Referring to student debt as a “bubble,” like the stock and housing bubbles of the previous decades, is becoming more commonplace, as is the observation that total student debt has surpassed credit card debt. Yet what evidence do we have that student debt is growing faster than the economy and not providing the value that its advocates claim it does?
Government Data on Non-Revolving Credit
In March 2010, President Obama signed the Health Care and Education Reconciliation Act. One of its provisions terminated the Federal Family Education Loan Program (FFELP), leaving the Department of Education (ED) as the sole originator of all federal student loans via the Federal Direct Loan Program, which has existed since 1993. Starting July 1, 2010, all new federal student loans would be direct loans, and this is a good thing, at least because the FFELP was monumentally wasteful. It allowed banks to play middlemen over nondischargeable student debt, grossed ED an average $1.22 on every $1.00 for every defaulted loan, and fueled the Student Loan Asset Backed Securities (SLABS) trade. Direct loans alone, the thinking went, would solve these problems once and for all. With this change in the law, we can compare government holdings of non-revolving debt (mostly direct loans) to other types and divide them by GDP.
Here’s what we get: The blue-boxed line is all non-revolving debt minus the federal government’s holdings; the downward triangle line is mortgage debt (right vertical axis); the upward triangle line is credit card debt; and the bottom line is government holdings of non-revolving debt.
While revolving debt (credit cards), mortgage debt, and all other non-revolving debt are contracting, government-held non-revolving debt is increasing against GDP. In fact, in its “2014 Midsession Review,” the Office of Management and Budget (OMB) projects that the federal government will lend out $1.4 trillion dollars by 2023—mostly student loans—even though GDP growth will not match it. (These charts also use the 2013, 2012, 2011 and 2010 Midsession Reviews for data on previous years.)
The government has replaced “tax and spend” with “borrow and lend,” believing that mostly nationalizing a credit market will provide it with revenue via interest rate arbitrage. Unfortunately, this plan will fail for two reasons and leave taxpayers on the hook for hundreds of billions of dollars.
Bad Accounting, Expensive Education, Nonexistent Jobs
The federal government is not like a private sector business, but it is legally required to behave like one when it comes to lending.
Until 1990, the federal government used a “cash accounting” system to determine its budget. This meant that if the government lent out $10,000, it would’ve recorded a ten thousand dollar expenditure on its ledger even though it should’ve expected the money to be paid back in subsequent years. To remedy this, Congress passed the Federal Credit Reform Act, which switched the government’s accounting methodology to “accrual accounting” for direct loans. This means that the Department of Education calculates the net present value of student loans by setting the loans’ interest rates to a statutorily mandated discount rate, which by law is the interest rate of U.S. Treasury securities. In other words, if lending a student money makes the government more than it would have by buying its own debt on bond markets, then it considers the loan worthwhile. While better than cash accounting, there are two serious problems with this methodology:
(1) The discount rate is arbitrary. The U.S. government’s borrowing is not constrained the way private actors’ is because the government can always borrow from itself or raise taxes. Direct lending is not how it makes money. Even the CBO admits this is a problem. For instance, when Congress contemplated terminating the FFELP in favor of direct lending in March 2010, Senator Judd Gregg asked the CBO to rescore the proposed law according to a “fair-value” accounting methodology. The CBO stated:
Although the FCRA methodology accounts for the average losses from defaults on loans, it does not include the cost of all of the risks that loans and loan guarantees impose on taxpayers. In particular, it does not include the cost of market risk—the risk that losses from defaults will be higher during periods of market stress, when resources are scarce and hence most valuable. The cost of market risk is excluded from estimates under FCRA because the law dictates that expected future cash flows be discounted at Treasury borrowing rates rather than at the higher rates that private investors would require to make the loans or guarantees. (Page 3)
Alarmingly, the CBO determined that the fair-value estimates for the current and proposed programs were both positive whereas the FCRA estimates were negative, meaning that the government would actually lose an average of 12¢ on every dollar lent out by the end of the decade (more than $100 billion) even though FCRA accounting states otherwise. (Table 3)
Worse, the CBO’s estimates did not include the losses that would result from graduates going onto the Income-Based Repayment (IBR) plan, which cancels graduates’ loans after twenty years. The cancellations will begin in the late 2020s, and it could cost the government tens of billions of dollars that aren’t included here. Instead, the CBO states:
The costs of income-contingent repayment, or of loan forgiveness or forbearance, are generally higher on a fair-value basis than under FCRA accounting, because borrowers are more likely to take advantage of those opportunities in economic downturns, when the value of the forgone payments is greatest. (Page XI)
The CBO has published a more recent fair-value estimate of government credit programs, albeit before the 2013 student loan interest rate reform. Student loans will still give the government a slight, $5.5 billion positive return, but the fair-value estimate differed from the accrual accounting estimate by $30.8 billion. The total difference between the two accounting estimates for all government credit programs was $55.9 billion. Undoubtedly, some student loan programs lose more money than others. For instance, the Grad PLUS Loan Program, which offers students the unlimited remaining tuition costs on top of unsubsidized Stafford loans and living expenses, is simply a wealth transfer to universities. An August 2013 accrual accounting estimate of government student loan programs indicated that under the new interest rate law, these loans would have a -50.4 percent subsidy rate, indicating the program is a significant money-making opportunity for the government that escaped private lenders’ imaginations.
(2) The Department of Education’s return on investment for direct loans is wholly monetary and unrelated to the quality or necessity of the educations students purchase. Because universities calculate their tuition costs without regard to the labor market value of their degrees, they can charge excessive tuition and the government will happily loan the money since the net present value of a direct loan is mathematically greater than the interest rate on U.S. Treasuries. The justification for subsidizing higher education is improving worker productivity (human capital), which increases economic output and income tax revenue for the government, but most analyses of higher education’s value are conducted by economists who ignore signaling theory. For example, in late 2012 the Treasury and Education departments released a report, discussed in detail here, titled “The Economic Case for Education,” which never once mentioned signaling theory and trivialized excessive student loan burdens. (See page 30)
Many college graduates do not need college education for the careers they enter, and “knowledge jobs” will not grow to replace the millions of manufacturing jobs that have been lost due to the United States’ persistent trade deficit. None of this is to denigrate education for its own sake or for the sake of molding wiser citizens, but it’s another thing entirely to claim that education is necessary for employment prospects when it is not.
With these facts in mind, IBR will cause the government to lose even more money on direct loans because not only will it not receive revenue in downturns, but it will also lose money because the degrees were overvalued and not calibrated to the labor market’s needs to begin with.
As a result of these two problems, the government will take a double hit because it will both lose money on the loans and it doesn’t hold higher educators accountable to charge students reasonably and prevent over-enrollment. The Direct Loan Program will only succeed in transferring wealth to higher educators while indenturing young people when they need access to credit to buy homes, start businesses, etc. Government-held nonrevolving debt will continue to pile up against stagnant growth until the government stops pretending it can be a bank that takes on no risk.