US ECONOMY — POLICY DESIGN
Student Debt Forgiveness Is Not The Stimulus The US Needs
Forgiving student debt is a hot topic, but it won’t solve the current pressing issues in the covid-hit US economy.
The US economy is in dire need of fiscal stimulus. The Federal Reserve conducts expansionary monetary policy not seen since The Great Recession.
In April, American citizens received $1,200 in a check from the government as part of the first fiscal stimulus package. Further cash transfers have been negotiated as part of a new package, but congress is yet to agree on the matter.
House Speaker Nancy Pelosi has urged the Trump administration to get back to the negotiation table, as no stimulus has been provided for several months.
While both sides appear to be standing their ground despite agreeing on the importance of reaching a deal before year-end, suggestions of a controversial component in the coming stimulus package have started to gain traction.
Forgiving student debt — mostly owed to the federal government — has for years been debated in relation to structural reforms of the post-secondary educational system.
First, as a provision in the Heroes Act — the stimulus bill proposed by congress. Second, by President-elect Joe Biden, who recently declared his support, urging the current government to amongst other things forgive everyone with public student debt $10.000.
But as argued below, loan forgiveness is an inefficient tool for stimulating the economy.
A First Glance at an Unconventional Measure
Advocates of student-loan forgiveness often argue their case with arguments of fairness or various positive economic outcomes.
In connection to the current recession, these outcomes would include large (relative to the cost) increases in economic activity following the relief of a debt burden that has reached more than $1.5 trillion.
There is little doubt forgiving student debt will be a relief for debtors. A National Bureau of Economic Research 2019-working paper finds forgiven debtors — occurring from a court ruling resulting in debt relief for thousands of debtors to the National Collegiate — were less likely to default on other debt such as credit card debt, auto loans, and home loans.
The forgiven debtors also reduced their debt from other sources by 25 percent, were more likely to buy a car, and increased their mobility — a factor often associated with better labor market outcomes.
Common for most of the studies is the focus on the various cost of debt faced by debtors. Less attention is given to the effects on the economy, and the (opportunity) costs of pursuing such policies are often disregarded.
Weighing the costs against the benefits is central to any policy decision, as is considering the distributional effects.
A $1.5 trillion government expenditure would need to be financed. This can be done in several ways — by raising taxes, reducing other expenditures, or running a higher deficit.
All of the financing measures have costs. Either direct monetary costs on taxpayers, or indirect costs for example in the form of worse public service.
At this moment though, the US government should not be worried about spending too much on stimulus, but rather spending it right.
Further, student debt is held by a subset of the population, and there are vast differences in the size of debt amongst those with student-loans. Forgiving student debt will primarily affect those with significant debt. As will be clarified below, such a targeted subsidy will affect income and wealth distributions.
How Can The Government Ensure Efficient Stimulus Measures?
The lockdown-induced recession has spurred much debate about optimal policy response amongst economists. Understanding the impact of both the pandemic and the large-scale lockdown on the economy is key when designing good policy responses.
When COVID-19 (C19) hit the western world in early 2020 and governments responded by imposing strict restrictions on people's ability to move, work, and consume, the economy was hit in several ways.
Economists refer to such an event as an exogenous shock — an external and often unforeseen factor that affects the economy. The shock affected both demand and supply across many sectors.
A demand shock can be thought of as a reduction of the ability and inclination of consumers to buy goods and services at any arbitrary price level. A supply shock similarly can be thought of as a reduction of the ability of producers to produce these goods and services at any given price level.
The lockdown can to a large extent be viewed as a supply shock. Sectors that supply services involving a high degree of physical contact or many people in tight spaces (restaurants, bars, hair salons, entertainment, etc.) were forced to shut down to reduce the spread of C19. The entire travel industry was shut down to avoid infected people to move around and accelerate the spread.
But the pandemic also changed people’s behavior. Going less to shopping malls and restaurants to reduce the risk of getting infected translates to a demand shock.
A first important characteristic of the pandemic and the following policy responses is thus that they directly affect both the supply and demand sides in the economy.
Workers who are being laid off or sent home from affected sectors may reduce their demand for other goods and services, and people not directly affected may reduce demand as a precaution.
