Of Bail Outs, Student Loans, and the Paradox of Thrift

 

This post was sparked by a request to write an article about the financial bailout and student loans for one of the schools where I teach economics.  It’s one that affects many American families.  I have three adult children:  One with a six figure student loan; one who, with his wife, have a mortgage-sized five figure student loan; and a third still attending college while living at home with a four figure student loan.  Hence, my opinions are rendered without prejudice toward anyone who has a student loan:  My family and I are in this boat with much of the rest of America.

 

The Theory Behind the Bail Out

 

You have no doubt heard of the “stimulus package”.  In economics, this is called an “accelerator” that sort of “jump starts” the economy.  Once you get it, the idea is that you will spend it and it will spread throughout the economy.  When Ronald Reagan applied this theory, it was derisively called “trickle down economics,” but when JFK announced his tax cut plans, it was called “the multiplier effect.”   

 

Thus, the whole bail out plan is predicated on this idea of economics, first expressed by an economist named John Maynard Keynes in his “General Theory” back in 1935.  He wrote that book during the Great Depression.  But Keynes had a zinger in his general theory.

 

Basically, if you and I save that “accelerator” instead of spend it, then the multiplier will be smaller than it should have been.  Another economist named Paul Samuelson, author of a text book series that every student who has majored in economics over the last 40 years has read, wrote: “By attempting to increase its rate of savings, society may create conditions under which the amount it can actually save is reduced.  This phenomenon is called the Paradox of Thrift.”

 

The thing is, if you and I don’t save, banks don’t have money to lend.  If they don’t have money to lend, businesses can’t create new jobs (because they need to borrow money to build a factory just like we borrow money to buy a house).  And, groups like Sallie Mae can’t get the money they need to lend to students who need student loans.

 

Now, the US has a negative 1% savings rate.  We have bought into “Keynesian Economics” BIG TIME.  How do we get money to invest in America to create jobs?  We borrow from the Chinese, the Taiwanese, the Japanese – all those “eses” who still think it’s a good idea to save money.

 

The problem is that none of these lenders (who bought from hedge funds, Fannie Mae, Freddie Mac, etc.) are sure what the value of all those houses that “stand behind the loans” as collateral are worth.  And, because they aren’t sure, instead of lending money, they’re holding the dollars they received from the bail out (something that Keynes warned could happen in what economists call a “liquidity trap).

 

Part of what Secretary Paulson and Ben Bernanke of the Federal Reserve have been doing is to increase the money supply.  They hope that by providing money (economists call it “liquidity”), banks will lend, people will borrow, and life will go on as usual.  In a liquidity trap, that doesn’t happen.  In fact, in a class I teach, the following appears on page 369 of Steven L. Slavin’s 9^th ed. of Macroeconomics where he summarizes what Keynes said:

 

“but during a bad recession perhaps people would just hold their money, waiting for interest rates to rise before they lent it out. … If the money supply were increased during a bad recession, said Keynes, the money would simply be held as idle cash balances by relatively well-to-do people.  Nothing would happen to the money until the economy was well on its way toward recovery, interest rates rose, and more investment opportunities became available.”

 

Now FED Chairman Bernanke is said to be an expert on the Depression and what Keynes said.  Yet, he ignored this piece of economic wisdom.  In fact, with the exception of Congressman Mike Pence from Indiana and a handful of others who spoke out against the bail out plan, virtually all the “smart people” in Washington and Wall Street ignored what I teach students in Economics 101 today!!!

 

And so, where do we find ourselves?  Well, the banks aren’t lending out the money.  What’s more, we aren’t going to stop with a bail out of the banks.  News reports indicate the auto industry, cities, states like California, home builders and others are lining up to get their bail outs.  Those who watch the Student Loan Industry are worried that Sallie Mae will be the next Fannie Mae and Freddie Mac.

 

What Should A Student Do?

 

If houses are what serve as collateral to back mortgages, then what serves as collateral to back a student loan?  The answer is that you, the student, serve as collateral with respect to your expected future earnings potential.

 

And if banks are hesitant to loan money because they are having a hard time calculating the value of a house that secures a mortgage, think of the implications as lenders try to calculate the value of a student’s future earnings potential.

 

Clearly, this is a difficult task, as hardly any individual student can project their future earnings, let alone a bank. And so, in answer to the question “what is going on in the economy and the recent bailout we have had and how it might affect student loans” that I was recently asked to address, here’s my answer, though you may not like it.  And of course, since it’s free advice, so don’t feel obligated to take it:

 

1.     Go to school because you have a clear purpose and plan for how you will apply your degree once you graduate.  This is what our adult daughter has done, and she is a medical doctor in her first year of residency as a surgeon.

2.      If you don’t have a clear purpose and plan for how you will apply your degree once you graduate, develop one.  This is an application of the “Problem Based Learning” decision making model taught in some of the schools I teach for, and is something my son and daughter-in-law had to do.  While they at first did not have a plan, they are presently in S. Korea teaching English and receiving free rent (though it is a one room flat and a bathroom).  They are using the money they earn and save to repay their student loans.  They estimate it will take 5 years, at their present pace, to pay off their loans.

3.     Finally, if you know you need an education but are not sure of a plan, work for a company that reimburses tuition expenses while you “figure it out”.  This is what our adult child #3 is doing, as he lives at home, goes to school by day, works nights, and is reimbursed by his employer.

4.     If you can’t do any of these three things, then don’t go to school and go into debt, as you will have little hope of bailing yourself out.  For more information on this, read “Will the Student Loan Industry be Bailed Out Next?”

 

All of us are in charge of the decisions we make.  If we wait for the government to bail us out, there’s going to be a long line ahead of us.  My wife and I are very proud of our three children and the decisions they are making.  Our family is in this boat with you, the reader, as we try to figure out what is the best course of action to take through these troubled times.

 

With respect to our leaders in Washington who got us into this mess, I’m angry as hell.  I’m not sure what, if anything, I can do about it – though I hope posting this article does some good.

 

In closing, I highly recommend “Paradox of Thrift R.I.P.” In that article, you’ll find this quote:

 

“Perhaps the single most destructive tenet of Keynesian economics was its denigration of saving. Keynesianism has been used to justify wasteful spending, massive deficits, and one after another scheme to redistribute wealth from those who would save it to those who would spend it.” (emphasis added)

 

I have more to say on the whole “Spread the Wealth” idea in my blog post “Joe the Plumber and the Character of the American People.”