Student Debt and a Broken Financial System

When the Class of 2009 entered college in 2005, they had good reason to be optimistic. The economy appeared to be healthy, and a college degree commanded higher wages. College, of course, is expensive. And almost 2 out of 3 students entering college took on some debt. They took on that debt believing that it would be easy to pay back given the strong market for those with a college degree.

But then the biggest recession in 80 years hit the United States, leading to a much worse job market for college graduates. Here is the unemployment rate as of October for college graduates who just graduated, by year from 2007 to 2011.

houseofdebt_201400505_1

The Class of 2009 had an unemployment rate of 18% — twice as bad as the Class of 2007 had when they graduated. The employment to population ratio also shows how bad the market was:

houseofdebt_201400505_2

This was horrible luck for students graduating in 2009 and 2010 — in some sense they were being punished for being born 22 years earlier in 1987 or 1988. You might guess that the punishment was short-lived — eventually these students would find good jobs once the economy recovers, right? Wrong. Research shows that there are long-run, persistent negative effects of graduating from college in the midst of a severe recession.

As mentioned above, many of the students in the Class of 2009 took on student debt. What happened to those interest payments? Unfortunately, the debt contracts taken on by the students didn’t care what the economy looked like upon graduation. Students had to either make the payments, or default and suffer the consequences.

Does this make any economic sense? The financial system is supposed to help the most vulnerable members of society insure themselves against unforeseen risks. But in this case, the student debt concentrated risk on young Americans trying to get ahead with a college degree.

The Great Recession was a completely unforeseen event, as unforeseen as an unexpected fire, storm, or car accident. A properly functioning financial system would help protect young Americans suffering from a horrible recession that was completely outside of their control. Instead, it actually hurt them even worse! And we all bear the consequences. It is quite likely that excessive student debt burdens are holding back the recovery.

We must rethink the financial system, which is a major theme of our book coming out next week.

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17 Responses to Student Debt and a Broken Financial System

  1. Xenophon on May 5, 2014 at 9:00 ami

    I would challenge the claim that the Great Recession was a “completely unforeseen event”. Economists like Dean Baker and Joe Stiglitz were pointing out that there was a major bubble in the housing market. Moreover, Wall Street banks were consciously trading toxic financial products related to the bubble. A number of hedge funds shorted the banks because of this.

    Hence, the Great Recession may have been completely unforeseen to radical financial market ideologues like Greenspan, Summers, and Paulson; but rational people, who were not clinging to dogmas, were able to put together what was happening.

  2. dilbert dogbert on May 5, 2014 at 9:08 ami

    I think this is real old news that graduating in a down year has long term effects on later income. The student loan **** just made it much much much worse.

  3. Richard Treitel on May 5, 2014 at 1:52 pmi

    Shifting risks onto the clueless and/or powerless is typical behaviour, and not just among financiers.

  4. Richard H. Serlin on May 6, 2014 at 3:42 ami

    “Unfortunately, the debt contracts taken on by the students didn’t care what the economy looked like upon graduation. Students had to either make the payments, or default and suffer the consequences.”

    Right wing and libertarian economists (I don’t mean you) love to ignore, or downplay as minor exceptions, the monumental and profound pure markets problems (externalities, natural monopoly power,…), as if, among so much else, environmental pollution, which would devastate our health, cut decades off our life spans, and turn the country into a cesspool, is just some minor exception. And, of course, that’s not to mention frying the planet with global warming.

    But here we see a huge gaping example of asymmetric, or just poor, information. So few students know that, really, any amount of (federal government) student debt need not be that much of a problem. Any student, even the grad with $200,000 in federal debt, can just instantly go on income-based repayment. Under the current program, Pay-as-you-Earn, the most your payments can ever be is 10% of your family’s discretionary income (which is usually much less than total income).

