The Staggering Scale Of Student Debt In USA - A $1.3 Trillion Crisis
Best way out? The interest rate for federal loans should rise or fall depending on the default risk of the student’s degree programme. More the risk, more the rate, and vice versa.
This would incentivise students to pursue degrees in line with labour market demand, because those programmes would carry the lowest borrowing costs.
The dramatic increase in student loan debt is limiting upward mobility for young Americans and eroding popular faith in the American Dream. That’s turned college loans into a volatile issue, one progressives have seized upon by calling for more regulation and government involvement in higher education. But the real culprit is the government itself. Bad federal policy has resulted in skyrocketing tuition, deteriorating educational standards, hope-destroying student debt loads, and write-down losses for taxpayers.
The solution is market discipline, and conservatives need to start providing it.
By now the numbers are familiar. Total student loan debt has tripled since 2004 and currently amounts to $1.31 trillion, making it the largest consumer debt category in the country behind mortgage debt. Current default rates stand at 11 per cent, eerily mirroring the peak of mortgage delinquency rates during the subprime crisis. And student loans carry the highest delinquency rate of any category of consumer borrowing. This should worry everyone.
The growth of student loan debt has depressed home ownership and consumption, creating an ever-growing headwind to economic growth. Missed payments ruin the credit ratings of individual borrowers and limit their capacity to assume risk—for example by starting a new business or moving to a new state.
The harms aren’t just economic. By dampening entrepreneurialism and creating a new generation of immobile, risk-averse young people, student debt actually has the capacity to change our national character. Borrowers have lost confidence in themselves and have turned instead to government for protective bailouts.
Hopelessness is festering into radicalism. Young people are furious with these restraints on their mobility, and currently that fury is being channelled by Bernie Sanders with his plan to socialise the cost of public university for all students. Instead of ceding this all-important ground to progressive activists, conservatives should be leaping over themselves to propose solutions to this catastrophe. After all, it was created by the federal government.
That federal government holds over a trillion dollars of student loan debt, and taxpayers are expected to take a net loss of $170 billion on these loans over the next decade. And the losses will only get worse. The easy availability of federal aid incentivises universities to keep raising tuition. Taxpayers cover those costs upfront in the form of federal aid, while the universities have no skin in the game if their students default after graduating. Tuition thus goes up and up, and the dominant policy response is always to make federal aid even more available, inflating the bubble further.
These incentives ensure that student borrowers receive the worst education possible. Since universities know that taxpayers will be on the hook if their students default, they have little reason to ensure that those students receive a good education. Instead of offering a strong value proposition, they lure student customers with up-front glitz in the form of rock climbing walls, lazy rivers, and other expensive amenities. Meanwhile, educational standards are allowed to collapse. Mediocre (or worse) institutions churn out poorly prepared graduates whose skills are completely mismatched for the labour market they’re entering. They find themselves with useless degrees, working retail with tens of thousands of dollars in debt hanging over their heads.
The pot of free federal money effectively turns universities into rent-seekers. Schools seek to protect their slices of the pie instead of creating value. Spending on administration has exploded while teaching loads fall and students learn less. A more dangerous system could scarcely be imagined.
To address this, we need to examine a simple policy choice that’s kicked the problem into overdrive: government caps on interest rates for student borrowers, which artificially hold down the cost of securing a federal student loan. In private loan markets, the cost of borrowing is linked to the riskiness of the venture. But if you’re an undergraduate student borrowing from the federal government, your interest rate is pegged to the 10-year Treasury bill, currently 4.45 per cent. That doesn’t change whether the borrower is a chemical engineering major at MIT or a communications major at the University of Phoenix—even though those two students represent vastly different levels of risk—because the federal government refuses to distinguish between them in its lending practices. That might sound generous, but it’s just predatory lending. The government is making it artificially cheap for vulnerable citizens to take on massive amounts of debt in pursuit of a risky asset. That taxpayers are on the hook if it all goes wrong is just icing on the cake.
The policy solution: link the cost of borrowing to the riskiness of the underlying asset. The interest rate for federal loans should rise or fall depending on the default risk of the student’s degree programme (that is, the default rate of graduates who attended the same institution and majored in the same subject as the borrower). By porting private market principles into the federal loan system, we can ensure that student borrowers are incentivised to pursue degrees that maximise their chances of paying off their debt.
When the government keeps interest rates artificially low for degrees that in fact carry a high risk of default, it induces more people to sign up for risky programmes. Interest rates are supposed to act as a signal that such programmes are not good investments. Absent that signal, students with unsophisticated understandings of personal finance and the labour market (and hopped up on Baby Boomer platitudes about following your passion at all costs) see no reason not to go deep into the red to attend a barely accredited university and major in film studies. If students want to do this, they should feel free. If they want taxpayer help to do so, they should at least think twice.
