An Access Advertising EconBrief:
The Student-Loan Bubble: Blackboard Economics Strikes Again
The subjugation of print and broadcast news media by the Internet has changed many aspects of the news business, but crisis mode still predominates. The financial crisis gave the Great Recession its headline stories, the biggest of which were the housing bubble and accompanying subprime-mortgage loan scandals. Ever since then the New Media have been beating the bushes for their next big crisis. The front-running nominee seems to be the impending student-loan debacle.
News outlets across the political spectrum have vied for shrillest note of alarm in detailing the deplorable state of the student-loan market. In fact, this use of the term “market” is highly stylized, similar to its use in government bonds, home mortgages and military-defense. Ever since 2010, the federal government has effectively monopolized the market for student loans obtained for purchase of higher education. This monopoly operates in a manner analogous to the federal monopoly on home mortgages enjoyed by Fannie Mae and Freddie Mac. And a popular consensus has formed around the idea that the student-loan result will duplicate that in home mortgages; namely, a bubble with disastrous economic consequences for the economy at large.
The Outlines of the Disaster in the Making
Why is everybody all het up? Here are the outlines of the disaster as the various sources see it coming:
Between the years 2003-2013 college tuition has risen by almost 80%. To put this rise in perspective, consider that it is roughly double the rise in the average cost of medical care over the same time period. That sounds bad, but a price increase is not a bad thing ipso facto. Marked increases in quality can account for a higher price, for example, by causing increases in demand. Demand can increase for other reasons, too. Might higher tuition derive from these causes?
Surveys have demonstrated that tenured professors now average between six and nine hours of teaching per week at public universities, compared to the former average of nine to twelve hours. A majority of courses are now taught by non-tenured faculty, consisting of full-time, non-tenured faculty members, part-time adjunct faculty and graduate students. In order to believe that students are now receiving higher-quality teaching, we must believe that this motley mix are better teachers than the older, better credentialed tenured faculty members.
On its face, that proposition seems wildly far-fetched. In fact, it is not at all unusual to observe younger, non-tenured faculty members winning teaching awards and popularity polls. But this still doesn’t make a case for higher-quality education, for if it were generally true then it would argue for the separation of teaching and research altogether. And indeed, this may well be the optimal organization of labor in higher education. We will never know until we deregulate the industry, cutting off all government funds and allowing markets to determine the question.
The real source of tuition increases is not an organic increase in demand for higher education. Since 1999, the total volume of student loans has grown by 511%. Thus, the felt, effective demand for higher education has increased dramatically because it is an artificial, subsidized demand.
This has led to about $1 trillion being allocated to student loans – more money than is currently tied up on consumer credit-card debt. The so-called average individual owes about $24,000. This form of personal debt is very tenacious. Unlike most forms of personal debt, it cannot be discharged in bankruptcy. Only death can extinguish it.
Not surprisingly, the high rate, volume and burden of student-loan debt have produced defaults on that debt. Some $146 billion worth of student-loan defaults have been recorded to date. The default rate stands at its highest level since 1996.
Where there is default, there are those seeking to deflect it. There is even a term used to describe this practice; it is called forbearance. A Wall Street Journal op-ed (“The Hidden Student-Debt Bomb,” by Jason Delisle, WSJ 12/31/14) describes the practice and its spread.
Forbearance is the generic term for various means of avoiding on-time payment of student loans. Of the total $1 trillion in student loan debt outstanding, the amount in forbearance is $125 billion and rising.
The standard forbearance benefit is usually granted by the company servicing the loan. The student calls the company and requests forbearance. Upon receipt, the student receives postponement of payments for as long as three years. Since this benefit is granted at the discretion of the company, there need be no qualifying criteria, although there are sometimes income qualifications.
Forbearance can also be used to cure a delinquency status. As author Delisle notes, this becomes rather quaint – accrued interest and principal accumulates on the loan so that the initial too-onerous-to-pay amount is now bulked up considerably by the time the next payment is due. Really, then, Delisle argues, forbearances should be treated as equivalent to delinquencies and defaults rather than as a treatment for them. Thus, their steady upward march in recent years (12.5% of repayments in 2006, 13.3% in 2013 and 16% of the $778 million in repayment today) is reason for alarm.
Another technique bases forbearance on ability to repay, or income. At an income of 150% of a poverty-level income or less, payment is zero. As income rises, payments rise on an ascending scale to between 1% and 15% of income. At some point – either 10, 20 or 25 years, depending on the precise details of the program – remaining debt is forgiven completely and taxpayers pick up the remaining tab. The interesting feature of income-based programs is their separation from standard amortization principles of debt repayment. For example, the most generous income-program cases do not even cover the accrued interest on the student loan! Thus, there is really no pretense that the loan will ever be repaid under these circumstances – the program just gives the student a thin layer of epidermis in the game. According to Delisle, “the Obama administration estimated in 2012 that the average amount forgiven in income-based repayment plans will be $41,000 per borrower” (!).
