There were as always interesting comments, butI will reply just to the one that was made most frequently. It is that there are external benefits from the study of certain subjects in college, such as English literature and other of the humanities (philosophy, classics, etc.), that would be lost without subsidized student loans. I disagree with this argument for subsidized loans, on several grounds. First, while there may be some external benefits to the study of the humanities, although I'd like to see the evidence or even the argument, I imagine that they are exhausted at a lower level than is generated by subsidization. Second, universities have flexibility with their endowments and they can allocate more endowment funds to the humanities if student tuition income drops because of withdrawal of loan subsidies. Third and most important, most of the ablest students go on to some form of graduate education, and for them the choice of an undergraduate major has few economic implications and so is unlikely to be affected by the existence of loan subsidies. One of the commenters pointed out that I myself majored in English in college. I think it was a valuable background to my subsequent legal studies and I would continue to recommend it as a college major.
I can be brief since the discussion among those commenting already answered many of the issues raised in other comments.
Some claim that a free market for student loans could not work well because lenders would charge high interest rates, like credit card companies do. But high credit card rates are mainly due to the high cost of servicing these accounts because they have relatively low dollar amounts per account, and high default rates. These forces raising market interest rates would be absent under my proposed student loan program because default rates on student loans would be much lower, and the typical amounts borrowed to finance education would greatly exceed the typical debt on a credit card.
Some of the comments reflect a concern that a free market in loans would place history and other humanity fields at a major disadvantage since earnings in these fields are below those in engineering, business, and other specialties. Of course, they are already at a disadvantage under the present student loan system. The best way to encourage these fields is not by continuing to subsidize all student loans, but rather directly to subsidize students who major in humanities with lower tuition, more easily available scholarships, and in related ways. If a subsidy is desirable for any activity, it is always more efficient directly to subsidize the activity rather than using roundabout approaches.
There were several allegations of declining economic benefits of higher education. In fact, during the past three decades these benefits have gone sharply up, not down, and unemployment rates of college graduates remain way below those of high school drop-outs and high school graduates.
Fannie Mae and Freddie Mac charge substantial amounts for their insurance of home mortgages-the current attacks on these companies allege among other things that they charge too much because of their monopoly power. But the default rate is low on insured and other mortgages mainly because borrowers have to use their homes as collateral. Since student borrowers in a free market for student loans could not use their education as collateral, I proposed to offset that defect with other advantages. Perhaps most important is to continue the present system that does not allow student loans to be discharged through declaring personal bankruptcy.
A young couple with modest earnings can buy a house that costs many times their combined incomes without putting down more than a small fraction of the cost, as long as they have reasonably stable employment and a decent credit history. They pay a market-determined interest rate to the lender that is presently about 6 per cent in the United States for a 30 year fixed rate loan. However, it is crucial that they offer their home as collateral, so that the lender can repossess it if they fail to meet their mortgage payments. They can borrow to purchase a car too, essentially by offering the car as collateral.
Yet with the exception of medical and a few other types of students, young persons cannot borrow on a purely commercial basis without parental or other co-signers to finance their higher education. The usual explanation has been that unlike homes and other consumer goods, education cannot be offered as collateral to guarantee repayment. This means that in the event of defaults on student loans, there would be no assets for lenders to repossess. Put differently, lenders cannot take ownership of the human capital they finance since that means taking ownership of the individuals receiving the education, and no modern country allows people or institutions to own other individuals. Still, even without such collateral, it is possible to encourage a fully commercial student loan market with a few straightforward changes.
Countries typically help students by paying most of the direct costs of higher education, and also sometimes by providing scholarships to help pay for the cost of living while in school. Though the stated reason for this is to allow poorer students access to higher education, the beneficiaries are mainly children from the middle and upper classes since they are the ones who attend these mainly state-run colleges and universities. Even in the Unites States, about 80% of all students are enrolled in subsidized state-run institutions. This system penalizes less prosperous families who do not have children at universities and colleges, but are nevertheless taxed to help support the education of children from richer families. Even children from modest backgrounds who do manage to get a university education tend to become part of the economic elite.
