Why Not a Free Market in Educational Loans? By Bryan Caplan

Suppose investments in education are every bit as fantastic as we’re supposed to believe: Ability bias and signaling are myths, so the entire observed education premium is causal and socially valuable. Even so, it’s hard to see why government should subsidize education. Why can’t students simply fund their ever-so-valuable investment in human capital with unsubsidized educational loans?

Non-economists’ favorite argument is something like: “The interest rates would be so high that few people would borrow.” At least on the surface, though, this objection clashes with the “education is a fantastic investment” premise. If education really has enormous benefits, people should be happy to pay high interest rates to acquire it. Furthermore, if education yields such reliable returns, lenders should be confident of repayment, and therefore happily lend at a low rate.

At this point, many economists will leap to the non-economists’ defense. Free-market educational loans would have high interest rates despite the fantasticness of the investment. Why? Because of imperfect information.

Now things get really interesting. Imperfect information, you say? Which kind? Symmetric or asymmetric?

Case 1: Symmetric Imperfect Information

You might say, “No one really knows if an educational investment will pay off.” If so, we’ve got symmetric imperfect information. Contrary to much loose talk, this is not a “market failure.” If an investment turns out to be worthless 5% of the time, the efficient response is to take this bad eventuality into account. Maybe the investment will still be worth it. Maybe it won’t. But it’s stupid for government to subsidize loans so borrowers and lenders act as if this 5% downside didn’t exist.

Case 2: Asymmetric Imperfect Information

You might say, “Borrowers know better than lenders if an educational investment will pay off.” If so, we’ve got asymmetric imperfect information. This can be a market failure. But it depends. If desire to borrow and default probability are positively correlated, you can get the standard market-for-lemons “unraveling” outcome. But is this really likely in the market for student loans? It seems like the people most willing to borrow will be the students with unusually promising post-graduation career prospects. So even with hidden information, the market could still work fine.

If desire to borrow and default probability do happen to be3 positively correlated, simple market responses remain. Can borrowers offer collateral? Down payments? Guarantees? If so, the market can still work very well despite the information asymmetry. To take an extreme case, suppose that educational lenders had as much latitude to recover bad debts as the IRS. Do you really think they’d still be reluctant to lend students money? Or consider this keyhole solution: For a small handling charge, the IRS directly collects student loan payments when you pay your income tax, and remits payment to your lender. Unless you flee the country, you’re on the hook for whatever you borrow – and the asymmetric information problem vanishes.

Before you take extreme measures to overcome asymmetric information, of course, you might want to double check that the problem is genuine. Would borrowers really have a big information edge over lenders? In a free market, lenders could – and probably would – verify students’ test scores, grades, school, intended major, and so on. Given all this information, it’s far from obvious that borrowers do have superior information. Yes, students know lots of details about their lives, but lenders have the power of actuarial science behind them.

Overall, then, neither symmetric nor asymmetric imperfect information provide compelling arguments against a free market in educational loans. But maybe this just reflects the narrowness of neoclassical economic reasoning. When people say “imperfect information” they often mean “irrationality.” Perhaps the problem isn’t that interest rates are too high, but that people are too myopic to see that even high-interest educational loans are, all things considered, a great deal.

While I’m sympathetic to this argument, it’s a double-edged sword. Yes, irrationality might lead borrowers to spurn good loans. But as we’ve seen in recent years, irrationality can just as easily lead lenders to make bad loans. In fact, lenders’ recklessness, not borrowers’ paranoia, had turned out to be the more serious psychological pitfall. Why then are we so sure that we need heavy government subsidies to make educational lenders even more reckless than they’d be on their own dime?