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Real World Economics: Academics of St. Paul’s college savings plan

The assertion of something being “good in theory but bad in practice” is overused. It’s often that the “good” theory is simply bad — or too general to execute for any specific situation.

Yet there also are policies that appear good in intention and practice for several reasons, empirical as well as theoretical, and could have positive effects when implemented, but remain undesirable overall. I fear that is true for St Paul’s new program of putting $50 in a college savings account beginning this year for each baby born in the city and moving in under age six.

Pushed by newly-elected Mayor Melvin Carter in 2018, similar programs already exist in some 50 other cities. Although a good idea from many aspects, there are demons lurking in the myriad of details.

Start with economic theory. At the Econ 101 level, it is straightforward: People’s “demand,” — their willingness to buy something — is influenced by the funds they have available. A frustrated farmer fixing a busted machine may say “Man, I’d give anything to have a new combine.” But “anything” is worth nothing if she can’t afford the price of the new machine. If she does have cash, she may well hasten to the local implement dealer.

Thus, theory says that if families have a child ready for post-secondary education, the more money they have set aside for that purpose, or even the greater their general savings, the more likely the child will, in fact, take this next step. Real-world research bears this out.

Therefore, advocates of this program argue, get the ball rolling with $50 contributions into an account established for each baby and, 18 years later, more of these babies will go on with their education after 12th grade. I hope so. While we as a society probably place too much stress on getting a traditional four-year degree, getting any post-secondary education, including that from community and technical colleges, is generally associated with higher incomes and better life outcomes.

Note the “is associated with,” however. These are weasel words economists use when they justifiably are wary of establishing a direct correlation.

But it goes beyond family finances. Valid real-world research demonstrates that children from families with some college savings enroll at higher rates than those who do not. This may be the simple availability of more money. But it also could mean that families that save for college place a higher value on it generally. They are more aware of its importance, place more stress on it in family conversations, manifest it more early and often in situations like parent-teacher conferences, PSAT test taking, and so forth. In addition to money, family culture, values and expectations are huge.

The city can establish college funds for everyone, but if the attitudes passed on to children by parents and other relatives don’t jibe, the increase in post-secondary enrollment rates 18 years later won’t increase as much as predicted.

Beyond economic theory though, there is the practical mathematics of savings. Programs such as this one are promoted with examples of great potential monetary growth from modest initial deposits that just do not fit with the global financial environment we are in.

These examples often use investment yields common 25 years ago: If you can earn 10 percent per year on an investment it doubles roughly every seven years. An initial $50 at birth would be $100 at age seven, $200 at age 14 and $300 at age 21. If the recipient entered post-secondary at exactly 19 years from the money being deposited, she would have $305.80 to help. If the rate is 8 percent, there would be $215.79.

Now consider the cost of college. These amounts would not buy books at the bookstore for one semester. The assumption is, however, that once accounts actually exist for children, parents or other relatives would be more willing to add additional funds, perhaps on a regular annual basis. If parents added their own $50 on every anniversary of the city opening the account, there would be an additional $2,280 beyond the first $50 at 10 percent and $1,872 at 8 percent. In both cases, the parents would have put in $900 and accrued earnings would be $1,389 and $972 respectively. Bullwinkle Moose would call that “antihistamine money — it ain’t nuthin’ to sneeze at.”

Moreover, if a grandmother or uncle also added $50 per year sums would grow proportionately.

Some refer to such growth as “the miracle of compound interest.”

The sad complication is that, while some state and corporate pension funds still plan on before-inflation returns of at least 7 percent, these may not be in the cards.

Interest rates, especially when adjusted for inflation, are at historically low levels around the world. This was emerging back in 2005, when Ben Bernanke was appointed the top economic adviser to President George W. Bush. Bernanke spoke of a “global savings glut” that was suppressing interest rates, distorting exchange rates and thus trade balances. But he hadn’t seen nuthin’ yet then either!

Under his leadership, after the global financial debacle and “Great Recession” began to unfold in 2007, the Federal Reserve drove short-term interest rates to unprecedented lows and held them there for a decade. This may have been necessary to stave off the sort of utter collapse of the U.S. and world economies unfolding after late 1929. It has meant, however, that safe investments, other than the volatile stock market, have seen the lowest returns in decades even before any adjustment for inflation.

Treasury Bills, risk-free and liquid, yielded 4.98 percent from 1989-1999, 2.83 percent from 1999 to 2009, and 0.64 percent per year from then through 2019.

Twenty-year high-quality corporate bonds yielded 8.19, 6.73 and 4.79 percent over those same respective decades. A family addition of $50 annually for 18 years would put $1,907, $1,657 and $1,397 on top of St Paul’s $50. The actual amount of earnings again would be $900 in each case.

All of this, however, neglects inflation, which while well below 1970s levels, still exists. Over the three decades it averaged 2.9, 2.5 and 1.7 percent respectively.

One might conclude that if current rates continue, there is little incentive for anyone to save, whether in a city-sponsored universal college savings plan or anything else, including 401(k)s. That, indeed, is the question facing the Federal Reserve at policy meetings every six weeks. Keep rates low to placate President Donald Trump and stave off recession and you continue to flagellate savers into a new decade. But most of us savers would also have much to lose if the economy fell into depression.

There is the issue of whether St Paul’s funds should be in some sort of “tax-advantaged” fund like the federally blessed 529 educational savings accounts or, as at present, in local banks at essentially money-market rates that currently are less than prevailing inflation. But leave that aside for now as part of the larger issue of subsidies delivered through special tax treatments.

Then there is the question of administrative costs relative to very small principal balances and interest earned. It costs nearly as much to account for and report on a city-sponsored college fund of $300 as on a 401(k) fund of $300,000. These costs can be very small relative to earnings for the large amount but can overpower those of tiny amounts. If not subsidized by the city or some private benefactor, even very austere accounting and reporting would eat up small funds.

There are many analogous situations. I recently had an adventure in Regions Hospital ER. After my various insurance plans and the hospital sorted out the thousands of dollars in costs for the care I received, we ended up getting billed for $2.20 and $6.65 in pain and sleeping pills. Clearly, the administrative costs of printing two pages and mailing it, writing out a check, addressing an envelope, putting a stamp on it, or for opening the envelope and entering a claim, transmitting $8.85 to the hospital, will all be near or above the amount billed itself. Admin costs on small educational accounts face the same problem.

But this is a very grinchy analysis. Sometimes good intentions outweigh poorly thought-out theory. Don’t conclude the plan should be tossed. If $50 in seed money incentivizes a family to save for, and value, college, all the better. But don’t set expectations too high.

St. Paul economist and writer Edward Lotterman can be reached at stpaul@edlotterman.com.