The Simple Economics of Student Loan Crises

Yesterday, my students heard my second lecture on supply and demand. You know, the one in which we examined how government policies like rent control and the minimum wage can affect market outcomes. Those are important examples, and I dutifully discussed both of them. But I must admit they also feel a smidgen stale – how many millions of students have seen a lecture on rent control and the minimum wage?

To spice things up, I threw in a third example of government intervention: the market for guaranteed student loans. As I mentioned a few weeks ago, the government has a major program in which it provides guarantees for private student loans. Under the program, lenders are protected against the risk of future defaults by the student borrowers. In return for providing these loans, the lenders receive interest payments that are limited by a formula that is specified in law. (These payments are determined completely separately from the amounts that are charged to students which, for simplicity, I will ignore in what follows.)

This program is currently the focus of a major political battle: the Obama administration has proposed eliminating the program and replacing it with direct loans from the government (which currently account for a much smaller portion of the market). But I didn’t get into that larger debate in class. Instead, the reason I focused on this program is that it has experienced two crises in recent years:

  • In 2006 and 2007, the crisis was kickbacks. In their enthusiasm to win more business, private lenders were offering “inducements” to schools and student loan officers in order to get preferred access to students who wanted loans.
  • In 2008, the crisis was a lack of lending. In large part because of the financial crisis, private lenders had no enthusiasm whatsoever for making loans. As a result, there was a real risk that students might not be able to get loans.

As I told my students, I think both of these crises had the same root cause: the fact that the government, rather than market forces, determined how much lenders were paid for making guaranteed student loans. In both cases, the government got the payment levels wrong, and the crises followed soon thereafter.

Back in 2006 and early 2007, the government had set payment rates too high. Lenders thus competed aggressively among themselves to win as much of the market as they could. Some of that competition had arguably beneficial effects (e.g., some lenders passed benefits on to students), albeit at a notable cost to the taxpayer. But the competition also took on unsavory characteristics, as in the kickbacks to the university officials in charge of deciding which lenders would get preferred access to students.

To their credit, the folks in Washington correctly diagnosed this problem. Late in 2007, the Congress passed and the President signed a bill that reduced the amount that lenders were paid.

Unfortunately, those reductions happened at the start of a financial crisis that dramatically increased the cost of private lending. In micro-speak, the private lending market experienced a negative supply shock. And all of a sudden, lender payments were too low. Lenders thus threatened to flee the student loan market, which could have left millions of students without funding for their education.

Again to their credit, the folks in Washington stepped up and eventually found a solution to this problem (which involved more financial engineering than I want to discuss right now). But it was a painful process.

To me, one attraction of this (admittedly simplified) description of recent student loan crises is that it focuses on a different type of government price-setting than the usual examples. Rent control and the minimum wage are situations in which policymakers believe that market prices are “wrong” (either too low or too high), and the point of the policies is to try to correct that (which turns out to be easier said than done).

The point of the student loan example, however, is that similar problems arise even when the government is trying to get prices “right”(i.e., to choose prices that are just high enough to get private lenders to provide all the guaranteed loans that students want). In practice, the government is hard-pressed to know what the “right” price is, and thus even sincere efforts will often result in prices that are too high (spawning kickbacks) or too low (spawning shortages).

I did not have time to get into this in class, but this line of reasoning ends up quite agnostic about the future role of government in the student loan market. Someone with a free market perspective could easily conclude: aha, government price-setting doesn’t work, so we should allow the marketplace to determine the interest rate that is paid to lenders. At the same time, however, someone more amenable to government intervention could easily conclude: aha, this system of setting payments for private lenders is fundamentally flawed, we might as well have the government make the loans itself (as the Obama administration has proposed).

The direct loan approach would certainly eliminate the Goldilocks question of whether private lenders are being paid too much, too little, or just enough. But a full comparison of the two programs should consider many other factors, e.g., budget costs and the relative capability of private lenders and the government in making loans and managing loan portfolios. I will leave such a comparison for another day. For now, my point is simply to suggest this might be an interesting example for other micro classes.

Note: I have, of course, skimmed over some pesky details of how this works in the real world.

First, I chose to present this as a situation in which the government is trying to set the “right” price, but sometimes makes errors. Of course, one could also portray this as a situation in which interest groups compete to influence the payment rates. In that case, the payments are the result of a political process in which charging the “right” price is only one consideration. (That changes the story, but not the underlying microeconomic message.)

Second, one could argue that the private loan market wouldn’t have worked in the depths of the financial crisis even if market forces were in full force. After all, many other financial markets seized up at the same time, without any government price-setting. Fair point. However, the fact of government price-setting meant that the payment rates couldn’t move up at all to address even part of the crisis. Even if market forces alone couldn’t have avoided the entire crisis, the absence of those forces made the crisis more severe (until the government stepped in with plan B).

10 thoughts on “The Simple Economics of Student Loan Crises”

  1. Direct loans does not eliminate entirely the government’s Goldilocks challenges. Someone has to figure out how much to pay the private firms that actually run the program. The challenge there is to pick contractors that won’t scrimp on service now that they won the bid.

    Where is the incentive not to do that?

