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Greenspan Warns Budget Deficits May Undermine US Economy

WASHINGTON (Dow Jones)--Large U.S. federal budget deficits could push up U.S. interest rates and hurt the economy "in the relatively near term," unless Congress takes measures to get the fiscal shortfall under control, U.S. Federal Reserve Board Chairman Alan Greenspan said Wednesday.

The work of reducing the U.S. budget deficit, projected by the White House to hit $521 billion for fiscal 2005, is urgent given massive increases in spending needs to come with the retirement of an aging population in the next decade, and the risks posed by the historically high U.S. current account deficit, Greenspan said.

"The fiscal issues that we face pose long-term challenges, but federal budget deficits could cause difficulties even in the relatively near term," Greenspan said in prepared testimony before the House Committee on Financial Services. " Long-term interest rates reflect not only the balance between the current demand for, and current supply of, credit, they also incorporate markets' expectations of those balances in the future."

Even projections of higher deficits in the future can boost interest rates today, Greenspan said.

"If market players become significantly more doubtful that the Congress will take the necessary fiscal measures, an appreciable backup in long-term interest rates is possible as prospects for outsized federal demands on national savings becomes more apparent," Greenspan said.

Higher interest rates could constrain investment and savings, he added.

Greenspan's position on the budget deficit is in contrast with comments from various members of the Bush administration. In testimony before House committees on President George W. Bush's $2.4 trillion budget proposal, U.S. Treasury Secretary John Snow argued that interest rates would already be higher, if investors didn't believe White House promises to bring the deficit down.

Greenspan's testimony Wednesday also leaves him open to critics who say that his support for Bush's tax cuts over the past two years are a direct cause of the reversal from budget surpluses to ballooning deficits.

In testimony to Congress in January 2001, Greenspan said "If long-term fiscal stability is a criterion, it is far better in my judgment that the surpluses be lowered by tax reductions, rather than by spending increases." He asked Congress to act "sooner, rather than later" on passing tax cuts.

Greenspan warned large budget deficits are an even greater threat in light of the U.S. current account deficit, now running at $550 billion, equal to a 5% share of the economy. Historically, economists have said current account deficits of such magnitude aren't sustainable and could lead to abruptly higher interest rates and a sharp decline in the U.S. dollar, if foreigners begin to find U.S. investments less attractive. In the 1980s, when the U.S. current account and budget deficits grew at a rapid clip, economists began referring to them as "twin deficits."

"Given the already substantial accumulation of dollar-denominated debt, foreign investors, both private and official, may become less willing to absorb ever-growing claims on U.S. residents," Greenspan said.

Reducing the budget deficit would make the current account deficit more sustainable, because it would increase the pool of U.S. savings available for investment, he said.

"The current account deficit and the federal budget deficit are related because the large federal dissaving represented by the budget deficit, together with relatively low rates of U.S. private saving, implies a need to attract saving from abroad to finance domestic private investment spending," Greenspan said.

This view again puts him at odds with the Bush administration. Treasury's top international policy advisor, U.S. Under Secretary for International Affairs John Taylor, recently told reporters the U.S. budget and current account deficits aren't connected. "These twins aren't related," Taylor said, noting the U.S. budget deficit fell in the early 1990s, while the current account deficit continued to rise.

Greenspan said the U.S. economy must maintain its flexibility and ability to adjust to shocks as insurance against a shift in foreign investor sentiment. For this reason, resisting trade protectionism is more important than in the past, he said.

"The cost of any new protectionist initiatives, in the context of wide current account imbalances, could significantly erode the flexibility of the global economy," Greenspan said.

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