Greenspan downbeat on US economy

Alan Greenspan yesterday painted a cheerless picture of a US economy part-paralysed by the threat of war against Iraq. He also delivered his clearest warning yet to the Bush administration not to let the soaring federal budget deficit get out of hand.

In the longer term, the Federal Reserve chairman declared that US economic outlook was promising, and new central bank forecasts yesterday predicted real growth of between 3.25 and 3.5 per cent in 2003, up from last year's 2.8 per cent.

But in a keenly awaited testimony to the Senate Banking Committee, he said that "heightened geopolitical tensions" – Fed-speak for the crisis over Iraq – were only adding to three years of uncertainties since the stock market peaked in early 2000, and recession hit the economy. The prospect of war, he said, posed "formidable barriers" to new business investment, and thus to a return to healthy growth.

Mr Greenspan, whose endorsement of George Bush's initial 2001 $1,300bn tax cut plan helped ensure its passage through Congress, avoided judgement on last month's $674bn package, which faces an uphill fight on Capitol Hill.

Though he endorsed its central feature, the abolition of dividend taxes, he said he was not convinced that further stimulus was required – at least until the Iraq crisis was past. He did not rule out yet more interest rate cuts if the economy does not pick up after that.

But by his own opaque standards, he was clear on one thing: the danger posed by the soaring federal deficit – a record $307bn for the current year, compared with a surplus of $290bn in the final year of the Clinton administration.

It was essential, he warned, that the level of federal debt as a percentage of the US economy did not rise. "It is crucial that we have a budget policy which does not destabilize the economy," Mr Greenspan said. "A necessary condition is that the level of debt to GDP not be rising."

"Modest small deficits" of about 1 to 2 per cent of GDP were unlikely to harm the economy. But he warned that if debt were rising, interest payments would rise as well, building debt upon debt. "There is an accelerating pattern after you reach a certain point of no return," he said. This year's $307bn shortfall is equivalent to about 3 per cent of GDP.

Hours before Mr Greenspan spoke, 400 prominent US economists, including 10 Nobel prize winners, took out a whole page advertisement in The New York Times, warning that the latest tax cut proposals were "the wrong approach", which would worsen the long-term budget outlook, adding to the country's "chronic projected deficits".

Mr Greenspan did not disagree with this thesis. Future fiscal policy should be neutral, he said, and prudent management "requires we do not drain the savings pool available to the private sector," he told one Senator. He also had ominous words about the need to reduce the soaring current deficit, financed by capital inflows from abroad to the tune of $2bn a day.

"It cannot go on," he said. The Fed chairman hoped for a gradual and gentle adjustment. "But there are other scenarios in which there are disruptions."

How adjustment will occur was unclear – "that it will occur is inevitable".

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