FED Warns on Government Spending

Greenspan, Fed Governors Warn on Government Spending (Update1)

Nov. 10 (Bloomberg) -- Federal Reserve Chairman Alan Greenspan says the growing U.S. budget deficit could destabilize the economy. Fed Governor Susan Bies says Congress spends like it's dipping into a ``a cookie jar.'' St. Louis Fed President William Poole says Social Security is in jeopardy.
In the last two months, Greenspan and at least seven other Fed officials have warned lawmakers about tax and spending policies that have led to record budget and current account gaps.
As Greenspan, 78, in January begins his last year atop the central bank, the comments suggest Fed members are concerned his successor will have less room to guide an economic expansion should they have to raise interest rates to counter a plunging dollar or surge in spending. Fed policy makers are likely to raise the benchmark rate by a quarter point to 2 percent when they meet today in Washington, a Bloomberg News survey shows.
The policy making Open Market Committee began meeting at 9 a.m. Washington time, a Fed spokesman said. The committee's decision on interest rates is expected around 2:15 p.m.
``If you get to a point of fairly significant long-term structural budget deficits, it begins to impact on the level of long-term interest rates,'' Greenspan told the House Budget Committee on Sept. 8. That means the government must pay higher rates to borrow money, leading to even higher deficits, he said.
``If you get into that sort of debt maelstrom, it is a very difficult issue to get out of,'' he said.
Record Deficits
The Open Market Committee has already raised rates three times since June to restore its benchmark rate to a level that neither slows growth nor sparks inflation. All 89 economists surveyed by Bloomberg predicted Greenspan and the FOMC would increase the overnight rate again at today's meeting because a more-than-expected gain of 337,000 jobs in October signals the economy is starting to use up spare capacity.
Budget surpluses from 1998 to 2001 helped Greenspan orchestrate the longest economic expansion in U.S. history. When the boom ended in 2001, low inflation allowed the Fed to cut the benchmark rate to 1 percent, the lowest since 1958, limiting the recession to just eight months.
Then the surpluses evaporated. President George W. Bush, who will choose the next Fed chairman, won passage of $1.85 trillion in tax cuts and raised spending for wars in Iraq and Afghanistan. Defense spending rose 12.4 percent in fiscal 2004 to $437 billion, the Congressional Budget Office said.
The budget deficit widened to a record $413 billion in the fiscal year ended Sept. 30, with government spending rising 6.2 percent from the previous year. The deficit amounted to about 3.6 percent of the country's $11.8 trillion gross domestic product, the highest percentage since 1993.
Policy `Out of Whack'
Social Security, the main government-funded retirement program, will spend more money than it takes in starting in 2018, according to a report by the program's trustees. Unless taxes are increased or benefits cut, trust-fund assets for retirees, now at $1.4 trillion, will fall to zero by 2042. A report by trustees of Medicare, a federal health-insurance program, shows their hospital insurance fund spending will exceed income by 2012.
``There are a number of things that are just extraordinary, beginning with the fiscal imbalance,'' said Representative Jim Leach, an Iowa Republican and former head of the House Financial Services Committee, which oversees the Fed. ``The Fed has less credible discretion the more out of whack fiscal policy gets.''
Possible Successors
Bush, 58, who won re-election on Nov. 2, hasn't mentioned a likely successor to Greenspan, whose nonrenewable term as governor ends Jan. 31, 2006, after a tenure spanning four presidents.
Alan Blinder, a Fed vice chairman from June 1994 to January 1996, said possible successors include Harvard University economist Martin Feldstein, 64, a Bush adviser on Social Security, and John Taylor, 57, Treasury undersecretary for international affairs.
Blinder, a 59-year-old Princeton University economist who was an adviser to Democratic nominee John Kerry, also named Fed Governor Ben Bernanke, 50, and former Fed Governor Lawrence Lindsey, 50, as potential candidates, at a Sept. 28 meeting of the Council on Foreign Relations in Washington.
Greenspan's successor must steer the economy through the effects of deficits, high oil prices and global terrorism, Leach, 62, said.
``These are extraordinary times,'' he said. ``Virtually all the risks in the world economy are on the downside.''
Crude oil for December delivery reached a record $55.67 a barrel in New York on Oct. 25. While prices have since slipped to $47.37 a barrel yesterday, oil is still 53.4 percent higher than a year ago.
$88.5 Billion Tax
San Francisco Fed Bank President Janet Yellen, 58, said the surge would result in a temporary boost in broad inflation and, as long as prices stay high, a tax on U.S. consumers. Greenspan said that tax amounted to about $88.5 billion this year, equal to 0.75 percentage points of GDP.
Former Dallas Fed President Robert McTeer flagged the record $166.2 billion deficit in the U.S.'s current account, the broadest measure of trade, as a threat to stability.
The current-account shortfall was equal to 5.7 percent of the economy in the second quarter, up from 5.1 percent in the first three months. The U.S. needs to attract about $1.8 billion a day from overseas to plug the gap. If other nations sour on U.S. securities, the value of the dollar may plunge.
