Speech

For release on delivery l pm EDT July 15, 1994 Testimony by Alan Greenspan Chairman Board of Governors of the Federal Reserve System before the Bipartisan Commission on Entitlement and Tax Reform Washington, D C July 15, 1994 The U S economy has recently been experiencing the ideal combination of rising activity, falling unemployment, and slowing inflation But we cannot let this good behavior lull us into neglecting the underlying problems of our economy that may prevent it from reaching its fullest potential over the longer run One of the most important of these problems is the prospect for federal budget deficits to begin rising once again as we move into the next century The effects of these deficits may not be obvious to every observer, but they are there, they are serious, and they will get worse the longer we take to address them Since we veered away in the early 1960s from the allegedly simplistic notion that budget balance should be the hallmark of sound fiscal policy, we have been struggling with deficits that have no precedent in our peacetime history The large structural federal budget deficits that have emerged in recent decades seem to persist despite considerable efforts to reduce them Some of these recent efforts by the executive and legislative branches, especially the imposition of spending caps, in fact have been helpful and have lowered the trajectory of deficit growth But much remains to be done. The deep reduction in defense spending will come to an end later in this decade At that point the underlying trend of civilian spending, mainly entitlements, will emerge as the dominant budget force On the basis of current law and policy, entitlements are programmed to grow at a rate that will surely exceed growth of the tax base, threatening a destabilizing escalation of deficits as a percent of nominal GDP Increasing the tax base or tax rates cannot solve this problem, for it would take enormous increases to fund the rising -2- outlays, and even such increases would only postpone the inevitable, because tax revenue growth cannot indefinitely exceed the growth in income Moreover, the disincentive effects of rising tax rates would eventually choke off economic growth and reduce the tax base Therefore, there is no alternative to scaling back growth in federal spending if we are to avoid growing deficits as we move into the next century Those deficits would cause financial stress and instability that would create great hardship Deficits are damaging because they pull resources away from private investment, reducing the rate of growth of the nation's capital stock This in turn means less capital per worker than would otherwise be the case and engenders, over the long run, a slower growth in labor productivity and, with it, a slower growth in our standard of living To some degree, the effects of federal budget deficits over the past decade or so have been muted by two circumstances that are unlikely to persist in the future First, to the extent that these budget deficits could not be financed from our meager level of savings, we imported savings from abroad But, it has become increasingly clear that reliance on foreign sources of savings is not desirable--or perhaps even possible--over extended periods As these sources are reduced, other sources must be found, or demands on domestic savings must be curtailed Second, we may be undergoing a once-in-a-generation improvement in the way we use our scarce domestic savings As I have outlined elsewhere, the extraordinary advances in computer software and hardware appear to be enabling us to employ our resources, both capital and labor, more efficiently This development may be imparting a decided uptilt to the growth of -3- labor productivity, obscuring, at least, for a while, the effect of the shortfall in capital investment on the growth of our standard of living Of course, government should pursue opportunities to encourage the private sector to sustain this faster pace of productivity improvement It can remove impediments to prudent risk taking, reverse inappropriate regulation that undermines investment incentives, seek to lower international trade barriers to foster growth in global income, and improve the functioning of our labor markets. These initiatives will mean higher standards of living at any given level of the structural budget deficit But these measures will not substitute for a direct approach to resolving the underlying deficit problem This problem has become too severe to grow our way out of it. As our population continues to age over the coming decades, entitlements will become an increasing share of our budget outlays and of our national income Taken separately, these programs have wide support among the American people But, in total, they are far more costly than people recognize If we continue to borrow to pay for them, the resultant high real interest rates will curtail the growth in living standards The process by which government deficits divert resources from private investment is only one of the many ways that the activities of the federal government inevitably preempt or redirect the usage of private sector resources Apart from deficit spending, on- or off-budget, the most important ways the government can reallocate resources are tax-financed spending, regulation mandating private activities, such as pollution control or safety equipment installation, that are financed by industry through the -4- lssuance of debt instruments, and government guarantees of private borrowing. When the government finances its activities with taxes, the capacity of individuals and businesses to spend is directly reduced, thereby diverting resources from private purchases The other financing methods divert resources in a more indirect manner, and operate mainly through their effects on interest rates When the federal government finances its budget deficit, for example, it increases the demands for scarce savings, thereby pushing up interest rates Similarly, the demand for credit increases and interest rates rise when a business needs to borrow in order to finance a government-mandated activity, or when the government reduces the costs of borrowing to certain investors by guaranteeing their loans Government and government-mandated spending is insensitive to these higher interest rates Purely private activities, on the other hand, are, to a greater or lesser extent, responsive to interest rates The demand for housing, for example, falls off as mortgage interest rates rise Inventory demand is a function of short-term interest rates, and the level of interest rates, as they are reflected in the cost of capital, is a key element in the decision on whether to expand or modernize productive capacity Thus, to the extent that there are more resources demanded in an economy than are available to be financed, interest rates will rise until sufficient excess demand is finally crowded out The crowded out demand will not, of course, be that of the federal government, directly or indirectly, because government demand does not respond to rising interest rates Rather, real interest rates will rise to the point that purely private borrowing is reduced sufficiently to allow the -5- entire requirements of the federal on- and off-budget deficit, and all its collateral guarantees and mandated activities, to be met How much rates must rise to bring the demand and supply for savings into balance depends on how responsive the demand of private borrowers is to those rates Whatever the responsiveness of private demand, rates must rise enough to crowd out a sufficient amount of private sector investment There is no alternative to a diversion of real resources from the private to the public sector In the short run, interest rates can be held down if the Federal Reserve accommodates the excess demand for funds through a more expansionary monetary policy But this will only foster greater inflation and economic instability; ultimately, it will have little if any effect on the allocation of real resources between the private and public sectors. Let me conclude by emphasizing that time is no longer on our side Any presumption that the deficit is benign is clearly false This is especially the case with so low a private saving rate Under current law, the deficit will begin to climb again by the end of the decade Moreover, demographic trends imply an inexorable upward path for government expenditures as the next century unfolds Allowing this to happen courts a marked sapping of our economy's vitality The longer we wait, the more draconian the remedies will have to be We must particularly eschew moving our programs off-budget This is mere bookkeeping There is no way around the need to deal with the allocation of real resources, and we must address that fact head-on I recognize that it is difficult to deal with a problem whose symptoms are hard to detect and whose full-blown effects seem to be years or decades away But financial markets -6- have a way of bringing future problems into the present Long-term interest rates are higher now because markets are anticipating rising deficits in the next century Those higher long-term rates reflect both a greater inflation premium and an expectation of higher real short-term rates in the future as government spending increasingly crowds out private spending As I noted earlier, higher interest rates hinder capital formation and leave future generations poorer We are already paying for our failure to come fully to grips with our long-term budget problem Further delay will only raise the total size of the bill that will eventually come due

Alan Greenspan (1994, July 14). Speech. Speeches, Federal Reserve. https://whenthefedspeaks.com/doc/speech_19940715_greenspan

@misc{wtfs_speech_19940715_greenspan,
  author = {Alan Greenspan},
  title = {Speech},
  year = {1994},
  month = {Jul},
  howpublished = {Speeches, Federal Reserve},
  url = {https://whenthefedspeaks.com/doc/speech_19940715_greenspan},
  note = {Retrieved via When the Fed Speaks corpus}
}