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A Market for Interest Rates on Student Loans

So here are my ideas on how an actual market for student loans would work.  None of this “market based approach” stuff that Republicans have cooked up (tagging interest rates to Treasury Notes is “market based” – what even?).

Here’s the description of a “common sense market based”

Republicans, and leading higher education and budget experts, Chairman John Kline (R–MN) and Representative Virginia Foxx (R–NC) introduced H.R. 1911, the Smarter Solutions for Students Act. This commonsense legislation simply moves all federal student loans (except Perkins loans) to a market-based interest rate. Under the bill, student loan interest rates would reset once a year and move with the free market, much like they did from 1992 to 2006. Interest rates for subsidized and unsubsidized Stafford loans would be based off of the 10-year Treasury Note plus 2.5 percent, capped at 8.5 percent. Interest rates for graduate and parent PLUS loans would be based off of the 10-year reasury Note plus 4.5 percent, capped at 10.5 percent.

Unfortunately, Republicans consistently don’t actually embrace “moving with the free-market”.  The fact that this bill isn’t an entire repeal of subsidized loans shows that Republicans are not committed to market based solutions for student loans.  The irony?  Further down the page, Republicans claim that  ”H.R. 1911 permanently removes Washington politicians from the business of setting student loan interest rates.”  What is a bill tagging interest rates with wiggle room and a cap but Washington Politicians (specifically, Republicans) setting student loan interest rates?

Market based solutions != tagging interest rates to Treasury Notes with some wiggle room and a cap(!)

Interest rates are dependent on a few things.  Looking at the Fisher equation (for nominal interest rates), interest= real interest rate + inflation rate.  What is not shown in the Fisher equation is a risk premium.  That is, how risky a loan is.  High risk means higher interest rate, low risk means lower interest rate.  There are “Market for Lemons” problems associated with loans, of course, but risk premiums still work out.  Risk premiums are usually tagged to some base level of risk – ie the least risky asset available.  For the market, this generally means Treasury Notes (as the government is seen as the least risky borrower – indeed in nominal terms they are 100% safe).

So to an extent, basing student loans on Treasury Notes makes some intuitive sense, since the market already uses it as a basis for risk.  However, letting interest rates rise to a cap of 8.5% and 10.5% doesn’t fully capture the riskiness of those loans.

So you may ask “But Cory, don’t we want people to have low interest loans so they don’t have high debt?”  The answer: absolutely not, we want interest rates that reflect risk as to allocate resources more efficiently.

Ignoring information asymmetry problems, risk premiums are essential to allocating resources efficiently.  Since the market allocates resources where they are needed, the opportunity cost of allocating scarce capital resources is key.  In Hayekian terms, we want to avoid “misallocation of resources” – and artificially lowering the price of money (interest rates) distorts price signals, which in turn distorts allocation of resources.  Alex Tabarrok found that over half of graduates with humanities degrees end up in jobs that don’t require college degrees.  Talk about debt and misallocated resources!  Why does this happen?  Daniel Lin has a two-part series on this question (Part 1; Part 2).  To summarize: government subsidies increase demand by giving money to students (a classic “income effect” of demand shifting right) while supply stays essentially the same – which allows colleges to charge higher prices.  Of course, governments see the rise in price and then subsidize more.  If you’d like to read more about this capture of governmental intervention, read my other post here.

You may continue and say “Alright Cory, since you think that the government doesn’t know how to assess loans for risk, how do you know how?  You aren’t even a bank!”

My answer: I don’t.  That doesn’t mean financial economists haven’t created models for risk – and I’ll take a stab at some theory as to how risk may be seen in student loans.  There are few ideas I have.

Risk associated with your major/minor.

Risk associated with your school.

Risk associated with your GPA

Risk associated with your major:

I don’t believe that there is a wedge between Social Marginal Benefit and Private Marginal Benefit for higher education.  Most definitely for public education K-12 (which is why we have free public education for all), but not higher learning.  The idea of this wedge would be that since people can’t afford an education (for public education, the poor and even middle class parents can’t afford to send kids to private schools, even with property taxes refunded) so there is a discrepancy between SMB/PMB.  With higher education, degrees that are in high demand (STEM degrees, for instance) have high wages that make paying off loans easy.  Engineers have low UE coming out of college and have initial average starting salaries of $50k.  Factor in life-time earnings, and college debt of even upwards of $100k is easily payable.

So, obviously degrees with higher demand, higher wages, and lower unemployment (in their field) leaving college would be deemed “less risky”.  So individuals graduating with quantitative skills (engineers, programmers, mathematicians, etc) would have lower interest rates.  This means we’d probably get more STEM and quant students going to college.

Degrees with less demand, lower wages, and higher unemployment (in their field) would be deemed “more risky”.  Of course, this means that, for instance, humanities degrees would have higher interest rates.  That means the marginal humanities major won’t go to college.  Since half of humanities graduates are in jobs that don’t need a college education, this means that a good portion of that half wouldn’t be saddled with debt and human capital that has absolutely zero value in the market.

I also would expect student loans to be adjustable rate loans, as I will explain farther down.

Risks associated with your school:

The Fox School of Business at Temple University has a pretty good job finding rate.  I believe something like 90%+ of students who utilize CSPD (Center for Student Professional Development) get jobs within 6 months of graduation, if not right out of college.  This means that a business degree at the Fox School would be less risky, which means a lower interest rate.  If you transfer to an even better business school (Wharton, Booth School), you’ll probably have even better job prospects, wage prospects, etc, lowering interest rates further thanks to lower risk.

Of course, this means that schools will probably have to be even more competitive, since kids who go to not-so-good schools will be strapped for cash thanks to higher interest rates.

Risks associated with your GPA:

Generally, higher GPAs will (on the margin) get you a job compared to a lower GPA student.  Of course, I don’t think that this is necessarily true in all degrees (journalism majors don’t really need high GPAs, just good skills; Econ students with high GPAs and good maths backgrounds are more likely to get hired than those with lower GPAs).

This means that loans would probably be adjustable rate – higher GPA, lower interest rate. This is similar to a “good student discount” for car insurance.  This also means your rate may go down over the course of your time at school, as well as giving an incentive to keeping up your grades.

I would expect in a market for interest rates to see wildly different rates for different students.  Of course, many object to the idea that colleges serve to prepare students for business world – it’s about an education (as if there’s an inherent value of “education”).  Others maintain that colleges are not businesses – or that it’s wrong to use colleges as ways for businesses to get the labor they want.

However, we no longer apply this logic to the housing market (which are long-term loans with risk associated with your income and such).  We no longer see housing as a quasi-right (the encouraging of sub-prime lending), because that was a confounding factor of the recent recession.

Also, we need to eliminate the state schools and public schools or really any school that can rent-seek (like Temple) for more money instead of looking to control costs (with our bloated administration and reckless spending on a new sports center – Pearson-McGonagall – that is only utilized by the small fraction of athletics students while our athletics is consistently terrible and little spending goes to teachers, educational capital, etc).  Drexel and Temple have both spent money on rock-climbing walls.  A professor (I can’t remember his name sadly) of sociology at Drexel said that the underwater basket weaving major is now going to have to compete with the prestigious rock-climbing major now.  Is this really what college education has come to?  I hope not.