Millions of borrowers in the federal student loan program are defaulting on their loans.  The Education Department now estimates the cost of student loan losses at more than $400 billion.  That exceeds the losses of banks during the sub-prime mortgage crisis.  As such, progressives are now pressuring Joe Biden to forgive student debt entirely.  The losses in the student loan crisis increase the federal deficit, imposing heavier tax burdens on current as well as future generations.  Citizens need to understand why the federal student loan program failed, and what impact this failure has on our society.

The federal student loan program was originally defended on the grounds of efficiency.  It was argued that private student loan programs were inefficient because students could not collateralize their future earnings.  This argument has proven to be false, as colleges have extended loans to students using income-based repayment schemes.  Private lending institutions are in fact efficient in allocating loans to students.  They have an incentive to practice due diligence, selecting borrowers who are likely to repay their loans.  Potential default on the loans sends the right signals.  Private lenders assume the risk when the loans are in default.  Credit agencies assign lower credit scores for lending institutions that extend loans to students who are not creditworthy.  During the financial crisis in 2008, some lending institutions with a risky portfolio of student loans in default went into bankruptcy.  Students who default on loans bear some of the cost of non-repayment, in the form of low credit scores that preclude them from borrowing for homes, cars, and other loans.

The private student loan program has been largely displaced by the federal program extending loans to college students directly.  The rationale for the federal student loan program was to extend loans to a broader group of students.  But the federal student loan program sends all the wrong signals.  Students have an incentive to take out loans they can't repay in order to capture the federal subsidy.  This incentive increases when students anticipate a federal bailout when they default on the loan.  The highest default rate is for students who take out loans but never finish a degree.  Many of these students are from low-income families, attending community colleges and private or for-profit institutions.  But most of the loans in the federal student loan program are extended to students from more affluent families.  The cost of these loans, both in the form of federal subsidies and loan default, is borne by all taxpayers.  Colleges have captured much of the benefit from the federal student loan program by boosting tuition more rapidly than the rate of inflation. 

The failure of the federal student loan program is not unique.  The fiscal stimulus programs enacted in response to economic shocks extend subsidies to banks, corporations, small businesses, agriculture, and state and local governments.  Subsidies are now extended directly to citizens by state governments, as well as the federal government.  Subsidies send all the wrong signals; recipients are like zombies sleepwalking along, waiting for the next bailout.  The bailouts are increasing debt at an unsustainable rate.  This is not just increasing tax burdens; it is diminishing economic opportunity in an economy experiencing retardation and stagnation in economic growth.  The U.S. economy is looking more like the stagnant Japanese economy.  In our recent book, Fiscal Cliff, we examine the impact of the Japan disease on the U.S. economy and explore alternative paths to this bailout society. 

John Merrifield and Barry Poulson (think@heartland.org) are research fellows with The Heartland Institute.

Image: Stilfehler.