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These $42B approval in student loan forgiveness could result in higher inflation and interest rates

The U.S. Department of Education recently approved $42 billion in student loan forgiveness for at least 615,000 borrowers under new flexibilities for public servants. This approval has important political implications for Biden’s run in 2024, especially since it was one of his key campaign promises. In fact, it strengthens his position among millennials and young demographics. Indeed, it must be said that President Biden managed to deliver on the promise of developing a program to forgive a chunk of student debt to the cheers of many Democrats and progressives who pushed him on the issue during his first two years in the White House.

The Biden administration has implemented student loan forgiveness relief through temporary flexibilities under the Public Service Loan Forgiveness (PSLF) program. The PSLF was created under the College Cost Reduction and Access Act of 2007 to provide indebted professionals a way out of their federal student loan debt burden by working full-time in public service. The PSLF program can cancel the federal student loan debt for borrowers who work as employees for nonprofit or government organizations. After making 120 “qualifying payments” (which is equivalent to 10 years if the payments are made consecutively), borrowers can achieve a complete discharge of their federal student loans.

While on the surface, canceling student loans may seem like a great thing to do, it does have important economic implications that could impact the economy to extensive degrees. Before digging into the economic consequences of student loan forgiveness, it is important to emphasize that student loan forgiveness does nothing to reduce the cost of higher education. Thus, they have no impact on current and future students facing historically high education costs. Thus, some institutions may also increase tuition rates with the assumption of future forgiveness.

It is important to comprehend that cancellation would not erase the amount of student debt owed but would rather shift the liability from an individual’s balance sheet to the federal government’s balance sheet. Let us emphasize that the U.S. government balance sheet is based on the taxpayer. A key concern about the debt forgiveness program is its inflationary impact in an environment where inflation has been persistently elevated for quite some time.

The real value of outstanding government debt must be matched by future surpluses of revenues over spending, properly discounted. But the federal government is currently in a deficit. The central insight is that it is the real value of debt that is backed by real future resources. The immediate impact of debt cancellation is that it reduces future interest and principal payments, which is revenue of the federal budget. Debt cancellation, therefore, leads to a sudden decline in expected net revenues, which becomes insufficient to back the outstanding level of debt. Thus, this would lead to an increase in the price level in order to reduce the real value of debt as future real revenues decline. If the price level increases to reduce the real value of debt, thus inflation occurs. As inflation occurs, interest rates will be raised to tame inflation. Currently, inflation is still high and interest rates are already high.

Currently, inflation is still high and interest rates are already high. According to the Committee for a Responsible Federal Budget, the influx of $10,000 to $20,000 for millions of borrowers could push inflation even higher, with personal consumption expenditure (PCE) inflation increasing by 15-27 basis points. In other words, if student loans continue to be canceled, then it is going to annul the work that the Federal Reserve has been doing to reduce inflation.


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