February 11, 2004

Alan Greenspan on the Budget Deficit

Alan Greenspan calls for help to deal with the budget deficit and bring sanity to America's fiscal policy. He wants someone to put a choke chain on the our current rulers: "...As I have noted before, the debate over budget priorities appears to be between those advocating additional tax cuts and those advocating increased spending..." And he warns the congressmen that even though the budget deficit is a problem for the long run, in economics the role played by financial markets means that the long run can arrive with terrifying speed.

Where are all the grownup Republicans?

WSJ.com - Text of Greenspan's Testimony: ...The outlook for the federal budget deficit is another critical issue for policymakers in assessing our intermediate- and long-run growth prospects and the risks to those prospects. As you are well aware, after a brief period of unified budget surpluses around the beginning of this decade, the federal budget has reverted to deficits. The unified deficit swelled to $375 billion in fiscal 2003 and appears to be widening considerably further in the current fiscal year. In part, these deficits are a result of the economic downturn and the period of slower growth that we recently experienced, as well as the earlier decline in equity prices. The deficits also reflect fiscal actions specifically intended to provide stimulus to the economy, a significant step-up in spending for national security, and a tendency toward diminished restraint on discretionary spending. Of course, as economic activity continues to expand, tax revenues should strengthen and the deficit will tend to narrow, all else being equal. But even budget projections that attempt to take such business-cycle influences into account, such as those from the Congressional Budget Office and the Office of Management and Budget, indicate that very sizable deficits are in prospect in the years to come.

As I have noted before, the debate over budget priorities appears to be between those advocating additional tax cuts and those advocating increased spending. Although some stirrings in recent weeks in the Congress and elsewhere have been directed at actions that would lower forthcoming deficits, to date no effective constituency has offered programs to balance the budget. One critical element--present in the 1990s but now absent--is a framework of procedural rules to help fiscal policy makers make the difficult decisions that are required to forge a better fiscal balance.

The imbalance in the federal budgetary situation, unless addressed soon, will pose serious longer-term fiscal difficulties. Our demographics--especially the retirement of the baby-boom generation beginning in just a few years--mean that the ratio of workers to retirees will fall substantially. Without corrective action, this development will put substantial pressure on our ability in coming years to provide even minimal government services while maintaining entitlement benefits at their current level, without debilitating increases in tax rates. The longer we wait before addressing these imbalances, the more wrenching the fiscal adjustment ultimately will be.

The fiscal issues that we face pose long-term challenges, but federal budget deficits could cause difficulties even in the relatively near term. Long-term interest rates reflect not only the balance between the current demand for, and current supply of, credit, they also incorporate markets' expectations of those balances in the future. As a consequence, should investors become significantly more doubtful that the Congress will take the necessary fiscal measures, an appreciable backup in long-term interest rates is possible as prospects for outsized federal demands on national saving become more apparent. Such a development could constrain investment and other interest-sensitive spending and thus undermine the private capital formation that is a key element in our economy's growth prospects.

Addressing the federal budget deficit is even more important in view of the widening U.S. current account deficit. In 2003, the current account deficit reached $550 billion--about 5 percent of nominal GDP. The current account deficit and the federal budget deficit are related because the large federal dissaving represented by the budget deficit, together with relatively low rates of U.S. private saving, implies a need to attract saving from abroad to finance domestic private investment spending.

To date, the U.S. current account deficit has been financed with little difficulty. Although the foreign exchange value of the dollar has fallen over the past year, the decline generally has been gradual, and no material adverse side effects have been visible in U.S. capital markets. While demands for dollar-denominated assets by foreign private investors are off their record pace of mid-2003, such investors evidently continue to perceive the United States as an excellent place to invest, no doubt owing, in large part, to our vibrant market system and our economy's very strong productivity performance. Moreover, some governments have accumulated large amounts of dollar-denominated debt as a byproduct of resisting upward exchange rate adjustment.

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. Taking steps to increase our national saving through fiscal action to lower federal budget deficits would help diminish the risks that a further reduction in the rate of purchase of dollar assets by foreign investors could severely crimp the business investment that is crucial for our long-term growth...

Posted by DeLong at February 11, 2004 10:04 AM | TrackBack | | Other weblogs commenting on this post

Where the hell was Greenspan these past three years ? Sorry Brad, that guy prostituted himself so much for the insane policy of Bush that he his forever stained.

