Student Loans: Solutions vs. Delusions

The total amount of federal student loans has been growing quickly. The following diagram from the Federal Reserve shows the growth of student loans since 2006.


The total amount at the time of writing is over 1.3 trillion dollars, and the federal student loan portfolio is 1.221 trillion dollars according to the latest data from the department of education. This huge increase in spending on student loans indicates both an increase in the number of people seeking a college education and a rise in the cost of college education.

The problem of student loans is one of the hot topics this election cycle with both presidential candidates on the left proposing some variations of free college to solve the problem. Many young students with large student loan balances surely cheer that, who doesn’t like free stuff? Free college may make some voters happy and may even win someone the elections but it won’t solve the fundamental problem with higher education.

Let’s start with asking why do people get a college education? Sound economic thinking says that they do that to raise their human capital and raise their productivity and income. College then is an investment that has expected return in the form of future earnings. People who don’t have the financial resources to make needed investments get loans to finance their projects. The interest rate on a loan is determined by the lender based on the borrowers’ ability to pay which depends on the risk of the project. So if two students with similar academic abilities applied for loans one for an engineering degree and the other for an animal studies degree the first will definitely get lower interest rate on his loan because an engineer has a higher earning potential than a person with an animal studies degree. The effect of interest rates will be to steer students towards more productive majors and only students who really are interested in low productivity majors will take the high-interest loans to get into these majors. The other effect of the interest rate is that they force borrowers to take the smallest loans that can meet their goals so each student will have a strong incentive to select the cheapest college program that gives him the education he needs. This will pressure the universities to be more efficient and offer better education packages to attract students with different budgets.

The current federal loan programs offer equal interest rate to all students regardless of majors. This may seem fair and nice to the social justice warriors but equal interest rates enable students who lack the academic abilities to apply for majors who they aren’t fit for and when they fail they end up with the huge loan balance. For students who graduate there is a loan forgiveness program that forgives the debt balance after 10 years for graduates who work in the government or a nonprofit organization. This basically removes the incentive for students to select a productive major and worry about future earnings. The federal loan programs also enable universities to keep raising tuition because the government will continue giving the loans regardless of the value of the education.

Making college free will remove students’ debt burden but it will not cut the cost to society because the cost of college will still be paid by the taxpayers. All the incentives that currently exist in the system to make students get an education they cannot afford or cannot succeed in will remain. All the incentives that currently exists to steer students towards less productive fields and away from private sector work will remain. College costs will continue to grow without any reforms or restraints.

The solution to the college cost problem is to get the federal government out of the business of offering student loans. Education will become like any other service in the economy, open to supply and demand with providers competing to offer the best value while consumers shopping around for the best deal.