The statistics on student debt are stunning. Many people believe a student debt crisis in the United States is eminent and concerns have been expressed about the situation in Canada. The level of concern has escalated in the last few months, as many economists have expressed concerns that we might actually be perpetuating a dangerous student debt bubble. Even if you disagree, most of the economic and social indicators, as they relate to student debt, are suggesting that how we currently finance post-secondary education is simply not sustainable and may be creating more economic harm than good.
According to a recent BMO poll of post-secondary students, 58% of Canadian student expect to graduate with almost $20,000 in student debt and another 21% expect to graduate with more than $40,000 in post-secondary debt. (http://www.cbc.ca/news/business/story/2012/08/17/student-debt-survey.html) The same CBC article also cites Federal Government statistics that shows the estimated cost of a 4-year program to be about $60,000. For individuals starting out in life and launching a career, this financial reality will be a drag on their standard of living at an important time in their lives. As many student borrowers know, there is an unfortunate overlap in the timing of student debt repayment and the timing of the other significant financial demands from the “building” phase of life, such as owning a home and starting a family. Evidence of this financial burden can be found in the growing propensity for adult children to live at home. According to the Globe and Mail (May 12, 2012), 73% of youth ages 20 to 24 and almost 33% ages 25 to 29 live at home with their parents. Furthermore, for the 60% of people graduating with student debt, they are 7 to 8% less likely to own their own homes or have investments and savings.
Without question there are personal, social and economic consequences to education debt repayment occurring early in one’s productive life. Since graduating with a substantial student debt means delaying the “building” phase of life, by the time people repay their post-secondary debt it is almost time to start saving for their own children’s education. This pattern suggests potentially a 25-year education repayment/investment cycle. Unfortunately, if parents are unable to save enough for their children’s education, then their children will have to rely more on student debt sources of funding. As a result, an intergenerational, debt cycle emerges. With post-secondary education costs on a fairly, consistent, upward trajectory, the student debt cycle perpetuates and deepens with each generation. (http://www.cbc.ca/news/business/story/2008/05/15/f-highereducation-tuitionfees.html)
The Motivation to Borrow
In general, being able to borrow from the future, to finance purchases today, suggests a future financial repayment capacity that justifies the debt obligations being made. Debt servicing problems arise when either the circumstances of repayment capacity changes or the initial expectations were simply not realistic. Each party to a debt obligation, borrower and lender, owns their part of proofing the expectations of the deal. Under regular credit circumstances, the lender will weigh the borrower’s current financial circumstances against their potential repayment demands, if they fully utilized all their current, known credit instruments. The lender is responsible for not extending credit if this potential repayment circumstance is not realistic. The borrower, on the other hand, is responsible for understanding the implications, financial and otherwise, of the repayment demands and ultimately weighing those implications against their original consumption motivation. For the most part, this describes basic consumer credit circumstances. Student credit, although regarded in the same basket as consumer credit, is very different because the decision to lend and the motivation to borrow are influenced by some future expectation of financial circumstance rather than current financial circumstance, which is almost by definition inadequate.
Credit availability aside, the size of a student borrower’s credit appetite should ideally reflect their future financial expectation and some internal rationalization of how far they are willing to financially commit to achieve their career goals. No doubt there are many students that have diligently weighed these variables in their decision to take on student debt. However, recent student loan statistics suggest that for many either their career expectations are not materializing as intended or there are other factors driving their propensity to over indulgence in student debt.
The Last Mile Mentality
If you were building a new railway line, how much would you be willing to pay for that last parcel of land needed to finish the track and reach your final destination? The answer is a lot. After all, what is the value of an unfinished railroad? Private land holders that stand between you and your destination would have an incredible ability to command way more than the real market price in these situations. This is the classic investment conundrum of these types of projects and is the primary reason why governments expropriate land at calculated fair value. Without this intervention mechanism, these sorts of investments would rarely happen. The risk that project expenditures could potentially become uncontrollably large, due to ransom-like, land premiums, would chase most investors away.
