Making Student Loans Dischargeable in Bankruptcy Could Be a Free-Market Idea

Student loans, unlike almost every other kind of loan available, cannot be escaped through bankruptcy. It wasn't always this way.
04/05/2012 09:06am ET | Updated June 5, 2012
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Here's a riddle that many Americans are familiar with: how are a house mortgage, credit card debt, and a car loan different from student loans? For the latter, the federal government has gone the extra mile to protect lenders by making them non-dischargeable in bankruptcy. This means that student loans, unlike almost every other kind of loan available, cannot be escaped through bankruptcy. With student loan debt approaching nearly $1 trillion nationally, a growing portion of Americans are facing a growing burden of inescapable indebtedness. This burden of debt is especially borne by the young, the group which has perhaps been hit the hardest by the economic slowdown.

It wasn't always this way. According to the non-partisan Congressional Research Service, until 1976, all student loans could be discharged in bankruptcy. Up until 1998, student loans could be discharged after a waiting period (of initially five and later seven years after repayment was scheduled to begin). In 1998, Congress made federal student loans nondischargeable in bankruptcy, and, in 2005, it similarly extended nodischargeability to private student loans. (Extreme hardship can still result in the discharge of some student loans, but this condition is rather difficult to establish.) Since 2000, student loan debt has exploded, and private student loans have grown at an accelerated rate. Somehow, people still went to college and were able to get loans prior to 2005. Clearly, certain lenders found it in their own interest to provide loans even when there was a chance of bankruptcy.

Some have tried to frame the issue of nondischargeability of student loans in terms of guaranteeing access to education. According to these arguments, the fact that such loans are not dischargeable allows students greater access to higher education: since lenders know that students cannot escape their debt, they will be encouraged to lend money out more easily (increasing the amount of money lent out and lowering perhaps the interest rates on these loans in some cases).

Such arguments would seem to ignore some of the hard lessons of the past decade, when gratuitous credit for both private individuals and corporations helped lead to an unsustainable bubble in real estate and securities. Moreover, at least people can declare bankruptcy and escape their mortgages (and certain favored companies can get government subsidies so that they can avoid bankruptcy). This is not the case for student loans. Furthermore, the argument that educational access is improved by creating an eternal tie between borrower and debt could be applied to other areas as well. By such reasoning, perhaps the nondischargeability of car loans would help Americans get better cars or the nondischargeability of credit card debts could improve the material comforts of Americans by giving them access to more credit.

There's another approach to bankruptcy, however. Borrowers' potential for bankruptcy represents a kind of risk for lenders -- a risk that encourages lenders to be efficient about whom they lend money to. And this efficiency may lead to results in the interests of both borrowers and lenders. Due to this risk, the lender needs to determine how likely the borrower will be to pay him back, and the lender's evaluation of this risk can lead to him not lending too much money to the borrower, thereby preventing the borrower from getting over his head in debt.

Consider the case of student loans. If these loans were dischargeable in bankruptcy, lenders (especially private ones) would have to be more prudent about how much money they lend out to particular individuals. Currently, lenders have relatively little compunction about lending out $75,000 to a student as they know that this student's odds of escaping this debt are relatively small: it might not be paid back on time, but the lender will maintain a perpetual claim on the borrower. If there were a greater risk of bankruptcy, however, lenders might be more targeted in the amounts they lend.

Ironically, this targeting might make education more -- not less -- affordable. There is a limit to what students and their families can currently pay, and, by limiting the ability of some to borrow against their future, regulators might suggest to colleges and universities that the spigot of ever-more money might be turned off. This economic pressure might encourage universities to be more efficient with their own spending, thereby slowing the rate of tuition growth. Increased lending standards might encourage students to be more prudent with their own money. Higher standards might raise hard questions. A student might ask herself whether she should go to a low-ranked private university for four years or instead spend her first two years at a much more affordable community college before transferring to another university. The end result for the student's employment prospects might be the same, but the debt accumulated along the way might be very different under those two scenarios.

Moreover, there is a matter of fundamental principle here. Bankruptcy has a proud tradition in free market economies. The ability to start anew is both good for the human spirit and economically beneficial: this ability encourages taking risks and gives a sense of hope in the face of adversity. It's true that a college degree cannot be repossessed like a car with delinquent payments can be, but there has been little evidence that, prior to 2005, there was massive abuse on the part of student loan borrowers. Conservative politics is not just about the crude application of abstract principles; it also involves attention to local realities. Yet it seems that there was considerable access to credit for student loans prior to their being made non-dischargeable in bankruptcy.

Republicans might have a particular interest in restoring market norms to student loans: by normalizing student loans, Republicans could at once stand for free market principles and demonstrate their empathy for younger voters. If conservatives are serious about spreading free market ideas (rather than merely using the rhetoric of the market to hammer the opponents of the moment), a right-led movement to make student loans dischargeable in bankruptcy could be one more point of evidence for America's youth that free market ideas can work for a wide variety of people.

News stories abound with examples of graduates who have borrowed colossal amounts of money and who have little potential of paying it back, at least in the short- and medium-term. These students are shackled to this debt. It's true that these graduates chose to borrow this money, but it is also true that the federal government has chosen to give protections to lending companies for a certain kind of loan. It is not clear whether these special protections for certain lenders are in the best interests of the nation and its citizens, nor is it clear why the loans taken on by some of America's youngest should be the hardest to discharge. Making student loans dischargeable in bankruptcy is not loan forgiveness: in filing for bankruptcy, an individual would pay a considerable price for the dissolution of this debt. But the ability to pay this price is one we offer to borrowers of countless other loans.

The mechanics of how to put in place such dischargeability are complicated. Would old student loans be made retroactively dischargeable in bankruptcy? Would there be a waiting period before someone could discharge his or her loans? Would both federal and private loans be made dischargeable? But these complications should not deter conservatives from taking seriously the free market case for student loan dischargeability.

In 2008, Congress decided it was in the national interest to rescue multinational banks from the prospect of bankruptcy, passing TARP. If corporate bailouts are good enough for billionaires, perhaps the possibility of student loan bankruptcy (far from a bailout) might be permitted average Americans.