Let’s consider the barely accredited university with the programme in film studies. In a world where borrowing costs are linked to default rates, this institution would respond in one of three ways. Firstly, it could choose to compete on price by lowering tuition in an effort to attract students by counteracting the effect of higher interest rates. This benefits the student by reducing her overall debt burden. Secondly, it could choose to improve the quality of its product, making sure that programmes are preparing students to succeed in the labor market. This would benefit the student by lowering her default risk. Thirdly, it could simply close the programmes with the highest default rates. In some instances, entire institutions with abysmal default rates may be shuttered. This benefits the student by eliminating debt traps that the market wants abolished.
It is striking that all three outcomes are improvements over the status quo. The easy availability of federal money disincentivises universities from lowering tuition or improving the quality of their education, while incentivising bad universities that sell a terrible product to stay open. Under this scheme, student borrowers and taxpayers suffer together. Every incentive is misaligned. An injection of market principles is essential medicine.
To illustrate how this might work in practice, let’s consider law schools. The largest law school in the country is Thomas M Cooley Law School. Its tuition is $50,790 per year, roughly equivalent to top law schools like Yale ($59,865), Berkeley ($52,654), and UT Austin ($50,480). And of course, the government will help you borrow at the same rate to attend Cooley as those other schools. But Cooley is not these other schools. Cooley is the worst subprime risk imaginable. Seventy-five per cent of its graduates were not employed in the legal field one year after graduation. Fifty per cent of its graduates weren’t employed at all. No rational lender would touch it, but the government’s drive for equity keeps it open. For the sake of its prospective students, Cooley must be made to get cheaper, get better, or close.
It’s fair to ask whether the government should be in the business of lending to students at all. But the private student loan market has had its share of dysfunction, and it’s easy to imagine unscrupulous lenders farming fees out of unsophisticated teenage borrowers. Additionally, the fact that a college degree is still a reliable income booster means that government has an incentive to offer guaranteed loans instead of allowing private banks to impose credit requirements to access education, as many young borrowers have no credit history at all. But perhaps the real answer is that voters would never accept a fully private system, and so the best that can be done is to ensure that the government causes the minimum amount of harm.
There is a downside to this proposal. Degree programmes in the humanities and fine arts will likely skew wealthy, because low-income borrowers will not want to pay the relatively higher borrowing costs that such programmes carry. This will strike many as unfair. But the current system is unfair, so the relevant inquiry is which creates the greater injustice. The present problem is that government policies are inducing low-income borrowers to load up on debt to get degrees that have no relationship with labour market demand. This results in an oversupply of fine arts and humanities majors. The students who are in the worst positions are those that major in these subjects at low-ranked, for-profit, and two-year schools. The question then becomes whether the government should subsidise fine arts and humanities programmes at such schools with artificially cheap debt. On the one hand, we feel good about letting students pursue their passions regardless of their means or talent. On the other hand, subsidising these pursuits may set these students up for failure.
The answer is that we should be willing to accept the cost of fewer low-income borrowers entering fine arts and humanities degree programmes. It is ultimately fairer for government policy to accurately reflect risks that the borrower herself will eventually have to bear. In the subprime context, the government was guided by an ideological faith in the moral goodness of homeownership to use Fannie Mae to artificially reduce borrowing costs. While extending access to homeownership felt good, borrowers wound up being more gravely hurt when market reality inevitably intruded on the enterprise. Likewise, we should not lead vulnerable student borrowers down the road to default out of an ideological desire to maximise access to all kinds of education regardless of risk. That would be the greater injustice.
Either way, when we remember that linking borrowing costs to default rates also incentivises schools to lower tuition and improve programme quality, many prospective fine arts and humanities majors may find their opportunities improved, not constrained.
For this reform to work, it must be accompanied by strong disclosure requirements so that interest rates can have the maximal effect on borrower behavior. We don’t have good information on how student loan interest rates affect enrollment, but behavioral economics tells us that consumer decisions are impacted most by salient incentives at the moment of decision-making. For interest rates to provide an effective incentive, schools must disclose the borrowing costs of its programmes upfront to prospective students. Luckily, conservatives are already out in front of the disclosure issue.
While our universities would improve under this plan, the real payoff would be in the gains to student borrowers. They would be incentivised to pursue degrees in line with labour market demand, because those programmes would carry the lowest borrowing costs. This of course aids the broader economy: more schools will open programmes that target areas of unmet market demand, for example, in STEM, high-skill vocational fields, and health care, creating graduates more likely to succeed while also correcting sectoral imbalances in the economy as a whole.
Student borrowers will trade the millstones around their necks for upward mobility, taxpayers will receive a return on their investment, and economic growth will quicken. Trading the government’s false pursuit of equity for market discipline benefits everyone and disentangles the distorting web that the student loan industry has become.
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