Student loans have been decried by progressives for putting an entire generation in debt in a way that is exploitative and fails to maximize welfare. They score a point. The level of college debt has contributed to the struggle of many millennials to invest in productive businesses or start a family. At the same time, students continue to be incentivized to take out loans they otherwise would not have taken, preventing competitive markets from adjusting rates to risk.
breathless defenses of student loan cancellations are regressive,
Understanding the economic concepts of the principal-agent problem and moral hazard can help us find tools to align incentives and bring debt down to sustainable levels. Under the current system, many of the student loans available are belonging to large quasi-governmental agencies like Sallie Mae, or a third party loan servicing company. Approximately 92% of student loans are federal, discussions of student loans should therefore focus primarily on the actions of institutions and their functions. Federal student loans are fixed at interest levels below market rates, are not subject to credit checks, and are not adjusted for school attended, grades, or major. Securing loans to universities through government student loans is a subsidy to universities, and taxpayers foot the bill. These grants are not offset by liability on the part of the university; after all, the university has no place in the game.
This combination of ingredients creates a situation of considerable moral hazard. First, if student loan limits are raised, ostensibly to increase the chances of low-income people, colleges absorb much of that money by raising their fees. Second, since interest rates do not depend on the student’s major, students with short time horizons are more willing to opt for easier but ultimately lower-paying majors. One way to determine if this is true is to look at student activities and the time it takes to graduate. The Heritage Foundation examined how college students use their time and found that students devote only a few hours a day to studies. Similarly, students are taking longer to graduate, suggesting that easy money from student loans is something students are receptive to. This third-party payment system creates moral hazard and discourages the efficient use of resources. For example, if money given to value-neutral majors were instead allocated to corporate capital, our society would likely experience greater growth than under the current system.
Making college “free” would make the situation even worse. Everyone becoming more educated seems desirable until you realize that this further creates credential creep, disproportionately affecting those with less time and financial stability to devote to education. In this sense, education becomes more of an arms race that we all pay for, with a diminishing relationship to the efficient provision of goods.
Solving the principal-agent problem might fix this system. Ideally, universities should be encouraged to care more about student loans. Shifting the damages of non-payment from taxpayers to colleges and universities would do just that. Manufacturing colleges responsible for failed student loans encourages schools to accept higher paying majors and offer better career services. Schools have more information about students than loan agencies, and shifting responsibility and costs to them is a step toward encouraging more economically rewarding majors. Moreover, it would give them a greater interest in ensuring that the students are diligent and hardworking.
Colleges already have intimate knowledge of students’ financial status, grades, majors, and other important aspects. Having them serve or be responsible for student loans provides a stronger financial incentive than donations from alumni. This would solve the principal-agent problem and lead to more efficient use of resources.
isadore johnson is a campus free speech advocate, an economics and philosophy major, and a regional coordinator for Students for Liberty.