Tuesday, September 15, 2009

Donald Marron has an excellent summary that ties together my recent posts on the government takeover of student loans and the problems with centralized economic control. Here are Marron's key points:
[The student loan program] has experienced two crises in recent years:

* In 2006 and 2007, the crisis was kickbacks. In their enthusiasm to win more business, private lenders were offering �inducements� to schools and student loan officers in order to get preferred access to students who wanted loans.

* In 2008, the crisis was a lack of lending. In large part because of the financial crisis, private lenders had no enthusiasm whatsoever for making loans. As a result, there was a real risk that students might not be able to get loans.

As I told my students, I think both of these crises had the same root cause: the fact that the government, rather than market forces, determined how much lenders were paid for making guaranteed student loans. In both cases, the government got the payment levels wrong, and the crises followed soon thereafter.

Back in 2006 and early 2007, the government had set payment rates too high. Lenders thus competed aggressively among themselves to win as much of the market as they could. Some of that competition had arguably beneficial effects (e.g., some lenders passed benefits on to students), albeit at a notable cost to the taxpayer. But the competition also took on unsavory characteristics, as in the kickbacks to the university officials in charge of deciding which lenders would get preferred access to students.

To their credit, the folks in Washington correctly diagnosed this problem. Late in 2007, the Congress passed and the President signed a bill that reduced the amount that lenders were paid.

Unfortunately, those reductions happened at the start of a financial crisis that dramatically increased the cost of private lending. In micro-speak, the private lending market experienced a negative supply shock. And all of a sudden, lender payments were too low. Lenders thus threatened to flee the student loan market, which could have left millions of students without funding for their education.

Again to their credit, the folks in Washington stepped up and eventually found a solution to this problem (which involved more financial engineering than I want to discuss right now). But it was a painful process.
Centralized decision-making on prices means that 1) many pricing decisions will be wrong, and 2) any such wrong pricing decisions are almost guaranteed to generate crises.