Cutting Student Interest Rates: A Half-Baked Idea

Washington, DC is abuzz with talk today about the Democrat’s proposal to cut student interest rates on loans in half. While the idea might sound nice, we are not too impressed with it and the proposal will probably end up doing more harm than good.

Below is an op-ed from Richard Vedder that appeared on National Review Online this morning and addresses the issue more fully.

Let’s Not Be 3.4 Percenters
American students don’t need government’s heavy hand.
By Richard Vedder
The new Democratic congressional majority is voting Wednesday to lower the interest rate of some subsidized student loans from 6.8 to 3.4 percent. On the face of it, this appears a welcome move to reduce the rising burden of student debt. Various student groups have been quick to endorse the idea.

Though I’ve written much about how high tuition costs have imposed increased financial burdens on college students, I oppose the new Democratic proposal. There is, of course, the legitimate Republican procedural objection that decisions of this sort should be made only after experts are consulted, evidence is gathered and presented, and reasoned debate concluded.

My concerns are different: the federal student-loan program is already Byzantine in its complexity, and has even been harmful to some students. The Democrats’ new move will do nothing to address these old problems.

A historical perspective is useful. The great growth in college participation in the United States occurred before federal financial aid was a reality. With the single, but important, exception of the GI Bill, there were no large federal student-aid programs before 1970.

In that year, total federal student assistance amounted to $1.6 billion. About $1,000 per student in 2007 dollars, this was less than one-fifth the commitment today, even adjusting for inflation and the higher cost of tuition. Yet the number of college students per 1,000 Americans aged 18 to 24 grew from 23 in 1900 to 324 in 1970.

The explosion in aid began in the 1990s. From 1990 to 2000, federal student assistance more than tripled, going from $19 billion to $63 billion, but the proportion of the population in the 18 to 24 age group going to college rose only modestly (from 506 to 545 in a thousand). Among some groups, including males, there was no growth at all over this period.

The explosion in aid has actually accompanied a slowdown in the growth in college participation. There is little evidence that the aid epidemic has increased the proportion of adult Americans who are college graduates.

Why? First, much of the increased student aid has gone to students who would have gone to college without the aid (e.g., recipients of federal tuition tax credits, who could afford tuition in the first place).

Second, and relevant to the current debate, more federal money increased the demand for higher education, raising sticker prices. The greater demand was not offset by supply increases, partly because prestigious colleges have put limits on undergraduate admissions.

Third, as the Education Trust showed convincingly recently, institutional financial assistance shifted sharply away from need to merit-based aid in recent times. The result? Higher tuition costs often more than offset higher aid for poorer students, so the burden of college attendance has risen, not fallen.

The real problem is not high interest rates on student loans, but exploding college costs. There are easily a dozen causes for this, but a few especially stand out.

Third parties (e.g., the federal or state governments, private philanthropists) pay a large chunk of the bills, rendering the customers relatively insensitive to prices (health care revisited).

Universities are mostly nonprofit institutions with few incentives to cut costs. The lack of a well-defined “bottom line” makes universities strive to improve their US News & World Report rankings, which are perversely enhanced by spending more money and restricting access.

A lack of well-defined property rights (who owns and controls universities) means the faculty is able to promote its own interests over those of relatively disenfranchised students and parents. For example, a drop in teaching loads has occurred not because of any nationally articulated research imperative, but because faculties have simply done it, with the approval of nominal bosses who politically need faculty support.

Why have universities raised tuition fees dramatically, creating the current brouhaha over student aid? Because they can get away with it. The solution to the problem is not reducing interest rates on loans, but getting the rise in college costs to remain below the income curve.

It would be far preferable simply to give students money in the form of an educational voucher and to let them use it in whatever fashion they wish than to try to artificially change the price of one of many cost items that determine the financial burden of college.

The method that the Democrats seek to pay for these new lower interest rates is predictable and problematic. The fees paid to private loan programs are to be cut, and the guaranteed reimbursement provided in cases of default are also to be reduced.

This is the strategy used in health care (cut fees to doctors and drug companies, lower costs to consumers), a move that has not stemmed the rise of health care costs, but rather threatens its quality in the long run. A similar outcome is likely if followed through in higher education.

In an ideal world, the government would get out of the financial-aid business. Excepting the GI Bill, it has not improved access to college. Financial markets, capable of handling small loans for home repairs and car purchases as well as billion-dollar loans to giant corporations, can meet borrowing needs of individuals wanting to go to college.

And still, there is growing evidence that governmental higher education support does not promote economic growth, the rhetoric those “educrats” who benefit mightily from rising subsidies notwithstanding. Why, then, shouldn’t the federal government limit its involvement at most to a Pell Grant program for truly low-income students, or perhaps get out of the aid business altogether?

Our great hope in stopping this express train is President Bush. One hopes he is beginning to realize that his role in history would be enhanced, not retarded, by just saying no to something. Vetoing an interest-rate subsidy bill would be a good place to start.