Posted by: ch2 on February 11, 2004 10:37 AM


Stan Collender provides an excellent critique of the Bush new Paygo proposal.


"The White House wants to reimpose the pay-as-you-go rules, but only for new mandatory spending. New tax reductions that do the same thing would not have to be offset with other revenue increases or outlay reductions.

In other words, a provision that created a new entitlement program for farmers who grow, say, kiwis, would be subject to Paygo. The kiwi subsidy would require a spending cut or revenue increase to compensate for the impact on the budget, and would likely have a lower chance of being adopted as a result. Yet a tax provision with the same impact on the bottom line that provided a similar incentive to kiwi growers would not have to be offset, and would therefore have far fewer political problems getting adopted.

That's the equivalent of a business deciding that an increase in marketing expenses would hurt the bottom line but that a reduction in price would not. Only one of the two options would appear to have a cost. That would always make a price cut the much more likely choice even though the marketing initiative might actually result in better sales growth and financial results.

So the Bush Paygo proposal would impose a cost on new federal spending initiatives but none on a revenue provision designed to do the same thing. That wouldn't change the likelihood that the government would get involved, only that everyone would come to Washington looking for a new tax expenditure rather than a new spending program. The impact on the number of kiwis available to consumers might be the same and the effect on the deficit might be equal, but the budget process would look favorably on one and not on the other."

Posted by: bakho on February 11, 2004 10:47 AM


Exactly. Greenspan was a key enabler of the fiscal trainwreck that is Bush Administration fiscal policy.

Posted by: section321 on February 11, 2004 10:48 AM


Note that the only mention by AG of revenue is passive tense.

"as economic activity continues to expand, tax revenues should strengthen"

He could have said "as more and more tax cuts phase in, revenues will plummet."

Where is the active voice "You must increase revenues if you want ot address the deficit!" ??

Posted by: bakho on February 11, 2004 10:54 AM


Explain to me why the 10 year treasury is at 4.00% right now. If the deficit is such a problem for Alan Greenspan, why are bond traders not the least worried? What am I missing?

Posted by: anne on February 11, 2004 10:57 AM


Michael Lewis quietly slipped by an intriguing Bloomberg article on the subject of Fed Chair Greenspan.

In the piece, titled "Did Greenspan Use O'Neill to Send Bush a Signal?," Lewis suggests that Federal Reserve Chairman Alan Greenspan was a willing accomplice in former Treasury Secretary Paul O'Neill's White House tell all/hatchet job via Ronald Suskind's The Price of Loyalty:

"The character in this drama with interesting motives isn't O'Neill but his more shadowy friend, Alan Greenspan. It's evident that Greenspan helped with the book; his fingerprints are all over the thing.

Why would the Fed chairman grant an interview, even off the record, to a journalist he knew to be armed and dangerous to the Bush White House? Surely, not out of a sense of loyalty to his old friend Paul O'Neill. If Greenspan had that gene, he wouldn't have lasted as long as he has."
Absolutely brilliant take on this issue; Frankly, I cannot claim I would have been able to tell if "Greenspan's fingerprints were all over" the book if I had forensically dissected the book. However, having read nearly everything else Lewis has written, I am more than willing to give him the benefit of the doubt (He's very good).

When you listen to SIr Alan's testimony, pay attention to what not-so-hidden message he may be sending to the President . . .

Posted by: Barry Ritholtz on February 11, 2004 10:58 AM


Remind me. Wasn't Alan Greenspan the person who was warning us in 2001 that the dread budget surplus was about to gobble up Cleveland. Slice taxes before the budget surplus attacks. Whooooo! Now, the defict is the problem? Or is this the call to start slicing up Social Security and Medicare? Surely Alan Greenspan is not asking for a tax increase. Duh.

Posted by: anne on February 11, 2004 11:03 AM


I also wonder why bonds are at 4% -- my model says they should be at 5%.

A big part of it is demand from China and japan
to support their exports.

But if you want to believe the bond market is a rational animal that is discounting what we as individuals do not know, the most obvious answer is that the bond market is discounting hard times
and deflation.

Posted by: spencer on February 11, 2004 11:18 AM



Interest rates are a puzzle. Can the low rates simply be attributed to China and India and the Asian tigers? Japan? A Japanese trader would have little reason to hold American debt and would convert to another investment or Yen. So, is this all Japanese bank support for American debt? Not convincing enough.

