Support for college students and banks: Not so different

Flickr

Elizabeth Warren at Paramount in Seattle, Washington on December 9, 2011.

Article Highlights

  • For students looking to finance their education, seeing the federal government as a last resort might be appropriate

    Tweet This

  • The analogy between federal support for banks and support for college students is worth developing more fully

    Tweet This

  • Bipartisan deal expects low student loan interest rates in the near term and higher rates in the future

    Tweet This

 A bipartisan deal reached in the Senate clears the way for legislation on federal student loans to undo the July 1 increase in interest rates on new loans to 6.8 percent from 3.4 percent. The House of Representatives previously approved a bill that embraced the key feature of President Obama's proposal, which was to link interest rates on student loans to borrowing costs for the government. The Senate approach includes this link, pegged to yields on 10-year Treasury notes.  The rate on new loans would adjust each year up to a cap, but an individual borrower's interest rate would be fixed over the life of the loan. This is expected to lead to relatively low interest rates on student loans in the near term and higher rates in the future as yields on Treasury bonds rebound with the economy over the next several years.

Mr. Obama in particular deserves recognition for putting forward a reasonable proposal that was in the ballpark of what Republicans would accept, and for rejecting partisan pleas to stick with his previous advocacy, electorally motivated, of setting low loan rates a year or two at a time. We can only hope to see similar leadership rather than partisan rhetoric from the president on other economic issues in his series of economic speeches beginning this week.

Left aside in the bonhomie was a proposal from Senator Elizabeth Warren, a Democrat from Massachusetts, that would have used the Federal Reserve's discount window lending as the benchmark for student loans while Congress worked on a "fair, long term solution." Under what was titled the Bank on Students Loan Fairness Act, college students would get their loans from the federal government for one year at the same 0.75 percent interest rate the Fed charges banks. The proposal garnered nine co-sponsors, all Democrats, along with a long list of endorsements from the likes of university professors and administrators and organizations representing students.

Others were not as welcoming. President Obama reportedly tried to steer Senator Warren toward the bipartisan compromise, while education experts from the Democratic-leaning Brookings Institution wrote that Senator Warren's proposal "should be quickly dismissed as a cheap political gimmick." The Washington Post's fact checker challenged Senator Warren's assertion that the government was racking up large profits from higher interest rates on student loans, assigning a "two Pinocchio" rating of "significant omissions and/or exaggerations" to the budgetary arithmetic behind the proposal. The idea that the federal government was balancing the budget on the backs of college students was among the motivating factors for setting a lower interest rate.

I am glad to see the prospect of a bipartisan agreement on student loans (and not just because I am a professor - the process by which the House and President Obama reached substantive agreement and then brought along the Senate suggests the possibility of similar progress on other economic issues). But I believe that Senator Warren has a valid point in making an analogy between federal support for banks and support for college students. This is worth developing more fully, in part because it sheds light on the government's role in the financial sector.

The Federal Reserve lends money to banks at the discount window; the interest rate has been 0.75 percent since Feb. 19, 2010, but reached as low as 0.50 percent starting on Dec. 16, 2008.  These loans are made in the Fed's capacity as the lender of last resort, under which it provides temporary liquidity (typically overnight) to solvent banks on a fully secured basis at a penalty rate. (Four lectures by the Federal Reserve chairman, Ben S. Bernanke, in March 2012 provide an accessible introduction to monetary policy.) Incredible as it might sound, the 0.75 percent interest rate charged by the Fed is indeed a penalty. Banks eligible to borrow at the discount window would normally borrow from other institutions in the federal funds market, where the interest rate has recently hovered around 0.1 percent, roughly in the middle of the Fed's target range of zero to 0.25 percent.

For students looking to finance their educations, seeing the federal government as a lender of last resort might be appropriate, since many college students would turn first to their parents if family resources permit. Even Senator Warren's proposed 0.75 percent interest rate on federal student loans might well be more than what Mom and Dad charge.

