Will Student Loan Debt Sink the Country into Recession?
In 2014 celebrity billionaire Mark Cuban had dire warnings about the student debt crisis, comparing the graduate debt marketplace to the mortgage crisis of 2008. He was right about the scope, but he was wrong about one thing—the student debt bubble isn’t going to burst. It can’t. And that should terrify everyone.
Cuban is far from alone in sounding an alarm about student lending. Experts from The New York Times to the Financial Times and more have spent years pointing out the accelerating instability that underlies student lending.
Similar to the mortgage crisis, student lending has virtually no relationship with either the borrower’s assets or future ability to repay. College degrees get ever-more expensive while the asset they purchase—entry into the job market—has seen little or no appreciation. The result has created a pool of debt held by people who can’t pay and have no secured asset to sell off if they slip into default.
And like the mortgage crisis which tipped off the Great Recession, even those who don’t hold the debt themselves have ample cause for concern. The U.S. economy currently stands at about $19 trillion and student loan borrowing over $1.4 trillion—a debt now worth more than seven percent of the entire GDP—and the pace isn’t slowing down. Over the past decade, these loan burdens have gone up by more than 170 percent, with the average 2016 graduate $37,172 in debt. More than 44 million Americans today carry some student loan burden, which is second only to mortgage debt in sheer volume, dwarfing credit card debt, auto debt, and small business and startup loans.
What are bubbles?
During the 2008 mortgage market collapse, everyone got a firsthand lesson on the mechanics of debt bubbles.
Prior to the Great Recession, relatively few people other than economists understood the way aggregate borrowing affects financial relationships beyond the borrower and the lender. Like many things in economics, debt bubbles are relatively simple in theory and hideously complex in operation. On a macroeconomic scale, they form when three major conditions are met:
Loans for a certain type of asset (homes, cars, businesses, etc.) grow to the point where they make up a meaningful portion of the economy.
The price paid for that asset, and so the underlying debt, becomes worth far more than the true value of the asset.
This becomes a widespread phenomenon, inflating the prices for an entire category of asset (for example, overpricing houses in general as opposed to a single home).
When the system works well, borrowers don’t go underwater on debt because banks won’t give out that loan in the first place. When the system fails and lenders extend unwarranted credit, however, it puts everyone at risk. Borrowers have negative value, because their debt is worth more than what they bought, and lenders end up writing off increasingly large losses on their balance sheets.
A bubble “pops” when prices correct to more accurately represent the true value of the underlying asset (think overpriced houses in 2007), and in a free market this typically happens with frightening speed. Once prices correct, borrowers go “underwater,” because their loans are no longer secured. They will still owe money even if they sell the asset, often leading to a mass sell-off as people try to escape the market before it collapses entirely. Businesses in the relevant market begin to suffer as the bottom falls out of their prices.
Lenders, now, start taking losses as borrowers begin to default and declare bankruptcy. As a result, they become more cautious about credit, restricting loans and (sometimes) raising interest rates. This slows down the economy overall as businesses have trouble getting the credit they need to grow and solvent consumers struggle to make large purchases.
When the mortgage crisis hit in 2008, it hurt people who had never even thought about buying a home. The cost of houses had spiraled until mortgage debt vastly exceeded the real value of those houses, and the losses ended up spread across the economy.
Now, it’s happening again. Not only has the cost of a college education skyrocketed in recent years, its value seems to be depreciating.
The student loan bubble
Student loan debt has spiraled upward. In 1970, a year at Harvard cost less than half the median family income ($4,070 including room and board against a median $9,870 income). Tuition cost $2,600 per year, approximately $16,650 in 2017 dollars. Today that same education costs more than $63,000 per year including room and board, with tuition accounting for more than $43,000 of that total. And it isn’t just the Ivy League schools. Between 1995 and 2015, in-state tuition at public universities rose by 296 percent.
As tuition soared, however, the average return for a degree has not. According to a study by the National Association of Colleges and Employers, a typical university graduate in 1960 commanded an average starting salary of $47,442 (adjusted for inflation) per year. In 2015 (the end date of their study) that same graduate took home a starting salary of $50,219. This is approximately a 6 percent growth in starting salary, but during the same period, the cost of college increased by more than 1,120 percent.
Although college graduates still out-earn those without a degree, they spend an increasingly large chunk of their income paying for tuition-driven student loan increases. In terms of sheer volume, tuition has grown from between 7 and 20 percent of an adult’s median annual income (for men and women, respectively) to between 25 and 40 percent. The result is that students graduate owing far more relative to their current and future income. They’re also much more likely to need student loans, as it has become much harder for families to save up for college.
Without major education and employment reform, this is a captive audience, as young people still have to attend college if they want to qualify for most careers. Colleges have no structural incentive to lower their prices, as student loans have created a pool of consumers who can afford almost any tuition increase. While some students shop for tuition, so far this hasn’t affected university enrollment. As long as colleges can still fill their freshman classes, and as long as the government guarantees the loans to pay tuition, there’s no reason to think the market will step in and correct this.
A generation on the sidelines
The situation isn’t just bad for student loan holders—it is bad for everyone, another indicator that we have a bubble on our hands.
Financial advisors like to say there are two kinds of debt in this world: good debt and bad.
Bad debt sucks up value in the form of interest payments without any real financial payoff, for example, credit cards. That new flat screen might be fun, but it will never be worth what you ultimately pay for it.
Good debt builds value above its cost, so that in the end you’re financially better off for having taken it. Advisors often cite student loans as an example of good debt.