Since those loans represent expenditures financed by the federal government, that means that the money was acquired by the federal government in one of the three standard (and exclusive) ways: by taxing, borrowing and “printing” (e.g., creating). That means that taxpayers have already paid for it or will pay for it in the future. If students do not repay their loans, that means that taxpayers will bear the burden. Then again, even if students do repay the loans, the only form of “repayment” taxpayers get is reimbursement to the Treasury, which defrays future expenses on some other boondoggle. But even if you discount the dubious notion that taxpayers are repaid by students, it is clear that the practice of forbearance encourages students to take on heavy debt loads and later shed them at taxpayer expense.
One obvious paradox is that the overall U.S. economy has been improving recently while the pattern of delinquency, default and forbearance on student loans has been increasing. This makes no economic sense. That makes Delisle wonder whether the purpose of student loans is political rather than economic.
Regular readers of this space should already have reached that conclusion by this point. Before broaching this issue fully, we should pause to ponder the question: Exactly what is the economic purpose of student loans for higher education underwritten by the federal government?
The Orthodox Economic Case for Government Subsidies to Higher Education
The economic case for subsidies to higher education by government can be found in virtually every undergraduate economics textbook. It is cited as an example of a positive externality. Ordinarily, an economic transaction involves a buyer and a seller – the benefits of the good being purchased are confined to the buyer and the costs of production were incurred by the seller. Education, it is claimed, benefits everybody, not just the student. So, there are benefits “external” to the parties immediately involved in the purchase, making the externality a “positive” one. (The presence of external costs would be a negative externality; pollution flowing from a production site would be an example.) Because students take only their own future benefits into consideration when weighing an investment in their human capital, they will not purchase enough education. It is up to government to subsidize education to make up for this inherent flaw in the free market. True, you and I are forced to pay for the education of others, but that is justified by the benefits we receive from their education – better goods and services that they produce, better conversation that they make with us, better government that they give us and more.
Even the apostle of free markets and laissez-faire, Milton Friedman, gives lip service to this argument in his treatise Capitalism and Freedom. And just as Keynesians like Ben Bernanke cite Milton Friedman’s slightest obiter dictum as support for their loose-money policies, so have government spenders cited him in support of spending on higher education.
This is a classic case of what the late Nobel laureate Ronald Coase called “blackboard economics.” Teachers will develop an argument on the blackboard, “prove” it using the assumptions they assert under the terms of their model. Then – because they probably had a vested interest to promote in the first place – they proceed to promote policies that are based on its validity.
“Economic policy involves a choice among alternative social institutions, and these are created by the law or are dependent on it. The majority of economists do not see the problem in this way. They paint a picture of an ideal economic system and then, comparing it with what they observe (or think they observe), they prescribe what is necessary to reach this ideal state without much consideration for how this could be done. The analysis is carried out with great ingenuity but it floats in the air. It is, as I have phrased it, ‘blackboard economics.’ There is little investigation of how the economy actually operates, and in consequence it is hardly surprising that we find…that the factual examples given are often quite misleading.”
Coase cited two famous blunders by famous Nobel Prize-winning economists. Paul Samuelson, author of the all-time bestselling economics text, followed the precedent set by several generations of economists going back to John Stuart Mill in the 19th century by flatly stating that lighthouses were an example of a positive externality and could only be provided by government, never privately in a free market. In reality, private lighthouses flourished for centuries. James Meade declared that bee pollination of orchards could never be handled by free markets, blithely overlooking the fact that beekeeping in the U.S. had done just that for many decades at the time (the early 1950s) that he wrote. Ironically, despite his suggestive term, Coase never applied his logic to higher education itself.
Coase implies strongly that the problem with “blackboard economics” is a lack of empirical investigation. He was trained at the London School of Economics and taught for many years in the Law School at the University of Chicago. Thus, he was exposed to the influence of two famous philosophical positivists, John Neville Keynes (father of John Maynard Keynes) and Milton Friedman. Both men developed a school of economic logic and practice that was very widely taught and practiced within the profession. It preached that economists should not only develop hypotheses but test them empirically using formal statistical inference. Only those hypotheses that pass the tests – that is, the ones that are empirically sound – should be vetted for policy purposes.
This philosophy is purportedly based on the habits developed by the natural sciences – physics, biology, chemistry et al. It sounds – or, more precisely, sounded– attractive, which accounts for its onetime dominance of the profession. It now lies in ruins. Few theorists pretend to “test” economic hypotheses today, although everybody goes on mechanically employing statistical tools and looking for new ones. The concept of “statistical significance” today brings a blush to professional cheeks after its scandalous misuse by generations of social scientists.
