It is essential that we come to grips with structural budget deficits but not because such deficits will cause inflation. It’s because large, sustained structural deficits vacuum up savings that could be put to more productive uses. Once the economy is back on track these deficits will make capital more expensive for private borrowers, crowding out the investments that are essential to boost productivity and fuel growth in real wages and living standards.

[W]hile the announcement that the Social Security trust fund will begin its decline one year earlier is an important fiscal event, the swelling of overall entitlement debt to more than one hundred trillion dollars has far more serious implications for economic growth—implications we are poorly positioned to address given the budget deficits we face today.

Our successor generations are coming to grips with this daunting reality. Faced with the prospect of a government that they believe may be unable to deliver on its promise of long-term fiscal balance—particularly with regard to entitlement programs—these individuals might logically begin to alter their consumption patterns, spending less today to save more for tomorrow. There is nothing wrong with increasing savings. But, in an economy driven by consumption, this intertemporal hedging may dampen the pace of future economic growth.

I am pleased to see that the new administration has embraced what was hitherto perceived as the third rail of American politics and brought the issue of unfunded entitlement liabilities to the fore. For the sake of our grandchildren, I hope that the administration and the Congress will take this vexing beast of a problem by the horns and tame it.

Right now, we—you and I—are launching fiscal bombs against ourselves. You have it in your power as the electors of our fiscal authorities to prevent this destruction. Please do so.

The estimates I have are reported in the 2007 Financial Report of the United States Government and therefore should be in the ballpark; they are for the next 75 years and reveal a Social Security shortfall of about $15-16 trillion and a Medicare gap of approximately $29 trillion. I think it fair to say that shortfalls of these magnitudes are considered both unsustainable and difficult to address.

Of the topics I have covered this morning, this fiscal imbalance is likely to matter most for the long-run performance of the economy. If debt financed, such deficits are likely to restrain growth over time through their effects on interest rates and, in turn, the consequences for investment, capacity, and productivity. If tax financed, there could be disincentives to work and/or to invest depending on the form of the increases, and the implications for growth would likely be negative. Finally, if program benefits are to be scaled back, it is far preferable to take this step sooner rather than later so that potential beneficiaries can plan appropriately and adjust.

Although demographic change will affect many aspects of the government’s budget, the most dramatic effects will be seen in the Social Security and Medicare programs, which provide income support and medical care for retirees and which have until now been funded largely on a pay-as-you-go basis.  Under current law, spending on these two programs alone will increase from about 7 percent of the U.S. gross domestic product (GDP) today to almost 13 percent of GDP by 2030 and to more than 15 percent of the nation’s output by 2050.  The outlook for Medicare is particularly sobering because it reflects not only an increasing number of retirees but also the expectation that Medicare expenditures per beneficiary will continue to rise faster than per capita GDP.  For example, the Medicare trustees’ intermediate projections have Medicare spending growing from about 3 percent of GDP today to about 9 percent in 2050--a larger share of national output than is currently devoted to Social Security and Medicare together. 

By 2030, almost one in five U.S. residents will be 65 years or older.  Well before then, beginning in about 2018, Social Security will start to pay out more in ben­efits than it receives from payroll taxes.  Even before that, -- in the neighborhood of 2010 -- Social Security will start exerting upward pressure on the unified federal budget deficit as its surplus diminishes, with a consequent reduction in net public saving, absent changes in the program itself, increased taxes, or reduced spending on other government programs.  

The situation for Medicare is similar and, potentially even more serious.  Payroll taxes to cover Medicare expenditures are currently in surplus.  Over time, however, Medicare spending is expected to increase more rapidly than related tax revenues, creating a deficit prob­lem that analysts see as potentially greater in size and more difficult to deal with than that associated with Social Security.   Thus, despite the relatively benign federal deficit we currently see, it is clear the situation will worsen dramatically over the next decade.  And, unlike the late '80s when deficits became a national concern, there seems to be no political consensus on the nature of this problem or its resolution -- a fact that should be a concern to all of us.

The Center for Retirement Research (CRR) has developed a National Retirement Risk Index to measure the share of working-age households that are in danger of being financially unprepared for retirement. Their findings are sobering.  They report that almost 45 percent of all such households are “at risk” of falling well short of the amount estimated to be necessary to maintain the household’s pre-retirement standard of living.  Younger households are particularly vulnerable, as are low-income households and those with neither a defined benefit pension nor a 401(k) plan. 

Several factors make today’s fiscal situation much more serious than indicated by the current ratio of the deficit to GDP. First, the deficit would be much larger, 4.1 percent for fiscal 2005, if it were not for a sizable surplus in Social Security ...The situation for Medicare is similar and, potentially, even more serious. Although payroll taxes to cover Medicare expenditures are also currently in surplus, over time Medicare spending is expected to increase more rapidly than related tax revenues, creating a deficit prob­lem that analysts see as potentially greater in size and more difficult to control than that associated with Social Security.

I believe that reducing the federal deficit is very important, especially in light of the need to prepare for the retirement of the baby-boom generation.  I urge the Congress to proceed on that effort in a timely manner and to pay particular attention to how its decisions on spending and tax programs will affect the US economy over the long term.  However, I also believe that in my role as head of the Federal Reserve, I should not be involved in making specific recommendations about the internal decision-making process of the Congress and the structure of its budget procedures.

Currently, 3-1/4 workers contribute to the Social Security system for each beneficiary. Under the intermediate assumptions of the program's trustees, the number of beneficiaries will have roughly doubled by 2030, and the ratio of covered workers to beneficiaries will be down to about 2. The pressures on the budget from this dramatic demographic change will be exacerbated by the anticipated steep upward trend in spending per Medicare beneficiary. The soaring cost of medical care for an aging population is certain to place enormous demands on our nation's resources and to exert pressure on the budget that economic growth alone is unlikely to eliminate.

Our current, largely pay-as-you-go social insurance system...is ill-suited to address the unprecedented shift of population from the workforce to retirement that will start in 2008. 

Globalization makes it harder to sustain a Social Security system based upon intergenerational transfers.  It exposes much more rapidly and acutely the inherent limits of such policies.  If our fiscal authorities were to take this and other real world verities into account, it might just encourage better policies.  And putting our fiscal house in order before our competitors do would further enhance our edge as an investment destination, securing the future of successive generations of Americans.

As I have testified on numerous occasions, current entitlement law may have already promised to this next generation of retirees more in real resources than our economy, with its predictably slowing rate of labor force growth, will be able to supply...We owe it to those who will retire over the next couple of decades to promise only what the government can deliver. The present policy path makes current promises, at least in real terms, highly conjectural. If fewer resources will be available per retiree than promised under current law, those in their later working years need sufficient time to adjust their work and retirement decisions.

Social Security is on a financially unsustainable path. Reforming the system will address some critical long-term economic issues. It will help address the looming unfunded obligations which threaten the fiscal outlook. Another key to reform is stopping the practice of the government writing itself IOUs, while spending dollars intended for Social Security on unrelated programs. This has to stop.