    And it’s very progressive, so it’s usually a lot less than 10%, and can easily be zero. Yet after 20 years of payments (including when the payment drops to zero, which it would if you were unemployed and single), no matter how much you still might owe, the balance is 100% forgiven. And there are programs even much better than that if the student takes a job that’s defined as “public service”. For more, see this article I did with the help of student loan expert, advocate, and Duke trained attorney Heather Jarvis:

    http://works.bepress.com/richard_serlin/20/

    And here’s another huge piece of asymmetric information – Income based repayment is only available from federal government student loans, not private student loans. And private student loans are inescapable in bankruptcy, ever (with extremely rare exception), since the 2005 bankruptcy law (BAPCPA). This makes them quite possibly the most dangerous debt in American history. But how many people know this? You even see on TV now predators posing as student loan saviors who try to get people to consolidate all of their completely safe federal government student loans into a private student loan, quite possible turning them into something tragically close to a lifetime inescapable indentured servant. For more on this see:

    http://richardhserlin.blogspot.com/2014/03/private-student-loans-so-important-so.html

    So we see again the market problems, like asymmetric and poor information here, are just so important and pervasive. And possibly the biggest problem with economics, and its teaching is the refusal to recognize this and act accordingly. Often, it’s willful, intentional deception to increase support for an economist’s libertarian or plutocratic ideology.

    • Patrick on May 6, 2014 at 11:47 ami

      That all sounds good until you realize that there is a massive gap that nobody talks about in the student loan world.

      All debt is not equal. Most students with heavy debt cap out on federal debt pretty quickly, then face a choice. Get a parent to take out a parent plus federal loan at reasonable rates, or take private loans at punitive rates.

      Those who have parents take out parent plus loans, but take the responsibility for repayment from their parents have no way to put that debt under their own name.

      The result is that after using income contingent repayment, they may have another half of the amount due to repay for their parents. Similarly, many with private student loan debt quickly find themselves in a position of moving that debt around to avoid punitive interest rates and find themselves in situations where they cannot count that debt towards a federal repayment plan.

      The asymetric and poor information is with the policy makers as well who often do not understand the real challenges facing the borrowers.

      • Richard H. Serlin on May 8, 2014 at 1:30 ami

        You’re right that the limits on federal student loan borrowing are often a serious problem. But again we see more ginormous asymmetric, or just poor, information. Still, it’s rarely worth the massive risk of a private student loan. It’s often better to do the first two years at a community college living at home, but then it can be hard to stay motivated. It’s really valuable to study hard in high school and AP out of a lot, but high school students have such horrible knowledge about education and the world they face.

        In fact, high school students? College grads applying for PhD programs are ridiculously misinformed about what PhD programs and jobs are like; it’s just a crime. I’d have done it anyway, because that’s just me, but I wouldn’t have waited until my late 30s! And I would have prepared hard for it starting in elementary school had I known.

        With regard to parent student loans. The parents may be eligible to get income based repayment (not as good as the Pay-as-you-Earn kind). It requires some tricks, and I’m not sure if it’s still possible. But here’s a 2011 post on this from student loan expert Heather Jarvis:

        http://askheatherjarvis.com/blog/parents-beware-of-plus-sized-student-loans

        Again, though, horrible asymmetric and poor information in the modern ultra-complex world. We’re not living in 1810 anymore, the good old days when the average lifespan was in the 30s and the 99% were dirt poor that the right wants to take us back to.

    • Richard H. Serlin on May 6, 2014 at 11:15 pmi

      Here’s some formal evidence: From Inside Higher Ed:

      In March, the New York Federal Reserve found 5 million Americans had fallen behind on student loan payments. Only 1.1 million borrowers are enrolled in income-based repayment. Another 474,000 are in income-contingent repayment, a similar program with slightly different rules, but many of those were automatically enrolled after defaulting on their loans. (Private loans, which make up about 15 percent of all student debt, aren’t eligible.)

      Student debtors and their advocates say the repayment programs remain something of a well-kept secret, little-known among recent graduates and struggling borrowers. Even for those in the know, enrolling can be complicated and confusing.

      At: http://www.insidehighered.com/news/2012/10/23/despite-student-debt-concern-income-based-repayment-lags#sthash.CZqpluMz.9MvcYXIh.dpbs

      • Patrick on May 7, 2014 at 9:18 ami

        I agree that these programs are not well known.

        I had personal experience with these programs when they were only permitted for government/non-profit employees. The customer support staff was very badly trained on these programs and regularly gave conflicting and inaccurate information. I received three different answers at various points on the same question. That contributes to the issues, and the fact sheets aren’t very helpful in distinguishing between income based, income contingent, public service variants, and the qualifications applicable to each type of federal loan between fed sub, fed unsub, parent plus, stafford, perkins, etc, etc.