In many respects, the educational path most people take in pursuit of a career shares some characteristics with building a new railway line. Since educational achievement is often the result of a long cumulative investment of both time and money, post-secondary education really becomes the proverbial last mile of track needed to open up career opportunities. As such, the cost of a post-secondary education could very easily exceed, even the most generous assessment of future financial benefit, and students would still be inclined to pay. This is not an irrational outcome if you consider that unlike the railway example, where investors might choose not to pursue a project, by the time young people face post-secondary decisions, there is a lot of track already laid and often very few economically viable career alternatives to not moving forward. The steady erosion, in the labour market value of a typical high school education, means that not pursuing some form of post-secondary education is not really an option for the majority of young people. All things considered, it is relatively easy to relate these natural, post-secondary market conditions to students’ inherent tolerance for high education prices.
Credit’s Role in Price Inelasticity
Natural market characteristics aside, we should expect some tolerance for high prices due to the widespread use of student credit. As most people have experienced, credit can make us insensitive to the price of goods because with credit purchases there is really no obstacle to prevent immediate consumption satisfaction, other than personal self-control. The challenge to our personal self-control is the insidious, rationalization of overspending by viewing the incremental cost as being insignificant when spread out over either the repayment schedule or the expected consumption horizon. This allows undisciplined, credit-driven consumers to easily absorb price inflation, and not have it significantly alter their consumption decisions. Someone paying cash, on the other hand, will respond differently to a price increase. The increase will either add more time to their original savings plan, thus deferring the purchase to a later date, or have to be accommodated by displacing consumption of something else. If a seller wishes to encourage more consumption in the present, their best strategy with customers paying cash, is to lower the price and effectively shorten the saving window. Clearly, using credit instead of cash changes market behaviour on both sides of a transaction.
The increasing reliance on student loans to finance post-secondary tuition, over the last 20 years, bears some responsibility for allowing tuition inflation to persist. If increases in tuition lead to empty seats in classes, then there would be some natural resistance to passing on budgetary cost increases to students. The practice of using credit to pay for tuition, on the other hand, makes it relatively easy for post-secondary institutions to pass on inflation, with almost no adverse impact on enrollment numbers. In fact, one can easily argue that the more credit made broadly available to students the more tuition inflation there will likely be, as easier credit access fuels demand for post-secondary spots that would not otherwise be there.
The Student Debt Bubble
Over the last few decades, the increasing reliance on student loans to finance post-secondary education has effectively facilitated the growing detachment of real expected returns from borrowing capacity. The continuing demand for post-secondary education discussed in the previous section and the availability of student credit have created conditions that effectively permits the price of post-secondary education to inflate unchecked by normal competitive forces, regulations or basic consumer budgetary constraint. Of course, this (credit fuelled) tuition inflation leads to students having to borrow even more which widens the gap between the expected real returns and the real financial borrowing cost even further. As a result, student borrowers increasingly find themselves leveraged into very precarious financial circumstances by graduation.
This credit fuelled, inflation dynamic is the primary characteristic that leads economists to define the situation as a debt bubble. The breaking point would be a sharp escalation in loan defaults due to adverse economic conditions affecting student employment or a sharp increase in borrowing rates. While the raw economic impact of widespread loan defaults is obvious, a quick tightening of credit conditions would likely create a budgetary shock to most post-secondary institutions and would have broader consequences as it reverberates through their respective organizations.
So what, now what?
Even if you disagree with the extent of the student debt problem, our current economic and social experiences suggest that this current situation is not sustainable in the long run. Economically speaking student debt is a serious problem for everyone – not just the borrowers. When students borrow from their future to finance post-secondary education, it impacts the broader economy because a lot of their income after graduation goes into debt repayment rather than general consumer spending and investments in things like houses, which are important bits of economic activity for any economy. It is not entirely clear that policymakers have factored the macro consequences of delayed economic contribution, into their long run economic growth expectations. Similarly, there has also not been enough discussion about how significant student debt alters future consumption patterns, investment patterns and savings patterns of borrowers. If in fact people graduating with student debt are less likely to own their own homes or have investments and savings, then we should try to quantify the economic implications long before we experience them. Finally, we need to be cognizant of the role of student credit, in tuition inflation. Left unchecked, credit driven inflation can have a very bad reckoning for borrowers, lenders and the economy in general. Even if we avoid a negative credit event and can justify the economic contribution disruption, the social consequences being experienced today are unsustainable and likely creating more (unintended) harm than good. If we reevaluate our current post-secondary financial model, factoring in the many known externalities, then we might be motivated to strive for a new deal for upcoming generations.