Is Federal Student Aid Among the Best or Worst Government Programs?

with 3 Comments

Jefferson and the Rotunda in the snow

We usually only recommend paying off as slowly as possible two kinds of debt. The first is a home mortgage because the government heavily subsidies your interest payments by allowing an itemized tax deduction. The second is Student Loans.

I’ve always assumed the general societal assumption that student loans were basically good public policy. I believed this even while also believing that smart families would minimize the debt that they saddled themselves with and would seek to fund college in less expensive ways.

It is normal to believe that well-intentioned feel-good programs will have a more positive than negative effect. But it is not usually true. Even those of us who lean libertarian succumb to utopian intentions. But economics and public policy should be based on the understanding the complex unintended consequences of artificially fixing one variable in the equation of supply and demand.

These complex workings are not always easy to follow.

In May of 2008 I published an article on subprime lending in which I wrote:

The unintended consequences of good intentions can do more economic harm than all the mean-spirited greed within capitalism.

Part of the good intention was forcing banks to be good neighbors by making altruistic loans that discriminated in favor of underprivileged communities. Any attempts by banks to set higher rates, terms or conditions on people with questionable credit was labeled “predatory lending” and used to hold lenders hostage. This form of price controls held the price on questionable loans artificially low.

The reality in the Fall of 2008 turned out to be even worse than I thought it would be.

Now it looks like some of the unintended consequences of our Federal student aid programs might be similarly bad.

Before you dismiss that idea as ludicrous, at least remember that people thought the subprime lending was wonderful public policy and praised it profusely up until it brought down our credit markets.

My perspective changed when I read an article by Richard Vedder, Professor of Economics at Ohio University, entitled “Federal Student Aid and the Law of Unintended Consequences.” This was one portion of the article that caught my attention:

Student loans have been growing eight to ten percent a year for at least two decades, and, as is well publicized, now aggregate to one trillion dollars of debt outstanding—roughly $25,000 on average for the 40,000,000 holders of the debt. Astoundingly, student loan debt now exceeds credit card debt.

The Debt Clock currently only stands at $15.8 trillion, and that is $50,460 per citizen. To think that the student loans have grown so large is to realize that the cumulative effect could now have serious consequences.

Just to be clear. Trying to dictate yet another variable in the equation through legislative policy would only make the other variables blow up more violently. Part of the problem is because those who pay, decide and benefit are all different parties. There is no negative feedback. And as I learned in my electrical engineering classes, systems with no negative feedback ultimately explode. As Vedder says in another portion of his article:

Related to this problem, colleges themselves have no “skin in the game.” They are responsible for allowing loan commitments to occur, but they face no penalties or negative consequences when defaults are extremely high, imposing costs on taxpayers. …

The alleged positive spillover effects of sending more and more Americans to college are very difficult to measure. And as the late Milton Friedman suggested to me shortly before his death, they may be more than offset by negative spillover effects. Consider, for instance, the relationship between spending by state governments on higher education and their rate of economic growth. Controlling for other factors important in growth determination, the relationship between education spending and economic growth is negative or, at best, non-existent.

Vedder’s article is extensive and I recommend reading it in its entirety. But here is an executive summary for those who want it:

  1. Student loan interest rates are not set by the forces of supply and demand, but by the political process.
  2. In the real world, interest rates vary with the prospects that the borrower will repay the loan.
  3. Perhaps most importantly, federal student grant and loan programs have contributed to the tuition price explosion.
  4. The federal government now has a monopoly in providing student loans.
  5. Those applying for student loans or Pell Grants are compelled to complete the FAFSA form, which is extremely complex, involves more than 100 questions, and is used by colleges to administer scholarships (or, more accurately, tuition discounts).
  6. As federal programs have increased the number of students who enroll in college, the number of new college graduates now far exceeds the number of new managerial, technical and professional jobs—positions that college graduates have traditionally taken.
  7. As suggested to me a couple of days ago by a North Carolina judge, based on a case in his courtroom, with so many funds so readily available there is a temptation and opportunity for persons to acquire low interest student loans with the intention of dropping out of school quickly to use the proceeds for other purposes.
  8. Lazy or mediocre students can get greater subsidies than hard-working and industrious ones.

Programs created with the noblest of intentions have failed to serve either their customers or the nation well. In the 1950s and 1960s, before these programs were large, American higher education enjoyed a Golden Age. Enrollments were rising, lower-income student access was growing, and American leadership in higher education was becoming well established. In other words, the system flourished without these programs. Subsequently, massive growth in federal spending and involvement in higher education has proved counterproductive.

Many liberals attack the good intentions of fiscal conservatives. Conservatives and Libertarians assume that liberals have good intentions. But we don’t want to ignore the unintended harm caused by many well-intentioned programs. It isn’t just that they are ineffective. It is that they are harmful and cause more misery than happiness to society as a whole.

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David John Marotta is the Founder and President of Marotta Wealth Management. He played for the State Department chess team at age 11, graduated from Stanford, taught Computer and Information Science, and still loves math and strategy games. In addition to his financial writing, David is a co-author of The Haunting of Bob Cratchit.

3 Responses

  1. Luis

    Commenting on your last statement which is just an opinion of yours how would anyone know what is best? Basically the only ideal being tested is the liberal policies of the last century. USA took over France as world leader in the 20th century. Social security, public schools, healthcare all part of those victory years. How is an unknown ideal libertarian policy better?

    • David John Marotta

      Greetings Luis,

      Thank you for taking the time to comment. I wrote earlier, “For those willing to examine the evidence objectively, this social experiment has been tried hundreds of time throughout human history.” And as I mentioned in the article above, it is based on the general idea that “those who pay, decide and benefit” should all be the same person. Only in that case can the decision of cost effectiveness even be made.

      We are seeing the effects of the federal student aid policy. The whole point of the article quoted above was to evaluate the evidence judging what is best. What is troubling is even after looking at the unintended consequences and harm being done many people are in favor of the policy anyway out of a sense of it is virtuous to have good intentions even if the policies themselves are detrimental.

  2. David John Marotta

    I read with interest Andrew Leonard’s rant in entitled “A huge student loan scam: With the help of Virginia Foxx, R-N.C., for-profit colleges are massively ripping off U.S. taxpayers” in which he wrote:

    The for-profit educational sector is an industry almost entirely subsidized by the federal government. Around 70-80 percent of for-profit revenues are generated by federal student loans. At the same time, judging by sky-high dropout rates, the for-profit schools do a terrible job of educating students. The Obama administration’s efforts to define a credit hour and require state accreditation were motivated by a very understandable desire: to ensure that taxpayers are getting their money’s worth when federal cash pays for a student’s education. In contrast, Foxx’s legislation is designed to remove that taxpayer protection. So here’s a more accurate title for her bill: “The Protecting the Freedom of For-Profit Schools to Suck off the Government Teat Without Any Accountability Whatsoever Act.” …

    The pathetic performance of the for-profit sector in delivering actual degrees becomes all the more alarming when you realize that most of the students who are dropping out paid for their educations with student loans that have to be paid back.

    What I find odd is that the obvious answer isn’t just to cut the funding? This isn’t a “for-profit” problem, this is a “government largess” problem. Wherever government let’s the milk flow you are going to find at least some fat happy lazy pigs.