Budget Deficit, Interest Rates, and Foreign Investors

Federal Reserve chairman Greenspan gave good news to a House committee this week. In presenting his semiannual report on monetary policy, Greenspan predicted that economic growth could reach as high as 5 percent this year and that unemployment should decline slightly. He also reported that inflation is expected to remain very low. However, mixed in with the good news on the immediate condition of the economy, Greenspan interjected some long-term concerns.

The concern centers mostly on the rapidly increasing federal budget deficit. Big shortfalls between income and spending at the government level could lead to higher interest rates in the near future, according to Greenspan. Those higher interest rates will cause even bigger fiscal problems as the baby boom generation reaches retirement age in the next decade. As these boomers begin to retire, they will place an ever-increasing strain on the fiscal operation of government through social security outflows.

"When the future surprises, history tells us, it often surprises us all," Mr. Greenspan said. "We must, as a consequence, remain alert to risks that could threaten the sustainability of the expansion."

Unlike many officials in the Bush administration, Mr. Greenspan warned that the projected deficits over the next decade could not only lead to higher interest rates, it could also increase the U.S. indebtedness to the rest of the world. Greenspan warned of the connection between the budget deficit and the nation's overall global indebtedness. Deficits must be financed and part of that financing comes from overseas from foreign investors.

"To date, the U.S. current-account deficit has been financed with little difficulty," Mr. Greenspan said. "Nonetheless, 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.".

(Updated April, 2004)