But this is looking less true by the day.
“I think that student debt is absolutely at a crisis level at this point,” said Mark Paul, a public policy researcher with Duke University. “The easiest way to think about this is that in the past decade alone we’ve seen the outstanding student debt increase fivefold,” he said, “but we’ve seen incomes remain largely stagnant. So, it’s clearly difficult for households to keep up.”
According to one study by Demos, education debt may actually hurt many graduates when it comes to lifetime earnings, even despite higher average salaries.
"Though a college education remains the surest path to a middle-class life,” the study found, “evidence has begun to mount that student debt may be far more detrimental to financial futures than once thought … over a lifetime of employment and saving, $53,000 in education debt [the average debt of a married couple with two bachelor’s degrees] leads to a wealth loss of nearly $208,000.”
Meaning many college grads are actually poorer in the long run for having gone to college than compared to their likely personal wealth earned with just a high school degree. With that kind of debt at such a young age, is it any wonder this generation sits on the sidelines of the consumer market?
“Despite the fact that we have a more educated workforce than we used to, the bottom 50 percent of the workforce has seen no gains,” said Paul. “What we have is a workforce that’s being told if they work and if they study hard they’ll see rewards from their education, but what we see is that those rewards don’t actually come through.”
As noted above, graduates today owe far more in principal relative to their overall earnings than they once did. An average borrower spends 8 to 10 percent of their pre-tax income on student loan payments (based on an average monthly payment of $351 balanced against average starting incomes). “Part of the reason that we’re seeing mediocre growth in the economy is that people have very little money to spend,” Paul said. “One of the major drivers of the U.S. economy is consumer spending, and if consumers are sending a large portion of their money to the U.S. government in student loans, they don’t have money to spend on other things.”
As businesses continue to wonder where their customers are, and as economists continue to ask the same thing about economic demand, perhaps they should consider what has become a generation-wide “youth tax.”
A for-profit flytrap
America got to this place through slow, incremental decisions to cut taxes, cut university funding, and shift the burden of higher education onto the students.
“What’s important to come back to is this is clearly driven by government policy,” Paul said. “Student debt is something that doesn’t exist in a free market by any means. The government continues to profit sizably. According to CBO estimates, over the next 10 years the government stands to profit $100 billion.”
Interest rates on a new loan currently range from 3.76 to 7.0 percent, depending on the nature of the loan and the degree pursued, making many student loans more expensive than paying a mortgage. Although undergraduate loans don’t always make the government money, and in some years they represent a net loss, the higher interest rates charged to graduate students are a cash cow. Thanks to the high tuition of graduate programs and the low cap on federally subsidized loans, students in law and medical school or those seeking MBA or PhD degrees have to rely on the far more expensive private and Grad Plus loans, often taking out hundreds of thousands of dollars in debt financed at interest rates of 5 to 7 percent or higher.
“The graduate students are a problem from the get-go,” said Josh Cohen, a lawyer who focuses on student loan issues. “My lawyers are averaging $200,000 [in debt]. My doctors, it’s not rare for them to average $350,000 to half a million dollars. Half a million! That’s ludicrous. There are parts of this country where if you took out a $500,000 mortgage you’d be living in a mansion.”
As Upton Sinclair once said, it’s difficult to get a man to understand something when his paycheck depends on him not to, and this has become one of the biggest problems in this debate. Thanks to a series of laws passed by Congress between 1976 to 2005, it is virtually impossible to discharge student loans in bankruptcy.
When a bubble can’t burst?
Just like in 2008, millions of borrowers are underwater: The debt has gotten more expensive while the value of the underlying degree hasn’t kept pace. The critical difference between student debt and a typical free-market bubble is the set of restrictions that force borrowers into repayment regardless of their means.
As a specialist in student debt, Cohen sees graduates with just about every kind of degree come through his office, and is the first person to point out that he wouldn’t have this career unless there was a crisis at hand. What he sees most of all, though, is a crisis of a brand-new kind, because there’s no way for the student debt market to correct.
“Everyone talks about the foreclosure bubble and that student loans are getting so large that it’s going to pop too, but actually student loans can’t pop. You can’t discharge student loans. If you’re a borrower, it can’t disappear in bankruptcy. If you’re a creditor, it can’t disappear in bankruptcy,” said Cohen.
The reason is both law and structure. Student loans don’t come with an asset subject to liquidation—you can’t just give that English degree back—and since borrowers can’t discharge their loans in bankruptcy, a delinquency means income garnishment, tax seizure, and other government collection actions.
“This is a pressure cooker with no release valve on it,” Cohen said, “and it’s so elastic that it will never explode. It can’t. There’s no way to pop it, so it just gets bigger and bigger and bigger.”
And since borrowers can’t declare bankruptcy to get out, the defaults have started. In 2015 alone more than 1.1 million borrowers entered default, and as of 2016, nearly 40 percent of borrowers were either in default or more than 90 days past due.
In an ordinary market this would be the pinprick that starts the bubble bursting, but not for student debt. Those defaulting borrowers will now be subject to summary collection action and seizure of their tax refunds, keeping them from ever escaping this debt and continuing to suck spending power out of the economy.
How that will play out nobody actually knows. There might be a big market correction coming, such as Cuban’s suggested scenario of mass college closures. But perhaps the economic doldrums of the past seven years are far more terrifyingly structural than anybody has yet realized, caused by a sea of young borrowers who feel they have no other recourse than to finance an education that may cost more than the house they grew up in.