By Mansoor Iqbal, Education Writer
International news over the past few months has been dominated by the very real possibility that the world’s largest economy might default on its debt. The effect, not just on the US itself, but on the rest of the world would have been catastrophic had this occurred, but a last minute deal struck by US President Barack Obama and the US legislature (Congress) earlier this week prevented this from occurring.
If you’re not well-versed in financial jargon and the in and outs of the US economy, then you may well have found the coverage a little opaque. Clearly, something big is happening, and it seems disaster has been avoided, but when it comes to actually explaining what is going on then things get a little more complicated.
If you’re considering studying economics, politics or finance (or anything which requires you to understand the events of the political and financial world) then this is important stuff! In order to help you get a handle on what’s going on, we’ve produced a short guide to the US debt ceiling debate; explaining what it means to students, and a glossary of terms which should help to make things clearer- let us know if this helps! If there are any more terms, or world events that you’d like explained, get in touch via our TopUniversities Facebook fan page.
The debt ceiling...
In terms of pure numbers, the US has the highest levels of debt in the world. However, if we consider the debt in comparison to its GDP, then it seems more reasonable. At present, debt levels are the equivalent of 95 per cent of the country’s GDP, which seems like a lot, but is normal – the percentage in several European and Asian financial powerhouses is even higher.
The US is unique in one way however – it has a debt ceiling, which limits the amount of debt the US can be in at any given moment. It was in fact this self-imposed limit that brought the country to the brink of a crisis. The ceiling, which stood at $14.3 trillion before this week, was reached in May, meaning that the US could not borrow any more money.
This created a problem as, without borrowing more money, the US could not afford to pay its bills, and, in order to borrow the money it needed, the ceiling had to be raised. This, it should be noted, is a pretty standard procedure – since the mid-1960s the ceiling has been raised over 70 times, including 10 in the last decade – 3 of which have been during the Obama premiership.
This time, however, things were not so simple. For it to be raised, both houses of Congress – the House of Representatives and the Senate – need to agree. The proposal ran into problems when members of the House of Representatives (controlled by the Republican Party) refused to raise the debt ceiling, unless the President and his Democrat colleagues also agreed to commit to cutting spending in order to tackle the deficit.
It was calculated that, if no more money was borrowed, the US would run out of the money it needed to honour its financial commitments by August 2nd (having kept afloat since May by stopping payments to certain pension schemes) – defaulting for the first time in its history. Amongst other things (the United States Dollar is the world’s reserve currency) this would cause the US to lose its AAA credit rating – the highest level possible – and sink to D, which would mean that banks could no longer use US debt as collateral.
The deal...
We have, however, managed to avoid this fate, thanks to a deal with which both parties are happy (for now!). President Obama has been allowed to raise the debt ceiling by at least £2.1 trillion. $400 billion will be added instantly, and another $500 billion can be added in February at the President’s discretion. The rest hinges on the balanced budget amendment, which is a proposal to add a stipulation to the constitution which will mean that the budget could not exceed revenue or 18 per cent of national income without the approval of a super majority. If this passes, $1.5 trillion can be added to the ceiling, if not (the likelier outcome) then only $1.2 trillion. Congress must consider this bill before the end of the year.
In return, he has had to agree to a similar amount of spending cuts over the next decade. Caps on discretionary spending are estimated to save $917 billion over 10 years – Obama has pointed out these will be the lowest levels of discretionary spending since Dwight Eisenhower’s premiership in the ‘50s. These cuts will include $350 billion from defence spending.
A plan for another $1.5 trillion of cuts will be drawn up by a 12 member bipartisan committee in November this year. As an added incentive for the committee to draw up a satisfactory plan, an automatic sequester will take effect if they do not. This will see a similar amount cut savagely from spending – half from the defence budget, and the rest from sources which include education, infrastructure and Medicare (social security and Medicaid are ring fenced) – the deal is designed to be unsatisfactory to both parties to encourage them to return to drawing board.
It should be noted that such long term plans are never set in stone though, and commentators have pointed out a similar automatic cuts plan made in 1985 was simply disregarded, with Congress voting to ignore them. It only takes a vote from a future Congress of a different mindset and operating in different times to change everything. Nobel Prize winning economist Paul Krugman has criticised the deal in a piece for the New York Times , in which he says cutting spending is the worst thing you can do in the current financial climate, though Obama has asserted he was not cutting too abruptly while the economy was still fragile.
The US credit rating is still likely to be downgraded from the top level, as Standard and Poor’s, one of the big three credit rating agencies who decide such things, demanded $4 trillion in deficit reduction measures to prove Washington’s commitment. It will not fall as far as it would have
How will this affect students?
In a fact sheet released by the White House, President Obama specifically earmarks aid for college students as crucial, which is a positive sign that education will not be the worst victim of the cuts. That there will be enough funding for presidential investment in Pell Grants, in fact, seems to be a cornerstone of the deal.
