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Consequences for Student Financial Aid If Congress Doesn't Raise the Debt Ceiling

Mark Kantrowitz

July 14, 2011

Spending on Student Aid Would Probably Be Suspended

Instead of defaulting on the debt, the White House would need to decide which among the other expenses must be cut. Social Security benefit payments account for about 20% of spending, Medicare and Medicaid for about 23%, other mandatory expenses for about 12%, the military for about 20% and discretionary spending for about 19%. (The interest on the national debt is about 6% of the budget.) Discretionary spending mostly includes spending through federal agencies and departments. The top seven department budgets (Health and Human Services, Veterans Administration, Education, Housing and Urban Development, Department of Homeland Security, State and Department of Justice) represent about half of the total, or about 10% of spending. The federal government cannot take the Social Security, Medicare/Medicaid and military budgets off the table and still cut spending by 40%. Cutting all discretionary spending just wouldn’t be enough.

In such an environment, spending on student financial aid would almost certainly be eliminated. Student financial aid is not one of the top spending priorities according to internal rankings by the Office of Management and Budget. It isn’t even in the top 10. Effectively this means that the Federal Pell Grant program and the federal education loan programs, which together represent more than $150 billion a year, would be suspended. This would force millions of students to drop out of college because they could not afford to pay for college without student aid. This, in turn, would force most colleges to lay off faculty and staff. Many colleges would have to close. The only alternative would involve doubling tuition rates, guaranteeing nationwide tuition riots.

But this is likely to be the least of many problems. A 40% cut in government spending would plunge the US into a long-term recession. Poverty would be widespread, especially among senior citizens, and mortality rates would increase significantly. Economic growth would stall and millions of jobs would be lost. Money market accounts would have to “break the buck”, causing significant losses for investors. If the Federal Reserve were forced to buy massive quantities of US Treasuries, it would lead to significant inflation. Defaulting on the debt would also hurt the world economy, since half of the US national debt is held by foreign investors.

Even if Congress ultimately increases the debt ceiling, the last-minute nature of the deal will raise the profile of political risk in evaluating the creditworthiness of US sovereign debt. This will hurt the US credit rating even if the federal government doesn’t default on its debt. Practically speaking, that will increase the federal government’s long-term borrowing costs by raising interest rates on US Treasuries. Every 1% increase in the interest rates on US debt will cost the US taxpayers an additional $145 billion a year. It will also have cascading effects, since interest rates on other debts, such as private student loans, are indirectly tied to the interest rates on US Treasuries. The interest rates on US Treasuries are often treated as a baseline risk-free rate of return in financial transactions.


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