President Biden announced plans to forgive $10,000 to $20,000 in student loan debt for individuals earning up to $125,000 a year and married couples earning up to $250,000. There can be many criticisms of this proposal. Here I consider just one – the precedent it sets and the expectations it creates for the future.
Whenever the government engages in a bailout, it creates expectations of future bailouts. Anyone debating taking out student loans today may do so more than ever, as they can now expect that at least some of the debt they promise to pay back will actually go to the taxpayer. According to a recent story The Washington PostThis isn’t just idle speculation on my part – we’re already seeing it happen:
Some students seeking to take advantage of the promised forgiveness have already signed up for more loans, according to Betsy Mayotte, president of the Institute of Student Loan Advisors.
“There are people who are applying for loans this semester or applying for more loans than they originally applied for because they assume they will be forgiven,” said Mayotte, who works closely with student and parent borrowers.
This fall, millions of high school seniors will begin applying to colleges for the 2023-2024 academic year. One wonders if they may overextend themselves with the expectation that they too will someday not have to repay part or all of their debt.
Is there a way to solve this new moral hazard problem? Perhaps, but it wouldn’t be pretty. A history of the English banking system provides an example of what I mean.
recorded as Fragile by Design: Banking Crises and the Political Origins of Scarce Credit, By Charles Calomiris and Steven Haber Throughout the nineteenth century, the Bank of England made a habit of bailing out financial institutions when they became liquid or insolvent. Predictably, this created a significant moral hazard problem, and the British banking system experienced serious banking crises in 1825, 1836, 1847, and 1857. Eventually, the Bank of England realized they could not sustain it They announced a new policy, declaring that they would be much stricter as lenders of last resort when a bank was liquid and that they would not be able to save institutions that were insolvent.
But political talk is cheap – it often needs to be demonstrated to be believed. Unfortunately, this meant that for the new policy to effectively reduce moral hazard, it actually needed to be demonstrated, which resulted in another banking crisis. When Overend and Gurney collapsed in 1866, this new promise was tested. The Bank of England stood firm and allowed Overend & Gurney, one of England’s largest financial firms, to fail in its bankruptcy. This made their stated commitment credible – and the performance and stability of England’s banking system improved significantly for decades to come.
We may be entering a situation where, despite the administration’s insistence that this is a one-time program, expectations of future bailouts or debt forgiveness take root. And it may ultimately be that the way to deflate this expectation is by allowing a full-blown debt crisis to occur. Absent that, we could be stuck with an ongoing series of bailouts, followed by more expectations of more bailouts, leading to more debt accumulation, and so on.
A pessimistic view? Probably. But am I wrong?
Kevin Corcoran is a Marine Corps veteran and a consultant in healthcare economics and analytics and holds a Bachelor of Science in Economics from George Mason University.