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Greenspan Warns on Budget Gap

He says the aging of the American population poses a fiscal risk.

Updated from 12:05 p.m. EST

For many stock investors, a ballooning budget deficit seems like an abstract concern. But

Federal Reserve

Chairman Alan Greenspan warned Wednesday that unless Congress takes steps to narrow the gap -- by cutting spending and reducing social security benefits -- the economy will inevitably suffer.

In a speech before the House of Representatives, Greenspan said the budget deficit is a "growing concern" that could result in higher long-term interest rates and "significant structural adjustments in the major retirement programs."

"The dimension of the challenge is enormous," Greenspan said in prepared remarks. "The one certainty is that the resolution of this situation will require difficult choices and that the future performance of the economy will depend on those choices."

The budget deficit widened to $375 billion last year and is projected to expand to $477 billion this year, according to the Congressional Budget Office.

To combat the problem, Greenspan urged Congress to rein in spending, saying that "a thorough review of our spending commitments -- and at least some adjustment in those commitments -- is necessary for prudent policy."

He also said that Social Security benefits for future retirees might need to be reduced, although the government must honor its obligations to those in or near retirement. "If changes need to be made, they should be made soon enough so that future retirees have time to adjust their plans for retirement spending," he said.

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President Bush said he had not heard Greenspan's comments, but believes benefits should not be changed for people at or near retirement.

Although Congress needs to apply the same scrutiny to taxes as it does to spending, Greenspan said a tax hike right now isn't the answer. "Tax rate increases of sufficient dimension to deal with our looming fiscal problems arguably pose significant risks to economic growth and the revenue base," he said.

Greenspan attributed the growing budget deficit to a downturn in the economy as well as increased spending and tax reductions from the government.

Although the deficit will narrow somewhat as the economy recovers and tax receipts go up, he said demographic changes -- specifically the retirement of the baby boom generation -- will place enormous demands on the nation's resources.

In 2008, the first group of baby boomers will be eligible to receive Social Security benefits and by 2011, these individuals will be eligible for Medicare. Federal spending on Social Security and Medicare currently amounts to less than 7% of GDP, but the CBO projects that these outlays will rise to 12% of GDP by 2030 and Greenspan said the ratio could be even higher.

"We could be in a situation in the decades ahead in which rapid increases in the unified budget deficit set in motion a dynamic in which large deficits result in ever-growing interest payments that augment deficits in future years," he said. "The resulting rise in the federal debt could drain funds away from private capital formation and thus over time slow the growth of living standards."

Although Greenspan reiterated that job creation has been limited recently, he was upbeat about the short-term outlook for the economy and said the probability of deflation is "very low." "The most recent indicators suggest that the economy is off to a strong start in 2004, and prospects for sustaining the expansion in the period ahead are good," he said.

Greenspan offered no more information about the outlook for interest rates, saying only that monetary policy remains "highly accommodative."

Earlier, Federal Reserve Governor Edward Gramlich said told the Euromoney Bond Investors Congress in London that both the budget and trade deficits are "worrisome" over the long term.

"At some point, continued large-scale trade deficits could trigger equilibrating, and possibly dislocating, changes in prices, interest rates, and exchange rates," he said. "Continued budget deficits will steadily detract from the growth of the U.S. capital stock and may also trigger dislocating changes."