The worry is that for all the Federal Reserve enthusiasm there is considerable worry about the labor market and no sense there will soon be more price leverage in the American economy.

Posted by: anne on February 11, 2004 11:27 AM



With 10-year Treasuries at 4.03% or so, there is a roughly 3% pick-up from borrowing overnight (1% Fed funds rate) to lend at 10 years. Three percent a pretty tidy margin, as long as Greenspan continues to calm fears that the trade may turn sour by signaling steady Fed funds rates. From the Japenese investor's point of view, the spread at 10 years is about 2.75%. If a Japanese investor borrows at overnight rates to lend a 10 years in the US, the pick-up in 4%, far higher than anything available on the JGB curve.

Greenspan argued today that, since foreign central banks invest intervention funds largely in shorter-dated Treasuries, there is little risk to US rates from foreign banks cutting back on Treasury purchases - short end rates are anchored by the Fed funds rate. What he neglected to mention was that overseas investors are buying more than the net new cash raised at meny Treasury auctions. That is to say, they are sucking Treasury debt out of US portfolios. That is happening more at the short end than the long end (he has that right), but that means domestic investors are then left with cash which has to go elsewhere. One choice is the long end of the curve. This would seem to imply a somewhat greater risk of interest rate volatility in response to a stop in fx intervention than Greenspan was willing to admit.

Posted by: K Harris on February 11, 2004 12:47 PM


If the bond market is discounting for deflation, and the bet is wrong, is it reasonable to assume that a significant run up in rates is in the cards relatively soon?

On another note: do you think that OPEC's announcement to cut production yesterday is an attempt to offset the weak value of the dollar?

Posted by: tony daniel on February 11, 2004 12:51 PM


"Meny"? I prbblbly ment "many".

Posted by: K Harris on February 11, 2004 12:54 PM


"Alan Greenspan calls for help to deal with the budget deficit and bring sanity to America's fiscal policy"
Paul Krugman, who else?

Posted by: Pippo on February 11, 2004 12:58 PM


Yield curve 300 point spread from funds to 10 year is about normal for this stage of economy.

This implies that it is very low fed funds that are keeping bond yields low -- funds are about 200 points below what a Taylor rule analysis would suggest. Harris comments would support this line of thinking. It is same with quality spreads.
Private investors are going long and into lower quality because short term rates providing too low a return. As long as private investors do not fear being caught by Fed tightening causing a capital loss they are willing to go out maturity and quality curves. What happened when Fed changed wording in press release also supports this line of thinking. At first, investors fear of fed tightening drove up bond yields. But as time passed they realized that wording change
did not really imply change in Fed willinness to raise rates, so bonds rallied.

Second point, foreign central Banks are not driven by profit maximization strategy. so the fact that they are not losing money is largely besides the point. For Japan & China central banks primary motive is supporting govt policy of
pegging their currencies .

Posted by: spencer on February 11, 2004 01:02 PM


Empiricism and theory: Bonds and the Asian market.

(Somewhat a response to Anne)

A good deal or not, the yield on T Bonds is so low because the demand is high. The demand is partly artificial, it is a result of the China and Japanese central banks trying to keep their goods more affordable to Americans. Japan has allowed a little float in currency. The Chinese none at all (see this weeks Economist section on the Euro and the dollar).

They can't do this forever. When the demand for American debt starts to decline we will see an increase in long term interest rates. Unless we see a rise in inflation this will be bad news for American homeowners.

I think AG *is* calling for a tax increase. I don't think he wants to close the entire fiscal gap this way, but he is aware that we can't do it by cutting spending unless we start touching entitlements. And a deficit caused by tax cuts is merely a way to put off those taxes to the future... unless the long term growth rate does something wildly unexpected.

Now here's a question: is China in a position to trigger a financial crisis, or even speculation about a financial crisis, by selling off bonds?

Posted by: Iain on February 11, 2004 01:14 PM


I am starting to suspect econ may be significantly weaker than we think.
jan auto sales of 16.1 is down 9% from Dec
sales level and below 3rd & 4th Q averages.
Just saw a sharp drop in info tech orders
over last couple of months -- concentrated in
commo equip but computers & components(semis)
orders also flattened out.
Still seeing very weak employment & income data--
4th quarter trade improvement seemed funny --
stemmed from sharp drop in oil imports and
big aircraft shipments -- neither would be caused
by dollar weakness. both seem to be one time events.

