What Should We Do About Student Loans?

By Richard Vedder

People of importance have asked me to offer my perspectives on the current student loan segment of the current fragility in financial and credit markets. I plan to do so with them privately, and am spending some time thinking about it. Let me share my first blush opinion about the whole topic.

Politicians and others are asking the Bush Administration to "do something" to guarantee that all students can borrow whatever they want within the limits of the law. Failure to do so might lead some students to forego a college education this fall, it is argued. Students shouldn't become victims to a financial crisis that was predicated on greed and imprudent policies of others, or so some argue.

My views may differ fundamentally from this view, and may seem harsh, and certainly are unfashionable. First of all, too many people are borrowing too much subsidized money to go to college, and while the current "crisis" may not be the optimal way of revising that trend, it is a step in the right direction. At the margin, too many Americans of dubious academic backgrounds go to school. Some who drop out do so rationally (because the return on their investment is low), and subsidies of loans induces some of them to do something that is probably not socially optimal, to attend school despite their correct instincts that there are better personal alternatives. In some work for Charles Miller and me, Whiz Kid Gordy Ruchti is finding that the earnings advantage of college usually advertised overstates reality by a factor of three. As Charles has said repeatedly to me, many seemingly irrational "dropouts" are doing the right thing given the dubious economic advantages of going to college.

Second, the students who will have trouble borrowing this fall are, I suspect on average, less promising than the average college student. The best and brightest are worth lending on, and can even acquire conventional private loans. The marginal students who may drop out for academic reasons and are greater lending risks are the ones who may get crowded out in the battle for funds this fall. By denying them funds very often we are doing them a favor.

Third, the government has distorted financial markets enough. The Fed started the whole fiasco by artificially lowering the cost of funds after 2001 below what human behavior dictates that cost to be. This led to excessive lending and a housing bubble. The same thing has happened to some extent with student loans, as my colleague Andy Gillen has said in this space and even more brilliantly in a soon to be released CCAP study on the "tuition bubble." Lending money to persons who are not credit worthy would merely worsen an already bad system brought about by trying to out guess market forces.

Fourth, we should use this crisis NOT to put a bandage on a sick system, but to reform the system. The ultimate reform must be for the government to get out of the lending business and end its distortion of the allocation of resources that accompanies its subsidies and contortions to ration credit. If the way to make that happen is to move to an expanded Pell Grant system, preferably refashioned as a federal opportunity voucher for lower income applicants, so be it.

My views were reinforced today when a student who I like a great deal came to see me and said: "Dr. Vedder, I am graduating in three months, have no idea what I want to do, have not been able to get a job, and have $50,000 in student loans." One option he is considering is to go to graduate school, borrow still more, and put off entering the Real World. He will be lucky if he gets a job paying $45,000 a year now --with $6,000 or $7,000 in annual debt service on a disposable income of perhaps $35,000 a year --if he is lucky. Trying to induce him to do more school by offering him more loans is a bit like offering more dope to the drug addict.