Over the longer-term, if we want to keep improving our standard of living, we must make sure that productivity growth remains robust. Faster productivity growth generates faster GDP growth. This boosts our well-being. It also helps make the adjustments to the current account and fiscal deficits a much smoother process than if we were facing them from a base of lower GDP growth.

Research by economists at the Federal Reserve Board of Governors suggests that an exogenous $1 reduction in the U.S. fiscal deficit would cause the current account deficit to decline by less than 20 cents. So, this evidence suggests the growing fiscal imbalances do not explain the bulk of the change in U.S. net saving or the current account.

Another risk to output growth is the current low savings rate in the United States. For the last three quarters of 2005, the personal savings rate was negative. That means that personal consumption spending exceeded disposable income. So while businesses have be en improving their balance sheets as a result of strong earnings growth, consumer debt has been increasing. The picture for government savings is not any better due to the current large federal budget deficit. Combined, strong consumer and government demand have caused imports to exceed exports, resulting over time in the large U.S. trade deficit, now approaching 7 percent of nominal GDP. To finance this trade deficit, foreigners have acquired large holdings of U.S. securities.  At some point, the domestic savings rate will need to increase to reduce this trade imbalance. Many economists expect that the transition to a higher savings rate will occur smoothly, but with an imbalance of this magnitude, there is a chance that a rapid transition could lead to a downturn in the economy through a sharp falloff in consumption.

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.

We cannot continue to run a federal budget deficit that raises our debt-to-GDP ratio indefinitely, without diminishing private investment through higher interest rates, thereby reducing productivity and long term growth. The current account deficit is also not sustainable at its existing size and rate of growth. If the amount we must borrow from abroad to finance spending is rising faster than GDP, at some point paying our debts will eat into our standard of living.

The federal deficit should be reined in before it begins to balloon as a share of GDP reflecting demographic change. While this is not a perfect solution, and it has real near-term costs, in the end it may be the only way to engineer a gradual way out of our debt burdens.

I am quite concerned about the intermediate to long-term federal budget outlook.  In particular, the budget is expected to come under severe pressure as impending demographic changes fuel rapid increases in entitlement spending.  By holding down the growth of national saving and real capital accumulation, the prospective increase in the budget deficit will place at risk future living standards of our country.  As a result, I think it would be very desirable to take concrete steps to lower the prospective path of the deficit.  Such actions would boost national saving and ultimately the future, prosperity of our country...Although the stock of debt held by the public would decline in absolute magnitude only if budget surpluses are run, fiscal actions that result in smaller deficits can slo the growth in the stock of debt held by the public and reduce the federal debt relative to the size of the economy.  The key is not so much the absolute level of federal debt, but rather that we take deficit-reducing steps to increase national saving and, hence, future living standars.

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.

The widening deficits over a period of years will reduce national savings, will probably exacerbate the current account deficit, may raise interest rates and will probably inhibit the dynamism of the economy.

If the deficit continues to run at a level close to 7 percent of GDP—and most forecasts assume it will for some time—the net international investment position of the United States will deteriorate sharply, U.S. net obligations to the rest of the world will rise to a very substantial share of GDP, and a growing share of U.S. income will have to go to service those obligations. This fact alone suggests that something will have to give eventually, and this raises the interesting question of how these imbalances have persisted on a path that seems unsustainable with so little evidence of rising risk premia.

Even if we could be confident that the world would be comfortable financing the United States on these terms for some time, that fact alone does not mean that it is prudent for the United States to continue borrowing on this scale, particularly given that doing so means that the net obligations of the United States to the rest of the world are likely to rise sharply relative to GDP.

The United States needs to restore a reasonable cushion in its structural budget balance to help deal with future shocks. If we are unable to begin to generate more confidence in the capacity of the U.S. political system to produce these improvements, we would face a greater risk of future increases in risk premia. And even though substantial fiscal consolidation would not by itself bring the external imbalance down to a more sustainable level, it would improve the prospect for a smoother adjustment to that outcome.

The U.S. economy has delivered a solid performance thus far in 2005. And, despite the disruptions of Hurricanes Katrina, Rita, and Wilma, economic activity appears to be expanding at a reasonably good pace as we head into 2006. However, the positive short-term economic outlook is playing out against a backdrop of concern about the prospects for the federal budget over the longer run. To be sure, the current pace of the ramp-up in spending on defense and homeland security is not expected to continue indefinitely. But, as the latest projections from the Administration and the Congressional Budget Office suggest, our budget position will substantially worsen in the coming years unless major deficit-reducing actions are taken.

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.

Addressing the government's own imbalances will require scrutiny of both spending and taxes. However, tax increases of sufficient dimension to deal with our looming fiscal problems arguably pose significant risks to economic growth and the revenue base. The exact magnitude of such risks is very difficult to estimate, but, in my judgment, they are sufficiently worrisome to warrant aiming, if at all possible, to close the fiscal gap primarily, if not wholly, from the outlay side. In the end, I suspect that, unless we attain unprecedented increases in productivity, we will have to make significant structural adjustments in the nation's major retirement and health programs.