This is a positive development, as Pell Grants (see the glossary for explanations of this and the other programs mentioned here) and student loans were areas where it was feared that substantial damage would be done. However, education was mentioned as one of the areas that would be affected if the automatic sequester took effect, which means that there is a good chance that the committee will be considering it as an area which can be cut – worrying news for universities who have already had to endure cuts at state level over the past few years.
The deal did include some less good news though. In order to keep Pell Grants safe, other forms of aid have not fared as well. LEAP grants, subsidized loans for graduate students and incentives for quick repayments for student loans have all taken a hit, as have second instalments of Pell Grants. TRIO programs, Perkins loans and the Supplemental Educational Opportunity Grant are areas which have been identified as at risk from discretionary spending cuts.
The discretionary budget also includes such bodies at the National Endowment for the Arts, the National Endowment for the Humanities, and the National Science Foundation, which are all consequently at risk from cuts. The former two have already been victims of reduced funding, and a stimulus package for the latter will run out this year, though a House of Representatives subcommittee has recently recommended that its current normal funding levels are maintained. The main fear of many is that, with not enough time to evaluate each program individually, the super committee may just advocate cuts across the board, which may prove much more damaging than if they were individually tailored.
Glossary
Asset: An item with economic value, owned by a person, corporation or country.
Automatic sequester: In this case, automatic, indiscriminate cuts made to anything that isn’t ring fenced. Sequester means to confiscate property while things are being resolved – in this case the property is the federal budget!
Bipartisan: Involving members of the both US parties – the Democrats and the Republicans.
Collateral: Back-up asset used in case a loan cannot be repaid (if you used your house as collateral on a loan you couldn’t repay you would have to give your house to the person you owed). Debt can be passed on as collateral – money previously owed to the borrower would now be owed to the lender.
Cut: You probably know this one, as this is a word which has taken on a lot of significance of late. It simply means to spend less money on something than before.
Debt ceiling: The maximum amount of money the US can borrow from banks and other such lenders in order to honour its financial commitments.
Default: Becoming unable to honour financial commitments. People owed money by the defaulting party (in this case this would be people, corporations – including banks – and countries) would not receive it, which, if large sums are involved, could cause big problems. Borrowing money in the future would also become extremely difficult, and as borrowing is essential for modern nations to operate this would leave the defaulter in a very difficult position.
Deficit: The difference between money going out and money coming in if the former is greater than the latter.
Discretionary spending: Expenditure that is set in the annual budget and can be changed from year to year – things like education, defence and scientific research fall into this category. The opposite is mandatory spending, which, legally, must be paid. This includes, in the US’ case, interest on the national debt and Social Security.
GDP: A country’s gross domestic product is simply the value of everything a country produces over a year. It is traditionally used as the measure of a country’s wealth.
LEAP grants: Grants provided to US states by the federal government to help them provide needs-based grants to students.
Legislature: One of the three branches of government (the other two are the executive – the president and his cabinet, and the judiciary – the courts). The legislature, as the name suggests, are responsible for passing laws. In the US, the legislature is divided into two branches – the House of Representatives (the lower house, which considers things first) and the Senate (the upper house, which considers things after the House of Representatives have passed them).
Liability: A financial obligation.
Medicaid: A means-tested program which provides health care for low-income families.
Medicare: A program which provides health care to those who are of retirement age, the physically disabled, and others who meet other special criteria.
Pell Grants: A federal program which provides aid – a maximum of $5,500 a year – for students from low-income families.
Perkins loans: Low-interest federal loans to help needy students.
Reserve currency: This is a foreign currency in which central banks and governments hold their reserves. These reserves are used to pay off international debt obligations, and to influence the domestic exchange rate (by allowing the central bank to purchase it). The dollar is currently the currency in which 60 per cent of reserves are held, and many international transactions are carried out in dollars as opposed to local currencies. Were it to fall in value as a result of a default it would, therefore, have had a negative effect around the world.
Standard and Poor’s: Along with Moody’s and Fitch Ratings, S&P are one of the ‘Big Three’ credit rating agencies. Its role is to give ratings to corporations and countries, based on their ability to repay their debts. AAA is the highest rating, an elite club which includes the world’s 16 most affluent countries (and the Isle of Man and Guernsey) and corporations such as Microsoft and Johnson & Johnson. Having this rating means that lenders are more likely to favour the holder with preferential rates and larger sums. Being downgraded means that the body being rated will appear less trustworthy, and as a consequence will have to make the risk worth the lender’s while by paying higher rates. The next rating down is AA+, followed by AA and AA-. Anything below BBB is considered to risky.
Super majority: In the case of the US Congress this means that two thirds of each house must vote in favour of a proposal in order for it to be passed.
Supplemental Educational Opportunity Grant: A program which provides grants to the undergraduates with exceptional financial needs. Pell Grants recipients with the lowest family contributions will be considered first.
TRIO programs: Federal outreach and student service programs whose goal it is to identify and provide services for individuals from disadvantaged backgrounds. Low-income students, first generation college students, and students with disabilities are amongst the people they are designed to help.
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