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Student Loans Need Real Privatization

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Student Loans Need Real Privatization

July 29, 2016

Over at the Brookings Institution, University of Michigan professor Susan Dynarski writes that the GOP platform on higher education fails to adhere to the party’s ostensible free-market principles. At issue is the platform’s language on student loans, which states that “private sector participation in student financing should be restored.”

Although it sounds free-market, the key word in the sentence is “restored.” Prior to our current student loan system, in which the federal government lends directly to students, there was no true free market for financing higher education. Instead, the government guaranteed student loans made by the private sector. It also set interest rates and borrowing limits.

The good old days of "private" student loans, to which the GOP platform implies an intended return, lacked the main benefits of privitization. Taxpayers bore all the risk, so lenders had no incentive to weed out poor-quality colleges. Predetermined interest rates eliminated any possibility of competition based on price. These shortcomings are part of the current, government-originated student loan framework, but they are hardly unique to it. Reverting to the old system would change little but the optics.

Dynarski rightly calls out the inconsistency here—Republicans want privatization in name but not in practice. However, her next assertion is that a private student loan market without government guarantees could never work. Not so fast.

The case that private student lending will face insurmountable market failures rests on the presumption that student loans, unlike car loans or home loans, would be unsecured. This is because people cannot put up their degrees as collateral the way one can put up physical property. Privatization critics claim that lenders will thus charge usurious interest rates, which will discourage many prospective students from borrowing and lead to underinvestment in education. As Dynarski mentions, the free-market economist Milton Friedman discussed this in a 1955 essay.

However, Friedman went on to say that the answer to such concerns is for students to put up their own income as collateral—student equity, not student debt. Under such a scheme, lenders would pay the costs of students’ education in exchange for set portions of their future income. Since some students will inevitably earn more than others, the inherent risk in student lending is diversified: high earners will pay more, and make up for losses that lenders incur from low earners. In theory, the underinvestment problem is solved.

The modern iteration of this idea is the income-share agreement (ISA). Dynarski addresses this concept, but claims it would not work because private investors could not track ISA recipients’ income. (Friedman, in his essay, also alluded to administrative burdens as a potential problem.) However, I imagine ISA lenders would not find this too troublesome. They could require the submission of tax returns, or request income verification through the IRS as do mortgage lenders.

A stronger objection to ISAs’ viability is lack of regulatory clarity. As Miguel Palacios, Tonio DeSorrento, and Andrew Kelly discuss in an AEI report, it is uncertain whether ISAs would be subject to usury laws, whether they could be discharged in bankruptcy, and what would be their tax treatment. It is not even clear which federal agency would regulate them. Until regulators make these decisions and offer ISAs a clear regulatory framework under which to operate, few investors will want to put money behind them.

Then, of course, there is the elephant in the room: the federal student loan program. The government lends to students at a loss which amounted to $21 billion in fiscal year 2016, according to fair-value estimates from the Congressional Budget Office. This, combined with requirements that colleges encourage students to exhaust federal loan options before turning to private providers, makes it quite difficult for any would-be private financier of higher education to get its foot in the door—much less one built on a new and untested model such as ISAs.

However high these barriers to ISAs, they represent failures of policy, not markets.

The current student loan regime has delivered rapid tuition increases, forced taxpayers to bear massive losses, and shunted off billions in taxpayer dollars to unscrupulous “colleges” such as Corinthian and ITT Tech. A truly free market in college finance, powered by ISAs, would align the interests of students and investors to make colleges provide adequate value for the tuition they charge. If students do not succeed, investors won’t either.

Skeptics of fully free markets should note that private ISAs can coexist with government loans—there is no reason to think that a thriving private market necessitates abolishing federal student aid. The key is that federal aid must be capped at a reasonable level, so that ISAs can make up the remainder of tuition costs. (Under the current system, standard student loans are capped at high levels and supplementary PLUS loans are effectively uncapped.) As long as government and private lending is kept seperate, there is no reason we cannot have both.

A reasonable cap on federal loans and a push for regulatory clarity would represent real change to the way Americans pay for college, unlike the pseudo-privatization the GOP platform advances. Perhaps Republicans can consider this in 2020.

This article originally appeared on Forbes.  

Preston Cooper is a policy analyst at the Manhattan Institute. You can follow him on Twitter here.

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