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Subject Area: Political Theory

Private Capital and Education - Leonard P. Liggio, Literature of Liberty, January/March 1978, vol. 1, No. 1 [1978]

Edition used:

Literature of Liberty: A Review of Contemporary Liberal Thought was published first by the Cato Institute (1978-1979) and later by the Institute for Humane Studies (1980-1982) under the editorial direction of Leonard P. Liggio.

Part of: Literature of Liberty: A Review of Contemporary Liberal Thought, 20 vols. 19781-982

About Liberty Fund:

Liberty Fund, Inc. is a private, educational foundation established to encourage the study of the ideal of a society of free and responsible individuals.


Private Capital and Education

West, E. G. and McKee, M.

  • Carleton University, Ottawa, Canada

“Imperfect Capital Markets as Barriers to Education.” Atlantic Economic Journal (USA), 5 (1977): 32–42.

Economists and laymen often assume that private capital markets are imperfect suppliers of loans for education. A parallel implicit presumption is that government-funded loans can correct this alleged imperfection in the market. Both views are empirically unverified hypotheses.

In order to support these hypotheses, one must first demonstrate that private market rates of interest for educational loans are excessively high (relative to some competitive rate), and second, that the government is able to charge lower rates on some economically justifiable basis. But even if we assume that private markets are imperfect in this area, it is doubtful that government could improve on the performance of the private sector, given the high and growing cost of supplying student loans in the public sector.

lf0353-01_1978v1_figure_033

The high cost of student loans results mostly from the high risk of nonrepayment and default in a group that offers no collateral for their loans. Usually individuals who are too young to have established a reliable credit rating make up this group. Because the government does not cover such default costs out of the revenues from its loan program, it understates the actual costs of governmental student loans. To find the true costs of governmental student loans, the hidden shadow rate, we must calculate the rate the government would have to charge to cover all costs including the costs of default plus a normal return. When calculated, the shadow rate of interest approximates 17% for government loans. To be an improvement over the private market rate, private loans would have to exceed rates of 17%. In fact, by more carefully screening loan applicants, the private market probably could underbid by several percentage points the government rate of 17%.

Why then does the private market not provide student loans more frequently? Two reasons appear relevant. First, the government under prices its loans since it transfers the costs of defaults from the class of borrowers to the general taxpayers. Second, it may very well be that students find returns to education in general not sufficiently high to warrant borrowing at even these lower market rates.

The private market, then, is not imperfect in the sense that public policy can improve its operation. Rather it is inoperative because the supply curve for student loans rises so high that it never intersects the demand curve in the positive quadrant. The implication is that recent governmental subsidies to education in the form of low priced student loans has probably resulted in a misallocation of resources.