yet another architectural monument to the pride and vanity of some self-fellating panjandrum. On a previously nondescript and inoffensive corner, some brand-name architect had erected at undoubtedly outrageous expense a swooping steel and glass science library not ten minutes walk from a central library big enough to house in triplicate every book, magazine, and pornographic pamphlet published since 1362 plus have room left over for a small suburban mall. I did not see it then, but I fully expect to encounter gilded toilet paper in the Faculty Club mens room on my next visit.

In short, private education in America spends money like a drunken sailor with Warren Buffett's credit card.

* * *

Why they should want to do so is completely clear. How they have been able to get away with it for so long is more opaque.

My view, which you are welcome to classify under Education, Gratuitous Unverified Crackpot Theories Of, is that private educational institutions have been able to charge whatever the hell they want to for so long because Education has become the new Religion of the socially ambitious. There is almost no other way to classify the fervor, zealotry, and passion with which the parents and children of upwardly mobile classes pursue, discuss, and glorify the imprimatur of an Ivy League or equivalent degree, and the supposedly necessary interim steps thereto. Ask the typical upper middle class parents on the East or West Side of Manhattan whether they would prefer Junior to save his immortal soul or graduate from Princeton or Yale with a 4.0 grade point average, and they will look at you as if you had three heads. There simply is no question in their minds that eternal salvation takes a back seat to the right sheepskin on the wall.

This belief also explains why some New York parents are willing to pay so much money—the equivalent of $30,000 or more per year—to send their little darlings to the "right" private preparatory schools plus donate generously to the school's headmaster slush fund annual giving campaign to boot. They are convinced that a degree from Dalton, or Chapin, or Collegiate is a one-way ticket to the promised land on the banks of the Charles River. Once there, of course, there is no question that Mom and Pop will pay whatever Harvard asks to keep their offspring in crimson clover. After all, the Catholic Church got rich in the Middle Ages in part by selling indulgences. Why should Harvard, Princeton, or the University of Chicago be any different?

The skeptics among you will no doubt remain unconvinced, but I find it somehow revealing (and disturbing) that President Faust makes a point in her letter of mentioning that families with incomes between $60,000 and $180,000 per year "and typical assets" can expect to pay around 10 percent of their income as tuition to the Great Red Mother. Tithing to Harvard: some cultural forms never change, do they?

* * *

Whether this new Religion of Education will become an ossified, out-of-touch edifice ripe for challenge and Reformation by the iconoclasts of Google, Wikipedia, and Web 2.0, or whether it will pass unreformed straight through to the increasingly marginalized, irrelevant, and underfunded status of actual religions in the leading centers of Western Civilization is unclear to me. As federal grant-grubbing denizens of academe are wont to say: further research is required.

What is clear to me is that while the spirit may still be willing, the flesh (or the wallet) is beginning to get weak. Spending over half a million after-tax dollars per kid just to say that Little Bobby lost his virginity at one of the best universities in the nation is becoming harder and harder to justify for more and more parents. (Especially since one of the major reasons to send him there in the first place was to guarantee him a position in the immensely lucrative and prestigious fields of investment banking, securities law, or private equity. Oops.)

There is even shocking anecdotal evidence leaking out that formerly flush lawyers, investment bankers, and luxury goods retailers are beginning to pull their progeny out of the hallowed "feeder" schools of Upper Manhattan because they cannot afford the freight. Laugh if you will, but this is the upwardly mobile's equivalent of "jingle mail." Having written more than my fair share of eye-watering checks to such schools, I can only hope that the formerly arrogant, self-satisfied Headmasters and Headmistresses of New York are beginning to wet their beds on a regular basis.

This problem is not limited to the Ivy League, or Manhattan private schools, either. The entire over-leveraged, over-invested edifice of higher education in America is beginning to teeter and sway, and cracks are spreading across the foundation. Gone are the days, in my opinion, when university and preparatory school administrators could add sums collected from private and public donors to income harvested from the endowment, subtract that total from the amount of money they would like to spend in a perfect world, and divide the difference by the incoming student body to set the tuition.

No, it appears that the iron laws of economics have finally arrived on the peaceful doorstep of the Academy.

It's about time, too.

1 Forget Pascal's Wager. If anyone needs definitive proof that there is a Supreme Being, that It has a wicked sense of humor, and that It is currently laughing Its Divine Ass off, one need look no further that the name of the current President of Harvard University. Irony much?

© 2008 The Epicurean Dealmaker. All rights reserved.