The Warren Bubble Act

Last week, Massachusetts Senator and former Harvard Law Professor Elizabeth Warren introduced her first piece of legislation, a bill that would require the Federal Reserve to allow students to take out student loans at the same interest rate as banks. The bill addresses the important affordability issue facing higher education, but it fails to do so with sound economics.

In her unveiling of the bill, Warren pointed out that it “isn’t right” that the Fed charges banks an interest rate of .75 percent, while the unsubsidized Federal Stafford Loan program charges students 6.75 percent. There are, however, many right reasons why the rates are different. The .75 percent discount rate is for overnight loans, which are loans only available to banks in good financial condition and which provide collateral for their loans. It is also not a day-to-day financing option for banks, but rather a last resort to ensure financial stability during events such as the September 11 attack. Student loans, on the other hand, are mostly risky long-term loans to individuals without credit history and collateral. Banks are very unlikely to default on their overnight loans, while 17.3 percent of student loans which originated in 2009 are expected to default over their lifetime. The suggestion that banks and students should have the same interest rate may be politically popular, but it shows Warren’s lack of understanding of debt and finance.

Senator Warren’s legislation aims to give young Americans access to artificially cheap financing options, but it could end up hurting the same people she is trying to help. The federal student loan programs make it easier to finance higher education, which increases the demand for higher education. The laws of economics predict that higher demand would increase both the price and enrollment of higher education. Indeed, between 2000 and 2010, college enrollment increased by 37 percent, while tuition increased by 71 percent. Tuition hikes cause students to borrow even more for their education, as student debt soared nearly 500 percent to $900 billion during the same period. The supply of artificially cheap loans has caused an arms race between tuition rates and increase of individual debt, and yet Senator Warren’s solution is to make student loans even cheaper.

One does not need to look far to find a historical metaphor for the student debt crisis. In many ways, the growing student debt is looking increasingly like the subprime mortgage bubble that plunged America into a recession. Both home-ownership and college education are part of the American Dream, the crux of the once-prosperous American middle class. In both cases, the government supported the expansion of credit to low-income communities. The political aura of equality and gauzy temptation of the American Dream disguised both bubbles as infallible "investments" that cannot possibly go wrong while ignoring the less promising economic reality.

Unfortunately, if the subprime bubble is any lesson, the student debt bubble will eventually pull down those who try to climb the increasingly steep economic ladder. Students who are encouraged by the government to make bad financial decisions at 18 may be excluded from future economic opportunities due to their poor credit histories. As more young people face an economically incapacitated life, the economy also suffers, as a generation of home buyers, consumers, and entrepreneurs are indentured to their student loans. The graduates’ ability to manage their debt is further deterred by persistent structural unemployment and global competition. A recent meeting between the Federal Reserve and an advisory body highlighted the macro-economic risks of high student debt, as the total student debt surpassed credit card debt and automobile mortgages. Given these grim signs, passing Senator Warren's bill would not be dissimilar to providing government-backed 0.75 percent home mortgages to everyone in the home-buying age at the brink of the subprime crisis. In the unlikely event that this bill becomes law, the bill’s poor timing and cavalier language will almost certainly make Senator Warren an easy target for political blame for a mess that she did not create but to which she merely added the final straw.

Given the poor economics of the bill, I can only hope that Senator Warren’s real intention is to garner publicity and popularity rather than actually implementing her policies. Senator Warren could, however, tone down her rhetoric and propose more realistic solutions. First, most student loans have notoriously inflexible terms. Making financing options more flexible will give graduates more financial autonomy on their existing debt. A floating rate on student loans can also allow new applicants to enjoy the current low interest rate. An ideal student loan system should also be more market-oriented. Students with different majors and who attend different types of colleges should have different risk profiles, and their loan rates should reflect these differences. Differentiating student loans would also encourage students to make more prudent educational and financial choices.

During her successful Senate campaign, Senator Warren established herself as a hardline liberal. However, as the subprime mortgage crisis and debt ceiling debate have shown, simple-minded rhetoric does not create good policies on complicated economic issues. It is perhaps time that Senator Warren puts more economic reasoning and less political point scoring behind her future bills.

Jonathan Z. Zhou ’14 is an applied mathematics concentrator in Eliot House. His column appears on alternate Wednesdays.