Commentary: Warren Student Loan Proposal is a Disaster

Senator Elizabeth Warren (D-MA) has proposed opening of the Fed's discount window to student borrowers, albeit indirectly.  The plan would mandate that the Federal Reserve lend to the Department of Education via the discount window so that it could charge students the same 0.75 percent rate that banks pay for emergency short term financing from the Federal Reserve.  To the uninitiated, this plan sounds great.  But it is nonsense, a disaster, and a disgrace that such a radical proposal would come from a sitting US Senator.    

Since my critics will no doubt accuse me of being a defender of the big banks, or a call me a fat-cat plutocrat, let's get some background out the way.  I voted for Barack Obama in 2008, and again in 2012.  Both times my support was enthusiastic.  I have generally supported Mr. Obama and his economic policies.  I am a strong supporter of a quick and easy path to citizenship for undocumented workers, and I believe in free universal healthcare.  But if my fellow democrats don't kill Ms. Warren's proposal immediately, I will be ashamed of the capital "D" after my name. 

 So what's wrong with the Students Loan Fairness Act.  In a word, everything.  But let's go through the details just so there isn't any doubt. 

The Fed lends money to banks against collateral, typically US government bonds or other highly rated securities, on a very short-term basis, usually overnight.  The purpose of such loans is not to enrich the banks or enable them to speculate.  It is a mechanism by which the banks can temporarily convert their loans into cash to meet withdrawal demands.  Without this safety valve, banks with a sudden surge in withdrawal requests would be unable to pay depositors, since it is not possible for them to "call" loans made to other customers.  

Furthermore, the Fed takes full custody of the pledged collateral, and earns all interest accrued during the term of the loan.  The bank is also still on the hook for the 0.75 percent for borrowing from the Fed.  So the bank is not only stuck paying interest on the loan, it also must forfeit the income generated by the collateral.  The result is a big net cost to the bank.  
 Banks would much prefer to borrow on the interbank market, where rates are lower and no collateral is pledged. 

Finally, the discount window is a boon, not a cost, to taxpayers.  Since 2008, the Fed has issued over 30,000 loans via the discount window, all fully repaid on time with interest.  The result has been over 300 billion in profits remitted directly to the US Treasury.  During its entire history, due to its ultra stringent lending standards, the Fed has never suffered a default.  

So where does this leave us with Ms. Warren's proposal?  

To start, because the Fed's awesome power to print money has great potential for abuse by politicians, the Fed was intentionally walled off from the rest of government.  The Fed never funds the government.  This sacrosanct rule of central banking is key to the Fed's credibility and that of the United States.  Countries which have resorted to money printing by the central bank to fund the government have suffered calamity after calamity.  Two recent examples include Zimbabwe in the 2000s and Argentina in the 1980s.  

Despite the lessons from history, Ms. Warren's proposal engages in overt money finance, or economist jargon for printing money to pay the government's bills.  She would direct the Fed to provide financing to the Department of Education to fund its Stafford student loan program.  While the goal of helping students is laudable, the means represent a dangerous crossing of the Rubicon which cannot be ignored. 

But perhaps worst of all, Ms. Warren's rhetoric in promoting her bill reminds of the cynical, rank, pandering usually employed by the Right.  Comparing central bank loans to banks, which are secured by firm collateral and usually last days, to student loans secured by nothing but the student's character and repaid over decades is the kind of despicable dumming down of issues that makes getting an education so important in the first place. 

Ms. Warren has made her career going after the excesses of Wall Street and helping to regulate the financial system.  She helped stand up the CFPB and assisted with overseeing the TARP bailout.  I therefore find it hard to believe that Senator Warren does not understand the basics of discount window loans or how it differs from loans made to consumers or students.  The fact that she would take advantage of the public's ignorance of an obscure but crucial function of government to score political points is shameful.  And ironic, since the objective of this whole exercise is supposedly to promote higher education.  Perhaps Ms. Warren should remember who exactly she is trying to help.