The system of financing college educations with debt is deeply flawed, says Chris Farrell. How about an equity solution?
Two college sports foster madness in American households come late March: basketball and mailbox-watching. Yes, 'tis the season when millions of high school seniors and their parents find out their college options, from where the applicants have been accepted to what kind of financial aid they'll receive. But with all the PhDs, MBAs, and other lettered luminaries produced by the American educational system, why haven't we come up with a better way to pay for college educations? No matter how you slice the numbers, the payoff from a college degree is high. For instance, over the past four decades, the median family income of adults aged 30 to 39 with a four-year college degree rose by 46%, according to data compiled by the Economic Mobility Project. In sharp contrast, incomes for their peers with a high school degree gained 7% and high school dropouts suffered a 6% decline. Despite the employment and earnings trauma of the Great Recession, the long-term trend is toward employers valuing college-educated workers. Problem is, many of those students and parents wonder how they'll pay for that education. For it's also true that no matter how you cut the numbers, the cost of a college sheepskin is steep. For more than three decades, students and their parents have funded a college-tuition bubble with borrowed money. An ample supply of loans allowed colleges to raise the cost of attending their institutions at four times the rate of inflation over the past two decades. High Borrowing, High Defaults
The credit-fueled spike in tuition costs has hit loan recipients hard. The number of borrowers maxing out on student loans has surged from 57% to almost three-quarters. The default rate on those loans is at ominous levels, too. For instance, studies reaching back into the 1990s and following students over the subsequent decade show that students with loans totaling $15,000 or more had nearly triple the default rate of those with $5,000 or less—19% vs. 7%. For African American students, the default rate was almost 40%. The college enrollment gap between children from well-heeled families and those from low-income ones is wide—80% vs. 34%. Fear of taking on large debt burdens is a barrier to enrollment among less well-off families. To top it off, the college pricing and application system is Byzantine and opaque. For instance, the basic financial aid form—the notorious Fafsa—is so complicated researchers have documented that it discourages applications from low-income students. (Consider that subprime mortgages, typically involving far larger amounts of money and far greater danger to the financial system, involved much less paperwork.) And when it's time to make good on the loans, borrowers are faced with a mind-numbing variety of loan repayment schemes. What Would Milton Say?
The Obama Administration and its allies in Congress are currently embroiled in a battle to end subsidies to private banks that make student loans and instead rely solely on direct federal lending. (The savings would go toward shoring up Pell Grants to low-income students.) But when looking for a bigger solution to a mess like this, it always pays to consult the late economist Milton Friedman, Nobel laureate at the University of Chicago. He had a genuine knack for devising simple yet powerful solutions for knotty financial problems. In a 1955 article, "The Role of Government in Education," Friedman noted that loans weren't a good way to finance higher education and professional training. "Such an investment necessarily involves much risk," he wrote. "The average expected return may be high, but there is wide variation about the average." Any small business entrepreneur will tell you Friedman was right. Debt is too risky for startups, whether a small business or a college freshman. "The device adopted to meet the corresponding problem for other risky investments is equity investment plus limited liability on the part of shareholders," he wrote. "The counterpart for education would be to 'buy' a share in an individual's earning prospects: to advance him the funds needed to finance his training on condition that he agree to pay the lender a specified fraction of his future earnings. In this way, a lender would get back more than his initial investment from relatively successful individuals, which would compensate for the failure to recoup his original investment from the unsuccessful." Think of it as making a student's four-year degree—and postgraduate pursuits—a kind of private equity deal with the government. A Hedge Against the Luck of the Draw
Forget family income and wealth. Eliminate the need for taxing parental savings and the tortuous process of figuring out expected family contributions. Get rid of forbearance and deferment. Have the baseline method for paying for college come out of future earnings. The repayments would come through the progressive income tax system eliminating the need for much of the existing bureaucracy. Grants could be targeted at low-income students. A system like this would allow graduates greater freedom to explore the job market. They would have some financial protection against the luck of the draw, such as graduating during the Great Recession. They would no longer have to worry about paying back their student loans if they had an accident or lost their job. The proposal is far from radical: Such arrangements are already on the books. For instance, the Education Dept. ran a small income contingent loan program starting in 1995. It still exists, but a better product was offered beginning last year: an Income-Based Repayment program. The payments are capped at 15% of discretionary income, and any remaining debt is forgiven after 25 years. The House is considering a change to the IBR program for student loans after 2014 that would cap payments at 10% of discretionary income and a 20-year expiration date. But a high-powered group of educators advocate going even further. The report from the Rethinking Student Aid study group published by College Board proposes a much broader expansion of the IBR, especially for low-income students. Better yet, Australia already does a progressive tax-based repayment system. There's nothing wrong with stealing good ideas. Mom & Dad Savings & Loan
Of course, there are many risks and pitfalls in a dramatic shift like this. Students with a clear desire for more lucrative careers may choose other ways to pay for their degree up front (tapping the bank of Mom & Dad, perhaps) so they don't end up facing high marginal tax rates later on. The cost of the program could balloon if it ends up attracting only students with low-income aspirations. Students could end up feeling they traded their financial freedom as middle-aged adults for financial freedom when they were younger and naïve. The overall cost of a college education will balloon for those who pay small amounts year after year. Nevertheless, the supply-side effects should more than compensate for the risks. The Obama Administration has ambitious goals to increase dramatically the number of young Americans with some form of college degree, from community colleges to private universities. It's classic supply-side economics. No one knows what the most in-demand jobs of the future will be. But having a ready supply of well-educated workers and entrepreneurs means having the kind of folks who can create new ideas, new markets, and new products. Indeed, America's embrace of mass supply-side economics when it comes to education helps explains much of the nation's economic growth, including the Morrill Land Grant College Act of 1862, the high school movement in the late 19th and early 20th centuries, the 1948 GI Bill, and the 1958 National Defense Education Act. The lesson of history is that more education is better than less. The lesson of the Great Recession is that America took on way too much debt. Let's turn away from borrowing and embrace equity financing in the nation's best and brightest. The investment will provide solid returns for the economy—and society.