Congress recently approved a bill to fund the government for the remainder of the fiscal year. It cuts Pell Grant funding 1.3%, from $22.8 to $22.5 billion. This reduction in the needs-based grant program will be reallocated to student loan service providers such as Navient and Nelnet, a move orchestrated by outgoing Senator Tom Harkin. This follows a policy enacted earlier this year by the Obama Administration to increase payments to loan servicers.
The justification given for the increasing funding is to encourage better customer service. Service providers have recently been criticized for a number of improprieties, including overcharging veterans, mistreatment of distressed borrowers, and failure to prevent borrowers from defaulting. The reallocation of Pell funding to these providers is like punishing one prisoner for good behavior and releasing a violent criminal early for assaulting prison guards.
End of Year Burn-Downs
The Pell Grant is a politically popular program, receiving widespread support from both sides of the aisle. As a discretionary budget item, Pell funding was targeted for a cut because it currently has a surplus. Government programs experience a surplus when appropriations exceed expenditures. Surpluses signal to lawmakers that more taxpayer funding was allocated than was needed for operation, creating pressure to subsequently reduce funding and reallocate it to programs without a surplus. Economic theory suggests this mechanism will incentivize directors to avoid fiscal prudence and instead be spendthrift. As a former federal contracting official, I have experienced the end of the fiscal year burn-down. Overtime was encouraged and cost-benefit analysis for purchases discouraged. This promotes the inefficient provision of goods and services that are disconnected from the preferences of taxpayers.
Surpluses are called profits in the market sector. Profits signal that consumers highly value a firm’s products and attract additional providers, enhancing competition that exerting downward price pressure. With profits, firms either: distribute them to owners; save them for a rainy day; or re-invest them to improve product quality, lower production costs, or enter new product markets.
Surpluses in the market sector enhance consumer welfare. Not so much in the government sector. Rather than allowing the Pell surplus to be saved to offset expected future program shortfalls, funding for the popular program is being reallocated to further subsidize allegedly unscrupulous loan servicers.
Rewarding Bad Behavior
Allegations of malfeasance by subsidized loans servicers are to be expected. Similar allegations were directed towards subsidized loan originators prior to the 2009 federal takeover of the student loan industry. Public policies that privatize profits and socialize losses create perverse incentives. They enable subsidized firms such as loan servicers to reap the rewards of signing up borrowers and capturing the taxpayer-funded fees for “serving” them without facing consequences for providing poor service.
These government-granted oligopolistic firms have little incentive to treat customers with respect and provide them with good service. Borrowers have little recourse –they cannot vote with their wallets as they can in a pure market setting. Borrowers have the option to pursue costly lawsuits or organize politically to attempt to institute change. Both are highly inefficient methods that are often futile because of the cozy relationship between government and the crony servicers.
In response to allegations of customer abuse, President Obama declared earlier this year: “We’re going to make it clear that these companies are in the business of helping students, not just collecting payments, and they owe young people the customer service, and support, and financial flexibility that they deserve.” Recent changes to contractual arrangements between Department of Education and loan servicers are intended to “strengthen incentives for them to provide excellent customer service and help borrowers stay up-to-date on their payments.” The plan is to dangle more money in front of poorly performing loan servicers such as Naveint in hopes of pushing them to perform better.
This is analogous to arguments that the 2009 fiscal stimulus would have promoted a robust recovery had more than $787 trillion been allocated towards politically favored projects. The problem is not the size of the payments, but the perverse incentives created by highly distortionary political resource allocation. Poor customer service and abuse by loan servicers is not a market failure in need of correction by government policy. It is a problem created by government intervention in an industry that would function better in a free market environment. The government should not be in the student loan business –not as lender, contractor of service provision, or subsidizer. Until government withdraws from this market, expect to continue hearing horror stories of students marred in debt and treated with the same level of customer disservice provided by the DMV.