The New History of Federal Students: From Sputnik to Sallie Mae Lending

Runaway college tuition. 25% of borrowers are in default. Rising debts. There could be as much as $500 billion of toxic debt. Millions of Americans are clamoring to have their student loans forgiven.

What is the secret to our success?

The Debt Trap: How Student Loans Became a National Catastrophe” is Wall Street Journal reporter Josh Mitchell’s answer to that question. Mitchell’s account on federal student loans over the past 63 years is much more interesting than it should be. The story of Americans who started out in earnest to help America’s children is told by “The Debt Trap”. Six decades later, many consider their efforts to educate America’s youth to have been a waste of time.

Federal student loans: where did they come from?

The Space Race began with federal student loans, which were created when the Soviet Union launched the first satellite Sputnik. Lyndon Johnson (Senate Majority Leader) was a beneficiary of a student loan and pushed for the creation by the federal government of the first student loan program. This would encourage science and technology education in America’s future generations. President Johnson, seven years later signed into law the successor program he believed would enable young people from all walks to go to college. The modern era of student loans was created.

Mitchell describes the program as “the quintessential type of crony capitalism.” The program privatized the profits and socialized the losses.

The federal government didn’t lend to students for most of its history. Congress delegated this task to banks and covered the banks’ losses when students defaulted. Banks made profits when students paid off their loans. However, the taxpayers borne the costs when it went wrong.

Sallie Mae was also established by Congress, which allows you to borrow at extremely low interest rates. This was a first: Until then only the United States could borrow at such low interest rates. Sallie Mae inundated banks with cash to purchase student loans or lend money using student loans collateral, a frightening foreshadowing the subprime mortgage crisis. This system provided banks with the opportunity and the means to make student loans.

Everyone involved–from politicians to banks to universities–convinced themselves they were heroes. The complicated system allowed many students with limited resources to go to college, which is true. However, student loan defaults rose at an alarming rate. So did college tuition.

The scheme brought in huge profits for Sallie Mae, the banks and other financial institutions. However, universities became just as rent-seeking as the financial industry. Mitchell points out, “Today universities employ more lobbyists that any other industry apart from pharmaceuticals and tech.”

The tuition rate grew well above inflation in the years following the creation of the modern loan program by Congress. The price fixing was done by elite universities. Universities found students willing to pay more for college because of the low cost federal loans. Instead of competing for the best education, schools began to compete on campus reputation and rankings. This vicious circle drove the costs up.

The modern loan program:

Congress eliminated the middlemen from the guaranteed student loan program in 2010. The federal government lends directly to students instead of guaranteeing loans from private banks. Although direct lending has saved money, Congress had to make savings to finance the Affordable Care Act.

Conservatives sometimes refer to the events of 2010 as a “government takeover” of student loans and express nostalgia for the days of “private” student lending. It is a misplaced sentiment. Mitchell’s book shows that the status quo before 2010 was only private in name. The guaranteed student loan program was the beginning of all the problems that conservatives deny in higher education, including high tuition and the arms race for amenities, as well as toxic student debt.

Liberals, on the other hand, believed that student loans would be solved by cutting out the financial sector. Even though banks are no longer making a profit, rising tuition and high default rates remain serious problems. Federal aid programs are still available to colleges, which receive more than $100 billion each year with very few conditions. Although the role of private banks in the student loan crises was regrettable, it is a mess that the government caused.

Move forward

Mitchell dedicates his final chapter to finding solutions. I’ve pointed out that proposals to address student loan troubles often don’t acknowledge the underlying cause of the problem: education that wasn’t worth the cost. You shouldn’t be paying student loan debt if your education was worthwhile. Your education was probably not worth the cost. If student loan defaults have reached the stratosphere it is a signal that we should reduce higher education subsidies and not increase them.

Mitchell is refreshing in that he doesn’t resort to enticing, but fundamentally hollow offers to forgive all student loans. Mitchell instead supports eliminating unlimited student loans for graduate students and promoting alternative four-year colleges. Mitchell also advocates forcing school to take financial responsibility for defaults on student loan debt. These are all great ideas.

Mitchell does not support free four year college but he supports making the first two or three years free. This is to allow prospective students to try college for a free period. Dropouts, who make up the bulk of student loan defaulters, don’t have to be stuck in debt for college that doesn’t go according to plan. If the student passes her first year, however, she would be allowed to borrow the next years. A student who makes it through her sophomore year is likely to make it to graduation. After obtaining her degree, there is a significant drop in the likelihood of defaulting on loans.

This proposal seems intriguing and is a better argument to get college free than any other. Colleges should cover at least some of this “free trial” period. A program like this could lead to another subsidy for higher education, with unintended consequences.

Mitchell’s book demonstrates that good intentions can lead to hell. The original purpose of student loans was to help all students go to college and increase the nation’s scientific and economic capabilities. The loan program is still in use sixty years later. Congress cannot repeal the law of unintended outcomes.

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