The Economic Drag of College Debt and a Novel Solution
College debt is one of the most pressing economic problems in 21st century America. Although ordinary Americans may hear more on the news about the national debt, unemployment rates, shady bank dealings, or even inflation, college debt is a just as pressing, if not more important, problem, one that not only affects students, but also the overall economy.
Recent decades have seen a marked increase in student debt. Even as college tuitions rise at a breakneck pace, 200% from 1997 to 2017, state funding for higher education has failed to catch up and in many cases, has even declined. But students continue to attend at increasing numbers because the evidence overwhelmingly shows the average earnings premium of a college education is both significant and rising, making a college degree almost a necessity. In order to afford college, many students and families have turned to federal loans. While these programs help to mitigate the burden, tuition rates have increased too quickly and the amount of debt is only increasing.
In testimony to Congress last March, Federal Reserve Chairman Jerome Powell expressed concern at the mounting college debt. At the end of 2017, college debt was reported at around $1.38 trillion. Just a year later at the end of 2018, the New York Fed reported the national outstanding student debt had swelled to $1.46 trillion.
While Powell noted the issue was primarily one for Congress to address, he noted the potential for the problem to affect monetary policy. Although Powell expressed uncertainty at what the longer-run economic effects would be, he nevertheless warned the ballooning debt could eventually undermine economic growth.
Looking at Powell’s comments, however, it’s not hard to see what some of those effects might be. As students struggle to pay their loans, spending by the demographic has correspondingly decreased. Simultaneously, the inability to repay loans negatively impacts their credit scores, inflicting long-term damage to sectors such as housing, automobiles, and durable goods.
Researchers at the New York Fed go further, looking at the effect of student debt on homeownership, one of the largest purchases most Americans make in their lifetimes. While they caution against inferring causation from their findings, they found evidence that graduates have higher homeownership rates regardless of debt amounts but that higher student debt balances were associated with lower homeownership rates.
Although recent trends in the millennial demographic show a growing tendency to rent, lowered homeownership rates as a result of student debt is still a concern. First, homeownership is a critical way for Americans to build equity over time. Second, the rising value of home equity increases consumer confidence and purchasing power. As a result, a decline in homeownership due to student debt will have long-term effects on the economic growth of the nation through decreased consumption of goods and services.
For the policymakers at the Fed, the above problems could eventually become economic drags. Its mandate of maximum employment would be threatened by decreased demand that hampers business and market performance which in turn would threaten the symmetrical inflation target. It is no wonder then that Powell is sounding the alarm on the amount of student debt in America and the need for solutions.
One solution that has recently surfaced is income sharing agreements. Originally proposed by Milton Friedman in the 1955 essay, The Role of Government in Education, ISA’s allow lenders to advance funds in exchange for a specified percentage of future earnings for a period of time. Although a modified version was attempted in the 1970s by Yale, it never caught on. Recently, however, it has come back in vogue.
In 2013, the Oregon state legislature voted to investigate a “pay it forward” proposal for tuition and fees at public colleges. Essentially an ISA that would last for 25 years after graduation, the proposal sought to address concerns about the affordability of higher education and student debt. Several other states and even the federal government have since begun to look into the viability and efficacy of such a program.
Income share agreements have many benefits that help increase access to quality higher education. First, the repayment of a percentage of income rather than a specific amount means borrowers would also be able to pay their loans. This is good because defaulting on a loan can significantly damage an individual’s credit score, and thus their purchasing power. While some express concerns that borrowers would then be inclined to work less or not at all, the fixed rate means working more leads to more residual income at any level. As a result, it’s not likely people would be disincentivized to maximize their earnings.
Second, students would be able to obtain the best education personally possible because rather than settling for a worse-performing school that was cheaper, students could choose more expensive schools that have higher graduation rates and better post-graduation outcomes. In the end, students earn more, lenders earn more, and high-performing schools are rewarded with increased attendance.
Finally and perhaps most importantly for the Fed, ISA’s will increase the amount of disposable income available to college graduates. Because students pay a percentage of their income rather than a specific amount, they will gain the ability to save for things like homeownership, stock investments, discretionary purchases, and even college funds for their own children. In the long-run, all of these will help to grow the economy and make it easier for the Fed to do its job.
Although income share agreements may not be able to address debt accumulated in the past, it could have a significant effect on future collegegoers. Rather than layering on even more debt because their parents are saddled with their own student debt and unable to pay, future collegegoers who participate in an ISA could break the cycle. Over time, the economic drag of student debt would decrease as it either gets paid off or borrowers simply die. Many solutions will be considered when Congress decides to address this problem. ISA’s should probably be one of them.
“Total Household Debt Rises as 2018 Marks the Ninth Year of Annual Growth in New Auto Loans.” Total Household Debt Rises as 2018 Marks the Ninth Year of Annual Growth in New Auto Loans - FEDERAL RESERVE BANK of NEW YORK, Federal Reserve Bank of New York, 12 Feb. 2019, www.newyorkfed.org/newsevents/news/research/2019/20190212.
Chakrabarti, Raji, et al. “Press Briefing on Household Debt, with Focus on Student Debt.” New York Fed, Federal Reserve Bank of New York, 3 Apr. 2017, www.newyorkfed.org/medialibrary/media/press/PressBriefing-Household-Student-Debt-April32017.pdf.
Cox, Jeff. “Student Debt Should Be Discharged in Bankruptcy, Fed Chief Says.” CNBC, CNBC, 1 Mar. 2018, www.cnbc.com/2018/03/01/student-loan-problems-could-hold-back-economic-growth-fed-chief-says.html.
Lockert, Melanie. “What Happens To Student Loans When You Die?” Student Loan Hero, Student Loan Hero, 31 Jan. 2018, studentloanhero.com/featured/what-happens-to-student-loans-when-you-die/.
Nelson, Libby A. “Can 'Pay It Forward' Pay for College?” POLITICO, 12 Nov. 2013, www.politico.com/story/2013/11/pay-it-forward-oregon-college-tuition-099695.