Streetwise Professor

May 10, 2013

We’re From the Government and Here to Help You-Translation: RUN!

Filed under: Economics,Politics — The Professor @ 10:40 am

The Obama administration is planning on easing repayment terms for student loans:

The White House proposes that the government forgive billions of dollars in student debt over the next decade, a plan that cheers student advocates, but critics say it would expand a program that already encourages students to borrow too much and stick taxpayers with the bill.

The proposal, included in President Barack Obama’s budget for next year, would increase the number of borrowers eligible for a program known casually as income-based repayment, which aims to help low-income workers stay current on federal student debt.

Borrowers in the program make monthly payments equivalent to 10% of their income after taxes and basic living expenses, regardless of how much they owe. After 20 years of on-time payments—10 years for those who work in public or nonprofit jobs—the balance is forgiven.

This is a statement against interest, and the proposal is hardly surprising, considering the source but I must say: This is a horrible idea.

We are constantly lectured how higher education is an “investment.”  Sometimes it is.  That investment has a rate of return.  What’s important that capital-financial, human, the opportunity cost of student time-earn a return that covers the opportunity cost of capital.  We want individuals whose ROR exceeds the relevant interest rate to make the investment, and those whose ROR doesn’t not to make it.  This isn’t rocket science.

Tying repayments to income totally undermines those incentives.  Hey, go get a low earning degree, one that has a poor rate of return-and likely, a negative rate of return-and you will make lower payments!  What could go wrong?

This reduces the cost of pursuing low-return majors, so we will have more graduates with psych or anthro degrees who will work in retail and fast food and other low-wage occupations.   That is horrible.  The exact opposite of what we want.

Try doing this at your local bank, by the way.  Not too many I know of advertise their wonderful Loser Loan Programs: “The worse your financial performance, the lower your payment!”

Yes, I know the idea is to provide insurance against income losses due to illness, or job loss, etc., but that insurance will be rife with moral hazard.

Another example of the problems when the government intervenes in the capital allocation process.  That worked out so well in the housing market, didn’t it?  This will work out no better.  It will raise expectations and saddle people with heavy burdens, thereby contributing to disillusionment and anger.

It is also highly cynical and manipulative.  Those most likely to get hurt are those who are least able to evaluate the costs and benefits of getting a college education.  Moreover, Obama administration policy is already screwing the young in ways that could teach the Kama Sutra some things, and this will add to that, all in the name of helping those who get screwed.

It is perhaps another example of what Raghuram Rajan identified as a feature of US polices ostensibly intended to reduce inequality.  He specifically focuses on subsidizing homeownership, but this is exactly the same thing that goes on with student loans.

Education can be a great thing, if you make wise choices.  One thing I’ve been on about for years is that learning programming is an important skill.  You don’t have to be a programmer, but you should know some programming.  It is a functional skill, and also helps you learn to think logically and precisely.  So I agree with this WSJ piece.

Unfortunately, easing student loan terms along the lines proposed by the administration will not provide incentives to do that.  It will provide incentives to do the opposite, and hurt most those it is intended to help.  Like the title says, run when the government-and especially this administration-says they’re doing something to help you.

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  1. We will ignore, delay,mitigate (and make worse) the problem until it blows up on someone else’s watch. After all our 90% plus constituency (Professoriates and the far vaster bureaucracy and union membership, and the source for our future jobs) must be fed.


    Comment by Sotos — May 10, 2013 @ 10:56 am

  2. Even worse, it incentivises “public or nonprofit jobs”. So basically, Joe Taxpayer is not only paying Bobby Bureaucrat’s salary, now he’s paying his tuition as well. Way to feed the beast.

