On Wednesday three of the nation’s top student loan lenders cut a deal with New York Attorney General Andrew Cuomo. Wachovia, National City, and Regions Financial Corporations agreed to a code of conduct that would prohibit questionable practices, such as giving kickbacks to financial aid officers in exchange for being listed as a “preferred lender” to incoming students.
Beyond these more moderate steps for reform, some politicians—such as Barack Obama—are calling to bypass the private lenders altogether, and have Uncle Sam assume direct responsibility for all of the nation’s student loans. By cutting out the middlemen and giving the money directly to the students, taxpayers would allegedly save billions.
This type of mentality betrays a fundamental misconception of how a market economy works. Because loans involve interest rates and other complications, we can correct the fallacy more easily if we momentarily switch contexts. So instead of discussing federal subsidies for student loans, let’s discuss a local government’s use of tax dollars to plow snow off the roads. True story: When I was growing up, someone wrote a Letter to the Editor of my town’s newspaper, and claimed that it was always cheaper for the government to plow the roads itself, rather than bidding for private companies to do the job. Why? I paraphrase from memory: “The government can do the job at cost, while the private companies have to add a mark-up for profit.”
There are two major errors in this line of thinking. First: In a competitive market, there is no guaranteed “rate of profit” that the firms automatically enjoy. If firms really were making unusually large returns, then others would enter the industry and push prices (and profits) down. It’s true, a given firm will normally take in more revenues than it pays out in explicit expenses, but this margin (accounting profit) is used to cover interest on the invested capital as well as the labor of the owners.
These are all “real” expen