Borrowing to spend

14/03/2012 § 2 Comments

Was the Prime Minister trying to wind up economists yesterday? ‘Cause several people pointed out to me his comments on students loans almost as soon as they were published. This morning,  Eric Crampton at Offsetting Behaviour notices, too, and offers the PM some advice. The comments were:

That is about the only thing that will get [young people] out of bed before 7 o’clock at night to vote, but it’s not politically sustainable to put interest back on student loans. It may not be great economics, but it’s great politics. It is a bit of a tragedy because it sends the wrong message to young people, it tells them to go out and borrow debt. [emphasis added]

My colleagues were stunned at the realpolitik. Eric suggests that the political calculus may not be so clear:

Would students really get out to vote en masse if new borrowing were subject to interest charges? Would Labour really look at the current deficit projections and reckon promising a return to zero-percent loans a great idea?

I don’t want to wade into the interest-free debate, since it’s been beaten to death, resuscitated, then flogged some more. No, I want to talk about the next sentence, about borrowing debt.

The life-cycle hypothesis (LCH) is that people do or should try to maintain a relatively constant level of consumption over their lifetimes. Income, on the other hand, isn’t constant: it has a definite life-cycle path. The appropriate response is for people to borrow when they are young and their incomes are low and repay when their incomes are high, then save for retirement. This neat plan is constrained by problems with intertemporal transfer of income or wealth, and there are additional issues with uncertainty.

Here’s the key point: this applies to consumption as well as investment. 

The investment part is simple to explain. I borrow to pay for my education, which raises my human capital. This additional capital provides me with a higher income. As long as the increase in income is higher than the cost of education, it is a good investment.

The LCH says that people should also borrow to fund consumption. Students borrowing money to live comfortably is just consumption-smoothing. That is exactly what textbook economics says they should do. We can quibble about the appropriate amounts and whether expectations of future earnings are well informed, but that’s a different discussion.

If young people going out and borrowing is a tragedy, the plot was written by economists.

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§ 2 Responses to Borrowing to spend

  • The real surprise isn’t the realpolitik, it’s the very forthright expression of it. I’m not sure if I’ve seen before the form “We’re doing the wrong thing, and we know it, because voters are too damned stupid to let us do otherwise”. Points for honesty at least.

    Agreed on pro life-cycle smoothing. I’d said the policy encourages ridiculous borrowing – should perhaps have meant “ridiculous from the perspective of policy’s intent”. Perfectly rational on the students’ part!

    • Bill says:

      I know you understand the students’ rationality, Eric, but I’m not sure the PM does. It isn’t a tragedy that they are borrowing, and certainly not a tragedy that they are borrowing more when it’s cheaper. At least, not from their perspective.

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