``The current account deficit is going to cause problems,'' said McTeer, 62, who resigned Nov. 4 from the Fed to run Texas A&M University in College Station, Texas. ``Flows will turn against us, and there will be a crisis that will result in rapidly rising interest rates and a rapidly depreciating dollar that will be very disruptive,'' he said on Oct. 7 at a New York event sponsored by Market News International.
Dollar Drop
Bush's pledge to make his tax cuts permanent also has traders predicting the dollar will continue to fall. The currency may fall to its lowest level ever against the euro for a second consecutive week after Bush signaled he would expand policies that fueled the deficits and the dollar's decline of about 20 percent against a basket of currencies since he took office in 2001, according to a Bloomberg News survey. Bush will also seek more funding for the war in Iraq.
Sixty percent of the traders, strategists and investors questioned on Nov. 5 from Tokyo to New York advised selling the dollar against the euro.
``A second term for Bush doesn't bode well for the dollar,'' said Samarjit Shankar, director of global foreign-exchange strategy at Mellon Financial Corp. in Boston, which manages $625 billion. ``There's no way of convincing the market additional spending on the war can be paid for if you have a lower tax base. It's a fundamental mismatch between spending and revenue.''
Can't Go On
Greenspan urged Congress on Sept. 8 to rein in spending and return to the ``pay-as-you-go'' system that was in place during President Bill Clinton's administration, whereby all new expenditures or tax cuts needed to be offset by reductions in other programs or higher fee income from government services.
``We cannot continue to just go on without saying, `We can have this, but not this,' and pay-go embodies that mechanism,'' the chairman said.
The costs of Social Security and Medicare are likely to balloon as the 84 million members of the baby-boom generation -- those born between 1946 and 1964 -- begin to retire in 2010, pushing federal government obligations higher, even as the taxpaying workforce shrinks.
``If we have promised more than our economy has the ability to deliver to retirees without unduly diminishing real income gains of workers, as I fear we may have, we must recalibrate our public programs so that pending retirees have time to adjust through other channels,'' Greenspan said in an Aug. 27 speech in Jackson Hole, Wyoming. ``If we delay, the adjustments could be abrupt and painful.'' Greenspan was chairman of the Commission on Social Security Reform from 1981 to 1983.
`Cookie Jar'
Since then, Poole, 67, of the St. Louis Fed, has made two speeches advocating an increase in the retirement age as a way to reduce the cost of Social Security.
Fed Governor Bies blamed lawmakers for sometimes spending taxpayers' money for political gain during the past four years.
``The part of it that has gotten me so upset is that in this whole election debate, nobody's been talking about the spending side,'' Bies, 57, said after a speech to investors in Rosslyn, Virginia, on Oct. 23, 10 days before the presidential election.
``If you take out Homeland Security and Defense, it has been a cookie jar over the last four years,'' she said. ``Everything has gotten loaded in. Money has gone into these appropriation bills that are funding everything under the sun.''
Another challenge facing Greenspan in his final year is the behavior of the labor market. The economy has created just 814,000 net payroll jobs since the end of the last recession in 2001, even with average annualized GDP growth of 3.3 percent. That's the slowest pace of any expansion of the last 60 years.
Presidential Pressure
Presidents and Congress have sought to influence Fed chairmen throughout the central bank's 90-year history to try to promote their own economic policies. Low interest rates can help finance budget deficits, stimulate economic growth and help offset the negative impact of tax increases.
Harry Truman, the 33rd president, invited Federal Reserve policy makers to the White House in January 1951 to try to persuade them to continue to keep yields on Treasury securities low to help finance the Korean War.
Former President Richard Nixon said he respected Arthur Burns's independence when he appointed Burns to the Fed chairmanship. Then Nixon said: ``I hope that independently he will conclude that my views are the ones he should follow,'' Fed historian Allan Meltzer, a political economy professor at Carnegie Mellon University in Pittsburgh, wrote in a recent paper.
Too Accommodating
Lyle Gramley, who worked as Burns's speechwriter before becoming a Fed governor, said: ``He'd talk to the president, and the president was concerned about where the economy was going. There was evidence of a good bit of pressure directly on him. He clearly in retrospect ran a too-expansive monetary policy.'' Gramley is now an adviser to Schwab SoundView Capital Markets in Washington.
Greenspan also faced political pressure early in his term. Former Treasury Secretary Nicholas Brady criticized the Fed for not lowering interest rates fast enough in 1992, when George H.W. Bush ran for a second term and lost to Bill Clinton.
Economic Hurdles
Greenspan's successor is likely to feel that kind of political pressure as long as there are economic hurdles to overcome, said Senator Richard Shelby, an Alabama Republican.
``Whoever is in there is going to face a lot of challenges,'' said Shelby, chairman of the Banking Committee, which has oversight authority on the Federal Reserve. ``There will always be political pressure, whoever the Fed chairman is, unless the economy is just robust.''
``It is going to be a period when the president will need someone who is going to work closely with the executive branch,'' said James Galbraith, an economist at the University of Texas at Austin who worked with the framers of the Full Employment and Balanced Growth Act of 1978, which reiterated the Fed's goals.
``Is there going to be a problem in getting an adequate growth rate and turning the next administration into a political success?'' Galbraith said. ``Yes.''