Not So Fast, Senator! How to Really Solve The Student-Loan Debt Crisis

Massachusetts Sen. Elizabeth Warren recently spoke at Northeastern University about the student-loan debt crisis and how to fix it. Americans owe $1.1 trillion in student loans, with $150 billion of new borrowing in 2013 alone. A typical 2014 university graduate will incur $30,000 or more in education debt. When interest and fees are added in, millions of people will spend their entire working lives trying to repay student loans.

But Warren's prescriptions fall short of the radical steps necessary to solve the problem. First, she claims that the federal government earns "enormous profits" from student loans. This likely comes from a Congressional Budget Office report in June 2013, which estimates upside potential income of $182 billion from student loans between 2013 and 2023. However, the same report warns that student loans could instead cost the government as much as $95 billion during that period. This disparity reflects the reality that the government makes money based on the spread between the rate it borrows funds and the rate at which it lends -- rates determined over time by economic conditions beyond our predictions.

Second, Warren asserts that the interest rate on federal student loans should be drastically lowered. The current rate of 3.4% for most federal loans is commensurate with mortgage interest rates. However, mortgage lenders have recourse to collateral (the house) in case the borrower defaults. Given that most students have no credit history and offer no collateral, the student loan interest rate is hardly predatory.

The senator is right about one thing: she has co-sponsored legislation to make private student loans fully dischargeable in bankruptcy. Currently, education loans are not dischargeable in bankruptcy unless the debtor proves that repaying the loans would result in "undue hardship." This is a high legal hurdle that few debtors can met. Private loans should be dischargeable because, unlike federal loans, lenders can make loan decisions based on credit worthiness, there are no interest rates or loan amount maximums, and private loans do not offer forgiveness for low-income or public service borrowers.

The real cost of student loans is the transformation of higher education from a price-elastic (price-sensitive) commodity to a price-inelastic one. As the price of higher education has increased at three times the consumer price index, students have coped by taking out more loans, while the delinquency and default rate is 20 percent and rising. Universities have been insulated from the price competition that would exist if students had to soberly confront the affordability of a school or program at the start of their education, rather than after graduation. The remedy is for the federal government to gradually reduce the amount it lends for higher education by half over the next 20 years. This will give the higher education marketplace time to become more cost-effective while reducing new student loan indebtedness.

There is a strong demand for higher education, and supply will meet demand at a commensurate price. For example, community colleges are substantially less expensive than traditional four-year colleges -- students are increasingly taking basic courses at community colleges, then switching to traditional colleges to complete their degrees. With reduced student-loan funds, schools must maintain both the quality and affordability of education, or their enrollments will decline. No doubt many programs will close, but the early casualties are likely to be proprietary, for-profit schools that enroll only 10 percent of higher education students, yet account for 25 percent of all student loans and 50 percent of loan defaults. Indeed, 98 percent of funding to these schools comes from federal student loans. With lower student-loan indebtedness and more efficient higher education, the student loan problem goes away.