In order to provide a better way to support students, or at least a way that complements direct subsidies, the United States about 40 years ago introduced a system of loans for college students that would be repaid gradually after they finish their schooling and are working. Similar systems have been introduced in a few other nations. To encourage private lending, the federal government guarantees repayment of defaulted principal and interest. The program has grown rapidly, so that the value of student loans outstanding has increased to over $400 billion. The current interest rate on new loans is about 31/2% (it is regulated and tied to short term interest rates). Interest rates on student loans are well below rates on mortgages, credit cards, and other sources of consumer credit mainly because the federal government rather than lending institutions bears the burden of defaults.
By the early 1990’s this burden became great indeed, as defaults on student loans ballooned to over 20 per cent. No commercial loan system would be viable with these default rates at the low interest rates allowed. Partly because wealthy lawyers and doctors allegedly were responsible for significant numbers of these defaults, politicians pushed for tougher enforcement. A 1998 law made it very difficult to discharge student loans by declaring personal bankruptcy- a privilege not available to credit card companies and many other lenders to consumers- the federal government began aggressively using private agencies to collect defaulted interest and principal on student loans, and these agencies could garnish significant fractions of the earnings of borrowers in arrears on their debt. As a result, default rates have plummeted to about 5%. They are in fact relatively low among graduates of professional schools and elite colleges, and are highest- among persons who had attended community colleges and trade schools.
Loans to finance education (and other investments in human capital) are a good idea, but why should the federal government subsidize them? College education raises earnings and improves health and many other aspects of living. Since these effects are huge and even larger than a few decades ago, loans to finance education should be attractive even without subsidies. It is especially inappropriate to subsidize loans to students coming from middle class and wealthy families who can expect very high earning over their lifetimes. Some writers lament the burden of large student loans, but even $100,000 in student loans is easier to repay than $150,000 in mortgages, a burden that many young families are clearly willing to bear.
Private lending institutions would be willing to make student loans without government subsidies at interest rates that I believe would not be much higher than mortgage rates if certain conditions were met that already apply to government subsidized student loans. The most important are that commercial student loans should be hard to discharge by declaring personal bankruptcy, that collectors could garnish a reasonable share of earnings in the event of defaults, and that interest on student loans could be deducted from taxable income.
Originators of student loans-Sallie Mae and another private institutions-typically repackage them, and sell them in a secondary market, similar to the way mortgages are repackaged and sold. So the “securitization” of student loans is a reality. What is needed to have a well functioning and extensive private commercial market in student loans are the various privileges already available to government-backed student loans that help overcome the absence of collateral when making loans for education. In addition, since education is an investment in human capital, the amount students invest- perhaps measured to start by the amount they borrowed to finance their education- should also be deductible over time from their taxable incomes, the way corporations can deduct the cost of capital from their tax liabilities.
A private commercial market in student loans under these conditions would not need government subsidies, and would have the flexibility to develop new contractual forms. These might include the often-suggested system whereby interest rates on student loans would not be fixed, but would rise with the eventual earnings of borrowers. Other innovations would emerge as freer and more imaginative competition in the market for student loans developed. It is surely time to rethink the conclusion by economists that commercial loans on education are not feasible because education capital cannot be used as collateral.
A critical question in deciding whether the government should subsidize student loans is what the market for college education would look like without any subsidy. An important aspect of the question is what the effect would be on college attendance: would many kids who now attend college decide not to do so because the cost would be too high? I doubt that. There would be a private loan market, albeit with higher interest rates. Because college is a good investment even after the higher future incomes that it makes possible are discounted to present value, most students who now borrow for college at the lower, federally subsidized rates probably would pay the higher rates. Others would borrow from their parents. Others would take part-time jobs during the school year or work more during summers. Still others would switch from expensive private colleges to state- or city-subsidized public colleges. Colleges would grant more scholarship aid and offer their own loan subsidies. Thus the burden of the higher interest rates would be shared among students, their parents, and the colleges, though the the colleges would try to shift some of the burden to the wealthier students, to faculty, and to donors.
