President Biden’s announcement on August 24, 2022 of a $10,000 student loan forgiveness plan came as no surprise to American politicians and political observers. Also of no surprise were a Goldilocks gamut of reactions that ranged from saying it was too much, it was too little, and it was just right. The purpose of this article is to set aside the political wranglings and instead to focus on the forgiveness plan purely from an economic perspective.

There are two fundamental policy engines in most economies: fiscal policy and monetary policy. Monetary policy works through interest rate hikes or cuts and concentrates on controlling borrowing costs. The Federal Reserve controls this policy and it is independent of whichever political party holds power. 

The fiscal policy, on the other hand, is the government budget. Depending on whether or not the government is running a deficit or surplus, the policy could be expansionary or contractionary.  
Right now, the Federal Reserve has a contractionary policy - they are aiming to bring down inflation and are hiking rates into a slowdown. Therefore, there is also a contractionary monetary policy (higher rates for longer). 

On the other hand, debt forgiveness is an expansionary fiscal policy -it increases people´s discretionary income. Assuming that lower-income people have a higher propensity to consume, it can be predicted that spending will increase.

This means that the fiscal and monetary policies are now in conflict. One is trying to accomplish an economic contraction, while the other is helping it to expand. This kind of contradictory usually leads to one of the policies overshooting on the wrong side, and cause a recession or overheat on one end of the spectrum. 

Let’s look at some of the specifics of Biden’s plan. Its most obvious outcome will be to cancel $10,000 in federal student-loan debt for borrowers with annual incomes of $125,000 or less, or $250,000 for married couples. Biden also extended the freeze on loan repayment for all borrowers through the end of 2022, the seventh extension since the onset of the pandemic. 

Eligibility is based on a borrower's adjusted gross income for either tax year 2020 or 2021. An individual’s adjusted gross income can be lower than their total wages because it considers tax deductions and adjustments, such as contributions made to a 401(k) retirement plan. 

The Department of Education says it already had income information for nearly eight million borrowers, likely because of financial aid forms or previously-submitted income-driven repayment plan applications. Those borrowers will automatically receive the debt relief if they meet the income requirement. Other borrowers will need to apply for the student loan forgiveness if the Department of Education doesn't have their income information on file. 

Students who received Pell Grants, which help low-income families pay for college, will be forgiven for up to $20,000. Pell grants are awarded to millions of low-income students each year, based on factors including their family's size and income and the cost charged by their college. These borrowers are also more likely to struggle to repay their student debt and go into default 

There are, of course, exceptions. Not everyone with a student loan is eligible. First, only federally- owned student loans qualify – private student loans are excluded. Secondly, high-income borrowers are generally excluded from receiving debt forgiveness. 

It’s been estimated that the policy will provide relief to more than 90 percent of the 45 million Americans carrying federal student-loan debt. The White House has estimated that 20 million borrowers would see their ledgers wiped clean altogether.

Some economists maintain that student loan forgiveness of any kind is highly regressive, benefiting those who graduated college at the expense of the roughly 60% of Americans who didn’t. One analysis concluded that approximately 42% of the benefits of student loan forgiveness would go to the wealthiest two-fifths of Americans, with the bottom fifth receiving just 12%. 

Some critics claim that those figures understate the extent to which this program harms working-class and poor Americans. The combined impact of canceling debt and extending the repayment freeze will cost taxpayers hundreds of billions of dollars. Worse, it is suggested, depriving the government of expected revenue will reduce funding available for investments in early childhood and kindergarten to twelfth grade learning that would be much more effective in promoting economic opportunity and future growth. 

Loan forgiveness doesn’t put cash into borrowers’ pockets, but it still risks fueling inflation by encouraging consumers to spend money they would otherwise have devoted to paying off their debts. It’s been claimed that wiping out debt now will only encourage students to take out still-bigger loans in the future, reducing incentives for colleges to hold down tuition costs — thus, in all likelihood, making higher education even less accessible for the middle class. 

Fiscal conservatives are insisting that Biden eliminate ambiguity about the end of the repayment freeze and clarify that all borrowers will have to resume making loan payments at the start of 2023. They maintain that administration should do more to protect taxpayers, for instance, by narrowing the public-service loan forgiveness program, which allows workers in public-sector and non-profit jobs to wipe out their remaining student loan balances after making 10 years of payments. Biden’s income-driven repayment plan would allow current and future borrowers to make monthly payments of 5% of their discretionary incomes, half the current amount.

It was predictable that Biden’s decision to provide financial relief to millions of Americans would be welcomed by his political base and condemned by his political opponents. It’s possible that, in the government’s enthusiasm to proclaim the policy, the fundamental conflict it created between fiscal and monetary policies was not given sufficient consideration. The end results cannot be accurately predicted at this point, but they could turn out to cause even more problems for the American economy than it already has. 

Would you like to ask Ardi some questions or share your own experiences? He would enjoy hearing from you at [email protected].