        I’d also note that federal discretionary income calculations do not sufficiently take into account regional cost of living factors, and the ICR is capped at the monthly cost of a flat 10 year repayment. I was personally shocked at how much of income the federal formulas consider “discretionary” and for many the line is 15% not 10%.

  5. dax on May 6, 2014 at 5:47 ami

    “The financial system is supposed to help the most vulnerable members of society insure themselves against unforeseen risks. But in this case, the student debt concentrated risk on young Americans trying to get ahead with a college degree.”

    Young Americans with college degrees are the most vulnerable members of society? On what planet?

    • Richard on May 6, 2014 at 11:10 ami

      Maybe not the most vulnerable, but most affected by the shape of risk in this country? Sure. Compared to older cohorts, they have a longer life ahead of them (and thus more future earnings potential). Compared to less-educated cohorts, they also have more earning (and spending) power. Thus a debt overhang on that class of people has a disproportionately greater negative effect on the economy and society as a whole.

  6. Indiana Patriot on May 6, 2014 at 7:35 ami

    Only bought and paid for economists “couldn’t” see the housing bubble and impending financial crisis.

    Paul Volker, Dean Baker, Josh Bivens, among the few other non-corrupt economists could see the financial crisis a mile away.

    Destroying middle class wealth and opportunity is the whole point. To get rich you have to loot someone! What happened to the class of 2009 was by design, not an unforeseen act of heaven.

  7. Patrick on May 6, 2014 at 7:45 ami

    Another factor in this student loan discussion is impact of near deflation on these students. Those of us graduating in the 2000s were supposed to be able to rely on 2-3% inflation to gradually erode the burden of this debt.

    If you took out student loans and bought a house in the 70s, by the time the 90s rolled around, the size of those loans and the size of that mortgage looked comically small due to inflation. In a near deflation environment with falling real wages, I’m ten years out from my student loans and their size is even more imposing than it was when they were taken out.

    Near deflation monetary policy is sending the millenials towards indentured debt servitude.

  8. Dan on May 6, 2014 at 8:34 ami

    Interesting twist, most people conclude we have to amend the way we pay for education.

    Either way, student loans are a scandal.

    Any constraint on spending by definition holds back a recovery, because a recovery is by definition more spending.

    It strikes me as an unnecessarily narrow focus to single out student debt in this regard.

    You also have some MPC issues and differentiation between agents to deal with to get to any debt being a constraint on aggregate spending rather than simply someone else’s income.

    obviously you are quite aware, and more of all this.

    The most interesting point about student loans isn’t on spending, but on inequality. If education is the key to equality – or at least higher incomes for those who get an education – who captures that higher value/income? if there are loans involved, it seems likely it is capital and not labor.

    ah well…

  9. Douglas on May 6, 2014 at 12:08 pmi

    Not to pile on, but I know you guys are fans of Calculated Risk — and McBride was warning about the housing bubble several years before it deflated. No, he (and the others mentioned) didn’t predict the exact nature of the impact it would have in the financial sector or broader economy. But it was obvious if you read his blog that something very very bad was coming…

  10. Richard H. Serlin on May 9, 2014 at 1:41 ami

    There’s one more thing I really should add: I’ve talked a lot about ginormous asymmetric and poor information being grossly underrated or ignored in economics. But also huge is not just the information, but the expertise to optimize well even if you have the information. It’s just a ridiculously complex and advanced world today, with people having tiny amounts of free time. So, of course it’s understandable that the level of expertise (and time to apply it) is so often way below the level necessary to come close to finding the optimal actions.

    Yet the only thing that you usually hear from economists about any possible deviations from perfect optimization is some Harvard evolutionary behavioral theory, because that’s fancy enough that you can publish it in a prestigious journal. Just saying, Hello? Hello? nothing fancy, just duh, understandably ginormous poor information and expertise, and it’s welcome to Southwest Montana State, even though this is at least of the same order of magnitude as a factor, if not much bigger, than these fancy behavioral explanations. For more on this, see:

    http://richardhserlin.blogspot.com/2013/12/surveys-showing-massive-ignorance-and.html