There’s a ton of talk in the news about how the student loan bubble looks like it’s about to burst. Most acknowledge that there is a real student loan debt crisis occurring in America – with over $1.5 trillion in student loans outstanding, and average debt that’s growing, and wages that are stagnant, there is a lot of adversity facing those with student loan debt.
And while the amount of student loan debt in the economy is troubling, unlike other debt crises – there is no mechanism from the student loan bubble to burst. Let’s break it down.
The Rise In Outstanding Student Loan Debt
Student loan debt is the second largest amount of debt behind mortgages, according to the Federal Reserve. Over the past decade, the amount of student loan debt has almost doubled, along with the average balance of graduating college students.
At the same time, the starting salary of new graduates has risen, but has barely kept pace with inflation. As a result, the median net worth of millennials is just $10,500. That’s a real problem – especially given the cost it takes out of a household income to service the outstanding student loan debt.
And based on current fiscal policy in the United States, this isn’t likely to change anytime soon. The economic factors that drive the cost of education and the amount of student loan debt both point to them rising, not falling. There is no incentive for colleges to lower the cost of admission, and given that policymakers allow virtually limitless student loan borrowing to pay for, the demand continues to grow regardless.
What happens if the growing amount of student loan debt can’t be repaid?
Why the Student Loan Bubble Can’t Pop
The mechanisms behind student loan debt really make it impossible to have a mass exodus like we saw during the housing crisis in 2007-2009. Unlike other forms of debt, notably mortgages and auto loans, the collateral that backs student loan debt is the borrower’s future earnings.
In other debt bubbles, the mechanisms behind the debt allow a “popping” to happen – a relatively quick unwinding of the debt and economic factors underlying it. For example, in the housing crisis, if a borrower struggles to pay their mortgage, the bank can foreclose on their house. The bank would then sell the asset, even at a loss, and the bubble can pop. This can happen relatively quickly, though the economic pain can be immense.
The same can happen with auto loans (repossession), credit cards and personal loans (balance sheet write-offs).
The problem is, this quick unwinding cannot happen with student loan debt. Given that student loans are a collateral on earnings, as long as there is earning potential, the ability to have the loans quickly “pop” via any financial mechanism is rare. Yes, bankruptcy for student loan debt is possible, but once again – rare.
Instead, our system has setup mechanisms around student loans that make it drag on borrowers – income driven repayment plans that artificially lower the repayment amount, loan forgiveness programs that are tied to specific milestones that take a decade or more to achieve. These mechanisms to eventually discharge student debt take years – the longest over 25 years!
As such, borrowers who can’t pay are left to struggle for a decade or longer. Even those with the ability to pay today, if that changes during the next economic crisis, might be struggling post-crisis with no recourse.
What the Effects of Rising Student Loan Debt Mean to the Economy
The net effect of this student loan crisis won’t be a bubble popping – it will be slow drag on the economy. And it’s an anchor that’s already taking hold and pulling back the American economy from what it could be.
Instead of a massive unwinding of debt with short term pain, the student loan bubble with unwind over decades, with a 1-2 percent loss of GDP or more during that entire period of time.
Because student loan debt is a drag on household spending, the ability for those with student loan debt to consume in the economy is diminished. They cannot buy housing, vehicles, or spend on consumer goods. Their ability to participate in the financial markets (i.e. invest) will be limited. All of these factors will have a negative trend on the economy – and it will happen over the long run as borrowers navigate these long term repayment plans and options.
And we’re already starting to see the signs – homeownership by age 30 has been on the decline for the past 6 years even though we are in a period of economic growth. Millennials have been said to be killing countless industries, but it’s more due to the fact they don’t have discretionary income to spend.
As the economy changes course in the next several years, unemployment rises back to historical norms, and industries continue to transition, the burden of this debt drag will become much more pronounced. Unless major regulatory reforms happen in the student loan space, there will not be an immediate unwinding of the student loan debt bubble like we’ve seen in past debt crises. And the end result will just be a prolonged stagnation impacting the economy.
The views of the author of this article do not necessarily represent the views of Gradifi. We make no claims, promises or guarantees about the accuracy, completeness, or adequacy of the information contained here. Readers should consult their own attorneys or other tax or financial advisors to understand the tax, financial and legal consequences of any strategies mentioned in this article.