Americans in general and college students in particular are showing concern about the rising college student loan debt burden and the growing possibility that students will have difficulty borrowing funds this fall.  

While the immediate causes of the loan crisis are discussed later in this essay, it is important to state upfront that the real culprit has been the long run explosion in college costs – not just to students, but to society at large. If college costs had not risen sharply faster than the rate of inflation, there would be no student loan crisis today, since borrowing would have been very small.  

The cost explosion is the result of a variety of factors, such as third party payments that reduce student sensitivity to costs, the non-profit nature of most colleges (which reduce incentives to be efficient), and the lack of good information on the outcomes of college students, making it virtually impossible to measure college productivity. 

As the cost of providing higher education has exploded, real state government appropriations per student has remained relatively constant over long time periods, forcing public universities to depend on tuition more than in the past. It is worth noting, however, that tuition fees have also exploded at private schools which are largely unsubsidized by state government. 

This increased reliance on tuition fees (especially at public universities) means that today the typical high school graduate does not have enough money to pay hefty tuition charges.  The solution has been to borrow, much of it through federally subsidized loan programs.  Seventy percent of all federal aid to students is in the form of loans, with many states and private lenders offering them as well.  The College Board estimates that students and parents borrowed $78 billion for the 2006-07 school year (double the amount of a decade earlier), of which almost $60 billion was borrowed either directly from the federal government in the Federal Direct Student Loan Program (FDSLP), or through another of its programs, the Federal Family Education Loan Program (FFELP).   

With the exception of students, who were piling up more and more debt as tuition rates continued to increase, everybody (i.e., lenders, colleges, politicians) was happy -- until last fall, that is, when two events conspired to derail the whole show.   

The first was the crisis that spooked financial markets.  Until recently, investors were willing to buy packages of student loans from lenders.  After getting burned by foreclosures from mortgage lending, however, investors have become wary about making such purchases, reducing funds available for loans by big lenders such as Sallie Mae.  

To make matters worse, Congress passed legislation that cut both the interest rates that lenders could charge, as well as the fees that they received for originating a loan.  The cuts were so drastic that a third of lenders stopped making loans altogether, and Sallie Mae, the largest lender, started losing money on every loan that it made.  The implications of this can be seen by looking at Stafford loans, which make up most of the federal loans.  Essentially, the FFELP program (where students borrow money from private lenders) was being destroyed, which left FDSLP (where students borrow directly from the government) to pick up the slack.  But FDSLP was ill-prepared for the task.  In 2006-07, it made only 20% of loans compared to 80% for FFELP, and would have to come up with around $40 billion more just to replace the Stafford loans that previously went through FFELP.   

To try and entice lenders they have driven out of the FFELP program, the government now wants to buy loans from lenders.  A Wall Street Journal editorial summed it up nicely: “Congress mandated a return on student loans that is too low to attract private capital in the current market. So Congress will now use your money to create artificial investor demand.” 

It seems clear that changes need to be made, but it is equally clear that a return to the status quo is not acceptable either.  The Project on Student Debt reports that by the time they graduate, students owe $21,100 in loans on average.  We have estimated that for the first time, the average debt of students exceeds 50% of the median income of recent college graduates.  This is up from less than 35% as recently as 2000.  This much debt cripples the financial future of many students, who are increasingly postponing traditional milestones of adulthood such as marriage, purchasing a home, and having children. 

Someone once said, “When we see the light at the end of the tunnel, the government goes and adds more tunnel.” That seems to be the case here. One partially governmental created “crisis” (the mortgage problem) led to a second problem (in student lending), which is being corrected by further inefficient taxpayer bailouts. Perhaps it is the time to restore our faith in the power of markets, not governments, in lending. 

Above all, however, we must stop the major long-term problem: excessively rising college costs.  This requires a fundamental change in the way we deliver higher education services in the United States. We must revise the nature and magnitude of third party payments by governments (perhaps by moving to subsidizing students, not institutions), encourage new for-profit entrepreneurial ventures, provide consumers with information on how colleges spend money and what students learn, etc.  Colleges are organized and run today the same way they were a century ago – and arguably no more efficiently. That needs to change. 

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Richard Vedder is the Director of the Center for College Affordability and Productivity and Andrew Gillen is its research director. Dr. Vedder is also a Visiting Scholar, American Enterprise Institute, and Distinguished Professor of Economics Ohio University, while Mr. Gillen is a doctoral student in economics at Florida State University.