    Comment by Allen — May 10, 2013 @ 11:10 am

  3. The student loan system is broken and must be fixed. In any well functioning debt market, lenders who make bad lending decisions suffer the risk of loss should the borrower default. By making student not subject to discharge in bankruptcy, lenders were absolved of their responsibilities to determine creditworthiness of borrowers and they exploited the situation. The capital markets were distorted when the lenders were granted special legal protections to force repayment. Heck, if I was a lender who was allowed to circumvent bankrputcy law, of course I would make bad loans. In case of default, I simply compound interest and, if necessary, have the government seize social security benefits to effect repayment.

    The solution to the student loan debacle is to clean it up now, as Obama seems to be doing, make student debt subject to discharge through bankruptcy and let the capital markets function properly. Lenders will cease to lend for low return majors and colleges that do not deliver valued degrees would close. The government should then resurrect the land grant college structure and support an education system that is less intellectually rigorous and designed to give targeted instruction in technical disciplines that the economy demands. If the wealthy want to fund low return degrees, let them do so out of pocket or by funding scholarships. This isn’t a difficult problem to fix.

    Comment by Charles — May 10, 2013 @ 11:56 am

  4. @Charles, shame on you for suggesting something that will work! Don’t you see that you will be forcing thousands of completely unproductive academics into jobs that might displace illegal (but voting) immigrants? How could you be so cruel?

    On a serious note -when bankruptcy protection was extended to these ass – -uh, lenders my first thought was what is next, debtors’ prison? Also the collection practices, late charges restructuring fees make the no doc origination practices look good. This system is a disgrace – not only should the lenders be subject to discharge in bankruptcy, I would argue it is time for the plaintiff’s bar to go after some of the lenders for predatory lending practices.

    Comment by Sotos — May 10, 2013 @ 1:39 pm

  5. The culprits in the student loan debacle are the lenders who gave excessive amounts of credit to students without the earning potential to reasonably repay. The first thing to do is to stop that practice. It will mean fewer prospective students will get loans, but such is life. The government also needs to demand land grant colleges return to their intended purpose and provide higher education designed to provide the opportunity for Americans of average means to get higher education in technologies demanded by our economy. If land grant colleges and universities need to drop degree programs and instill more internet based education, so be it. This problem is solvable, but we need to quit burying young people with debt incurred in pursuit of non-marketable skills or education that produces negative economic returns. I’m not suggesting we create barriers to upward economic mobility. What I am suggesting is more economic mobility. The student loan system we have now is robbing too many young kids of a chance at economic prosperity.

    Comment by Charles — May 10, 2013 @ 4:11 pm

  6. How will absolving former students of their obligations — a contract (i.e., loan) is a legally binding obligation entered of one’s own free will — produce anything but irresponsible behavior? And not inflate the tax liabilities of taxpayers — those few, those precious few who actually pull the cart up hill? This is the nanny state run wild.

    For the life of me, I cannot understand the focus of this administration: They’re hellbent on creating massive state-funded upper and middle classes totally dependent on the government, which are never held accountable for any of their stupidity (loading up on student debt is not illegal, just stupid) or criminality (totally illegal behavior that is never prosecuted). Obama and his folks act as if everyone’s a banker deserving of a bailout after they’ve blown up their firm and perpetrated fraud on their customers! Maybe he should put Holder in charge of collecting on student loans, to assure nothing is done and the student-debt scofflaws can have a field day (just like the bankers).

    Comment by markets.aurelius — May 11, 2013 @ 7:51 am

  7. @market- The irresponsible behavior occurred when Congress decided to protect lenders from default risk and thereby created a financial incentive for lenders to load up as much debt as possible on whemever they could. The result is too many young adults realizing after the fact they had made serious mistakes. While any other borrower would follow the rule of law and restructure their debts and move forward, this option is not available to student debt borrowers. What solution is there other than to create a structure where borrowers unable to pay their debts are allowed to restructure? I don’t agree allowing student loan borrowers to restructure would be any different than allowing most other borrowers to restructure.

    Once troubled borrowers are allowed to restructure, Congress would need restructure eligibility for future borrowers, hopefully by allocating the numbers of degrees they would subsidise (X accounting, y engineering, etc) and let students compete for resources. Finally, to provide for upward economic mobility, Congress would need to resurrect the land grant college system to provide affordable, practicalhigher education.

