Academic journal article Review - Federal Reserve Bank of St. Louis

Student Loans under the Risk of Youth Unemployment

Academic journal article Review - Federal Reserve Bank of St. Louis

Student Loans under the Risk of Youth Unemployment

Article excerpt

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Many college graduates may face spells of unemployment and/or underemployment before they find jobs that match their qualifications. These spells may be long, especially for some college majors, and can lead to serious financial difficulties, including obtaining credit and repaying student loans and other forms of debt. Aside from their direct welfare costs, the hardship and volatility during the early stages of labor market participation can impair-and even dissuade altogether-productive investments in human capital, especially for those from more modest family backgrounds.

In this article, I explore the optimal design of student loan programs in an environment in which younger individuals, fresh out of college, may face a substantial risk of unemploy- ment. In my model, the risk of unemployment is endogenous and subject to incentive problems. In particular, I assume that a problem of "moral hazard" (hidden action) distorts the implementation of credit contracts. More specifically, I examine an environment in which costly and unverifiable effort determines the probability of younger workers finding a job. The costs of unemployment for a young worker are in terms of zero (or very low) earnings and missing opportunities to gain experience that would enhance his or her labor earnings for subsequent periods. Moral hazard and other incentive problems have been studied extensively by economists in a wide array of areas ranging from banking and insurance to labor markets. Yet, only recently has the explicit consideration of incentive problems been introduced in the study of optimal student loan programs.1 Despite the extensive literature on unemployment insurance since the 1990s (e.g., Wang and Williamson, 1996, and Hopenhayn and Nicolini, 1997), the integration of an unemployment insurance scheme within the repayment structure of student loans and the optimal design of such a scheme is an aspect that remains unexplored.

In this article, I first consider a simple three-period environment. In the first period, a young person decides on his or her level of schooling investment. In the second period, a hidden effort governs the probability of unemployment. In the third period, all workers find employment, but their earnings are affected by their schooling level and their previous employment. I contrast the resulting allocations from two contractual arrangements: the first-best (i.e., unrestricted efficient) allocations and the optimal student loan programs when effort is a hidden action (moral hazard). I then extend the simple environment by dividing the potential postcollege unemployment spell into multiple subperiods. I use this extension to examine the optimal design of unemployment insurance and compare the human capital investments resulting from a suboptimal scheme without unemployment insurance. In all these cases, I restrict the credit arrangement so the creditor expects to break even in expectation (i.e., in average over all possible future outcomes). Therefore, my conclusions can apply not only to government-run programs, but also, under similar enforcement conditions, to privately run student loan programs.

I derive three main conclusions. First, the optimal student loan program must incorporate, as a key element, a transfer mechanism should college graduates face post-schooling unemployment. This conclusion holds even if unemployment probabilities are endogenous and job searching might be subject to moral hazard. This simple and perhaps not surprising result is worth highlighting given the limited scope for insurance in existing student loans. An unemployment insurance mechanism not only alleviates the welfare cost of potentially catastrophic low consumption for the unemployed, but can also help to enhance human capital formation as individuals and their families would not need to self-insure by means of lower-return assets and reduced schooling.

Second, and related to the last point, despite the presence of moral hazard, a well-designed student loan program can deliver efficient levels of investments for at least a segment of the population. …

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