The debate over student loans often focuses on the importance of education for commanding a good salary land avoiding unemployment later in life. Going to college is often analogized to making an investment in plant, property or equipment. As MIT economist Jonathan Gruber writes in Public Finance and Public Policy: "Just as firms invest in physical capital, education is the individual's means of investing in human capital. More education raises a worker's stock of skills and allows her to earn more in the labor market."
The analogy between education and physical capital investment is a good one - but commentators should take it a step further. Just as there are good and bad physical capital investments, there are also good and bad human capital investments. Unfortunately, student loan and other government education subsidies usually fail to take this distinction into account.
Imagine that we decide to build a hotel. In theory, that's a good use of capital. After all, more and more people are travelling and need a place to stay. But in the case of our hotel investment, we make some mistakes. First, we choose to build the hotel on unattractive scrub land far away from the nearest airport, city or recreation area. Second, we use shoddy materials and an incompetent general contractor to build the structure, resulting in a building plagued by mold and falling plaster. Finally, we don't do much to advertise the existence of our new hotel.
The likely result of these mistakes will be a lack of guests staying at our hotel. We may have invested millions of borrowed dollars to build our hotel, but it generates no cash flow. This is not really an investment, but a malinvestment. If our bank had good credit analysts, it might have prevented us from making these errors by denying us the loan in the first place. Otherwise, the bank loses money on the deal and will probably be more careful next time (assuming it cannot get a bailout—which it should not).
So what does all this have to do with student loans? If a student chooses a major for which there is limited demand, attends a school with an undistinguished reputation, earns poor grades due to lack of study and fails to conduct an effective job search campaign, their education will also prove to be a malinvestment.
Since student loans are provided with very little due diligence, there is no mechanism for avoiding poor lending decisions. When the malinvestment manifests itself in the form of an unemployed or underemployed graduate, taxpayers are often stuck with the impact of default. The outcome is also bad for the borrower, who may struggle to repay the loan or suffer from damaged credit in the event she cannot continue to make payments.
Thus, we would all be better off if student loans are properly underwritten, with borrowers having to show lenders that they have created a viable plan to capitalize on their education and that they are effectively executing this plan. It is hard to imagine how the government could manage such an underwriting process, which will become ineffective if subject to accusations of discrimination and political pressure. Then again, the government never should have taken over the student lending business in the first place. Instead, student loans need to be the responsibility of private players with skin in the game.