At wholesale level (PPI) seeing sharp run up in prices The core ppi at crude level is rising at rates not seen since 1970s. At intermediate and final products level pricing has bottomed and is strating to accelerate. In line with cap use data where basic cap use at 84.6, intermediate at 77.7% and final products at 71.8%. this is either creating margin pressures at final end and/or will start to show up in CPI in the 1st quarter -- probably some of both. Oil at over $30 has to have a negative impact on econ-- my heating bill much big than last year.

Posted by: spencer on February 11, 2004 01:17 PM


K Harris - Spencer
Thank You!

Got it got it got it. Of course, look at the contribution of GE Capital to overall earnings at GE. I have known this, but forgot how powerful the effect can be till the rates begin to rise seriously. By November 1993, there was no question the Federal Reserve would soon raise the funds rate, but there were large long term derivative positions held to the end in February 1994. The losses on long term debt were needlessly high. Remember, the funds rate was 3% in November 1993. Now, the funds rate is 1%.

Posted by: anne on February 11, 2004 01:22 PM


"Is China in a position to trigger a financial crisis, or even speculation about a financial crisis, by selling off bonds?"

K Harris and Spencer have really answered the question. There is simply no reason for China or Japan or India to sell American debt. However, we have to consider how much long term debt might be sold by American institutions when rates finally begin to rise.

Posted by: anne on February 11, 2004 01:30 PM


I think the economy is actually going pretty well and might actually improve. I'm starting to hear some anecdotal evidence from various source about a pickup in the job market.
But, I can not say I understand what is going on in the economy, and I'm pretty sure no one else does either. It's going to take years, several of them, before we have an idea of what's happening now.
That being said, I continue to be bullish on the U.S. economy and markets but would not have any of my money in fixed income right now.

Posted by: William on February 11, 2004 01:43 PM


Materials pricing pressure, such as it is, is being offset by stable labor costs. There does not seem to be reason to expect meaningful general price pressure for consumers.

Posted by: anne on February 11, 2004 01:49 PM


I was a fed watcher before Greenspan when they did not tell what they were going to do.

This financial market impact of knowing Fed
policy and avoiding suprises is the big change under Greenspan. He gives financial market time to unwind positions before he tightens. I do not know how much of this stems from crash of 1987 that happened right after he took office and the first time he tried to raise rates. but it had to scare the pants off of him and probably a major reason he now telegraphs his moves.

Anne -- what i am afraid of is that although China will continue to run large surplus with US, its overall trade balance is going into deficit
sometime this year. China may start selling treasuries at that point to finance its imports from rest of world.

Posted by: spencer on February 11, 2004 01:54 PM


F- it. The stock market and the bond markets are all republicans now- and they believe the Cheney bullsh*t that deficits *don't* matter! (Of course the gold market is looking mighty inflationay now, isn't it?)
Down the slippery slope we slide- how long will AG blow bubbles....in his tub instead of enjoy his retirement. Moral of the story- don't stay to long at the party, somebody has to clean up.
Of course if I were him, I would let Banzai Ben drop the helicopters of cash on the public- shoot the advance straight into my account, please.

Posted by: Allen M on February 11, 2004 02:03 PM


Just remembered. China is going to increasingly use dollar debt to stregthen the balance sheets of its large banks. The huge private saving pool should hopefully be enough to finance continued investment and imports as long as the banking system is sound. Interesting.

Posted by: anne on February 11, 2004 02:10 PM


Two add-on points to the discussion of why aren't 10-year bonds yielding higher now.

First, there was an interesting article in Sunday's NY Times about how much the bond market is yawning at the deficit, which contained this striking quote:

"Under Reagan in the 80's, I remember headlines day after day saying we were leveraging our children's future," said Lundy R. Wright, a managing director and top bond trader at Morgan Stanley. "But in good times, we got back to surpluses. I think the lesson is, you can borrow when times aren't so good and cyclical factors will help get you out of it."


In short, a Morgan Stanley MANAGING DIRECTOR thinks that the deficit problem took care of itself, so why worry? (I am reminded of Bill Simon's low opinion of the intelligence of bond traders.)

Second point: Prof DeLong has done some back of the envelopes about the cost to Japan and China to continue to subsidize exports by buying US government paper. It isn't sustainable indefinitely, although when the market decides that it isn't sustainable requires a Morgan Stanley managing director to figure out....

