Statement 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 percentage of nominal gross domestic product.
Increasing the tax base or tax rates cannot solve this problem, for it would take enormous increases to fund the rising outlays, and even such increases would only postpone the inevitable because growth in tax revenue 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 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, the government should pursue opportunities to encourage the private sector to sustain this faster pace of improvement in productivity. 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. …