If despite these responses to abolition of the federal student-loan program, many college-qualified young people decided not to go to college, the question would then be—from a strictly economic standpoint and without regard to distributive justice (which I discuss below)—whether society as a whole would be a loser from having a less well-educated population. Maybe so. Educated people are more productive, as indicated by their higher incomes, and they cannot capture the entire benefits of their higher productive value for themselves; for one thing, income is shared between the earner and the Internal Revenue Service, and the latter’s share goes to benefit other people. Probably a more important consideration is that educated people are less likely to commit crimes or to end up on welfare, and more likely to vote, which may confer a benefit on the public as a whole by increasing the perceived legitimacy of election outcomes.
But the “externalities” argument for subsidizing college education depends not only on how many kids would not attend college without the federal subsidy, but also on the cost of the subsidy to the taxpayer. I have no strong sense that the net external benefits are positive. If they are positive, it is very unlikely that they are large, considering the indirectness of this method of subsidizing education.
Nor is it even clear that the subsidy transfers wealth from the better off to the worse off members of society. The subsidized loans are available to everybody, not just the needy; and the costs of the loans are paid out of federal taxes, which are no longer highly progressive.
So I am dubious about the student-loan program. But if it is retained, I see no merit in making student loans nondischargeable in bankruptcy. The effect is to reduce the interest rates on such loans, but at the same time to increase the risk to the borrower—and why is that an advantageous trade? If it is an advantageous trade, why shouldn’t consumer bankruptcy simply be abolished, so that all consumers, and not just students, can obtain the benefit of lower interest rates in exchange for losing the privilege of discharging debts by declaring bankruptcy? The benefit to borrowers of surrendering the right to discharge their debts in bankruptcy is especially illusory when one considers that someone who has a nondischargeable debt will have to pay higher interest rates to his other creditors, because if he goes broke they’ll have a reduced expectation of being able to recover any part of their loans in the bankruptcy proceeding.
This is part of a larger puzzle about secured lending. The effect of making student loans nondischargeable in bankruptcy is to make the students’ future income in effect collateral for the loans. When part of one’s property becomes security for one lender, the amount of property available for other lenders is reduced, so they charge a higher interest rate, which tends to offset the lower interest rate that one can extract from a creditor by giving him security. In the case of the home mortgage, the debt secured by the mortgage so dominates other debts for most families that the interest tradeoff clearly favors collateralization. But is that true with respect to student loans, where the collateral is income? The law does not permit a creditor who garnishes his debtor’s earnings (as the creditor of a nondischargeable debt is permitted to do) to take more than a modest percentage of those earnings. Enforcing student loans may therefore turn out to be quite costly for the lenders in relation to the benefits to them. If so, the net interest rate benefit to students from abolishing the privilege of discharging student loans in bankruptcy may be slight.
Let me respond briefly to a few comments that present interesting analytical issues.
One such issue is whether, given the large, perhaps infinite, number of low-probability disaster scanarios, it is possible to defend against all of them without bankrupting a nation, or the world. It is not possible to defend against all of them; indeed, it is not even possible to imagine all of them. Ideally, they should be ranked by expected cost (probability times loss), and the expected costs compared with the costs of prevention. A disaster-protection budget could then be determined and allocated across the different disasters in such a way as to minimize the total net expected costs. The approach will not work perfectly because of uncertainty about both probability and loss with respect to many of the possible disasters (and also means and costs of prevention, in many cases). But there appears to be no better approach.
My book Catastrophe: Risk and Response lists a number of disaster scenarios, with some effort at estimating probabilities, losses, and precaution costs. However, to create a comprehensive ranking along the lines suggested above would require consideration of a number of additional disaster scenarios--including tsunamis, which I mentioned only in passing in the book. Such a ranking would be a worthwhile research project.
A related point is that poor countries may not have the resources to create tsunami warning systems or take other precautionary measures that wealthy countries could afford to do. I would rephrase the point as follows: the budget for disaster prevention will depend on the competing claims on public and private funds. The more urgent those competing claims, the rationally smaller will be the budget devoted to disaster prevention. It is really the same point that I made in my original posting in noting that value of life estimates are positively correlated with per capita income. This is not because the lives of poor people are worth less in some ethical sense than those of the rich, or even that poor people consider that their life is worth less. One must understand that the value of life estimates, while useful in cost-benefit analysis, are really just arithmetic transformations of estimates of willingness to pay to avoid a risk of death. If a person will pay $70 to avoid a .00001 risk of death, we divide the first number by the second and call the resulting figure of $7 million the "value of life." The reason for the transformation is not to make an ethical point but to facilitate comparison between the costs and benefits of precautions.
