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Motor City financial madness and institutions of higher debt

September 13, 2013
| By Brad Stamm |
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Most of the world’s major economies have developed a cavalier attitude toward debt that is not only unique to them but also held by millions of households that are financing college education. The “new-normal” acceptance of large amounts of borrowing rarely takes into account the negative consequences of potential increases in interest rates. 

Partial blame for the nonchalant approach to debt financing can be placed on Franco Modigliani, 1985 Nobel Prize winner in economics, due to his theory that debt-to-equity ratios are of little consequence. 

While almost every other type of debt is declining, college debt remains on the increase. The debt burden for graduates, notwithstanding a rise in interest rates, has had several negative repercussions. Many parents have had to co-sign loans and put their personal assets in jeopardy. Students are finding it more difficult to get car and home loans, and even get approved for renting an apartment. 

The average college graduate has $26,000 in government loans, $19,000 in private loans, $18,000 in state loans, $13,000 in personal and family loans, and $3,000 in credit card debt for a grand total of $79,000. Most of these funds are being financed at historically low rates of interest. President Obama recently signed legislation keeping the Stafford loan rate at 3.86 percent as a means of abating the financial burden on college students and keeping the door open for new entrants into institutions of higher learning. 

What is not well known is that these rates are tied to 10-year Treasuries, which are subject to moving upward. Families are extremely price sensitive when it comes to college costs. Last year, 67 percent of families eliminated colleges based on cost during the admissions process, thus the attempt to moderate the price of a bachelor’s degree.

College debt is not the only one hindering economic growth. U.S. national debt now totals $17 trillion, with state and local debt another $3 trillion. Add to that consumer debt of $2.8 trillion and $1 trillion in college debt, putting our nation $24 trillion in the red. If interest rates go up a mere 1 percent, the cost to the economy would be $240 billion, or 1.5 percent of our GDP. 

Given our moderate rate of income growth, this amount is not inconsequential. Unless we follow in the footsteps of Japan, there is only one direction for interest rates to go, and that is up.

On a global level all major central banks are keeping their interest rates at historic lows, both as a means of supporting their own economies and as a competitive measure, not dissimilar to the inter-war period in the last century when countries were, in essence, exporting their unemployment by devaluing their currencies. But this time it works through lowering the cost of capital and, in turn, encouraging both spending and investment for the sovereign nation. If debt service goes up 1 percent, it will cost the global economy $510 billion per year. 

Although wrongly denied by some, you can’t separate Detroit’s bankruptcy — the largest on record — from its impact on the rest of the state of Michigan. The Motor City’s bankruptcy has had a negative short-term effect on borrowing by other counties and municipalities, such as Saginaw and Genesee counties, the city of Battle Creek, and Ypsilanti Community Schools. 

The state, overall, is paying a 50 basis point premium on its 10-year general obligation bonds. Increases in market rates of interest almost always have unintended consequences, such as Detroit’s impact upon other municipalities attempting to issue new debt or refinance existing. 

We have become increasingly dependent on low interest rates. Higher education is playing by the same set of new-normal rules as the U.S. government, where low interest rates and high levels of debt are an acceptable practice. Rates will inevitably rise and so will the risk to individuals, cities and countries alike, with the unintended consequence being a nation less educated and subsequently less productive.   

Brad Stamm is an economics professor at Cornerstone University.

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