Banks provide collateral for their loans in the form of securities such as Treasury bonds, and the owners of banks must finance their activities in part with their own capital at risk.  It is natural to view college students as solvent-but-illiquid to the extent that their education unleashes the higher future earnings with which to repay their loans. Students thus put up as collateral their own human capital: it is quite difficult to walk away from federal student loans, meaning that a college-age borrower's future earnings effectively serve as the surety for repayment. Indeed, a further motivation for the low interest rate proposed by Senator Warren is the concern that the burden of college debt is having a negative impact on graduates' spending and thus on the overall economy.  On the other hand, others have raised concerns that easier financing spurs higher college tuitions and thus does not improve college affordability.

The analogy between banks and students is not perfect.  A challenge for making the connection between the interest rates charged to banks and to students is that the Fed generally provides overnight lending at the discount window, whereas students have 10 to 25 years to repay their loans.  President Obama's proposal, adopted by Congress, to tie student loan interest rates to the 10-year Treasury note thus makes eminent sense.  At the same time, students signing loan contracts for the 2013-14 academic year will benefit from the Fed's activities even without Senator Warren's bill, just not directly.  Through its third quantitative easing program, QE3, the Fed is intervening in the Treasury bond market and likely holding down borrowing costs for the federal government, including the interest rate on 10-year Treasury notes.

The other potential difficulty for students in connecting their loans to federal support for banks is that to get access to the discount window, banks are subject to a wide-ranging regulatory and supervisory regime. For college students, the analogy would be to have a federal examiner watch to make sure they do their homework and get through the required readings ahead of a lecture. As a professor, I can see the attraction of fleshing out this aspect of Senator Warren's proposal to give college students the same federal support as banks. I am not sure that my students would agree.

 

Phillip Swagel is a professor at the School of Public Policy at the University of Maryland and was assistant secretary for economic policy at the Treasury Department from 2006 to 2009.

 

Also Visit
AEIdeas Blog The American Magazine
About the Author

 

Phillip
Swagel
  • Phillip Swagel, an economist and academic, was assistant secretary for economic policy at the Treasury Department from 2006 to 2009, where he was responsible for analysis on a wide range of economic issues, including policies relating to the financial crisis and the Troubled Asset Relief Program. He has also served as chief of staff and senior economist at the White House Council of Economic Advisers and as an economist at the Federal Reserve Board and the International Monetary Fund. He is concurrently a professor of international economics at the University of Maryland's School of Public Policy.  He has previously taught at Northwestern University, the University of Chicago’s Booth School of Business, and Georgetown University. Mr. Swagel works on both domestic and international economic issues at AEI.  His research topics include financial markets reform, international trade policy, and the role of China in the global economy.


    Follow Phillip Swagel on Twitter.
  • Phone: 202.687.4869
    Email: pswagel@aei.org

What's new on AEI

image Dad and the diploma: The difference fathers make for college graduation
image A better way to finance that college degree
image Fracking for bigger budgets
image Earth Day: Hail fossil fuels, energy of the future
AEI on Facebook
Events Calendar
  • 21
    MON
  • 22
    TUE
  • 23
    WED
  • 24
    THU
  • 25
    FRI
Wednesday, April 23, 2014 | 12:00 p.m. – 1:30 p.m.
Graduation day: How dads’ involvement impacts higher education success

Join a diverse group of panelists — including sociologists, education experts, and students — for a discussion of how public policy and culture can help families lay a firmer foundation for their children’s educational success, and of how the effects of paternal involvement vary by socioeconomic background.

Thursday, April 24, 2014 | 12:00 p.m. – 1:30 p.m.
Getting it right: A better strategy to defeat al Qaeda

This event will coincide with the release of a new report by AEI’s Mary Habeck, which analyzes why current national security policy is failing to stop the advancement of al Qaeda and its affiliates and what the US can do to develop a successful strategy to defeat this enemy.

Friday, April 25, 2014 | 9:15 a.m. – 1:15 p.m.
Obamacare’s rocky start and uncertain future

During this event, experts with many different views on the ACA will offer their predictions for the future.   

No events scheduled this day.
No events scheduled this day.
No events scheduled this day.
No events scheduled this day.
No events scheduled this day.