The Next Government Meltdown

Government interference has blown up a student-loan bubble.

Many years ago, our government set up two agencies, Fannie Mae and Freddie Mac, to offer low-cost housing loans.  The idea was to make it easier for renters to buy their own homes and participate in the Great American Dream.

As noble as the goal might have seemed, this really was yet another example of government solving a non-problem.  Canada and England have no such government support of homeowners, but about the same percentages of renters versus owners as does the United States.  Somehow, the good citizens of those countries found a path to homeownership even without a government-paved yellow brick road.

Although neither of these quasi-agencies was formally owned by the government, investors believed that their debts were guaranteed by the government.  Lenders therefore had more confidence that they'd get their money back than from an ordinary private bank, so Fannie and Freddie were able to borrow money more cheaply than commercial banks.

If you're in the business of lending money and you pay less to get the money to loan than your competitors do, you can lend it on better terms than your competitors can.  This was no accident: Congress rightly figured that lowering the cost of loans would make it easier for would-be homebuyers to get them.

However, this artificially low cost had a perfectly foreseeable side effect: given that they had the lowest cost of money around, Fannie and Freddie came to dominate the home mortgage business in the US.  The vast majority of home loans are now held by these two quasi-government entities.

There was another serious side effect which was not so readily predictable, but seems obvious in hindsight: In strictest accordance with Adam Smith's laws of supply and demand, making more money available for home mortgages and making more people eligible to get them pushed up home prices.  Sellers were aware of how much Fan and Fred were willing to lend, so they priced their houses accordingly.  As F&F lobbied for more lending authority, prices edged ever higher, resulting in the famous property bubble.  We all know how that turned out.

Instead of owning up to their mistake of pouring excess money into the housing market, Democrats in Congress and the Senate are urging the officials who're charged with winding Fannie and Freddie down, supposedly with minimum taxpayer losses, instead to reduce the principal on people's mortgages so more people can keep houses they couldn't afford in the first place.  In effect, it's a taxpayer-funded bailout of people who bought too much house.

The Peter Pan Theory of History

The opening line of Walt Disney's 1953 film Peter Pan is, "All of this has happened before, and it will all happen again."  It's been observed that our leaders really hate to admit mistakes.  The blocked all efforts to shut down disastrous government meddling in the mortgage market, so it's no surprise that they don't want to head off the same sort of looming disaster in the college loan market.  USA Today reports that our benevolent government will lose even more money than expected on its student loan program:

Last October, President Obama announced a broad initiative to provide relief for college graduates struggling to repay student loans. In a speech at the University of Colorado in Denver, Obama said the plan will lower monthly payments for 1.6 million borrowers.

Jessica Fernandez won't be one of them.

The article goes on to bemoan the fact that Jessica borrowed money from private lenders instead of from the government.  Those loans "have few of the protections provided for borrowers with federal student loans."

By "protections," USA Today means that students who borrow from private lenders can't defer payments if they're unemployed or have the balance of the loan forgiven after 25 years.  Private lenders can't do that sort of thing because they'd go broke.  The government doesn't like to think it can go broke as easily, of course.

How We Got Here

When I entered college 50 years ago, tuition at MIT was $1,750 per term.  Admittedly, thanks to inflation that's not quite as cheap as it sounds, but it's still equal to about $12,500 in 2011 dollars.  You would be hard put to find a community college charging that little today, much less a first-rank institution known the world around.

Back then, a student could easily combine summer work with work-study and graduate nearly debt-free.  Such a life was hardly luxurious, but it was perfectly viable and many thousands of Americans lived it.  The ability to combine work and education also had a beneficial side effect: making a college degree require that much work separated out those who didn't want to work hard.  Today's endemic college party animals were all but unheard of save for a handful of rich legacy brats.

This work-study situation was unacceptable to elected officials such as Sen. Claiborne Pell of Rhode Island.  Disregarding the fact that it was possible to work one's way through college with essentially no money up front, his major concern was making college education available to poor people who, he feared, might not be able to get or keep a job.

When his signature "Pell Grants" were first offered in 1972, college graduates earned a great deal more money than people without a college degree; sending people to college seemed like a good way to increase the amount of income tax they would pay over their lifetimes and was thus a worthwhile public investment.  Unlike the Stafford student loans which are administered by a different program, Sen. Pell's grants do not have to be paid back.

These grants certainly helped a number of people go to college who otherwise might not have been able to go, and for the first few decades the increased tax revenues from the students they helped probably paid the cost.  Unfortunately, this government subsidy had an unintended, undesirable, but perfectly natural side effect - college tuition went up.

Why?  Because students still had the same ability to earn money with summer jobs and work-study programs, but now in addition they had free money from the government.  In those days, few people worried about the return on a college investment; they attended the best college that accepted them which they could afford.  The free government money might have allowed more people to afford top-rank colleges - except that, of course, those colleges were already running at capacity and couldn't instantly accept more students.

Supply was fixed in the near term; demand increased, along with the money available to pay.  As Adam Smith would have predicted, the costs quickly rose.

What did colleges do with these newfound riches?  They spent fortunes on new buildings, raised faculty salaries a bit, and hired hordes of administrators to track all the wonderful new government programs.  By throwing money at the education system, government made it possible for prices to go up - but there is absolutely no evidence that a college education in 2011 is better in any substantive way than one in, say, 1960 - and quite a few arguments that it's worse.  Sound familiar?