Coase made a minor point, all right; economists were arrogant for not at least peeking out the windows of their ivory towers before applying the theories they formulated so carelessly. But the decisive point is theoretical, not empirical. The externalities argument is badly reasoned in the first instance. Coase himself proved this when he laid the groundwork for the so-called “Coase Theorem,” which shows that when transactions costs are disregarded, the existence of an externality does not make a case for government involvement. The two parties involved have an incentive to bargain their way to a solution.
The positive externality argument for government subsidies to higher education has an even bigger hole in it, one big enough to drive a truck holding $1 trillion through.
When Is An Investment Not An Investment?
When we stand back and view the positive externality argument and today’s reality of student-loan spending by government in some sort of perspective, it is blindingly obvious that something is missing. Something vital was overlooked all along in the mad rush to get money in the hands of students. What was it, exactly?
After Forbes Magazine published one of the cautionary articles referred to earlier, a young student sent in a dissenting response. His economic arguments were chillingly naïve: Since the loans are made and supported by the government, the private sector is “protected” against the fallout from default, unlike the case with the mortgage default on subprime loans; the loans are not securitized via derivative assets and thus have less potential for harm. But most telling of all is his closing comment that “after all, education is not a cost, it is an investment.”
Incredible as it seems, this is the same hazy-crazy-lazy blue-skies frame of mind with which economists themselves have approached the subject. Let us rectify this carefree, careless approach with some incisive thinking. Education is a good. The purchase of education by an individual is an investment that entails a cost. The cost is the highest-valued alternative foregone by that individual in the purchase as it is viewed BY THAT INDIVIDUAL. The benefit is the discounted present value of the future benefits expected to accrue from the human capital created as they are viewed BY THAT INDIVIDUAL. Nobody else’s views matter in evaluating this investment. Nobody else can evaluate the benefits because they are his or her benefits – nobody else’s. Nobody else can evaluate the cost because it is his or her cost – nobody else is foregoing the alternative(s).
Are there other people who gain in some way from that individual’s education? Fine – let them subsidize his or her education, if they want to. If they want to run the risk that he or she will purchase too little education, let them run it. If they don’t perceive sufficient benefit to them from his or her education to subsidize it, then the only sensible policy is to treat that external benefit as negligible. In practice, we see various people and institutions willing to subsidize the educations of others.
Now the shortcoming of the current system sticks out like the proverbial sore thumb. As it stands out now, the education decision is NOT an investment – because the individual making it considers only benefits, not costs. By manipulating the system, the student-borrower can slide out from under a very substantial proportion of the nominal cost.
And that’s not all. The investment decision is further distorted by the fact that, when the buyer perceives the cost to be zero or very low, the quantity demanded will be very high. Thus, the price – tuition – will be driven artificially high. Expansion of capacity – that is, supply – comes rather slowly because public funding to build more universities or expand existing ones comes from legislatures, while private universities are funded largely from endowments.
The Political Basis of the Current System
Delisle’s conjecture about the political basis of the current system is well-founded. Conservatives sometimes act as if sin originated with the election of Barack Obama in 2008, though, and iniquity in public education goes back over a century. The economists who formulated the positive externality theory worked for the government, as do most economists today. The 20th century saw education become a captive of the state. The subjection of students via student loans is only the latest foray by a marauding government.
The current design of student-loan programs is not the result of laxity or well-meaning over-generosity, but of political calculation. The concept of “predatory lending” has absolutely no meaning in a private, free-market economy because private, profit-seeking businesses have no incentive to write bad loans. But government does and the student-loan program is the locus classicus of predatory lending a la government. Its purpose is to entrap students in loans from which they have no alternative except to default. Government is both their benefactor – for “giving” them a college education – and their savior – for rescuing them from financial ruin and penury with forbearance. Thus, government has now created a built-in, guaranteed constituency. Moreover, this new constituency comes complete with an army of bureaucrats that also owe their jobs to government. Bureaucrats first of all to administer the loans in the first place – fill out the forms and check eligibility (as if!) and recruit new borrowers and keep the loans flowing; bureaucrats later on to administer the forbearance phase in which de-facto defaults are carefully managed and nurtured to their soft landings.
Both these new constituencies will vote for big government forever.
And “forever” lasts just as long as it takes for the money to run out and the ultimate financial debacle to take down the whole monetary and financial system.
Bust Up the Blackboard
Most utter debacles come about in spite of economic theory and logic. This one was carefully engineered with the aid of economics and economists. We cannot fine-tune out way out of this disaster. The only way out is to privatize education at all levels. Severing the financial lifeline of these subsidies is the only way to kill this two-headed student-loan beast that devours our real income with each mouth.