Journalists and academics have recently begun giving more scrutiny to federal government involvement in the market for student loans in the United States (e.g. Huffman, 2013; Norris, 2014; Wall Street Journal, 2014). The federal government offers several types of loans to finance higher education, with interest rates ranging from about 4-7% (“Studentaid.gov,” 2014). These interest rates are typically lower than those available from private creditors and offer more flexible repayment terms.
The market for student loans has many of the classic characteristics used by economists to judge whether government intervention is appropriate. The principal failure in the credit market as it currently exists is that American law prevents students from using their future earnings as collateral for an educational loan (Zimmerman and Miles, 2014 – see page 776 for an illustration of the market for student loans with and without government intervention). This means that low-income students without the means or credit history to offer sufficient existing collateral would either not be offered loans by private creditors, or be offered higher interest rates than they are able or willing to take on.
Government intervention to increase the availability of higher education to low-income students also has the goal of reducing income and wealth inequality. The U.S. Bureau of Labor Statistics found that in 2013, those with a bachelor’s degree earned nearly twice the median weekly salary of workers with only a high school degree (Bureau of Labor Statistics, 2013). Federal student loans with low interest rates thus increase the demand for a college education among low-income students who would otherwise not have been able to pay for or borrow to finance tuition, increasing their chances of boosting their future earnings and emerging from poverty.
However, the increase in demand for higher education from students now able to finance their studies with federal loans has brought an accompanying increase in the supply of higher education, including many for-profit institutions that often derive as much as 90 percent of their revenue from federal financial aid (Morgensen, 2014; GAO, 2010). Researchers have found that students from households at or near the poverty threshold are overrepresented at such for-profit institutions, that students of these institutions graduate at lower rates and with higher debt burdens, and that they are more likely than students at other types of institutions to default on their educational loans (IHEP, 2011; Deming et al., 2011). Default on federal student loans can affect future employment prospects and earnings, and is one of the only types of loans that are not discharged in bankruptcy, making the consequences of default are severe and long-lasting (“Federal Student Aid”).
The market for student loans is, therefore, an excellent case study of the general economic costs and benefits of government intervention to reduce poverty and inequality through incentivizing higher education.