Pell grants and the accompanying loans also made it possible to students to major in subjects with essentially no commercial value.  Students who put themselves through college with money they'd earned themselves had businesslike objectives - the plan was to increase one's lifetime share of GNP, which meant that they cared deeply about what job they'd be qualified for when they finished and how much it paid.  Again, only the relatively few trust fund kids could mess around with a degree in Ancient Languages or History of Art.

Students who're spending someone else's money, though, don't seem to worry as much about getting a return on the investment.  Government meddling made college costs go up and reduced the value of a college degree.

Today, there's an enormous gap in starting salaries of newly-graduated engineers ($55,000) versus economically-useless degrees in "recreation" or the arts ($30,000).  Yet every year we graduate fewer engineers.

The Educational-Loan Financial Bubble

The third unintended consequence was heavy losses on student loans.  Suppose you've gotten out of college with a huge debt to the government.  You have no job and no assets other than maybe a second-hand car.  You hit a bad patch and have trouble paying your loans.  What do you do?

So many recent graduates declared bankruptcy that instead of fixing the program by tightening lending standards or getting out of the business entirely, the government changed the laws so that student loans can't be discharged via bankruptcy.  No matter what you do, student loans follow you until you pay them off or die.

Jessica Fernandez says she didn't understand the ramifications of asking her mother to co-sign when she applied for a private loan to attend a for-profit business school. If someone had explained it to her, she says, she would have attended a less-costly community college or worked her way through school. Fernandez has been told by Sallie Mae that if she doesn't come up with the money to repay her loans, the lender will take action against her mother to collect the debt.  [emphasis added]

Once again, we see awkward results when government meddles in a market.  The government-sponsored program made so much money available that tuition skyrocketed.  Even so, Jessica knew that she could have worked her way through school.  If she'd done that, her work record would have made it easier to find a job - employers prefer graduates who worked their way through, for obvious reasons.  This article shows that the program isn't needed - Jessica herself said that she could have gotten an education without it!

What's the government's solution?  More regulation, of course.  Richard Cordray, Mr. Obama's illegal appointment to head the Consumer Financial Protection Bureau, criticized the private student loan market, saying, "It has operated in the shadows for too long."

With government being able to let borrowers stop paying at any time and piling more regulations on private lenders, they'll soon have most of the student loan market just as Fannie and Freddie got most of the mortgage market because government subsidies let them offer more attractive loan terms.

Total outstanding student loan debt surpassed credit card debt for the first time in 2010.  Estimates vary, but the total seems to be nearing $1 trillion.  Given the President's eagerness to forgive student debt, we taxpayers are going to pay the bills, just as we were on the hook for all those bad housing loans.

Oh, well, at least Mr. Obama will get some votes out of giving away our money.  Makes you feel proud to be a taxpayer, right?

Will Offensicht is a staff writer for and an internationally published author by a different name.  Read other articles by Will Offensicht or other articles on Economics.
Reader Comments

Wow, While reading the article I thought that I was reading my mind. Does this scenario not remind you of the parallel to Atlas Shrugged's government interference and its destroying the economy?

I, like Offensicht, went to school when students worked their way through in order to get a diploma. Loans were out of the question but there were ways to make enough money to pay for the necessities of life. Students had work programs with companies, study/work programs at the university, or simply found a job in the local community. If you wanted to get a degree there way a way.

The answer to this obvious problem is rather simple, shut the program down. Would it keep some students from going to college? Yes but it is my opinion that not everyone os cut out for college. It is a waste of their valuable time studying the history of art when they could be developing skills at an age when the mind is fertile and is ready to learn.

And while we are at it, what would happen to the universities if we were to implement my draconian measure of shutting down the government's interference in education loans and education? Their pipeline to free, easy money would be shut off and they would be forced to produce a product like the rest of our economy. We would have less morons like the professor at Colorado who said that the 9-11 victims deserved what they got. Tenure would be suspended and the professors would be held responsible for results, real teaching would be in vogue again.

When government interferes government corrupts and destroys as the unintended consequences always are much worse than what they had intended to help. They only help with other people's money. Someone had to pay that tax bill in order to give away the Pell grants. If Joe Six Pack ever learned that he was supplementing the educations of other people's kids he'd blow a gasket but you won't see that reported in the news. The compliant media always comes down on the side of slavery.

January 18, 2012 12:06 PM

"No matter what you do, student loans follow you until you pay them off or die"
This is obviously a problem. Perhaps we should throw the corpse in debtors prison and refuse the family the right of burial or cremation until their ancestors college loans are repaid.
When I graduated, I owed my Grandfather $500 that I had borrowed for text books. Paid it off the first month that I worked in my field. Today a bachelors degree is not much better than a high school diploma was back in the 60's. No, all kids in our educational system are not above average. You have to be home schooled to say that.

January 18, 2012 4:26 PM

It's worse than you think. If you study the loan terms closely enough and use your God-given brain, there is a way to borrow as much money as you like and never pay a dime back. Despite being in the 1%, we borrowed every penny to finance our two son's educations. And in fact, I am contemplating that when I retire in a few years, going back and getting a degree in philosophy. All of this (probably $500,000) will be at the eventual expense of the taxpayer (or the public at large, if we inflate our way out of things). I didn't make the rules, but I can play the game and given what I pay in taxes (six figures), I rationalize that I am getting my money back in the form of education.

January 18, 2012 4:29 PM
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