Does This Explain Opposition to Market-Based Interest Rates?

As of this writing, it appears that the U.S. Senate has finally reached an agreement on student loan interest rates after subsidized Stafford rates doubled from 3.4% to 6.8% on July 1. The general terms of the agreement are similar to what President Obama proposed in his FY 2014 budget and what the House of Representatives agreed to back in June, with some compromises on each side.

The big difference between current law and the Senate agreement is that interest rates for nearly all student loans will be tied to the 10-year Treasury rate, which currently sits at about 2.5%.  (Undergraduates would pay a 2.05% premium above the Treasury rate on Stafford loans to account for program costs and the risk of offering the loans.) However, the Treasury rate is expected to increase to 5.6% by 2016, pushing the interest rate for undergraduates to 7.65% from less than 5%. The plan includes a cap at 8.25%, which may be reached according to the CBO report.

The Senate agreement is not without its critics, particularly on the political Left. Senator Bernie Sanders, a Vermont independent and a self-described “socialist,” criticized the plan as “dangerous” in an article in The Hill. His criticism lies in the fact that interest rates can rise well above the current 6.8% over time, a very real concern given the interest rate projections. While the plan is expected to pass the Senate (and the House), some other Senate Democrats will likely vote no as well.

At this point in the great interest rate debate, I have to wonder if there is another reason some politicians oppose market-based interest rates. Tying student loan interest rates to the 10-year Treasury note directly connects students’ future payments to the cost of federal borrowing. And that cost of federal borrowing is influenced by the federal government’s fiscal policy.

This connection between federal borrowing and student loan rates could potentially have the following repercussions. If loans are tied to Treasury notes—and there is no way to fix the rate as has been done for the past seven years—students should have an incentive to push for federal policies which lower the federal government’s cost of borrowing. (With the decline in home ownership rates among younger adults, fewer 20- and 30-somethings have mortgages, which are affected by federal borrowing costs.)

The policy that best reduces the cost of borrowing is a balanced budget, which reduces the need for additional borrowing. The passage of the Omnibus Budget Reconciliation Act of 1993, which reduced the budget deficit through a combination of tax hikes and spending cuts, had the effect of driving down long-term interest rates. (For more on this, I highly recommend reading Bob Woodward’s Maestro about Alan Greenspan’s role in the policy discussions.)

My question to readers is whether you think that some politicians may oppose market-based interest rates because more young adults may place pressure on Congress to find some legislative solution to balance the budget—although the solutions certainly vary by political persuasion. Say it’s 2016 and undergraduate Stafford rates are 7.5%, with hitting the 8.25% cap becoming more likely. Could we see student advocacy organizations pushing for a balanced budget to bring down interest rates? I don’t know how many people will think this way, but it’s something to consider.

Can “Paying it Forward” Work?

While Congress is deadlocked on what to do regarding student loan interest rates (I have to note here that interest rates on existing loans WILL NOT CHANGE!), others have pushed forward with innovative ways to make college more affordable. I wrote last fall about an innovative proposal from the Economic Opportunity Institute, a liberal think tank from Washington State, which suggests an income-based repayment program for students attending that state’s public colleges and universities. The Oregon Legislature just approved a plan to try out a version of its program after a short period of discussion and bipartisan approval.

This proposal, which the EOI refers to as “Pay It Forward,” is similar to how college is financed in Australia. It would charge students no tuition or fees upfront and would require students to sign a contract stating that they would pay a certain percentage of their adjusted gross income per year (possibly three percent of income or one percent per year in college) for at least 20 years after leaving college. It appears that the state would rely on the IRS to enforce payment in order to capture part of the earnings of those who leave the state of Oregon. This would be tricky to enforce in theory, given the IRS’s general reticence to step into state-level policies.

While I am by no means convinced by simulations conducted regarding the feasibility of the program, I think the idea is worth a shot as a demonstration program. I think the cost of the program will be larger than expected, especially since income-based repayment programs decouple the cost of college from what students pay.  Colleges suddenly have a strong incentive to raise their posted tuition substantially in order to capture this additional revenue. In addition to the demonstration program, I would like to see a robust set of cost-effectiveness estimates under different enrollment, labor market, and repayment parameters. I’ve done this before in my research examining the feasibility of a hypothetical early commitment Pell program.

Needless to say, I’ll be keeping an eye on this program moving forward to see how the demonstration program plays out. It has the potential to change state funding of higher education, and at the very least will be an interesting program to evaluate.