Yesterday, the United States House of Representatives passed a historic bill to raise the government’s debt ceiling and cut spending by $2.4 trillion. The Senate is expected to approve the plan today. But the question remains: How does this fit into the big picture?
What’s Been Going On So Far
Over two months ago, the U.S. hit its debt limit, requiring Congress to authorize the Treasury Department in order to borrow more money. Although it sounds idyllic to say that we should not borrow any more money, the U.S. government might have had to default on its payments to bondholders if it didn’t. A modern U.S. default would be totally unprecedented: The last serious default was when FDR, saddled with war debt, refused to redeem gold bonds in the 1930s. The economy is very different now, and a default would rock the world economy.
How the Government’s Budget Works
Just like us, the government has a budget. Here are some basic facts about how the government’s budget works:
- Income: The government gets money by collecting taxes like income tax, property tax, payroll tax, etc.
- Spending: The government spends money to operate and provide public services. This ranges from maintaining roads and running public schools to providing Social Security and Medicare.
- Loans: The government borrows money from regular people, businesses and other countries through bonds. Many “regular” people own government debt in their mutual funds or savings bonds. As of the beginning of this year, just under half of America’s debt was owned by foreign countries like China, Japan, the U.K. and Brazil. (China singlehandedly owns about a quarter of America’s foreign-held debt.)
Government Default Would Be Terrible for Investor Confidence
Defaulting would be incredibly damaging to the U.S. because government bonds are traditionally seen as some of the safest debt around. If the U.S. defaulted, it would be a shocking blow and would make borrowing money a lot harder in the future.
Just like us, governments have “credit scores,” as measured by international credit rating agencies like Moody’s and Standard & Poor’s. The highest credit score is AAA, which is what the U.S. government currently holds. Even if the deal passes, these events put the U.S. government at risk of losing its AAA rating. When our individual credit score takes a dip, our ability to get a loan weakens and our interest rates go up. The same thing happens for the U.S. government. Credit ratings are signs of a borrower’s ability to “make good” on debt and help determine countries’ interest rates. If the rating is demoted, our government would have to pay even more to borrow money from now on. (Learn more about how interest rates work.)
Also, a demotion to AA rating could upend the idea of government bonds as traditionally safe investments. On one hand, bonds might take a dive as people become more nervous about the government’s ability to repay the loans … but on the other hand, more investors might flock to these investments since their interest rates will probably go up.
Your Cheat Sheet: The Debt Deal Boiled Down to the Basics
After weeks of bickering, President Obama and congressional leaders finally agreed on a deal. The proposal would:
- Raise the debt ceiling by $2.4 trillion.
- Cut spending by $2.4 trillion to offset the raise.
- Separate the $2.4 trillion spending cut into two installments. The first installment will be $917 billion in spending cuts over 10 years; the second will be determined through a committee, which will cut another $1.5 trillion through overhauls of the tax system and safety-net programs.
The bulk of the cuts (the $1.5 trillion) are being punted, leaving tough decisions about what programs to cut to congressional committees. According to the deal, a congressional “super-committee” of six Democrats and six Republicans will need to reach a conclusion on spending cuts by November 23, 2011. These proposed cuts will need to be approved by Congress by December 23, 2011; if they are not approved in time, an array of prearranged cuts will kick in. Most of the fighting over programs and services is just getting started.
Your Cheat Sheet: The Key Players
By now, there have been so many proposed plans that it’s hard to keep them all straight. Here are the most important players:
- Senate Majority Leader Harry Reid: This Democrat has been key to the debates, proposing a compromise of his own last week. He’s endorsed the current pact.
- Speaker of the House John Boehner: This Republican has also been a key player, but he’s had to struggle with a conservative contingent in his own party, which keeps pushing back on him. He was forced to rewrite his proposed plan last week.
- House Minority Leader Nancy Pelosi: She is not thrilled with this new deal because it doesn’t include any revenue (tax) increases, only cuts.
- President Barack Obama: Criticized by some pundits like Paul Krugman for giving in to Republican demands, the president has said: “This process has been messy and it’s taken far too long.” In earlier weeks, he and Boehner were seeking a “big deal” to cut a great deal of spending and also raise revenue, but those talks broke down.
- Rep. Charlie Dent and the Tuesday Group: A small group of relatively centrist Republicans. In Dent’s words, “People have to stop talking about what they can’t do or what they won’t do, and start talking about what they must do.”
- Gang of Six: Six Republican and Democratic Senators created an earlier bipartisan plan that would have saved $3.7 trillion over 10 years and overhauled the tax system. It did not come to pass.
What This Means for You
Here are some things you should do to make sure you’re prepared for what’s to come:
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- This deal will almost certainly mean that the government won’t be available to throw more money into a future economic stimulus package, so you’ll need to create your own security blanket. Make sure you have a robust emergency fund with at least six to nine months of living expenses. This will protect you in case (heaven forbid) you lose your job or encounter some other dire circumstance.
- The spending cuts will mean reduced funding for Social Security, so you can count less than ever on the government’s help for retirement. To make sure that you won’t have to work through the entirety of your golden years, start saving more aggressively for retirement through a 401(k) or IRA. If you’re looking for extra guidance on how to invest in those accounts, our Retirement and Investing Courses can help. (Will Social Security exist when you’re ready to retire?)
- You can also expect Medicare and Medicaid funding to be cut substantially, so safeguard yourself now by making sure you have the best health insurance for your lifestyle and circumstances.
A walk-through of the debates that happened on Friday: Read here.
Here’s a breakdown of the issues around the debt ceiling debate. Click here.
Image: House GOP Leader/Flickr