Incentivism is a type of economic system whose philosophy emphasizes the use of financial reward rather than punishment to alter an individual’s personal self-interest to make it consistent with that of society.
An Application of Incentivism to The Student Loans Debt Crisis
An ongoing bi-monthly series February 20, 2018
If you wish to either catch up or review the “Education and Information without Fabrication” contained in our first 3 issues, the links are:
All you need to understand is the definition of Incentivism which every issue begins with: Yes, it’s THAT simple. Incentivism: 1) uses a reward system to replace punishment and 2) aligns the self-interest of an individual more closely with that of society. So, to apply it to the Student Loan Debt Crisis, we need to be a bit more specific. The self-interest of the BORROWER (the student) must be aligned with both that of the LENDER (the Bank or the Federal Government) and SOCIETY.
The Student Loan Debt Crisis
A better education for all members of society is very much in its interest for a variety of reasons. Higher education provides substantial benefits to society including a correlation with increased levels of 1) employment, 2) productivity, 3) compensation, 4) taxes to repay the system and 5) financial independence, requiring less from government assistance programs. It’s also correlated inversely with crime and violence. However, it comes with a cost.
The key questions to ask are:
- Do the Benefits outweigh the Costs to all three parties?
- How can we enhance those Benefits and/or minimize the Costs?
- How do we replace Punishment with a Reward System?
History and Background
Student Loans guaranteed by the Federal Government were initiated by a government sponsored enterprise known as the Student Loan Marketing Association which was founded in 1973. Its focus since then has changed substantially. Now called SLM Corporation, it became public in 1997 and its primary business is originating, servicing and collecting private education loans. Better known as Sallie Mae Bank, it produces some interesting statistics which can be found in this report on grad school lending: https://www.salliemae.com/research/how-america-pays-for-graduate-school/
One statistic really stood out. Half of graduate student loans borrowers expect their loans to be forgiven. HALF!!!
Navient Corporation was formed in 2014 as the original Sallie Mae spun off the servicing and collecting parts of the business into an independent and publicly traded corporation. Navient services more than $300 Billion of existing loans issued to 12 million borrowers. The company also packages Student Loans into bundles and sells them to investors.
Navient has been an unmitigated disaster from the beginning. It has been fined, investigated or sued not only by its investors in a class action lawsuit, but also by the Consumer Fair Practices Bureau and Department of Justice for various violations of the laws governing fair debt collection. In addition, it has been met with protests by dissatisfied students.
The entire Student Loan industry is estimated at $140 Billion per year and the entire amount outstanding is approaching of $1.5 Trillion, exceeding both consumer revolving loans and residential mortgages. https://www.statista.com/statistics/468512/value-of-loans-outstanding-usa-by-category/
Critics of the programs point to the default rate which has been approximately 11.5% according to Department of Education statistics but has been as high as 14.5%. As high as those numbers may appear, they represent the percentage of borrowers who defaulted within their FIRST YEAR of repayment! https://www.ed.gov/news/press-releases/us-department-education-releases-national-student-loan-fy-2014-cohort-default-rate Perhaps a more revealing rate has been recently published by a website called Student Loan Hero. Of all the Direct Student Loans outstanding, 37.5% are in default, their grace period, forbearance, or are delinquent by 90 days or more! https://studentloanhero.com/student-loan-debt-statistics/
Types of Student Loans
Student loans come in many stripes and flavors. A small portion are initiated by private commercial banks and are like personal loans in they require good credit, or a co-signer with good credit. They differ from personal because the use of funds is limited to education only and is paid directly to the school not to the borrower. The interest rate is usually below the rate on personal loans because of the restrictions on how the funds are utilized.
Loans provided by the Federal Government are primarily from the William D. Ford Federal Direct Loan Program. Of the 21 million students enrolled in colleges and universities in the fall of 2016, eight million of them received federal loans under this program. These students took out nearly $140 Billion in loans, or about $17,000 per student.
Direct/Subsidized Federal Loans are based on a formula that considers the family’s financial capabilities. These are typically the least expensive and are the first place sought for funding. They are limited per student and not everyone qualifies under the formula. These loans do not accrue interest while the student is still in school.
Direct/Unsubsidized loans, which are available to everyone, are then used to supplement the amount available if the subsidized needs-based loans are insufficient. These accrue interest, but any payments are still deferred until after the borrower graduates. More important, unlike private banks, no credit check is required https://www.debt.org/students/types-of-loans/
Costs and Benefits to Borrower
The benefits to the borrower for graduating with a degree include the likelihood for higher compensation and more employment options. The costs are primarily two-fold: 1) the “opportunity cost” of being out of the workforce for the time until the graduate has found employment and 2) the direct costs of paying for the education such as tuition, books and living expenses.
The financial benefits are a function of the degree sought and the time needed to graduate. The average high school graduate who enters the workforce starts at $30,000 per year. This compares to the $50,000 starting salary with a 4 year college degree.
But, the student loses at least 4 years in the workforce plus the total costs of 4 years of college, which averages $100,000 for in-state public college and $200, 000 for a private college. https://www.collegedata.com/cs/content/content_payarticle_tmpl.jhtml?articleId=10064
If this student borrower goes on to seek a professional degree like law, they then has at least 3 more years of absence from the workforce and three additional years of Law School costs. US News and World Report did the math in 2017, comparing the benefits, which were few and far between, while the costs had skyrocketed to the moon, averaging about $60,000 per year. The glut of graduates led to the declining amount of extra compensation, thus making the investment devoid of any benefits. https://www.usnews.com/education/best-graduate-schools/top-law-schools/articles/2017-03-15/us-news-data-law-school-costs-salary-prospects
The student might also get some intangible benefits from their elevated education such as prestige. However, the intangible costs grow significantly when they borrow because now they have created an enormous future liability which future salary may not cover. The result is enormous stress on the borrowers regarding the ability to make timely payments to another party as well as the possible negative consequences of defaulting. (This is the “punishment” that needs to be replaced with a reward system). Even bankruptcy isn’t an option to wipe out the debt.