Obviously a person who can avoid starvation only by taking a risky job will demand less to assume the risk than a rich person would. That is rational behavior and if we forbid him to take the risk and force him to starve we won't be doing him any favor.
But to keep matters in perspective, although per capita incomes in the nations affected by the recent Indian Ocean tsunami are roughly 10 times less than the per capita income of the United States, the four countries principally affected--Indonesia, Thailand, India, and Sri Lanka, have an aggregate GDP of hundreds of billions of dollars. A tsunami warning system might cost only a few million dollars a year.
The Indian Ocean tsunami illustrates a type of disaster to which policymakers pay too little attention—a disaster that has a very low or unknown probability of occurring, but that if it does occur creates enormous losses. Great as the death toll, physical and emotional suffering of survivors, and property damage caused by the recent tsunami are, even greater losses could be inflicted by other disasters of low (but not negligible) or unknown probability. The asteroid that exploded above Siberia in 1908 with the force of a hydrogen bomb might have killed millions of people had it exploded above a major city. Yet that asteroid was only about 200 feet in diameter, and a much larger one (among the thousands of dangerously large asteroids in orbits that intersect the earth’s orbit) could strike the earth and cause the total extinction of the human race through a combination of shock waves, fire, tsunamis, and blockage of sunlight, wherever it struck. Other catastrophic risks include, besides earthquakes such as the one that caused the recent tsunami, natural epidemics (the 1918–1919 Spanish influenza epidemic killed between 20 and 40 million people), nuclear or biological attacks by terrorists, certain types of lab accident, and abrupt global warming. The probability of catastrophes resulting, whether or not intentionally, from human activity appears to be increasing because of the rapidity and direction of technological advances.
The fact that a catastrophe is very unlikely to occur is not a rational justification for ignoring the risk of its occurrence. Suppose that a tsunami as destructive as the Indian Ocean one occurs on average once a century and kills 150,000 people. That is an average of 1,500 deaths per year. Even without attempting a sophisticated estimate of the value of life to the people exposed to the risk, one can say with some confidence that if an annual death toll of 1,500 could be substantially reduced at moderate cost, the investment would be worthwhile. A combination of educating the residents of low-lying coastal areas about the warning signs of a tsunami (tremors and a sudden recession in the ocean), establishing a warning system involving emergency broadcasts, telephoned warnings, and air-raid-type sirens, and improving emergency response systems, would have saved many of the people killed by the Indian Ocean tsunami, probably at a total cost below any reasonable estimate of the average losses that can be expected from tsunamis. Relocating people away from coasts would be even more efficacious, but except in the most vulnerable areas or in areas in which residential or commercial uses have only marginal value, the costs would probably exceed the benefits. For annual costs of protection must be matched with annual, not total, expected costs of tsunamis.
In my book Catastrophe: Risk and Response (Oxford University Press 2004), I try to be more precise about how one might determine the costs of catastrophes. There is now a substantial economic literature inferring the value of life from the costs people are willing to incur to avoid small risks of death; if from behavior toward risk one infers that a person would pay $70 to avoid a 1 in 100,000 risk of death, his value of life would be estimated at $7 million ($70/.00001), which is in fact the median estimate of the value of life of an American. Because value of life is positively correlated with income, this figure cannot be used to estimate the value of life of most of the people killed by the Indian Ocean tsunami. A further complication is that the studies may not be robust with respect to risks of death much smaller than the 1 in 10,000 to 1 in 100,000 range of most of the studies; we do not know what the risk of death from a tsunami was to the people killed. Additional complications come from the fact that undoubtedly more than 150,000 people have died or will die—and the total may never be known—and that there is vast suffering and property damage that must also be quantified, as well as estimates needed of just how effective precautionary measures of various scope and expense would have been. The risks of smaller but also still destructive tsunamis that such measures might protect against must also be factored in; nor am I confident about my “once a century” risk estimate. Nevertheless, it seems apparent that the total cost figure of the recent tsunami will come in at an amount great enough to indicate that there were indeed precautionary measures to take that would have been cost-justified.
