To Curb Student Debt, Let Borrowers Declare Bankruptcy

(Bloomberg Opinion) -- Education can be the best investment you make, unless it's for graduate school. Students seeking advanced degrees make up only 25% of student borrowers, yet they account for nearly half of outstanding student loans.

Many Americans feel they have no choice but to keep pursuing more education after they graduate from college. There was a time when that first degree was enough to ensure a good job. But degree inflation compels many graduates to keep going, even if that second degree puts them into debt and doesn't always offer great value. Since 2000, the number of master's conferred jumped nearly 80% compared with a rise of 55% for bachelor's.

Here's one way to break that debt cycle: Allow graduate students to discharge their loans in bankruptcy.

The average debt load for master's candidates is about $70,000, almost double  the $36,000 for undergrads. Getting an undergraduate degree offers no guarantees either, but the payoffs are generally better. The median salary for college graduates is almost 65% higher than for those who only complete high school.

After that, though, there are diminishing returns to education, with a masters degree lifting wages roughly just another 20%. Unlike undergraduate schooling, advanced degree programs promise to train students for work in a specific field. Many graduate degrees do pay off, especially for certain professional schools (such as business) or in STEM fields. Health and medicine graduates more than double their lifetime earnings. But that's far from the case for other programs. Some degrees can transform your career while others are just unnecessary and expensive.  

Despite these different payoffs, the cost of a year of graduate school is pretty much the same no matter what's being studied. A year of tuition and fees for a Masters of Fine Arts at Columbia (a two-year degree) is about $73,000. The cost of a year of Columbia business school (also a two-year degree) is $86,000, which, considering the big lifetime earnings differential between MBAs and MFAs, is not a large difference.

Students of either program can easily get both federal and private loans to finance their degrees at the same interest rate. That easy access to funding makes students less sensitive to price, which in turn has made graduate degrees a big source of revenue for universities.

Student loans have grown to $1.57 trillion, making the country increasingly aware of the long-term burden this debt is having on household finances. President Joe Biden this month extended his pandemic-prompted moratorium on loan repayment through the end of January, but calls are rising for the government to forgive at least part of the debt. Considering that many of the holders of large loans are now high-earning professionals, this would be regressive and wouldn't fix the root of the problem. While universities may not be comfortable acknowledging it, the truth is that it's way too easy to take on lots of debt to complete a degree that's not a great investment.

A better solution is to change how and to whom credit is allocated. In all other industries, getting access to credit and the interest rate you pay depends on the quality and riskiness of the investment. In no other industry would a debt-financed investment that's the equivalent of going to medical school be considered the same as a film-studies degree. The student-loan market is broken in large part because of that lack of discernment, and because it's nearly impossible to discharge student debt if the graduate declares bankruptcy.

To start, graduate students should be able to more easily discharge their loans if they declare bankruptcy. This would force lenders to account for the risks involved with each degree when making a loan. There are two types of lenders for student loans, the government and private banks who charge higher interest rates but offer loans beyond what the government would offer. The prospect of bankruptcy would transform the private student loan market. Private lenders will be much less likely to lend tens of thousands of dollars to someone seeking a film studies degree who may declare bankruptcy. This would make credit less available to certain degrees, which would make students more price conscious and demand better value.

However, the vast majority, more than 90%, of student debt is government loans, where the government lends money directly to students  without accounting for the borrower's credit worthiness or the value of the degree. Allowing bankruptcy relief in that case could create a moral hazard, where someone might borrow from the government to obtain an expensive degree, then declare insolvency and stick taxpayers with the bill.

How big of a risk is that, though? There's a high correlation between debt repayment and earnings. For anyone who is able to repay their loans, it's better to do so than declare bankruptcy because bankruptcy poses large costs in terms of credit rating, getting a job or securing a mortgage. For others, economist Beth Akers argues there are ways to mitigate the moral hazard, perhaps by requiring several years of payments before the borrower could discharge the loan. Another option is sharing the costs with universities, making them pay back some of the tuition to the government if a student declares bankruptcy.

There will surely be some abuse. But there is already abuse. The government lending someone hundreds of thousands of dollars, at below-market interest rates, for a masters in folklore studies also costs tax-payers and has no sign of ending. Allowing bankruptcy relief would increase the level of scrutiny given when extending credit to students, helping break the debt cycle by forcing more discretion in who gets how much funding for what type of degree — and perhaps motivating students to pursue higher-value degrees to obtain that credit.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Allison Schrager is a Bloomberg Opinion columnist. She is a senior fellow at the Manhattan Institute and author of "An Economist Walks Into a Brothel: And Other Unexpected Places to Understand Risk."

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