Center for Business and Public Policy
at the University of Illinois, Urbana-Champaign

The big news here at the University of Illinos this week is the announcement of a hiring freeze along with mandatory, unpaid furloughs for university administrators, faculty and staff.  These actions were made necessary due to the continued inability of our Governor and Legislature to engage in good fiscal management.  The state has provided only 7% (that’s right – single digit, seven percent) of the promised funds to the university thus far, and given a nearly $2 billion projected state deficit, the short-term does not look bright. 

I could write at length about the fiscal problems of the State of Illinois, or how the University ought to respond, but I will save those posts for later (or for others).  Today, I simply want to tee up a particular issue of whether the University ought to use some of its endowment funds to cover the shortfalls.   

To my knowledge, the University of Illinois system has so far not made any decision to dig deeper into its endowment funds in order to help weather what most believe to be a temporary budget problem (to be clear, temporary could be a few years – the point is that it is not permanent.)  Yet there are some compelling reasons to think we should. 

Yes, I can hear the criticism already of those who might argue that the University should not “raid” its endowment, or that doing so would be “short-sighted.”  But is it?  The answer really depends on why universities have endowments.  On this point, there is a masterful paper that was published in the Journal of Legal Studies nearly two decades ago by Henry Hansmann of Yale Law School entitled, aptly enough, “Why Do Universities Have Endowments?”  In the paper, he rigorously analyzes a wide range of possible justifications (intergenerational equity, rising costs of education, lumpy gifts, tax incentives, and so forth) and finds that many of them are not consistent with how institutions actually behave. 

One of the many possible reasons, of course, is to maintain liquidity by having “a reserve against financial reversals.”  Universities may be less able to borrow than private firms, are unable to issue equity, and have “only limited flexibility in adjusting their scale of operations on a short-term basis” due to the tenure system.  This is one perfectly sensible reason to build an endowment – to serve as a buffer stock that can be drawn upon on rainy days. 

Of course, Universities do not appear to be using endowments for this purpose (I’ll have some new research to share on this point in a few weeks).  As Hansmann points out, “the spending rules … which call for spending a given fraction of the real value of the endowment annually, are directly inconsistent with a policy of using the endowment as a financial buffer.  Such a rule commits an institution to using its operating budget as a buffer to absorb shocks to the market value of its endowment, rather than vice versa.”  In essence, only if a University is willing to spend a LARGER fraction of its endowment during tight budgetary times would the endowment serve a useful purpose as a reserve.  Perhaps that is exactly what the University of Illinois should consider doing – dipping into its “quasi-endowment” funds (those that are not subject to binding restrictions on the timing of their use) in order to help cover current expenses.

To those who don’t like the idea of “spending the principal,” consider this: the primary purpose of the university is the production and dissemination of knowledge.  The University of Illinois has tremendous comparative advantage in this area, and by freezing hiring we are partially divesting from this activity.  In contrast, we do not have a comparative advantage at investing in stock and bond markets.  Does it really make sense to partially divest from an area in which we have a tremendous comparative advantage – and which is core to our mission - just to avoid spending down part of our financial endowment?  Might not the marginal returns to our investment in human capital generate greater social returns over the long-run that our marginal investment in the markets?

Put another way, this is really a question of what type  of investment we want to do.  One form is to invest our resources in hiring outstanding faculty today and continue to support the cutting edge research and knowledge-creation that is vital to our economic progress.  The other form is to invest money in financial markets with the hope of having more money to hire faculty in the future.  Given that many universities are in “hiring freeze” mode, the opportunities for hiring exceptional researchers are probably better now (when there is less competition for good talent) than they will be when the economy improves and everyone starts hiring at once.  

At minimum, we ought to be having the conversation …