NEW YORK (CNN/Money) -
Fed Chairman Alan Greenspan said Wednesday the economy is in good shape but warned that Americans urgently needed to save more -- and he endorsed the idea of private accounts as part of Social Security reform.
The Fed chairman also indicated the central bank would continue to raise interest rates gradually.
Greenspan waded into one of the more contentious issues facing Congress coming out in favor of fundamental changes in the Social Security system, but he urged caution. The Fed chief said the move toward private accounts should be gradual to limit borrowing needed to keep benefit payments, while payroll taxes are diverted into the new accounts.
And under questioning by Democrats, he conceded that private accounts by themselves would not boost the nation's saving rate. But he said that not making changes to Social Security was risky and not sustainable. Once the transition costs are paid for, a Social Security system with an individual account element would add to the net national savings rate, said Greenspan, which would strengthen the economy and help retirees.
He urged action before 2008 to prepare Social Security for the coming wave of retiring "baby boomers," and said separately it was "imperative to restore fiscal discipline" in the United States to help narrow the nation's huge trade deficit.
"If you're going to move to private accounts, which I approve of, (you) have to do it in a cautious, gradual way," he said in response to the first question he received from Committee Chairman Richard Shelby, an Alabama Republican.
In response to another question from the ranking Democrat on the committee, Paul Sarbanes of Maryland, Greenspan said he would back some borrowing for the transition to private accounts, but not more than $1 trillion. Some experts say $2 trillion or more might have to be borrowed to pay for the move to the accounts.
Greenspan said the current system of paying promised benefits to retirees cannot be sustained as the Baby Boomers start retiring.
"There are basically two models we're confronting, one a pay-as-you-go model, if we can fully fund, will work, and the other is the forced savings model. I've always supported a move to private accounts. The issue with respect to the financing is difficult to answer. But because the pay-as-you-go system will be very difficult to manage, we need an alternative," he said.
"Real progress on these issues will unavoidably entail many difficult choices," he said in his opening comments. "But the demographics are inexorable, and call for action before the leading edge of baby boomer retirement becomes evident in 2008."
Bullish on economy
On the economy, Greenspan said the central bank's recent policy of gradually raising interest rates to end an era of cheap money has worked well in keeping the economy growing while keeping inflation in check.
But he tempered his optimism by warning that the relatively tranquil economic conditions of recent decades must not be taken for granted.
"History cautions that people experiencing long periods of relative stability are prone to excess," he said in his remarks to the Senate Banking Committee. "We must thus remain vigilant against complacency, especially since several important economic challenges confront policymakers in the years ahead."
Greenspan was relatively bullish on economy, even as he acknowledged problems including the nation's low savings rate and ongoing sluggish hiring by employers.
"All told, the economy seems to have entered 2005 expanding at a reasonably good pace, with inflation and inflation expectations well anchored," he said. "On the whole, financial markets appear to share this view."
But he also indicated that despite the central bank's recent moves to boost short-term rates, they remain low in historical terms.
"The cumulative removal of policy accommodation to date has significantly raised measures of the real federal funds rate, but by most measures, it remains fairly low," he said. The central bank has raised its target for the fed funds rate, an overnight bank lending rate, six times since last summer, from 1 to 2.5 percent.
Before he began testifying, Sarbanes and Jim Bunning, a Republican from Kentucky and frequent Greenspan critic, urged the Fed to pause from raising rates.
"If you don't see any evidence of inflation, I would hope you take that into consideration at the next meeting," Bunning said. "You don't have to raise rates just because many expect you to do so. Low interest rates are not necessarily a bad thing."
But economists said Greenspan's comments were a sure sign the Fed will keep to its path of measured rate hikes.
"Yes, Greenspan does admit the obvious, that the real federal funds rate has risen considerably, but he quickly concludes that the rate 'remains fairly low'," said Anthony Chan, senior economist with JPMorgan Fleming Asset Management. "This is Fed-speak for the notion that the Fed will continue to raise rates by a quarter percentage point ... as far as the eye can see."
Greenspan acknowledged that business spending has lagged behind corporate profits, adding that caution has depressed hiring compared to other post-war recoveries.
"In contrast to the typical pattern early in previous business-cycle recoveries, firms have appeared reluctant to take on new workers and have remained focused on cost containment," he said.