The Hazards of Student Loan Reform

Obama's student loan program is an example of government policies that provide short term relief at the cost of long term economic health. While loan subsidies and debt relief may benefit their recipients, the long term hazard is that they provide perverse incentives for systemic increases in debt and economically unsound behavior. Here are a break down of the policies and their unintended consequences:

1. Eliminating the middleman: Obama claims that by having the federal government directly directly handle student loans (rather than subsidize private sector loans) he will save the tax payers billions of dollars. For the sake of the discussion, let's assume that there will be short term savings, based on the general track record of federal programs we can assume that over the long run the public sector has little if any incentives to allocate loans with even a modicum of economic logic. A private financial institution that does not enjoy lavish government subsidies is far more likely to factor in a student's capacity to repay the loan in their decision making criteria. Why? Because, the market would castigate them through decreased profits and eventually dissolution. On the other hand, when faced with systemic losses, the federal government's first impulse is to increase funding, which leads to a greater tax and debt burden.

2. Increase Pell Grants (and other subsidies): In the short run this will increase access to college, however in the long run this will contribute to the very serious issue of continued cost inflation in higher education. Economic laws dictate that when high demand is artificially sustained by government subsidies, incentives to control cost inflation are diminished. What this means is that universities will avoid taking necessary steps to control costs. The dangers of loose financing can be seen in the housing market; when housing finance was plentiful, demand soared, driving up prices and increasing debt. The same phenomena applies to the student loan market.

3.Increased Funding for Minority-Serving Institutions: The new legislation includes $2.55 billion in support for schools that primarily serve minorities. I question the constitutionality and economic logic of racial preferences in the allocation of federal funds.

4.Lower Income-Based Payments: After 2014, those who struggle to make loan payments will be able to take advantage of income-based repayment plans. Under the new rules, loan payments cannot exceed 10% of the borrower's discretionary income. This policy sound positive, however the question to ask is: will it encourage more people to take out loans that are beyond their means? And by lowering monthly payments (regardless of the size of the loan), many students will see the terms of their loan lengthened, which leads us to the 5th element of Obama's program:

5.More Forgiveness Opportunities: This part of the law also takes effect in 2014. Borrowers who stick with their income-based payment plan for 20 years will then no longer owe a balance, even if they haven't yet paid back all of their loans. Borrowers employed in public service will see their balances wiped out in 10 years.

Although this sounds appealing, coupled with longer term loans (see point 4) this will clearly provide perverse incentives to not pay back their loans at the cost to tax payers. This will also provide incentives for more individuals to opt for an already bloated public sector, rather than the private sector.

In many ways the sharp recession that we are facing was a market correction of more than a decade of unsound economic behavior, most notably the excessive debt and malinvestment that millions of individuals and enterprises undertook. Even in the face of higher unemployment and declining incomes, the American public began paying down their debt and undertaking wiser investments. And costs fell for most goods and services, except for sectors that are largely shielded from market forces: health care and education. And well meaning government intervention, such as Obama's student loan reforms, provides perverse incentives for Americans to return to the economically unsustainable behaviors of the past.

Read more: http://www.sfgate.com/cgi-bin/article.cgi?f=/g/a/2010/04/08/investopedia43354.DTL#ixzz0lQaTaoA6