I’ve been reading quite a bit about student loans for the last few days. These exist where those who don’t have the cash to study up front – i.e. most people – have to borrow if the government isn’t paying for it. Reading around this topic raises a number of basic principles that I’m trying to think through. Some of this connects with tuition fees and social justice (see here), but this blog is on the economics of the loans. Apologies if this looks a bit dry, but it’s important and (I think) quite interesting. Excuse the pun…
Interest and Inflation
The interest rate is how much something increases in worth, like the rising value of your savings, your house, or stocks and shares. Working against interest is inflation, which is where money loses its value because prices in general increase over time. In other words, inflation dictates that the money in your pocket today will buy you less and less in the future, so if you follow the old cliché of keeping your nest egg under your mattress, you’ll be worse off in the long run. Interest rates for bank accounts and loans are controlled by financial institutions, while inflation is largely an external issue and a bit less ‘tame’.
Combining these two ideas can be bit of a mental juggling act. For your investments or savings, you want the interest rate to be higher than inflation because then your money actually grows in ‘real’ terms. For ‘negative’ sums such as loans, you want your interest rate to be low as this reduces how much you pay back. Also, the closer that rate is to inflation, the less the loan costs you as its value decreases. Private loan companies generally charge much more interest than the inflation rate; they’d go bust if they didn’t as their debts would outstrip their incomes. Governments, on the other hand, loan money at lower rates when they want to encourage activities they see as beneficial to wider society/the economy (or the next election). Student loans are an example of this…
Why have student loans?
Governments loan money to students because they want people to go to university but (increasingly) don’t want to pay for it. They see university graduates as useful because there are a heap of ‘external’ benefits that they can (but don’t always!) generate. These include:
- Higher general education levels through schools and a generally more literate society;
- Improved physical well-being thanks to health professionals and medical research;
- Legal systems run by qualified, competent lawyers;
- More efficient/profitable organisations due to improved technology and management systems;
- More tax income as graduates tend to earn more.
These benefits certainly exist but calculating the value of the first three, for example, is virtually impossible because they aren’t measurable. In any case, ‘reducing’ a decent education, a functioning legal system, or good health, to a financial number hides a host of their essential merits. There is also little predictability for anything on that list. Some people will be healthy, well-paid and in long-term employment, but this obviously varies depending on a mixture of luck and judgement.
Inflation, Interest and Student Loans
Coming back to inflation and the interest rates, these combine to specify how much a student loan will really cost. If the interest rate on your loan is less than inflation then the real cost of your borrowing actually goes down, even if the actual ‘number’ at the bottom of the balance sheet is getting bigger. It would make sense not to pay it back at all but you’re not generally allowed to do this! Having a quick look round, federal student loans in the US have interest rates at 4-6% (private ones range from 3-10%) while in New Zealand the rate for domestic students is zero. Nice New Zealand, sort of! In the UK, student loans attract up to 3% interest, depending on how much you’re earning and whether or not you’re still at university. Because the UK’s inflation rate is currently just over 2%, the effective – or ‘real’ interest – rate is either slightly negative or just under 1%. I think this means that the value of these loans is pretty much static as things stand at the moment.
Predicting The Future
The next logical step might be to work out whether university is ‘worth it’: will lenders and students earn back more than they dished out or took? In the case of the UK, the government is not gaining from the loans themselves, and it’s not costing the students more than they borrowed. Beyond that, I’ve come to the conclusion that this question is more or less unanswerable, but explaining why might be useful. It’s mostly to do with our collective and individual futures being unknown.
I’ve already explained that many of the benefits of having a degree don’t come back to the graduate directly, like the overall benefit they have on the society and the economy – this is why governments want people to study in the first place. Also, not all degrees have the same probable ‘returns’, and it can differ a great deal between countries and according to your university, subject, and social background, among other things (again, see my previous blog). Many of these benefits, as I mentioned before, are observable but hard or impossible to quantify. Even if you ignore all of the ‘unmeasurables’ and look at what we might get the numbers for, working out if the investment pays for itself is still difficult.
At the ‘big’ level, the troughs and peaks in our economies aren’t foreseen (as regular as they seem to be), and neither are natural disasters, outbreaks of Ebola, civil or international war, and so on. On a grand scale, we’re a bit like skydivers in that we can control some of our sideways motion and speed, but we can’t halt the downward passage!
On the personal level – i.e. our earnings (and their tax) – we would hope that earnings increase above the rate of inflation over our working lives. This partly depends, of course, on the economic climate, your own luck, education, hard work, career choices and so on. Not everybody wants to – or can – follow the same upward trajectory over their adult life. You might want to change direction, or the field that you work in can shrink or disappear, and some people stop work to have a family or due to injury or illness. However, even for the people who keep doing the same thing in a profession such as teaching or law, inflation seems to overtake income rises towards the end of their careers. It’s like the tortoise racing the hare: it’ll get you eventually!
Will it all be worth it?
Student loan lenders first of all don’t know exactly how much the borrowers are going to pay back. They can assume that the highest earners will pay their loans off and in some cases will pay even more, but you can’t totally guarantee who those people will be. Heading ‘down’ the salary scale, the loan defaults increase as some people can’t afford to pay. The lenders know about this and some of it is supposed to be built in to the system. In many cases the lower earners aren’t expected to pay when their income falls below a certain level. Governments could be running the whole loan thing at a loss (accidentally or intentionally), estimating or guesstimating (or blindly hoping) that the overall effect is positive. However, as they can’t measure all of the benefits and can’t truly predict any of them, they’ll have to cross their fingers and hope the numbers don’t end up deeply in the red.
For the borrowers, we’ve seen that you can’t calculate some of the personal benefits. For what is financially countable, though, will you be in credit after the payments, interest, and inflation have been taken into account? In wealthy countries, it seems that graduates earn up to double what non-graduates do. If that difference equates to the total cost of your loan, then perhaps it was worth it, or maybe you want a better return than breaking even. This gap between graduates and non-graduates, though, is an average, and varies enormously (again, see my earlier tuition fees blog). I didn’t have to pay tuition fees for my undergraduate degree or my PhD, although I did pay for the Master’s. I’ve had quite a varied career, with long periods of unpaid travel and different kinds of work. My bank manager (and to some extent my wife) might have been happier if I’d taken a different route, particularly after my Bachelor degree. However, having one, two, and then three degrees has changed me hugely– and positively – as a person. I’ve become either an asset and an absolute hoot in conversation or a dreadful bore, depending on your perspective!
So, do student loans add up? It seems that the jury’s out, and we may never know the real answers. From the perspective of the graduate or the taxpayer, this can only really be judged partially and in hindsight. You’d need to somehow take the unmeasurables into account, as well as the individual and societal highs and lows, recoveries and recessions, over about 50 or more years. By the time we had an idea, the politicians who told us that the system would work out will either be editing the third edition of their memoirs or propping up the daisies.