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Creeping Ivy, Soaring Tuition

Low inflation pervades the economy--but not the bursar's office. After several years of relatively tame increases, college tuition is soaring again, according to the latest numbers from the Bureau of Labor Statistics. The tuition component of the consumer price index jumped 6.4% over the 12 months ending with February, 2002. That's up from 6.1% in the year ending December, 2001, and far bigger than the 4.5% increase in 2000 (chart).

What's behind the jump is a mix of factors including state budget cuts, shrinking endowments, and rising faculty salaries. The state cutbacks have the biggest impact on America's tuition bill, since about 80% of all undergraduates attend state universities and colleges. Many state budgets swung from surplus to deficit in 2001. The result was as much as a 10% decline in some states' higher-education budgets, according to Michael S. McPherson, president of Macalester College in St. Paul, Minn., who has written extensively about the economics of higher education.

Private schools were also affected by the downturn as their endowments shrank. A large part of the decline was due to the dismal stock market performance of 2000 and 2001, but charitable giving also slowed during the recession.

Surprisingly, as state funding and endowments shriveled, teacher's salaries continued to climb. In the 2001-02 academic year, faculty salaries at colleges and universities rose 3.8%, according to the latest survey by the American Association of University Professors. After inflation, that's a 2.2% increase.

The reason for this big increase is that faculty salaries for 2001-02 were generally decided in the spring of 2001, before states saw their surpluses melt away into deficits and before the falling stock market cut into endowments. That suggests faculty pay increases could moderate next year. "Salaries in higher education tend to lag the economic news," says McPherson.

Nevertheless, the trend toward higher tuition costs, especially at state universities, is likely to persist, says McPherson. As state governments provide increased funding for elementary and high school education, they have less money available for higher ed. And that could mean big tuition increases for years to come. High volumes of trading, narrow bid-ask spreads, and other measures of liquidity are generally seen as signs of a healthy stock market. But evidence has mounted in recent years that periods of high liquidity are usually followed by periods of poor returns, both for individual stocks and the whole market.

Harvard Business School professor Malcolm Baker and Harvard University economist Jeremy C. Stein think they have found the culprit: "dumb investors." In a new National Bureau of Economic Research paper, they say the extra liquidity is provided by irrational investors who drive prices unsustainably high. During buying frenzies, such as the Internet stock bubble of the late 1990s, it's as if "the inmates have taken over the asylum," the authors write. Liquidity rises when dumb investors are active because they ignore subtle market signals that other investors heed, and thus they are happy to buy when others are selling. Dumb investors can also be overly pessimistic, the authors say, and then they simply withdraw, reducing liquidity.

The "dumb investor" effect is not small. The authors calculate that when the turnover of shares is 12% higher than its long-term average, stock returns in the following year are 4% below their long-term average.

Baker and Stein say their "dumb investor" theory helps explain another puzzle of corporate finance: why a company's stock price tends to underperform after it issues shares. The standard explanation is that managers have inside information that enables them to time their issuance of shares for when prices are high. The authors agree that's a factor. But they say another explanation may be that managers are simply trying to minimize the impact of new shares on the market price. By doing so, they pick periods of high liquidity--which just happen to be followed by periods of underperformance. The economic slowdown in Europe doesn't seem to have quenched wage demands on the Continent. Hourly wages in the euro zone rose by 3.4% in 2001. And unions are demanding more: Some French public-sector workers and doctors recently staged warning strikes in support of pay rises of up to 10%, far higher than this year's forecast euro-zone inflation rate of 2%. IG Metall, the powerful engineering- and metalworkers' union that sets the pace for pay rises in Germany, is asking for a 6.5% increase this year. That compares with 2% offered by employers. "Employees' expectations are high," says IG Chairman Klaus Zwickel. "It is possible that we will face highly explosive negotiations."

Many economists fear that big demands by labor will raise the prospect of inflation and unsettle the ever-cautious European Central Bank. On Mar. 7, ECB President Wim Duisenberg warned that high wage hikes could force the ECB to raise interest rates. "Wage moderation is crucial to support the ECB in ensuring price stability," he said.

The real question now is whether euro-zone unemployment--now at 8.4% and rising--will force IG and other unions to accept a moderate increase of 3% or less. It may be tough for companies to pay more.

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