The Failure of the College Loan Program

By Richard Vedder

“College-Loan Debt Hits Parents Hard” screams a front-page headline in the December 3 Wall Street Journal. We are told by triumphant President-elect Joe Biden that the extremely high financial burden of going to college will be substantially eased in his administration by dramatically lowering the enormous accumulated student debt burden through loan forgiveness for most borrowers… “The government to your rescue” he proclaimed during his successful campaign.

But what Biden didn’t tell you was the very student loan debt problem bringing financial headaches and misery to millions was largely caused by the federal government.

It first got involved helping finance college with the Servicemen’s Readjustment Act of 1944 – the GI Bill, really a form of deferred compensation to military personnel drafted to fight during World War II. During the Cold War scare arising from the Russian Sputnik launching in 1957, there was some modest new federal college financing involvement, including loans for students in the STEM (science, technology, engineering, and math) disciplines.

However, even in 1965, federal student loans totaled only $159.2 million, roughly $1.3 billion in today’s dollars, and a fraction of 1% of what Americans spent annually to educate the nearly 6 million Americans then attending college. By contrast, in the last decade, new loans typically have approximated $100 billion annually, and accumulated debt now exceeds $1.5 trillion, far more than borrowing for credit cards, autos, home equity loans, etc. Only home mortgage debt is larger.

The Higher Education Act of 1965 led to a vastly expanded student loan program, one that, with a 1978 mega-expansion under President Jimmy Carter, led to the financial misery college students and many graduates suffer today… the best example I know of “the law of unintended consequences.” Legislation designed to improve college access for lower-income students for whom college posed a big financial obstacle has in fact led to a much higher financial burden on all college students and their families… and has actually diminished college access to low-income Americans it ostensibly was originally supposed to help.

Data provided by the College Board and the Federal Reserve System shows many popular misconceptions about student borrowing
for college:

• A majority (56%) of federal student loan debt is held by the 16% of borrowers owing $60,000 or more.

• As of March 2020, a majority of federal borrowers owed less than $20,000.

• According to pre-pandemic (2019) Federal Reserve data, the top one-third of holders of student debt had an average net worth of nearly $300,000 (excluding their student debt), far more than those borrowing less.

• A majority of the large (top one-third) borrowers had a family member with at least a master’s degree.

• More than one-third of borrowers fail to complete their college degree.

• The popularity of new federal student loans has declined significantly, with new loans in last decade falling 27%. In the same period, nonfederal loans grew by 48%.

• Default rates have historically been much higher on student loans than other forms of consumer lending. Most defaults come from those owing $10,000 or less on their loans.

Why do we have these federal loan programs? Why, when Americans are on average richer than ever and have a high standard of living, do they depend on federal government help to finance college? More generally, have these programs worked as intended? The answer to that is a resounding “no.” There are at least nine problems with the programs.

First and foremost, federal student financial aid programs have contributed mightily to the huge tuition price inflation of modern times. From the middle of the 19th century to 1978, tuition fees in the United States rose about 1% more each year than the overall rate of inflation… If prices generally rose 2%, then tuition fees would usually go up around 3%. Universities are labor-intensive institutions, and it was argued that universities cannot substitute cheap machines for increasingly expensive labor, explaining moderate college tuition price inflation. Moreover, since real incomes were going up 2% annually, the burden of financing college was still falling for most Americans.

Since the massive expansion of the federal programs beginning in the late 1970s, however, colleges have felt they could raise fees aggressively – students can simply borrow more. Education Secretary Bill Bennett first observed this in a 1987 New York Times op-ed. Empirical work at the New York Federal Reserve Bank and the National Bureau of Economic Research suggests the Bennett Hypothesis is valid. The research says that for every $1 a student receives in new federal loans, schools raise their fees by $0.60 or $0.65, capturing most of the income generated from the loan. Colleges, not students, are the prime beneficiaries.

Colleges have used much of their enhanced tuition revenues to finance expanding university bureaucracies – the era of big federal student loan lending is also the era of administrative bloat at America’s colleges. I have estimated that if tuition fees had risen after 1978 at the rate they were before that date, college fees today would be about one half of what they actually are – and people could finance their education much more easily without large borrowing.

Second, the federal loan programs were hyped as a way of providing college access to low-income Americans. Yet the proportion of recent college graduates from the bottom quartile of the income distribution today is lower than in 1970. High sticker prices for colleges have scared away low-income college prospects, more so than more affluent ones. Also, the big borrowers and beneficiaries of student loans are moderately to very affluent Americans getting advanced degrees. Why should the federal government subsidize someone getting an M.B.A. degree from Harvard who will make $150,000 or more annually after graduation?

Third, one thing the loan programs did do successfully was raise the demand for college, leading to increased enrollments. That, however, led to increased “underemployment” of highly educated Americans. In 1970, about one of every 150 taxi drivers had a college degree. The 2010 Census showed that number was about 24. I suspect it is higher today. Do you really need a college degree to be an Uber or taxi driver? A large number of college graduates, expecting a good job providing a comfortable middle-class life, are quite disappointed about their low paid employment… and owing student loan debts to boot.

Fourth, these federal programs were sold as costing taxpayers nothing. It was argued that the federal government can issue bonds paying under 2% interest and then lend the money to students at a still-low 5% interest rate, making a modest profit (allowing for administrative costs). In reality, much of the loan money has not been repaid. Recently, a consultant to the U.S. Department of Education estimated that the losses expected from the current federal student loan portfolio is $435 billion – about 80% the amount of losses on subprime mortgages during the 2008 financial crisis. At a time when the most recent annual federal budget deficit equaled 14%, losses of this magnitude increase the probability that the U.S. soon will be viewed like Argentina – an irresponsible and risky place to lend money.

