Knee-Jerk Privatization

Jonathan Chait looks at Republican attempts to sell the student loan scandal as an indictment against big government:

Loan Wolves, by Jonathan Chait, TNR: Conservatives have a theory about Washington scandal, which holds that scandal is a function of Big Government--the more powerful the government, the bigger the temptation to pay it off. The recent wave of GOP scandals, by this theory, was proof that the party had abandoned its small-government faith. "It's no accident," editorialized National Review last year, "that congressional Republicans were cleaner when they were much more serious about limiting government."

It's certainly true ... that you can't have government scandal without government. ... But ... conservative ideology has less to do with the size of government than with the way government operates. And the conservative style, I'd argue, actually makes corruption more likely. As Exhibit A ..., I present the college-loan scandal.

[N]umerous college-loan administrators took kickbacks from lenders. Everybody agrees it's sleazy. What everybody doesn't realize is that it's a direct result of anti-government mania. ...

Bill Clinton ... tried to reform the inefficient student-loan program. The system he inherited was this: Students who wanted a college loan would go to a private lender; the lenders, in turn, would get paid a government-set interest rate by Washington; and, if the student defaulted on the loan, Washington would pay it back for them.

Clinton proposed to replace the guaranteed loans with direct loans--which meant having the federal government cut out the middleman and make the loans itself. Every independent agency that has calculated the cost--the Congressional Budget Office, Clinton's Office of Management and Budget, even George W. Bush's Office of Management and Budget--has concluded that direct lending would save the government billions of dollars each year.

Naturally, the middlemen did not take kindly to being cut out of the deal. They launched a fierce counterattack ... embraced by conservatives... Their main line of argument was that direct lending amounted to Big Government. (Or, as Grover Norquist called it, Clinton's "scheme for a government takeover of the student-loan program.") Conservatives forced a compromise that created direct loans but also kept guaranteed loans and let colleges choose which kind to use.

Both sides assumed that the cheaper direct loans would dominate. But...: After an initial burst of popularity, direct loans stagnated, and many colleges began returning to the old guaranteed-loan system. Conservatives held this up as proof of the superior efficiency of the free-enterprise system. ... The gloating continued over most of the next decade. As Stephen Moore ... crowed two years ago, "Some five hundred colleges have stopped participating [with direct lending] because of shoddy management and financial losses."

Only it now turns out that the private lenders' success came not through superior efficiency but through superior graft. The emerging college-loan kickback scandal is a vast scheme by private lenders to bribe colleges into foisting their services onto students. Lenders plied college-loan officers with meals, cruises, and other gifts. Some loan officers were given lucrative stock offers. ... Some lenders offered millions to the universities themselves to drop out of the direct-lending program. ...

[T]he very thing that drove conservatives to oppose Clinton's reform--the vast private profits made available by guaranteed loans--is what enabled the scandal. ...

The conservative approach to health care runs along the same lines. Most conservatives opposed the prescription-drug bill, but they approved of the provisions funneling recipients to private insurers, even though such plans cost around 20 percent more than traditional Medicare. ...

The latest development in the college-loan scandal is that the U.S. Department of Education didn't notice the massive scandal unfolding under its nose. In fact, one of the key Department officials charged with overseeing student loans, Matteo Fontana, turns out to have owned more than $100,000 in stock in one of the private companies that benefitted from his lax oversight. (It's the ownership society in action!) When Congress held hearings into this fiasco, GOP Representative Ric Keller offered up a novel interpretation: The Department's failure demonstrated that the guaranteed-loan program--where all the corruption had occurred--was superior to direct lending. His logic? Since the Department was so lax in its oversight, said Keller, "Why should we put the federal Department of Education in charge of all student loans?"

I would've thought that the spectacle of GOP hacks allowing business interests to corrupt a conservative-championed privatization program might prove sobering for free-market enthusiasts. But apparently it just proves, once again, that they were right about Big Government all along.

Why should government be involved in the student loan market? Why guarantee student loans? To correct market failures. One is the difficulty in borrowing against human capital, but there are others such as asymmetric information about ability and effort, and external social benefits.

The difficulty in borrowing against human capital arises because unlike, say, a loan for a house, there's no collateral to offer. Without collateral, banks are reluctant to make these loans, and for low-income families who do not have other resources to draw upon, this can create a barrier to education. One solution, then, is for government to guarantee the loans which helps banks overcome their reluctance.

In general, when the government is providing a good or service, it's for a good reason, usually to overcome a market failure. In such cases privatization - if it is feasible at all - is not as easy as simply having the government step out of the way.

A poorly designed privatization program in the presence of market failure can cause substantial inefficiencies. As Hal Varian notes about the student loan program, "Remarkably, banks are not required to bid for the right to issue these loans, and a result has been both an inefficient mechanism for student aid and a windfall for banks." And that windfall can, of course, be used for kickbacks, etc., to further distort the outcome.

Governments are not perfect, but no market is perfect either and it's not always the case that the laissez-faire outcome will outperform the outcome with government either regulating the market in some way, or providing the good or service itself.

Privatization may be feasible in some cases, but it requires thinking about the negative incentives that exist in these markets and designing policies that can approximate the competitive outcome. Again, quoting Hal Varian, "property rights should be one of the first places to look for solutions to the problems that bedevil public programs. But they should not be the last place, or the only place, to look."