    I am not an Obama supporter, but every then even a hopeless socialist gets it right and in restructuring a broken student loan system, he is making a good first step. The alternative of having misguided decisions from from their early adulthood burden the next generation throughout their lives and let these people know from an early age they have no hope at economic prosperity. If they know the deck is stacked against them when they are 25, why should they even try? Some of the best and brightest wrongly project their futures and we turn them into wards of the state for the next 60 years of their lives?!?

    Comment by charles — May 11, 2013 @ 8:21 am

  8. Well stated, Charles.

    I would observe, however, “too many young adults realizing after the fact they had made serious mistakes,” “misguided decisions from from their early adulthood,” and similar justifications for unwinding legally binding commitments completely undermines the whole notion of contracts and markets. Congress continually makes bad decisions re protection of lenders (c.f., housing). This is not a reason to absolve those who behave in a reckless manner — either because they’re stupid, or are nefarious and knowingly commit fraud. To absolve (or not prosecute) such people makes a mockery of prudent behavior. This only tells those who would otherwise behave prudently that they’re suckers, and that they too should load up on unsupportable debt in the near-certain knowledge Uncle Sugar will make sure they’re relieved of any obligation to service it or retire it. We all can’t be AIG Financial Products, you know.

    This sort of initiative is not unexpected from the gaggle of lawyers and politicians who have taken up permanent residence in the great watering hole known as the District of Columbia. They are not trained to think of economic consequences, even tho it is the efficient functioning of the economy that provides the wherewithal they assume as an immutable fact of nature (like the sun) that will forever provide them an endless supply of funding to enact whatever their most powerful or vocal constituents demand. The economy does not work that way: It is individuals making choices as to how they will allocate their scarce resources — talent, knowledge, strength, experience — in order to secure those things they need and desire. Sometimes they’re right. Sometimes they’re wrong. The market handles this better than any mechanism yet discovered (or at least it used to). And it is undermined every time Congress or the executive branch summons the force of law to incentivize behavior the market will not and cannot sustain.

    The real danger here is what Obama wants in this case — as in so many others — ultimately undermines the very notion of contracts and contracting. Once that happens, you no longer have markets as they have evolved throughout our history as homo economicus: The very foundation of markets is the ability of strangers to contract with each other knowing their contract will be enforced by a disinterested judicial system. We abide by the law because rule of law is better than living in a state of nature, which we are not far removed from. (Re the state of nature, remember your Hobbes: “No arts; no letters; no society; and which is worst of all, continual fear, and danger of violent death: and the life of man, solitary, poor, nasty, brutish and short.”) We grant the legal system the right to decide and enforce our contracts, and permit it to marshal the modern state’s monopoly on the use of force to ensure contracts are honored. This was true in the pre-Hittite Levant, where merchants carved contracts on clay tablets, as it is now when we move them at the speed of light over the internet. Contracting is responsible for the advancement of civilization. Once the notion of contracts is transformed into something that no longer need be considered legally binding, the state must take over more and more of the functions once performed by markets — chiefly the allocation of scarce resources. Once that happens, you quickly (i.e., within a few generations) get post-Republic Rome, post-Weimar Germany, modern Russia, Wall Street: You get thugs taking over the institutions with control over the disbursement of society’s scarce resources.

    Then it’s Hobbes all over.

    Comment by markets.aurelius — May 11, 2013 @ 10:15 am

  9. @Charles makes excellent points, but to play devil’s advocate:
    – What about caveat emptor? We’ve had Internet for almost two decades. How are so many students making stupid decisions?
    – If students can default on their student loans, interest rates will rise substantially, making college less affordable than before. I think this would be a good thing (encourage students to study fields that lead to jobs, choose more affordable colleges), but it will lead to a backlash.

    Comment by Jack P. — May 13, 2013 @ 1:44 pm

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