The United States government will find out soon enough what “moral hazard” means. Clearly it does not know already, or President Joe Biden would not have announced earlier this week that his administration would forgive U.S. student debt worth around 1.6% of GDP.
It’s natural to ask, as critics have, whether the new policy is fair. Should regular taxpayers subsidize those who went to college — who, after all, have above average human capital and earning potential? Should those who have already paid back their loans subsidize those who have not?
The real question, however, isn’t whether the policy is equitable. It’s what kind of choices such sweeping loan forgiveness will incentivize among borrowers and political leaders.
The answer: bad ones. There are enough examples from across the world to make clear that loan cancellations for political reasons are almost always costly and counter-productive.
India, for example, has repeatedly waived loan repayments for many of its small and marginal farmers. While college graduates in the U.S. might be in the top 1% globally, marginal Indian farmers certainly are not; they number among the poorest people in the world. Purely on the basis of fairness and justice, it’s hard to argue against bailing out those of them burdened by heavy debts.
But the consequence of loan waivers, as they are called in India, have not been at all positive for farmers. Economists have noted that the waivers have encouraged farmers to take on more credit than is justified by their productivity, saddling them with more debt. This cycle of forgiveness and indebtedness reduces the overall flow of agricultural credit, while privileging the minority of borrowers willing and able to game the system. Over the years, multiple cycles of debt forgiveness have not improved household savings, investment or credit flow.
Nor have the loan waivers necessarily even reached the poorest farmers. Those who need help most are the ones least likely to be able to navigate the red tape required to prove their bona fides. In India the programs have wound up helping wealthier landowners and institutions. That should give the Biden administration, which has touted the fact that its own program will be means-tested, pause.
The politics of debt relief is also deeply damaging. State governments in India heading into elections announce loan cancellations often and World Bank economist Martin Kanz has found, unsurprisingly, that voters “strongly reward” candidates affiliated with whichever party or coalition enacted the bailout.
In other words, once you announce a loan waiver program, the incentives of borrowers and politicians change to make both future defaults and future forgiveness more likely. In the U.S., it’s entirely likely that future administrations will succumb to demands to extend bailouts to those with private loans, for example, or to raise the cap to something more like $50,000 per person.
The long-term implications of such generosity could be dire. Even if Larry Summers is wrong and this particular round of debt forgiveness in the U.S. isn’t too inflationary, a structural change towards debt forgiveness by the federal government would have major negative implications for the deficit and debt. That’s certainly been the case in most places that loan waivers have been tried.
The U.S. debate on financing higher education is oddly disconnected from the evidence that emerges from elsewhere in the world. If U.S. voters decide that college should not be a luxury or seen as a rational investment in a particular career, then the government should just make college free rather than having periodic student loan bailouts. Several European countries have free college, after all.
Even that might not lead to more equitable outcomes, however. In fact, a 2017 report from the Brookings Institution found that following the end of free college in England a decade ago, “after many years of widening inequality, socioeconomic gaps in college attainment appear to have stabilized or slightly declined.”
Most Americans probably still think that college is an investment in the future. If so, as with any investment, incentives for both borrowers and lenders need to be properly structured. Writing off loans is bad policy and a terrible precedent — and one uninformed by both theory and global practice.
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ABOUT THE WRITER
Mihir Sharma is a Bloomberg Opinion columnist. A senior fellow at the Observer Research Foundation in New Delhi, he is author of “Restart: The Last Chance for the Indian Economy.”
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
