I’ve heard a lot of whining over the last few days from the college student crowd over the impending doom of the fact that the interest rate on certain federal student loans (about 55% of the federal student loan market) is set to double “unless Congress acts.” Most of the media coverage on this is typically vapid, lacking in the basic facts required to fully understand the issue (although the Washington Post article I link above is surprisingly useful).
Missing entirely from the conversation on all of the coverage, unsurprisingly, is one simple question: How exactly did we arrive at a situation where the interest rate for student loans is determined by the decree of politicians, rather than by traditional market forces, and why should we continue to tolerate such a bizarre state of affairs?
Personally, student loans have never been a part of my life, so this is not a topic I’ve done a great deal of research on. Given that private education loans are still legal, one can assume that the reason federal loans dominate the student loan market is because they are preferred by consumers, for various reasons. The most likely reason would be that they cost less, in terms of offering a lower interest rate. Given that private loans have to respond to market forces, and will therefore charge a legitimate interest rate which genuinely reflects the time preferences of the market participants, the fact that government loans charge a lower rate tells us something useful. It tells us that the recipients of these loans are receiving a subsidy from the federal government in the form of a below-market interest rate. Whether the loans are called “subsidized” or not is irrelevant. Students are receiving a product for lower than its market value, with the difference being made up by the taxpayer.
One might think that students would be very grateful to the taxpayers for this generous gift. If they were left to their own devices to obtain credit without government subsidizes, we can presume they would be paying a significantly higher (but appropriate) rate of interest. But alas, our culture of entitlement has blinded them to the obvious fact that they are receiving free money from unwilling taxpayers. Instead, they decry that their rates are about to rise. As a side-note, even the “un-subsidized” Stafford loans (which already have the dreaded 6.8% interest rate) already make up a larger percentage of the student loan market than all private loans combined. We can infer from this that even after the rate on the “subsidized” loans doubles, it will still be a below-market interest rate, and recipients will still be, in effect, getting free money at taxpayer expense.
It’s tough to blame short-sighted college students, most of whom have very little understanding of real economics, for favoring programs that transfer wealth from others to themselves. However, they should understand that they are receiving a gift, and as such, have absolutely no business dictating the terms of the gift to the giver. In a free market, interest rates would be set by the traditional forces, the time preferences of the public at large, with appropriate risk premiums assigned based on all relevant factors (most of which are probably illegal to consider these days). While this procedure likely would result in higher interest rates for the majority of students, it would also provide an easy and consistent framework within which individuals could recognize how rates are determined, and project what they are likely to be in the future.
The alternative, relying on the government to provide subsidized loans, means that the rate is set by one of the most dysfunctional bodies in the history of the world. It means that partisan wrangling, party politics, and favors owed are the primary factors in setting the interest rate for future loans. Regulatory uncertainty rules supreme, as political forces rather than market forces determine the future for prospective students. Attempts by Republicans to tie the interest rate on these loans to current treasury-bill rates, while a step in the right direction, still result in a government subsidy rather than requiring students to obey market forces in the same way that everyone else has to (not to mention the fact that t-bill rates are largely influenced by the actions of the federal reserve…).
The long and short of it is that federal involvement in student loan markets distorts the market, which has led to some pretty terrible consequences, not just for taxpayers, but for students themselves. Interest rates are a form of price, and prices convey valuable information about individuals’ preferences. Distorting market prices in the name of “helping students” ensures that the information students receive is incorrect. Perhaps if students were required to pay the true price of their education, they would be a little more circumspect with their money. Perhaps they wouldn’t flock in large numbers to obtain degrees that do little to increase their employment opportunities post-graduation. Astute readers might note that this entire chain of events is quite similar to the Austrian Business Cycle Theory’s explanation of recessions, depressions, and financial crises, briefly summarized as: The Fed artificially expands credit, entrepreneurs view low interest rates as evidence that capital investments will be profitable, eventually they find out the low interest rates were phony and their investments aren’t profitable after all, and the whole thing blows up. By offering an artificially low interest rate for student loans, the federal government tricks students into believing the cost of their education is lower than it actually is, thus encouraging malinvestment, which will ultimately be disastrous for students, as well as the economy as a whole.