Posted by: howard on February 11, 2004 02:36 PM



I agree completely regarding the trade deficit. Higher oil prices and a give-back from higher aircraft shipments in Q4 mean the trade deficit will be a sizable negative for GDP in Q1. We will, however, get some tenths of a GDP point in both Q1 and Q2 from tax refunds and lower payments to cover that problem. That’s no great comfort from a current account standpoint, but it will mean a smoother showing from GDP. GDP in Q3 is another matter.

The issue of whether (how long) China and Japan need to keep intervening will be at least partly determined by the Fed. When the Fed does begin hiking rates, yields on dollar-denominated debt will become more attractive, so the dollar should require less official help to stay afloat. That works out pretty neatly on paper, but it remains to be seen whether the transition is smooth in reality. True that central banks are not profit maximizers. They ought to be domestic welfare maximizers. However, the BoJ does have capital preservation concerns. That can be seen in the stop-gap deal between the Finance Ministry and BoJ in which the Finance Ministry loaned yen (I think) to the BoJ to buy dollars, with an implicit imbedded option: the BoJ could not lose on the dollar position it acquired with the lent yen.


I agree that domestic banks’ curve trades are a worry. It is beyond me whether domestic or foreign holders of US debt are a bigger worry. The perpetual concern over foreign holders might contain just a whiff of jingoism, though less so as foreign holdings approach double the level of 10 years ago.

Posted by: K Harris on February 11, 2004 03:20 PM


Allen M wrote, "The stock market and the bond markets are all republicans now- and they believe the Cheney bullsh*t that deficits *don't* matter!"

I don't understand this either. I've moved most of my fixed-income investments to short term.

howard wrote, "'But in good times, we got back to surpluses. I think the lesson is, you can borrow when times aren't so good and cyclical factors will help get you out of it.'"

That guy's definitely a moron. If he knew anything about the Bush tax cuts, he'd know that they're designed to induce structural deficits, not just cyclical ones.

Does anyone know if the spread between Treasuries and high-rated corporates is still extremely high?

Posted by: liberal on February 11, 2004 03:55 PM


bakho---thanks for posting Collender's point.

I'm no budget guru, but my impression is that if the Republicans were serious about the deficit, they'd resurrect the 1990 Budget Enforcement Act, which combined PAYGO with constraints on discretionary spending (and was apparently much more effective than Gramm-Rudman-Hollings).

Posted by: liberal on February 11, 2004 04:11 PM


liberal, i'm not clear if you read me correctly.

I was quoting a moron (hence my remark about bill simon's opinion of the intelligence of bond traders); i don't agree for a second with that perspective. I just don't understand how someone who thinks that way became a managing director at Morgan Stanley....

Posted by: howard on February 11, 2004 04:52 PM


You don't get promoted at Morgan Stanley, or any of the others, by being bearish on your product. No matter what your product is.

Posted by: Sparks on February 11, 2004 09:12 PM


When the Fed does begin hiking rates, yields on dollar-denominated debt will become more attractive, so the dollar should require less official help to stay afloat. That works out pretty neatly on paper, but it remains to be seen whether the transition is smooth in reality.

It's never been smooth -- not in my 20+ years of watching the markets anyway. Given the recent flows into the emerging markets, it's pretty easy to predict what will happen there. The interesting question, I think, is whether the financial backwash will flow back into dollar/Treasuries, as it did in '97-98, or into eurodebt. I would guess it would still be the former (old habits die hard) but there are a lot of imponderables. How much credibilty does the dollar have left?

Either way, though, I'm guessing the uproar in the U.S. bond market is likely to be even more pyrotechnic -- given how much the mortgage hedging tail now wags the Treasury dog.

Posted by: Billmon on February 11, 2004 09:22 PM


howard wrote, "liberal, i'm not clear if you read me correctly."

Sorry---my quoting wasn't obvious enough. If you look closely, it's supposed to be
" '...' "

For whatever reason, the font used here in the comments section doesn't distinguish single from double quotes, so my too-clever quoting scheme came up as *triple* quotes, which you reasonably took as double quotes.

Posted by: liberal on February 12, 2004 01:57 AM


Some things cannot be taught, only discovered.

Posted by: Lowry John on May 3, 2004 10:28 AM


You are free and that is why you are lost.

Posted by: Baty Janna on June 30, 2004 11:21 AM


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