The market failure for student loans.

Author:Carver, Andrew B.
Position:Report
 
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Abstract

Scholars have argued that the unique nature of an investment in education results in a market failure for student loans. This market failure is said to exist despite the empirically established, attractive risk-return profile of educational investments. This paper reviews the literature on school loan market failure and argues against the market failure hypothesis. It also suggests that the most significant threat to the school loan market is a failure to properly define and protect a borrower's property rights to his own future income. Finally, it makes the case that protecting property rights and eliminating loan subsidies should result in a healthier market for educational funding.

Introduction

A young person's most valuable asset is typically his ability to apply his skills in the workforce to earn a stream of future income: what economists commonly call human capital. Starting with the work of Schultz (1961) and Becker (1967), scholars have recognized the economic value of building human capital through education. While experience has shown that free markets in the buying and selling of traditional forms of capital have done wonders for economic growth, the market for student loans is still dominated by federal programs. Eighty percent of the total school loan volume originates from federal programs; of this, 84% comes courtesy of the Stafford loan program, which sponsored a total of $52.6 billion worth of loans during the 2004-2005 school year. (1)

This government intervention in the marketplace comes in spite of the attractive risk-return characteristics of an investment in education. In a meta study involving 98 countries, Psacharopoulos and Patrinos (2004) estimate that the rate of return to investments in higher education is 19% per year (see Table 1), easily exceeding the long run real rate of return on U.S. equities of about 7% (Siegel, 1998). What's more, this return is typically achieved with low levels of risk. Judd (2000) and Davis & Willen (2000) find that future income streams resulting from educational investments are low in volatility when compared to traditional investments such as equities and some classes of debt. In addition, the risk is not highly correlated with other classes of investment (Judd, 2000), which implies that investors should be willing to accept lower rates of return from these uncorrelated assets due to the superior portfolio diversification they provide (Sharpe, 1964). With both a high rate of return and low risk, mutually beneficial gains from trade should be available between the lender who provides capital and the borrower who has an opportunity to make the educational investment.

The two most common justifications for the current government involvement in the student loan market are the existence of a market failure and positive externalities that make the privately funded level of educational attainment socially sub-optimal (Patrinos, 2000; Poterba, 1996). While some economists consider positive externalities to be a type of market failure, this paper focuses on a stricter interpretation. (2) Specifically, market failure theories include information asymmetries that produce an adverse selection problem for lenders, and a student borrower's insufficient collateral to use for securing loans. This paper discusses the relevance of market failure theories to the ability of private markets to adequately fund postsecondary education. It suggests that borrowers only lack collateral if they are unable to use their most valuable asset, human capital, when collateralizing loan contracts.

After discussing the two market failure theories, this research will examine recent evidence suggesting that the market for student loans is actually far from failing. Studies aimed at establishing whether or not student borrowers are constrained from obtaining sufficient funding due to credit constraints have proven inconclusive. Furthermore, non-governmental involvement in the loan market has increased substantially in recent years, validating the ability of private markets to meet educational funding needs. The paper will conclude by emphasizing the importance of a true free market in educational funding.

Theories of Market Failure for Student Loans

Adverse Selection

As described in Akerlof's (1970) classic model of the market for lemons, when two parties engage in trade with asymmetric information, a market failure can result. Asymmetric information is said to produce an adverse selection problem in which cost-conscious consumers of some products are unable to dstinguish "good" products from "bad," and hence inevitably end up with the bad because sellers of the bad product have a lower reserve price. Stiglitz and Weiss (1981) extend adverse selection to the credit market by devising a model of debtor-creditor interaction in which borrowers, each with an investment project, have private information about the quality of the project that is unobservable to the lender. They argue that due to a borrower's private information, the market could reach an equilibrium that results in the supply of credit being constrained.

Such a model...

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