Clinton's Student Loan Plan Deserves An `F'

President Clinton has proposed changes in the way the federal government subsidizes the education of college students. He wants to eliminate banks from the lending process, compensate students who perform what is deemed community service, and give students another option on how to pay back their debt. These ideas are misguided in every major respect.

To cut out middlemen expenses, the President would bypass banks by having the federal government make loans directly to students. The House Education & Labor Committee has already approved this part of the package. But if governments are better at lending than the banking sector, they should take over lending to companies for investments and to families for housing and cars. Despite many well-publicized failures of private banks, government agencies do a much worse job of lending money, which is why the worldwide movement toward privatization highlights banking and other financial activities. I do not know of one federal lending program--including those to small businesses and farmers--that gets high marks for its efficiency.

Banks can provide a valuable service in screening student borrowers and monitoring repayments. But under the present system of student loans, banks have no incentive to perform these functions, since the federal government covers all bank losses on student loans. This explains why the default rate is a disturbingly high 10% and why many more borrowers are in arrears. The savings and loan scandal has shown what happens when banks are relieved by government guarantees of their responsibility for unwise lending decisions. Thus encouraged to make extremely risky loans, they reap all the gains from profitable ones while taxpayers foot the bill for the mistakes.

YOUNG BEGINNERS. The solution is not to eliminate banks and their experience but to require them to bear a larger share of the cost of their bad student loans. Banks covet the student loan business. When the default rate on a bank's student loans increases, it should have to pay a higher insurance premium.

In return for two years of community service after students finish their education, Clinton wants to forgive up to $10,000 in loans that help pay for college or vocational training. Qualifying jobs are to be selected by state governors and other officials from the categories of education, the environment, public safety, and human services. To be sure, these four categories all have problems, but they are not going to be solved by giving politically determined jobs to young beginners who are trying to qualify for tuition grants. And why these categories? What about other charitable activities and private employment in profit-making companies?

The President's plan sends a dubious message to young people. It rests upon the proposition that it is more beneficial to spend time helping to build housing for the homeless--one frequently mentioned example of community service--than to contribute to the productivity of the U.S. economy by becoming better engineers, computer programmers, architects, etc. This is a dangerous message for the economy at any time, but especially when the U.S.'s capacity to compete in world markets is being severely tested.

Student borrowers from the federal government now pay fixed interest rates on their debt after completing their education. The President would keep this as an option, but he wants to offer students another one whereby those who earn more pay higher rates.

FIXED OR VARIABLE. The new option is designed to balance larger payments by high earners against smaller ones by low earners so that the average earner would pay about the same interest rate as under the present system. But the desirable objective of insuring repayment on student debt against uncertainties about future earnings isn't likely to be attained because of a phenomenon that economists term self-selection. Students who expect to go into law, business, and other well-paying fields will tend to choose the fixed-interest-rate option, under which they pay a lower rate. Those who expect jobs that pay little will select the option whereby people with low earnings pay back less--the variable-rate option. Since much of the borrowing is by professionals and graduate students, many loan applicants know whether they are preparing for fields that pay well or poorly.

Either fixed or variable repayment rates are manageable, but not both. On the whole, the existing approach is probably better because the many students who know they are in fields that pay a lot will not participate when rates are tied to earnings. When Yale University in the 1970s made repayments depend on earnings, it found that students going into law, business, and medicine generally chose not to borrow from Yale.

The President's proposed reform of the student-loan program may be good politics with its call for community service, saving middlemen expenses, and an option that allows borrowers who earn less to pay back less. But from the standpoint of the nation as a whole, it won't be as good a way to reform federal assistance to students.