Let’s Tie Our Hands on Student Loans

Odysseus, in Homer’s Odyssey, orders himself tied to the mast of his ship so he can hear the beautiful song of the Sirens without risking the usual gruesome fate of those who sail too close to the singers.

This lesson – if you know you are going to make a bad decision you should tie your own hands to prevent it – is one that Washington should heed when it comes to student loan interest rates. There are now at least six different proposals to deal with the scheduled interest rate increase from 3.4% to 6.8% for some student loans. Fortunately, four of them are trying to applying Odysseus’ lesson, though unfortunately, the other proposals are getting much more attention.

This is more than a little bizarre, since policymakers have not determined whether the government is making or losing money on student loans (the current numbers do not answer this question accurately) and how much we want to (and can afford to) pay to subsidize student loans. In other words, policymakers are arguing over the best route to take, despite the fact that they have no idea where we are right now or where we’re trying to go. Predictably, this results in a political circus, as exemplified by two recent examples.

The first is Senator Elizabeth Warren’s proposal to lower the student loan interest rate to 0.75% from 3.4% (scheduled to increase to 6.8% next month). The ostensible rationale is that 0.75% is the rate the Federal Reserve charges banks for lending at the discount window. This is a seriously flawed idea. Three key determinants of the interest rate for any loan are the length of loan, the chance of defaulting, and how much collateral is pledged. Loans from the Fed discount window are often for one night, are given to the same “lenders” who have a long histories of repayment, and are required to have collateral pledged.

In contrast, student loans are typically not repaid for at least a decade, have no collateral pledged, and result in a 13.4% default within three years. Why anybody would think discount-window loans and student loans should have the same interest rate has stumped most analysts. Brookings scholars Matthew Chingos and Beth Akers said it best when they concluded:  “Sen. Warren’s proposal should be quickly dismissed as a cheap political gimmick.”

A second example of the political circus is President Obama’s Rose Garden event last week, during which he called the House Republicans’ student-loan interest rate proposal “not smart.” This was a very strange thing to say, given that the Republican proposal is so similar to his own that they could be mistaken for long lost twins (See Inside Higher Ed’s table).

These examples, combined with last summer’s student-loan interest rate “crisis” amply demonstrate that Washington may well be incapable of setting student loan interest rates in a rational manner. In a rational world, overall student-loan interest rates would change for two reasons: changes in our collective decision of how much money we want to/can afford to lose on them and changes in the overall economy.

Determining how much we want to/can afford to lose on student loans is a job that Washington policymakers should handle. While their recent behavior doesn’t inspire confidence, it is their job to weigh this type of spending against other competing priorities and ensure that public money is spent wisely. 

However, when it comes to determining how much interest rates should change due to changing circumstances in the broader economy, policymakers should acknowledge that their past actions demonstrate that they are likely to make bad decisions in the future. They should therefore follow the example of Odysseus and tie their own hands to take themselves out of the picture. 

The best way to do this is to tie interest rates to the government’s own cost of borrowing (the interest rate on T-Bills) so that the interest rate on student loans will fall when the government’s cost of borrowing falls, and rise when the government’s cost of borrowing rises. This automatically moves student-loan interest rates in a rational direction when economic circumstances change, while avoiding the politically driven bad decision-making that we’ve recently witnessed. Having the baseline interest rate updated automatically will ensure sensible changes in rates. Policymakers could still tweak this rate. For example, if they want to increase the overall subsidy for student loans, they could change the interest rate from the T-Bill rate plus 3% to the T-Bill rate plus 2%.

Fortunately, such a move is exactly what four of the six proposals seek to do (President Obama, House Republicans, and Senate Republicans all (at some point) supported tying interest rates to the 10 year T-Bill rate, and one of the Senate Democrat proposals seeks to tie interest rates to the 91-day T-Bill rate). Yet, given Washington’s recent history on this issue, I’m not holding my breath that this unusual bout of bipartisan wisdom will win out over the usual short-sighted, politically driven pandering. Just today, President Obama backed off his own reasonable proposal, and advocated kicking the can down the road instead. 


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