Concerns about long-term health of US economy

Creeping trade protectionism and bloated budget deficits pose a risk to the US’ long-term economic vitality, Federal Reserve Chairman Alan Greenspan warned today.

Creeping trade protectionism and bloated budget deficits pose a risk to the US’ long-term economic vitality, Federal Reserve Chairman Alan Greenspan warned today.

“Developing protectionism regarding trade and our reluctance to place fiscal policy on a more sustainable path are threatening what may well be our most valued policy asset: the increased flexibility of our economy, which has fostered our extraordinary resilience to shocks,” the Fed chief said in a speech to an economic conference here, sponsored by the Federal Reserve Bank of Kansas City.

Maintaining economic flexibility is especially important, Greenspan said, to deal with what he called some of America’s current economic imbalances: the swollen current account trade deficit, which surged to a record £370billion last year, and the housing boom.

Greenspan also worried in his speech about what will occur with the ending of the recent sustained period of low interest rates and low risks for investors. “History has not dealt kindly with the aftermath of protracted periods of low risk premiums,” he said in his prepared remarks.

Rising stock and home prices have made households feel more wealthy and has helped to support consumer spending, a key ingredient of the economy’s good health. But Greenspan seemed to caution that people shouldn’t count on that paper wealth, which can evaporate if economic conditions deteriorate rapidly.

“What they perceive as newly abundant liquidity can readily disappear,” he said. “Whether the currently elevated level of wealth-to-income ratio will be sustained in the longer run remains to be seen.”

Low interest rates have powered the booming housing market. Home sales have hit record highs four years in a row and house prices are surging. In previous speeches, Greenspan has warned of “froth” and “speculative fervour” gripping some local housing markets.

If house prices were to suddenly fall or if interest rates were to rise rapidly, some local housing markets, homeowners and lenders could get hurt.

“Greenspan is giving individuals ample warning that they need to take that into account,” Allen Sinai, chief global economist at Decision Economics, said in an interview.

He and others believe Greenspan was strengthening his warning about the booming housing market. But they didn’t believe he was signalling a new concern about the development of a national housing price bubble. Instead, they said, he seemed to be stressing his oft-stated worries about bubbles in local housing markets.

Stock prices and house prices are factors that Fed policy-makers are increasingly needing to consider when setting interest-rate policy. “Our forecasts and, hence policy, are becoming increasingly driven by asset price changes,” Greenspan said.

During the high-flying stock market days of the 1990s, the Fed chief in December 1996 famously questioned whether Wall Street investors were engaging in “irrational exuberance.” Despite the warning, stocks continued to soar. In 2000, the stock market bubble began to burst and wiped out trillions of dollars in paper wealth.

Greenspan said that “fear of change” is behind stalled international trade negotiations and the hesitancy of Congress and the White House to “face up to the difficult choices that will be required to resolve our looming fiscal problems.”

In the past, Greenspan has urgently called on policy-makers to shore up Social Security, saying a big wave of baby boomers starting to retire in 2008 will put massive strains on the system and if not fixed can imperil the overall economy as well.

On other issues, Greenspan said the economy thus far seems to be weathering reasonably well the run-up in energy prices over the last two years.

Greenspan’s speech was to a conference titled “The Greenspan Era: Lessons for the Future.”

The Fed chief, who has steered the world’s largest economy through both smooth and choppy economic waters for 18 years, plans to step down in just five months.

Greenspan’s appearance at the annual Fed conference, which is attended by other Fed policy-makers, economists, academics and central bank officials from around the world, is expected to be his last as Fed chairman.

Looking back over his tenure, Greenspan said that a key hallmark of his approach to monetary policy-making has been preparing for a wide spectrum of economic outcomes: from the most likely to the most unlikely.

The Fed’s worry in the summer of 2003 about the remote threat of deflation – a widespread decline in prices that can severely harm the economy – prompted the Fed to keep cutting short-term interest rates, Greenspan noted.

“Given the potentially severe consequences of deflation, the expected benefits of the unusual policy action were judged to outweigh its expected costs,” he said.

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