The problem with US Student Loans

Biden is considering a Student Loan Forgiveness Program. The issue masks a very fundamental flaw in government incentives.

Photo by The New York Public Library on Unsplash

The student loan problem is complex. It comprises different loops that operate independently and intersect, feed into each other and cancel each other at times. I wanted to simplify the issues into nuggets below.

1. Any story on loans is a story of risks and returns.

   1. Loans cost more if there are higher risks. The cost appears in terms of interest rate (how much you pay monthly) and duration (for how many months you have to pay).

   2. Risks are of various types but the relevant one is the chance banks may not be paid back. This is assessed through a credit check. If you have been paying everything diligently for the last 2/5/10/15 years, you are likely to continue to pay henceforth.

   3. Students do not have a credit history.

   4. A good stable job (reliable income stream) will offset the lack of credit history.

   5. Risks can be reduced by adding things to the mix. A rich guarantor will reduce the cost of a loan.

   6. Government can also reduce risks DIRECTLY. The government can pay part of the interest costs (interest subvention). This would be a direct incentive to students.

   7. Government can reduce the risks INDIRECTLY too. This is done by giving educational loans special status - they cannot be written off in case of bankruptcy. Some governments allow educational loans as tax deductions. Some other governments give the creditors/banks first right over the salary earned (educational loan EMI gets deducted automatically).

   8. Why do loans get written off in bankruptcy? Loans are like investments - the investor must do her own due diligence to verify if the venture is risky and whether it will be successful or not. If the venture fails, then all investors lose money. Creditors lose less, but they do lose. The lender then has skin in the game.

   9. If there is no risk of bankruptcy, there is no skin in the game. If it were allowed, the lenders would sell the students into slavery to make up their payments. The loans get stuck to the student as a leech.

   10. Now it depends on the student WHAT she is taking the loan for. Good loans are those that yield higher returns - income enough to pay off the loan AND lead a comfortable life. The bad ones do not generate enough income to pay off the loan itself.

   11. If risks are reduced, you can borrow larger sums.

2. The first Loop

   1. Students do not have any credit history of any sort. In general, this would increase the cost of loans available to the student. If rates are sufficiently high, then students may choose not to go to college - a waste of talent in the economy. The government policy on education loans allows them a chance to access credit without having a prior history.

   2. A graduate school with better learning infrastructure necessarily has to charge more to pay for that infrastructure. When you think of infrastructure, think of technology labs, nuclear research labs, machines and equipment related to robotics, electronic microscopes, CSI-style biology labs etc.

   3. This infrastructure is giving the students an advantage and therefore increasing their earning potential. The return on education investment becomes high. This reduces the credit risk on student loans making it easier to get a loan if you get into these premium institutes.

   4. This pushes a general fee rise across institutes as institutes rush to invest in educational infrastructure.

   5. Ideally speaking, educational institutes stop investing when the return on educational investment (salary of their graduates over the next X years) becomes low.

   6. Putting it in another, more sinister way - institutes will keep hiking their fees so long as the return on educational investment (salary of their graduates over the next X years) is positive.

3. The deviant loop

   1. A way was discovered de-linking educational investments from returns on educational investments through new types of educational streams - the humanities.

   2. Social Sciences and humanities, done properly, would need a very large investment (study of society is not cheap). But the investment is not tangible (no electron microscopes or MRI machines for medical research). It is easy to give an appearance of investment while making do with very little actual investment.

   3. The return on Social science and humanities education is driven by the reputation of the institute rather than actual exposure to cutting edge. They are therefore very low cost.

   4. Many of the jobs and roles do not have tangible contributions either.

   5. That does not mean they are not valuable but only that their value is difficult to assign. For example, you can arrive at a fair estimate of the value of a machine, but it is difficult to assess the value of a painting.

   6. Thus the return on educational investment in humanities education depends upon the appraisal of the same group as the one teaching it - a serious conflict of interest. But this allows the institute to increase the fees as long as it maintains its reputation and gets its graduates into lucrative positions that pay well.

   7. As the pay increases, the credit risks reduce and you can take on a larger loan. This allows the reputed institute to increase its fees. Higher fees mean a better reputation - a positive spiral indeed.

   8. Thus, the humanities have two advantages. First, they do not need much investment. Second, their returns are based on what the reputed experts assert them to be. It makes them a darling of Universities - the most profitable departments.

   9. I know what you are thinking - this can’t be true. I point you to the rise in administrative costs in universities.

4. The Killer loop

   1. We entered a low and declining interest rate regime. This reduced the risks for banks. In the aftermath of 9/11, Subprime and subsequent Quantitative easing era banks were eager to make low-risk loans.

   2. It fanned the Fees-Loan spiral to a dangerous degree.

   3. Bailout culture meant that you could survive dumb business mistakes if you were too big to fail OR you make a big pile of shit when you go down. So the lenders lent big and lent recklessly - to pay for degrees and students who were not going to pay it back.

5. The sad reality of bailout

   1. This is not a bailout of the students - it is the bailout of the lenders.

   2. Students will eventually pay for it through loan repayments or higher taxes or higher inflation or all of them.

   3. The students are equally to blame. They got into these commitments with their eyes wide open. Now running away from consequences is impossible.

6. Important Learnings

   1. Students do not have bargaining power in this equation. Whatever you give them, someone else will take it away.

   2. Proper regulation does not give money to the helpless. Proper regulation realises that people are helpless BECAUSE they do not have bargaining power. It gives them bargaining power, and they take care of themselves.