The Student Loan Bubble Explained

by Chase Donnally

There is currently more than $900 billion of outstanding student loan debt held in the United States, more than any other type of debt held by Americans. Nearly 60% of all students must borrow money to help cover the costs of their college education each year, and that number is sure to increase as the price of education continues to rise.

Student loan debt cannot be erased through bankruptcy, and if you default on your payments, the government can garnish your wages, unemployment benefits, tax refunds, and even social security to make up the payments. Many recently graduated students owe more than $28,000 on their student loans, and often have degrees that don’t open up doors to very high paying jobs. And with the price of a college education on the rise, things are only looking to get worse.

Tuition and fees in the UC System have increased by more than 50% since 2008. If it were not for the ability to take out student loans, it would seem that a large portion of college students would be unable to keep up with increasing costs and would have to drop out of school. So should we be singing the praises of government assistance, or could this be an example of government breaking your legs and handing you crutches? That is to say, could the federal student loans program actually be a major contributing factor to the rapidly increasing costs of higher education in the United States?

The federal student loans program provides students with low-interest loans that would otherwise be difficult for prospective students to obtain. The loan standards for these loans are practically non-existent to make sure that young future students are able to qualify. You don’t need to have any significant credit history or source of income, so for most students the only way they’ll be able to pay off their loans is if they land a good job after they graduate.

In economic terms, what the government is doing is extending a cheap line of credit to students, with interest rates below the actual market value. This expansion of credit makes college appear to be a better investment than it actually is, and artificially increases demand in higher education. This artificial increase in demand (specifically, an increase in the ability to pay) leads to schools raising their prices over time. In normal market conditions, these increases in price would decrease demand, and lead to students dropping out; but because students are able to get cheap loans from the government, they are able to pay the increasing costs.

This fact has not been lost on universities; they are well aware that they can continue to increase tuition costs without reductions in revenue coming as a result of students dropping out. This ability of schools to increase tuition rates indefinitely ultimately benefits schools and is detrimental to students.

Does the situation above sound familiar? It should. We recently experienced a very similar bubble in the housing market, which eventually led to the crash in 2008. The root cause was the same: an expansion of credit, this time by the Federal Reserve, and various legislation meant to increase home ownership, leading to increasing home prices.

Unfortunately, the increasing prices could not be sustained forever. Eventually, when the mortgage default rate became too high, the bubble started to collapse, and we experienced the crash and the resultant recession. The Student Loan Bubble, as it has come to be called, will experience the same collapse when the default rate of student loans reaches an unsustainable point. As it stands, the default rate is already quite high at nearly 9%.

Those graduates who are unable to pay face their wages, tax refunds, and unemployment benefits being garnished, which has led to calls for student loan debt to be forgiven by the government. While this no doubt sounds like the perfect panacea to those students in default, it will likely only worsen the inevitable crash. If the loans were forgiven, that would mean a loss of nearly one trillion dollars in projected revenue to those holding the debt, which will almost inevitably result in another major government bailout.

The resulting increase in the government debt will only hasten us toward a sovereign debt crisis like those being experienced in the Eurozone.

The student loan bubble is a looming disaster, but not one that can be solved by more expansion of credit, government spending, or inflationary policies. The best possible solution, while it sounds unappealing and painful, would be to phase out the student loans program. Colleges would be forced to either lower their prices in order to accommodate those students unable to pay the currently outrageous fees, or face a dropout rate of more than 50% and the massive reduction in revenue that would go along with it.

It would certainly not be painless, but the damage is already done, and any attempts to avert the hangover will simply serve to put it off until later, when it will be much worse.

The economist Ludwig von Mises summarized this quite well in his magnum opus, Human Action, when he said, “There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.”

Given those options, the better choice seems pretty obvious.

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10 comments

  1. Student loans are both unsecured debt and the modern form of indentured servitude.

  2. What is being missed is the perspective of the student or parent.
    For parents college attendance creates the illusion of productivity and success for their children. They are all for it as long as they don’t believe they are paying the bills.
    Most students view college as a ‘life experience’ rather than a financial investment. They are perfectly happy to charge their women’s studies and classics courses on the invisible government credit card.
    Typically the kids graduate with no prospects and move back in at which point the parents get to play the victims and soak up sympathy.
    But really, i wonder how a pizza tastes that isn’t delivered by a college graduate?

  3. “Power Does What It Wants.” – George Carlin… http://vimeo.com/50460060

  4. nice, you made mention of von mises.

    the sooner the government gets out of student loan regulations, the sooner lending institutions can go back to proper risk assessment. If they don’t regardless? don’t bail them out. the threat of bankruptcy is quite the regulation

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