Why, then, weren’t such measures taken in anticipation of a tsunami on the scale that occurred? Tsunamis are a common consequence of earthquakes, which themselves are common; and tsunamis can have other causes besides earthquakes—a major asteroid strike in an ocean would create a tsunami that would dwarf the Indian Ocean one.
There are a number of reasons for such neglect. First, although a once-in-a-century event is as likely to occur at the beginning of the century as at any other time, it is much less likely to occur in the first decade of the century than later. Politicians with limited terms of office and thus foreshortened political horizons are likely to discount low-risk disaster possibilities, since the risk of damage to their careers from failing to take precautionary measures is truncated. Second, to the extent that effective precautions require governmental action, the fact that government is a centralized system of control makes it difficult for officials to respond to the full spectrum of possible risks against which cost-justified measures might be taken. The officials, given the variety of matters to which they must attend, are likely to have a high threshold of attention below which risks are simply ignored. Third, where risks are regional or global rather than local, many national governments, especially in the poorer and smaller countries, may drag their heels in the hope of taking a free ride on the larger and richer countries. Knowing this, the latter countries may be reluctant to take precautionary measures and by doing so reward and thus encourage free riding. Fourth, countries are poor often because of weak, inefficient, or corrupt government, characteristics that may disable poor nations from taking cost-justified precautions. Fifth, people have difficulty thinking in terms of probabilities, especially very low probabilities, which they tend therefore to write off. This weakens political support for incurring the costs of taking precautionary measures against low-probability disasters.
The operation of some of these factors is illustrated by the refusal of the Pacific nations, which do have a tsunami warning system, to extend their system to the Indian Ocean prior to the recent catastrophe. Tsunamis are more common in the Pacific, and most of the Pacific nations do not abut on the Indian Ocean, but even if the risk of an Indian Ocean tsunami was only a tenth of that of a Pacific Ocean tsunami (a figure I have seen in a newspaper article), it was still worth taking precautions against; but there is a tendency to write down slight risks to zero.
An even more dramatic example of neglect of low-probability/high-cost risks concerns the asteroid menace, which is analytically similar to the menace of tsunamis. NASA, with an annual budget of more than $10 billion, spends only $4 million a year on mapping dangerously close large asteroids, and at that rate may not complete the task for another decade, even though such mapping is the key to an asteroid defense because it may give us years of warning. Deflecting an asteroid from its orbit when it is still millions of miles from the earth is a feasible undertaking. In both cases, slight risks of terrible disasters are largely ignored essentially for political reasons.
In part because tsunamis are one of the risks of an asteroid collision, the Indian Ocean disaster has stimulated new intereset in asteroid defense. This is welcome. The fact that a disaster of a particular type has not occurred recently or even within human memory (or even ever) is a bad reason to ignore it. The risk may be slight, but if the consequences should it materialize are great enough, the expected cost of disaster may be sufficient to warrant defensive measures.
Economic Effects of Tsunamis and Other Catastrophes- Becker
A Reaction to Posner's Discussion
John Stuart Mill, the great 19TH century English economist and philosopher, optimistically, but I believe accurately, remarked on “…the great rapidity with which countries recover from a state of devastation, the disappearance in a short time, of all traces of mischief done by earthquakes, floods, hurricanes, and the ravages of war”. The history of both natural and man-made disasters during the subsequent century and a half generally supports Mill.
The 9/11 terrorist attacks were quickly recognized as the beginning of a series of possibly more destructive attacks on US citizens and property, and many commentators then believed it would cause a major economic depression. Yet it had a slight overall impact on the course of GDP and employment in the United States, although some industries and New York City were affected for several years. The Kobe earthquake of 1995 killed over 6000 persons, and destroyed more than 100,000 homes, still the economic recovery not only of Japan but also of the Kobe economy was rapid. The flu pandemic of 1918-19 killed about 30 million persons worldwide without having a major impact on the world’s economy. The lasting economic effects are similarly small for most other natural disasters that have occurred during the past couple of centuries.