Uncertainty about the near term future affects the behavior of people.
Therefore, shutting down some sectors will also impact other sectors, both due to general reductions in consumer demand, and because other sectors may be part of the supply chain of shut down businesses.
Thus, a second characteristic of the current recession is that shocks that initially reduce supply trigger larger retractions in aggregate demand.
The below illustration shows the economy as a complex system of exchanges. Agents (people/households, firms, governments, etc.) trade time, resources, and money with each other in different markets.
For example, in labor markets, households trade away time that could otherwise be spent on leisure to firms in need of labor in return for salaries. These salaries are saved or used either to purchase goods produced by firms or to pay taxes.
In every exchange, there’s a buyer and a seller. Restricting one agent from economic activity will propagate through the rest of the economy.
As illustrated, lockdowns severely affect many of the linkages in the economy directly, while wait-and-see behavior from uncertainty around the pandemic and risk aversion toward being infected lessen demand further. These disruptions to parts of the economy will indirectly affect all other parts.
Another important feature of the COVID-shock is that it severely affects some sectors, while others are barely hit — at least directly. The pandemic disproportionally affects businesses and workers in some sectors.
At last, an important characteristic of the shocks stemming from the pandemic and lock-downs is their transitory nature. Eventually, a vaccine will be developed and distributed, and the population will reach herd immunity.
But the economic damage that followed can be persistent if governments and central banks don’t counteract.
Figuring out the best policy response to the current economic distortions is not straightforward, but the below principles can help policy-makers design sufficiently good policies.
Former Havard professor and former chair of President Obama’s Council of Economic Advisors, Jason Furman, has summarized some key guidelines to consider when designing the policy response to the pandemic:
- Act fast.
- Rather too much than too little. The risk of overstimulating is low.
- Use existing mechanism if possible.
- Diversify measures and don’t be afraid to duplicate
- Enlist the private sector as much as possible
- Ensure persistent stimulus
Why Loan Forgiveness Is Not Ticking The Right Boxes
Forgiving student loan is regressive (you can read why here). It implies that forgiving debt will benefit high-income households more than low-income households and thus increase income and wealth inequality.
It can be argued stimulus measures should spur economic activity and policymakers shouldn’t be too concerned about distributional effects if this condition is met.
But regressive policy measures aren’t always effective at spurring economic activity. Households with high income will not see their per period disposable income change much from debt forgiveness, since loan repayments amount to a small share of their income.
This means demand for consumption won’t increase much. In turn, the fiscal multiplier — measuring the effect on activity from the change in policy — is expectedly low.
A useful benchmark to consider is helicopter money — direct, unconditional transfers of money from the government to households (financed by government debt held by the central bank).
Helicopter money would significantly increase present disposable incomes of households with relatively low income.
These households have a greater consumption share (of disposable income) and would likely spend greater portions of their stimulus checks than high income households. Thus, direct money transfers does a better job increasing consumer demand.
If the goal of stimulus policy is increasing economic activity and the fiscal multiplier of debt forgiveness is lower than for helicopter money, it doesn’t make sense to advocate debt forgiveness strictly as a stimulus tool.
For any given level of stimulus related government expenditure, direct monetary transfers to US citizens would be a better use of the money than student debt forgiveness.
Spending $1.5 trillion (or in terms of flow $86+ billion a year in foregone revenue from interest payments) on debt forgiveness would — if decided upon — likely stand in the way of policy measures better suited for the current situation, even if the government should not be afraid to keep the foot on the stimulus-gas.
Policy-makers need to clarify the problems they want to address, weigh different policies against each other, and choose those that are expected to do the trick at the highest efficiency.
Pushing through policy because it has some partial good effects risks forgoing the opportunity to address more important issues, or choose other measures better fit for the problem at hand.
The US post-secondary education system undoubtedly has room to improve, but broader structural reforms than just forgiving debt will be needed to address its issues.
While fiscal stimulus is needed to support the US economy, forgiving debt shouldn’t be on the mind of policy-makers aiming to support the economy. Legitimate reasons for forgiveness exist, but:
As a stimulus tool, student-loan forgiveness is just bad policy.