Student Loan Debt: The Case for Discharge

It seems pretty clear to me that student loan debt has reached crisis proportions.  I’ve posted about the growing amount of student loan debt, which now exceeds credit card debt, and the increasing attention drawn to the issue by politicians, protesters, and the media.  The simplest and most direct solution to the problem is to allow some (not all, but some) student loan debt to be discharged in bankruptcy.  Here’s why I think that is the only logical, effective, solution to the problem.

To start, I’ll need to go backwards.  Stay with me, I’ll only take a minute.  Bankruptcy exists as a matter of federal policy for one simple reason–it is good for all of us.  The idea of a bankruptcy discharge (or forgiveness of debt) grows out of the recognition that when an otherwise honest person is saddled with more debt than he can ever repay, it is better to forgive that debt and allow him to become, once again, a productive member of society.  That works out better for all of us than the alternatives: jail him, or deny him the opportunity work, or deny him the incentive to work because he gains no benefit.  The idea of a bankruptcy discharge also recognizes that punishing an honest but unfortunate debtor also makes that debtor’s dependents wards of the state, all of which costs the rest of us more than if we let people periodically discharge their debts.

I could talk all day about this idea, which actually goes back to Bible times, when the ancients recognized the humanity, but also the practicality, of allowing periodic forgiveness of debt.  For now, though, I’ll just leave it at this:  bankruptcy exists because as a society we recognize that it is not productive to keep people enslaved to debt.  People who are struggling to pay overwhelming debt can’t do a lot of the things we want them to do.  They can’t spend money.  They can’t save money.  They can’t buy homes.  They can’t keep the homes they have.  They can’t save for retirement.  They can’t become entrepreneurs, so they aren’t able to create jobs for others.  They can’t send their own children to college.  And if the debt is overwhelming enough, it is even a disincentive to work at all–why work just to pay debt?  Just think about the experience of the Soviets on collective farms, which proved that people will work harder when they get to keep the fruits of their labors.

Student loan debt is like any other debt.  If you are trying to pay back overwhelming student loan debt, you can’t do any of those things.  You can’t save, you can’t contribute, you can’t be entrepreneurial.   So why treat student loan debt differently?  The short answer is that student loan lenders have really good lobbyists.  That is true; otherwise how do you account for the fact that currently it is easier to discharge tax debt owed to the IRS than student loan debt?

I’ll be honest, though.  That’s an oversimplification.  There is a difference between student loan debt and other types of debt.  In theory, student loan debt allows you to prepare yourself to earn more money.  So it makes sense that it would be harder to discharge student loan debt  than, say, medical bills.  Should you be able to borrow for your education, and before reaping the benefit of that education, discharge student loans in bankruptcy?  No, of course not.  What doesn’t make sense, however, is that student loan debt can never be discharged.

The student loan crisis, like the mortgage crisis we have been living with for the last few years, is largely the result of incentivizing (if that is a word) the wrong parts of the equation.  Like mortgages, student loans have been packaged and sold as investments, and because they can’t be discharged in bankruptcy, they are attractive to investors.  So, originators have the incentive to make the loans.  Since there are lenders who want to make the loans, colleges and universities have the incentive to raise tuition or admit more students.  (Traditional colleges and universities are guilty of chasing these dollars, but for-profit institutions have sprung up like mushrooms, and some are guilty of deceptive practices.)  And because the money is available and everyone “knows” that you get a better job if you have a college education, students take out the loans without a cost-benefit analysis.  Notice that no one in the process is looking at the end result:  will this college education fit the borrower for a job that will earn enough to pay back the loan?  Stephen Gordon puts it really well:

If you want a good job (the thinking went) there really wasn’t much of a choice. You went and you paid whatever price they put in front of you.

But what’s the advantage of a good job if the salary difference between that job and a non-college-level job is lost servicing student debt? It’s a reasonable question that has become more pressing as the amount of student debt required to get an education has risen.

Should the borrower be asking this question?  Absolutely, but many of these borrowers are teenagers, or twenty-somethings.  After all, part of the reason you go to college is to hone your critical thinking skills.  Students are reassured by guidance counselors and student advisers that borrowing is the norm, and that they are “investing” in themselves.  But the lenders and the colleges bear responsibility for critical thinking in another way as well.  Should you lend a kid who is majoring in social work (not picking on social workers, but not a lot of high-paying jobs out there for you guys) $120,000 for an undergraduate degree?  I’m thinking no.  Many institutions of higher learning (to give them a dignity they may not deserve) oversell the earning capacity of their graduates, and I am sorry to say that law schools may be among the worst offenders.  Other practices increase the amount of borrowing far beyond that necessary for tuition and books, like institutions that encourage students to borrow for living expenses instead of working, or give kids debit cards that draw down their student loans.

Borrowers’ potential for bankruptcy represents a kind of risk for lenders – a risk that encourages lenders to be efficient about whom they lend money to.  And this efficiency may lead to results in the interests of both borrowers and lenders.  Due to this risk, the lender needs to determine how likely the borrower will be to pay him back, and the lender’s evaluation of this risk can lead to him not lending too much money to the borrower, thereby preventing the borrower from getting over his head in debt.

Allowing some student loan debt to be discharged in bankruptcy would force lenders to re-order their priorities, and conduct a traditional analysis of whether a particular loan makes sense.  Dischargeability of student loans will also require investors buying student loans (or ratings agencies rating those investments) to consider the real possibility of default and discharge.  (That risk already exists, because you can’t get blood out of a turnip.  The non-dischargeability of those loans just allows a convenient blindness on the part of those who want to believe student loans are low- or no-risk investments.)  When student loan lenders no longer have the incentive to make loans no matter what the risk, perhaps colleges will no longer feel free to raise tuition and admit ever-larger classes (and build a for-profit college on every street corner).

Ironically, this targeting might make education more — not less — affordable.  There is a limit to what students and their families can currently pay, and, by limiting the ability of some to borrow against their future, regulators might suggest to colleges and universities that the spigot of ever-more money might be turned off.  This economic pressure might encourage universities to be more efficient with their own spending, thereby slowing the rate of tuition growth.  Increased lending standards might encourage students to be more prudent with their own money.  Higher standards might raise hard questions.  A student might ask herself whether she should go to a low-ranked private university for four years or instead spend her first two years at a much more affordable community college before transferring to another university.  The end result for the student’s employment prospects might be the same, but the debt accumulated along the way might be very different under those two scenarios.

Whether student loans are dischargeable after a certain period of time, or whether they are dischargeable based on some factor of the debtor’s income, or a combination of the two, discharging student loans is a lifeline to those saddled with unreasonable debt, and it makes sense for all of us.  A change in the law is the only way to keep a whole generation of student loan debtors solvent and productive, and protect the rest of us from the next bubble.

When I started writing about student loans, I really didn’t intend to make it a series, but I find I still have more to say.  So next I’m going to post about the current law and hardship discharge, or what Russ DeMott calls the “very, very disabled standard.”

Photo: iStock/RonBailey