Government Failure in Student Loans

By Richard Vedder

Congress is frantically trying to pass legislation subsidizing student lenders, in order to avoid insufficient funds being available for college students this fall. As I indicated earlier, the denial of credit to some students is not an altogether bad thing, and in the market economy credit is generally allocated efficiently between alternative uses, with some would be borrowers unable to get credit at the market interest rate. But Congress wants no students turned away this election year.

As the Wall Street Journal so accurately editorialized today, the student loan crisis is not a case of market failure --of the forces of demand and supply failing to meet human needs. Rather it is a classic case of government failure. As I said before, the two big culprits are the Fed, the nation's central bank and a quasi-governmental institution, and Congress itself. Three points here:

1) The Fed has provided huge funds to fuel credit market expansion since 9/11, pushing interest rates for most of the period below the appropriate rate consistent with human behavior, leading to the housing boom, overlending in housing, and the housing bust.

2) Congress did the same thing with respect to student loans, making large sums available to students with dubious prospects of repaying the loans, and making those loans available at very, very low interest rates.

3) George Miller and Ted Kennedy, aided by both Democrat and Republican co-conspirators, tried to fund a Pell Grant expansion by mandating dramatically lower fees for servicing government subsidized but privately provided loans. This contributed to an exodus from student lending by many providers. The concern about rising student defaults associated with the rush to credit quality occasioned by lender reaction to the housing/mortgage debacle has aggravated this tendency.

Sure, private lenders were over exuberant in their lending. Credit quality fell, in part aggravated by new financial instruments led lowered incentives for banks to insist on high credit quality. The private sector made mistakes --but the environment that led to these mistakes is a product of governmental interference in a market that would be best left to private lenders. We have too many marginal students going to college, dropping out, and facing big debts. The federal government is largely to blame for that phenomenon. Their latest "cure" for the problem they created is worse than the disease itself.