Many natural catastrophes have very low probabilities of occurring, but cause considerable destruction of both life and property when they do happen. The recent tsunami in the Indian Ocean is one horrible example: it killed many more people than either 9/11 or the Kobe earthquake. But bad as it is, the loss of life is much smaller relative to the populations of the nations affected than some previous disasters. For example, the Lisbon earthquake of 1755 may have killed 60,000 people, other earthquakes in the past are alleged to have killed in the hundreds of thousands, and I mentioned the flu epidemic of 1918-19 that killed tens of millions worldwide.
History and analysis both indicate that the economic recovery of the nations most adversely affected by this tsunami will be rapid, although it will take longer in the resorts and coastal regions hit the hardest. The expectation of rapid recovery explains why Asian stock markets did not change much after the tsunami struck: Indonesia’s and Malaysia’s actually rose a little during the last week of December, while Thailand’s declined a little, and Sri Lanka’s declined by a few per cent.
I fully agree with Posner that it is worth spending considerably more to provide better early warning systems about the future occurrence of earthquakes and tsunamis, asteroids that might strike the earth, and other catastrophes. But no matter how much is spent and how much planning takes place, natural catastrophes will continue and will sometimes be unexpected.
There are two ways to protect against natural and other disasters: one is through insurance that helps compensate persons badly hurt by loss of family member or property. The other is through self-protection, which means actions to reduce the probability of the disasters from happening- as when a person drives more carefully to reduce the likelihood of getting into an accident, or when countries agree to reduce emissions of greenhouse gases in the hope of reducing the probability of severe global warming.
As more is learnt about various natural disasters, more self-protective actions would become available. But for many of the very infrequent ones, even given generous estimates of the value of life of the type discussed by Posner, it does not pay to take expensive self-protection actions. The best response in these cases is to have an effective insurance system for those badly harmed. So I concentrate most of my comments about protection against disasters on insurance.
Survivors of disasters that strike rich nations usually have medical coverage to pay for their treatment and rehabilitation, and insurance to cover much of their property destroyed, while those who perish usually leave life insurance for their families, and the opportunity to obtain decent education for their children. By contrast, most individuals in poor nations of Asia and elsewhere mainly rely on help from their families and neighbors when disasters strike. Unfortunately, such help is not available when disasters attack many members of the same family and whole neighborhoods, as in major tsunamis and earthquakes.
An effective way for poorer nations to respond in the longer run would be to encourage greater investment in education. Since education raises the earnings of individuals and the per capita incomes of countries, education clearly makes it easier to cope with disasters- as Mill had already recognized when he emphasizes the importance of knowledge in hastening the recovery from disasters. Beyond that, however, my colleague at the University of Chicago, Casey Mulligan, and I have shown that educated persons take a much longer time perspective in their personal decisions. This means that they are much more likely to anticipate the incidence and location of natural catastrophes when they decide where to live and how their houses are built, and they better self-protect and self-insure themselves in other ways as well.
But in the short run, greater access to private market insurance, even if subsidized by governments, is important. Regrettably, such insurance is not likely to be available to, or chosen, by the type of very poor families disproportionately affected by this tsunami. The large outpouring of aid from rich nations will help only temporarily in the very near term. The next best alternative to private insurance would be government disaster programs in poor countries that designate areas hit by major earthquakes, hurricanes, and other catastrophes, man-made or natural, as eligible for disaster assistance. Such programs could make sufficient payments to poor families of husbands and fathers who died, and to families that lost most of their property, to help put them on their economic feet, without causing much of a drain on the government budgets of even poorer developing nations like Indonesia and Sri Lanka.
The moral hazard effects of such programs are always worrisome- families might continue to build homes on earthquake fault lines if they expect government compensation when their homes are destroyed, or continue to build close to the shore in potential water-borne disaster areas. There is no perfect offset against such rational responses to government coverage of losses, but incomplete protection (“co-payments”), and regulatory exclusion of certain types of construction and other vulnerable activities in potential disaster regions would encourage individuals to consider the risks involved in their actions.