Subsidization is a form of government interference which interrupts the normal free market checks and balances. Subsidization normally results in the oversupply of the good or service being subsidized. (see An Introduction to Incentivism, part 3, Section on Price Controls discussing government subsidies of cheese).
The oversupply situation in the student loan industry nearly wipes out all the intended consequences of higher salary and taxes paid back into the system. It replaces them with Unintended consequences as the default rate rises and growing numbers unemployed or under-employed seek government assistance.
In a competitive market, if the benefits FAR outweigh the costs more people will opt to take the additional cost as the likelihood of a net benefit is very high and risk very low. However, with subsidization of student loans as the number of borrowers grows and the amount of outstanding debt grows, the average compensation that each degree yields will decrease for EVERYONE, which magnifies the costs to all three parties.
If the loan is from a private source such as a commercial bank, the lenders self-interests are the profitability of the loan which is typically not very well aligned with the borrower. The private loan market is currently a small fraction of the student loan market. If the lender is the Federal Government and subsidizing the borrower, then the student will borrow more than they would without the subsidy. As a result, society’s interest will not align with the borrowers’ nor be served.
It is absolutely in society’s interest to have a better educated populace but not at such a steep cost. Even if the loan is not “subsidized” by definition, it is still subsidized because it is available to everyone and without any credit check. It will attract from the pool of least credit-worthy borrowers causing the default rate to balloon. Either way, no parties’ self- interest will align or be served but the unintended consequences will still affect all three parties.
Creating the Optimal Alignment
So, how does one align all three party’s interests?
- By aligning costs and benefits to the borrower, lender and society.
- By replacing punishment with rewards which are also aligned with risks for each party. (Keep in mind that the punishment for defaulting is extreme and not even bankruptcy can’t wipe it clean).
Since benefits are primarily created by the extra compensation, it becomes mandatory that the cost required to those who have achieved the increase is not greater than the benefit. The increase in compensation from education is a benefit for every party. There is only one way to properly align borrower and lender, especially when the Federal Government is involved. Share the benefits and share the costs in the same ratio (the “sharing ratio”).
Since a college graduate earns on average an extra $20,000 per year, some portion of the after-tax increase can be made to be equal to the real cost of borrowing. If the borrower pays the entire after-tax amount of extra income to a lender per year (sharing ratio of 100%), there is absolutely no motivation to borrow. On the other hand, if the loan costs the borrower zero, or is completely forgiven, the borrower keeps all the extra income (sharing ratio of 0%), then the student is highly likely to overborrow to the maximum amount and drive the costs to the taxpayer up enormously.
The sharing ratio operates somewhat like a tax. Thus, the optimized sharing ratio ought to be akin to a marginal tax rate, probably settling in the range of 10% to 40%. If the borrower’s obligation is only a portion of the extra after-tax income, they can’t default, the punishment part of the equation is now completely erased. The benefit is not, since they retain a sufficient portion of their extra income for having taken out the loan. Under this scenario, some borrowers will overpay their balance. This is offset by the extra earning power they attained because of the loans.
The lender’s aggregate cash flows should remain about the same since they are “spread” over many overpaying and underpaying borrowers. This is no different than when credit risk is factored into the lender’s interest rate. The lender must diversify credit risk, but now diversifies to balance between overpayment and underpayment amounts.
Student borrower, lender and society would each save the tangible and intangible costs created by the risk of default. Even the intangible cost of stress removed from the borrower could be huge. Who operates efficiently when they’re under prolonged stress? There are no benefits to stress, just massive costs.
There would be no form of “punishment” for the borrower to bear, but the incentive to earn more extra income would remain so the reward system adequately replaces the punishment.
The federal government’s role in originating student loans could even disappear completely, as new private lenders rush in and add different sets of terms to the list of choices, which only adds to everyone’s benefits. Terms could include: caps on overpayments, caps on the how long the borrower would be subject to the sharing ratio, or a diminishing rate of the sharing ratio if extra income reaches certain levels.
Government interference would be gone as the new private lenders create an abundance of choices to suit any individual’s risk/reward preference and compete for a slice of this $140 Billion per year business. Competition in the market will keep the sharing ratio from being either too high to generate new loans or too low for each type of degree since the extra income is different for each type of degree.
No externalities are passed on to innocent third parties, especially the taxpayer who had previously footed the cost of subsidization. Society would get its wish granted as more people pursue higher education. The benefits would always be greater than the costs involved as the various choices attract more individuals to the student loan market.
The student loan market would cease to be a lending market but would become an investment market. Lenders and borrowers are both invested in the SAME OUTCOME, the borrower’s future. Both parties are ALIGNED PERFECTLY in their wish to see the borrowers succeed in their post education employment. Thus, allowing them to be able to overpay on their investment.
Quite possibly, the Lenders could even incentivize the Borrowers further by employing them after graduation, thus practically guaranteeing them at least full repayment if not overpayment of the loan. Borrowers would benefit by lessening the time needed to find employment and reducing the cost of unemployment to everyone. The lender benefits from being able to draw from a pool that they deem to be overachievers and know their employment costs in advance.
Ironic, isn’t it, that the best way to make either a good or service more expensive is to try to make it free? The Governor of the State of New York recently proposed making tuition free public schools. Would someone out there send him a copy?
Marina del Rey, California
February 20th, 2018
Markonomics101@gmail.com to join the mailing list or any questions.