    The customer is a bystander in all of this. Consumer advocates should be concerned, but seem to be cheering on the replacement of retail competition, as imperfect as it may be (where is it perfect?) with a government monopoly.

  2. I’ve often wondered about a different problem: The fact that in recent decades, the cost of an education has risen far more quickly than the rate of inflation.

    Data point: Costs have also skyrocketed in two other major sectors of the economy that are also heavily subsidized by the government: Health Care and Housing.

    Hypothesis: Cheap, easily available student loans are a way of coping with the rising costs of education. But paradoxically, they’re also largely the *cause* of the rising costs. We’ve simply built ourselves a tuition-increase machine.

    Not sure if this is true or not. Someone’s surely studied this?

    – Alaska Jack

    1. Good question. I don’t know the answer to this, but there are certainly folks who make that exact argument. Based on some quick Googling (which I still use despite the fact that they apparently removed my blog from their index), I find this paper from Cato, for example, which lays out that line of argument:

      http://www.cato.org/pub_display.php?pub_id=3344

      The basic qualitative prediction seems certainly right — in micro speak, the supply curve for college must be upward sloping, etc. The real question is magnitudes.

  3. Hello! Purely my non-professional economics opinion, but…

    I have to strongly agree with Alaska Jack. I think student loans bid up tuition prices as they dramatically increase demand for a college education. Plus, they remove market forces which might cause universities to ensure production costs stay low…i.e., if the student has virtually unlimited government fiscal resources to pursue his or her education, why would the college do its best to contain costs? They wouldn’t – after all, the student will pay whatever they ask!

    Second, these loans have seemed to produce a sort of “degree inflation.” That is, many more people are going to college, many of them unnecessarily, so the market is saturated with college graduates! A visit to the local Starbucks coffee shop will confirm that! I bet there are quite a few bachelors or even masters degree-holding baristas out there. To that point, as a personal example, I have a bachelor’s degree in professional piloting. The idea is preposterous. All that one needs to be a pro pilot is a commercial pilot license and some experience, which can be gotten from any local flight school. But, my Mom and Dad always said I had to go to college (god love ’em), so I did…and the government made it very very easy to pay for, at least initially.

    In my ideal world, if they wanted a loan, students would have to prove to a bank that they’re apt at learning and that the course of study they’d like to pursue has market value so that, upon graduation, there would be a high probability that the student will have the resources to pay the loan back. No government guarantees — just good, solid lending practices. This will inevitably cause the cost of college to come down, as colleges will have to provide prudent pricing or else the bank won’t loan. Ideally, however, tuitions eventually could come back to something a student could actually pay on his or her own with some savings…my Mom used to pay $15 a semester hour – while prices that low might be impossible given inflation, it gives an idea of what things could look like.

    With all the technology improvements in the past few decades, education should be getting cheaper, not more expensive. Without a doubt, these loans remove any market pressures to find better ways of educating our students and a subsequent reduction in tuition costs (or at the very least, an arrest of these rapidly inflating tuition prices).

    It doesn’t matter whether it’s a housing bubble, Nasdaq bubble, or whatever – easy credit is always a bad idea. Education is no exception to this. I think many of us out there are already seeing that our education cost far more than it was worth, much like homeowners are seeing in the depreciation of their homes. It all comes back to easy credit.

  4. For years there were efforts to move away from Congress determining the quarterly interest rate guaranteed to lenders and to implement a market mechanism — whether it be some type of auction, some type of loan sale, or bidding on interest rate guarantee. The participants in the FFEL program fought it tooth-and-nail. Despite their “private sector” patina, they have long opposed anything that even smelled like actual competition. Student loan has long been a voucher program for the lender, where the lender is guaranteed a yield.

    Most recently the 2007 law contained an auction process for participation in a small part of the student loan program — parent PLUS loans. Still, participants in the FFEL program, despite their weakened standing, had the huge amount of power available to quash it even though it was the law.

    They may now be regretting their opposition to introducing any elements of competition into the “private sector” student loan program.

  5. Greece and Spain won’t pay back. This was a calculated Risk, and a Lesson for the Banking System. What is happening in Greece, is a very well orchestrated show, to get granted €110bn aid, to avert meltdown. A new deception compared with the old Trojan Horse. The only thing Germans can do is:
    REPOSSESS 170 Leopard 2AEX Battle Tanks from Greece, and 190 Leopard 2A6E Battle Tanks from Spain.
    U.S.A must REPOSSESS 170 F-16 Jet Fighters from Greece, … the rest is gone with the wind …forever …
    Greece must stop paying lucrative pensions with borrowed money, reform the free health care system, and cut down, 4 times the military budged.
    Greece’s problem is too much debt. Greece has a budget deficit of 12.7% of GDP – meaning that the country is spending 12.7% more than the value of one year’s economic output.
    Greece is no different to a serial credit card borrower who can’t pay back his loans. But just like a serial credit card borrower, as long as Greece keeps relying on borrowed money to fund itself, the problem won’t go away. It will just get worse.
    http://www.defenseindustrydaily.com/Greece-in-Default-on-U-214-Submarine-Order-05801/
    But don’t worry; the ECB, the Fed or both will print the money.
    And all of us will share the pain, with our hard-earned money.
    Bad is never good until worse happens.

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