Fed Chairman Bernanke Warns Budget Deficit Could Hurt Economy

Federal Reserve Chairman Ben Bernanke warned the U.S. Congress that failure to take action soon to deal with the budgetary strains posed by an aging U.S. population could lead to serious economic harm.

"Unfortunately, economic growth alone is unlikely to solve the nation's impending fiscal problems," Bernanke told the Senate Budget Committee. The comments were the Fed Chairman's most extensive on the challenges facing the United States with the looming retirement of 78 million baby boomers, the oldest of whom will start retiring next year.

'Calm Before The Storm'

Bernanke acknowledged that official projections suggest the U.S. budget deficit could stabilize or shrink in the next few years, but cautioned: "We are experiencing what seems likely to
be the calm before the storm."

Left unchecked, the costs of so-called entitlement programs, such as Social Security and Medicare, are set to soar as increasing numbers of the baby boom generation retire.

"Dealing with the resulting fiscal strains will pose difficult choices for the Congress, the administration, and the American people," Bernanke said.

"However, if early and meaningful action is not taken, the U.S. economy could be seriously weakened, with future generations bearing much of the cost," he added.

Bernanke cited projections by the Congressional Budget Office that showed spending on entitlement program would reach about 15% of U.S. gross domestic product by 2030.

He said a worrisome implication of such projections would be the much larger national debt and related higher payments to bondholders.

'A Vicious Cycle'

"Thus, a vicious cycle may develop in which large deficits lead to rapid growth in debt and interest payments, which in turn adds to subsequent deficits," Bernanke said.

The Fed chief said that whatever decisions were taken to prepare for the budgetary pressures presented by an aging population, tax rates would need to achieve a balance between spending needs and necessary revenues.

Bernanke said advocates of lower taxes would have to accept lower spending on entitlement programs. Likewise, proponents of more-expansive government programs must recognize the need for higher taxes brought about by higher spending, he added.

The budget deficit last year totaled $248 billion, a four-year low. But forecasts call for the deficit to worsen for the 2007 budget year. The Congressional Budget Office is projecting $286 billion in red ink, while the White House is predicting an even bigger shortfall of $339 billion.

President Bush now wants to work with Congress to balance the budget by 2012. He'll be out of office by then.

A Number Of Social Security Fixes Available

The U.S. government has several options to fix underfunding of Social Security, including alternative ways of indexing the retirement system to inflation, Bernanke said, in response to a question from a member of the committee.

"There are both revenue-raising measures and ways to cut spending," Bernanke said.

He also said the retirement age could be raised as one of several ways to curb benefits paid out.

However, Bernanke did not endorse any specific proposals to narrow the entitlement gap, nor did he make any recommendations on taxes and spending.

Tax Cuts Don't Always Pay For Themselves

Speaking in general terms, Bernanke said tax reductions usually don't pay for themselves. The economic impact of tax cuts often depends on the nature of the tax cut, he said, in response to a question.

"The general view is tax cuts don't pay for themselves," he said. He added, the issue is whether the balance of taxes and spending is right for the economy.

When asked about the regulation of the hedge fund industry, Bernanke said the market discipline approach has worked well to date, but it is "always worth reviewing."

Income Inequality Growing

In addition, Bernanke said, U.S. households and governments are investing more than they are saving, leading them to borrow from foreign investors.

"The fundamental source of our trade imbalance is that we as a country are saving much less than we are investing and therefore we have to borrow the difference abroad, whereas
other countries are saving more than they are investing and therefore they are lending to us and that is the essence of the imbalance we have," he said.

U.S. income inequality is growing and greater than many other major countries, with the exception of Brazil, Bernanke said.

"The degree of (income) inequality has been rising ... It's certainly an issue. I would reiterate it's a very long-term trend," he said.

According to Bernanke, there are some strategies that can be used to encourage people to save more.