Fifth, the federal student financial program is a confusing administrative mess, excessively complicated with multiple types of federal loan programs (subsidized loans, unsubsidized loans, and PLUS loans to parents). Why not have one simple grant program (Pell Grants) and one loan program?

Sixth, these programs have contributed to a decline in quality in American higher education. Too many students of negligible academic promise (low grades and test scores) get federal loans and enter school, lowering average student quality. After teaching college for 55 years, I know that leads to dumbing down material to allow marginal students to be at least somewhat competitive. Grade inflation has soared with expanding student loans. The average American college student is less literate and knowledgeable than his or her counterpart of 50 to 60 years ago, spending far less time on academic studies.

Seventh, it is probable that the sharp decline in American births in modern times at least is partially a consequence of debt-burdened students feeling they simply cannot afford having children. Families forego having kids in order to keep working to pay off debts, including federal student loans.

Eighth, the student loan programs have probably contributed to a decline in personal savings and consequently lower investment in capital and technology. In the 1960s and early 1970s, before widespread student loans, Americans typically saved close to 10% of their personal income. In the last couple of decades, the savings rate has averaged less than one-half as much. Previously, families saved up to pay for their kids’ college. Now, some think, “We can just borrow the money from the Feds.”

Ninth, the loan programs are commercially not viable. Good students are more likely to graduate from college and pay off their loans, but the loan program treats under-achieving students the same as good ones. Indeed, under-achieving students go to school longer because of mediocre academic performance, borrow more, and get inferior post-college jobs – and maybe not even graduate, defaulting on their debts – yet pay the same interest rates as safer borrowers. Colleges have zero incentives to turn away mediocre students as they have no “skin in the game,” that is to say they face no adverse financial consequences from admissions decisions leading to loan defaults burdening the taxpaying public.

Biden Administration Solutions

The Democratic president aspirants in 2020 engaged in a bidding war trying to outdo each other promising relief from college expenses. President-elect Biden wants to forgive at least some student loan obligations for those making under $125,000 annually. Obviously, this would reduce by potentially hundreds of billions of dollars repayments that the government expected from loan recipients. If the average loan forgiveness were $8,000 for the about 45 million who owe on their loans – that would be $360 billion, or about 1.5% of a year’s national output.

Loan forgiveness is highly dubious on both economic and equity grounds. It creates a horrible problem that economists call “moral hazard.” Why would any current debtor under the student loan program ever make timely repayment of their loans if there were a good prospect that politicians at some point will forgive that obligation? Loan defaults are dramatically higher than for other kinds of loans already.

The idea is extremely inequitable on two grounds. First, many Americans have dutifully sacrificed buying nice cars or taking fancy vacations so they could pay off their loans, while other spendthrifts did not meet their legal obligations, spending liberally and consuming luxuries. With loan forgiveness, the government tells those responsibly paying off their loans, “You were fools.”

Moreover, while Biden and his team profess to favor helping poor and minorities, there is no question student loan forgiveness benefits mainly the relatively affluent. Let me quote from a new National Bureau of Economic Research paper by Sylvain Catherine and Constantine Yannelis, “Full or partial forgiveness is regressive because high earners took larger loans.” Also, “Blacks and Hispanics would also benefit substantially less than balances suggest.” Andrew Gillen and Thomas Lindsay of the Texas Public Policy Foundation and I have similarly confirmed this finding using new data from the U.S. Department of Education.

Radical Reform Is Needed

Given the fundamental problems with federal student loans outlined above, ideally our nation would move to eliminate the programs. Already, new federal lending has been declining as potential borrowers question the value proposition of college and as more hear horror stories about the burdens of student loans. In the absence of federal lending, private lending – already rising in recent years – would grow substantially. Moreover, a new method of financing college that is already in limited use, income share agreements, might take hold, where individuals give up a share of postgraduate earnings to private investors for a few years in return for help in paying college bills.

In the current political environment, reform likely will not happen. Universities, even private ones, are largely wards of the state, and the Democratic party benefited hugely from donations from university staffs who have also provided many of the ideas and personnel who will be running the executive branch of the federal government. They like the status quo.

A less radical but useful modification of current programs might be politically feasible, particularly if the Republicans continue to control the U.S. Senate: make colleges have some “skin in the game,” sharing in the financial burden currently born by taxpayers when borrowers of student loans default. If colleges with a history of having high levels of students default on their obligations had to pay part of the defaulted loans, it would incentivize them to show greater care in who they admit.

The federal government cannot even devise a simple form for those applying for federal student financial assistance (the FAFSA form has over 100 questions). Therefore, it’s probably asking too much to have them meaningfully change a disastrous system, and loan forgiveness is an especially inappropriate approach to reform.

Richard Vedder is a Distinguished Professor of Economics Emeritus at Ohio University, where he has taught since 1965. A graduate of Northwestern University and the University of  Illinois, he has authored numerous books including his 2019 Restoring the Promise: Higher Education in America (Independent Institute) and his opinion pieces have appeared in  numerous printed media, including the Wall Street Journal, Investors Business Daily, and Forbes. He also served on the Spellings Commission on the Future of Higher Education.