Sometimes you hear something that sounds so much like common sense that you end up missing how it overturns everything you were actually thinking, and points in a far more interesting and disturbing direction. That’s how I’m feeling about the coverage of a recent paper on student loans and college tuition coming out of the New York Federal Reserve, “Credit Supply and the Rise in College Tuition: Evidence from the Expansion in Federal Student Aid Programs,” by David Lucca, Taylor Nadauld, and Karen Shen.

They find that “institutions more exposed to changes in the subsidized federal loan program increased their tuition,” or for every dollar in increased student loan availability colleges increased the sticker price of their tuition 65 cents. Crucially, they find that the effect is stronger for subsidized student loans than for Pell Grants. When they go further and control for additional variables, Pell Grants lose their significance in the study, while student loans become more important.

There’s been a lot of debate over this research, with Libby Nelson at Vox providing a strong summary. I want to talk about the theory of the paper. People have been covering this as a normal debate about whether subsidizing college leads to higher tuition, but this is a far different story. It actually overturns a lot of what we believe about higher education funding, and means that the conservative solution to higher education costs, going back to Milton Friedman, will send tuition skyrocketing. And it ends up providing more evidence of the importance of free higher education.

Thus begins this piece by Mike Konczal, fascinating throughout. This is a true mystery, because why does tuition rise more student loans are available, and why doesn't it rise just as much if funding comes in the form of Pell Grants? Konczal explains why this is strange:

David Boaz at the Cato Institute has a snarky post in response to the study, saying that “[u]nderstanding basic economics” would have predicted it. This is false, because economics 101 would have predicted the opposite. Economists fight a lot about this [1], but the simple economics story is clear. According to actual economics 101, letting students borrow against future earnings should have no effect on prices.

This derives from something called the Modigliani-Miller Theorem (MM), the frustrating staple of corporate finance 101 courses. A quick way of understanding MM is that how much you value an asset or investment, be it a factory or higher education, should be independent of how you finance it. Whether you pay cash, a loan, your future equity, a complicated financial product, or some other means that doesn’t even exist yet, you ultimately value the asset by how profitable and productive it is. In this story, which requires abstract and complete markets, expanding credit supply won’t drive tuition higher.

Now what would change your valuation, according to this theorem, is getting subsidies, say in the form of Pell Grants. This would make you willing to buy more and pay a higher price. This is one of the reasons why so much of the economics research focuses on Pell Grants instead of student loans: the story about what is happening is clearer. But, again, extensions of the credit supply, not subsidies, are doing the work here.

Conservatives position an increase in the student credit supply as enabling them to borrow against future earnings. I even read somewhere last year about a company that wanted to allow actors or other celebrities to sell ownership of their future owners. You could become a shareholder of, say, Jennifer Lawrence by fronting her some cash now in exchange for her take from future Hunger Games and X-Men movies and whatever else she does.

In the case of education, this entire proposal doesn't work if the increase in credit supply is met with an equal increase in tuition. Why does tuition increase in lock step with credit supply? Konczal isn't sure, and it's the central mystery.

Note that it isn’t clear why students borrowing more against their future is driving increases in tuition they’ll pay. It could be “rational” under arcane definitions of that word. It could be that in a winner-take-all economy, in which those at the top do fantastically and those who don’t make it do not make it at all, leveraging up and swinging for the fences is a smart play. It could be that liquidity and credit are important determinants of the economy as a whole rather than a neutral veil over real resources. It could be as simple as the fact that 18-year-olds aren’t highly calculating supercomputers solving thousands of Euler equations of their future earnings into an infinite future, but instead a bunch of kids jacked up on hormones doing the best they can with the world adults provide them.

This article on public options dives in deeper on the topic.

So far, so familiar. The interesting question is what happens when we generalize this logic to other areas, like higher education. Imagine a state that's considering a choice between spending, let's say, $1 million either subsidizing its public university system, enabling it to keep tuition down, or as grants to college students to help them pay tuition. On the face of it, you might think there's no first-order difference in the effect on access to higher ed -- students will spend $1 million less on tuition either way. The choice then comes down to the grants giving students more choice, fostering competition among schools, and being more easily targeted to lower-income households; versus whatever nebulous value one places on the idea of public institutions as such. Not surprisingly, the grant approach tends to win out, with an increasing share of public support for higher education going to students rather than institutions.

But what happens when you bring price effects in? Suppose that higher education is supplied inelastically, or in other words that there are rents that go to incumbent institutions. Then some fraction of the grant goes to raise tuition for existing college spots, rather than to increase the total number of spots. (Note that this must be true to at least some extent, since it's precisely the increased tuition that induces colleges to increase capacity.) In the extreme case -- which may be nearly reached at the elite end -- where enrollment is fixed, the entire net subsidy ends up as increased tuition; whatever benefit those getting the grants get, is at the expense of other students who didn't get them.

Conversely, when public funds are used to reduce tuition at a public university, they don't just lower costs for students at that particular university. They also lower costs at unsubsidized universities by forcing them to hold down tuition to compete. So while each dollar spent on grants to students reduces final tuition costs less than one for one, each dollar spent on subsidies to public institutions reduces tuition costs by more.

The same logic applies to public subsidies for any good or service where producers enjoy significant monopoly power: Direct provision of public goods has market forces on its side, while subsidies for private purchases work against the market. Call it progressive supply-side policy. Call it the general case for public options. The fundamental point is that, in the presence of inelastic supply curves, demand-side subsidies face a headwind of adverse price effects, while direct public provision gets a tail wind of favorable price effects. And these effects can be quite large.