Dons Dollars and Cents

For the better part of last year, talk on Wall Street and in Washington on the topic of education centered around frozen credit markets and worry that student loans would be in short supply. Lenders were dropped out of federally backed student loan programs, and banks were hoarding cash amid widely held concern over financial turbulence related to free-falling housing prices. This left some parents and students scrambling at the last minute to secure loans to pay for college. Yet, after initial concern it became apparent that there would be enough money to go around, although some lending would be under less attractive terms or with higher interest rates.

However, as one crisis passes, another looms on the horizon for college students. Deflation, when prices go down instead of up as they tend to do, would cause a serious problem for all borrowers, including those holding student loans. As prices decline, the value of a dollar increases because it buys more goods; however this means problems for borrowers because declining prices also mean the real value of debt increases. For every percentage point of deflation, the real value of debt students owe would increase by one percent. Deflation would significantly increase the cost of debt to college students, just as the job market for new graduates looks bleakest.

While the U.S. economy is not currently experiencing deflation it is getting awfully close; prices rose by just 0.01 percent last year, the smallest increase since 1954. At a meeting last Thursday, St. Louis Federal Reserve Bank President James Bullard expressed his concern over deflation and predicted that prices could “end up in negative territory” this year, as was reported by Reuters.

While deflation is bad for student borrowers, more inflation is actually a good thing, at least for students with fixed interest rate loans like the ones issued by most federal loan programs. If, for example, a student owes $25,000 in debt, and inflation is 3 percent per year, which is the long term average in the U.S. economy, then each year the real value of that debt goes down by three percent. Historically, increases in wages outpace increases in prices, so once a student hits the 9-5 circuit, he or she should expect their wage to increase by at least the rate of inflation. Increases in wages due to inflation coupled with fixed rate loans means that a worker will be making the same loan payment every month but earning a higher and higher salary, above and beyond any promotions or pay increases related to increased experience or responsibility. In the end, inflation can reduce the real amount of money a student borrower pays back in the long run.

Student borrowers have everything to lose from deflation and those with fixed interest rate loans have everything to gain from inflation. For these reasons students should champion inflationary policies like the economic stimulus bill and other government spending as well as increases in the money supplied to banks via the Federal Reserve.