ATLANTA, Jan 7 - Federal Reserve Governor Donald Kohn warned on Wednesday that burgeoning U.S. budget deficits were troubling, and said Bush administration tax cuts may have boosted growth at the risk of causing long-term harm. "The prospect of large federal government deficits stretching out into the future looks worrisome," Kohn told a dinner sponsored by the Federal Reserve Bank of Atlanta. Tackling the second of the U.S. twin deficits, Kohn said fears that foreigners may grow reluctant to fund big gaps in the U.S. current account -- the broadest measure of U.S. trade -- have factored into a "significant" drop in the dollar's value since early 2002. However, he said "to date" the currency's fall had not posed a problem for the United States. Kohn's stern words on fiscal policy are the latest since the federal government posted a record $374.79 billion budget deficit in 2003. The shortfall is on track to hit some $500 billion this year, according to Treasury Secretary John Snow. Earlier on Wednesday, an International Monetary Fund paper said the U.S. budget and current account gaps would weigh on the dollar in foreign exchange markets. The warnings come as the Bush administration presses to make tax cuts set to expire at the end of the decade permanent. Snow told the U.S. Chamber of Commerce on Wednesday that failure to do so would put the economic recovery in peril. The Treasury chief acknowledged deficits were "a matter of concern" but insisted they amounted to only about 4.5 percent of total national output -- a level he called "entirely manageable." President George W. Bush, facing an election, has pledged to halve the gap within five years. His planned budget next month will face close scrutiny, particularly from Democrats, over whether it addresses the need to rein in spending.
BORROWING COSTS MAY RISE
"The fiscal stimulus of the past few years has been quite helpful in promoting recovery, but we do need to consider the longer-term implications of the policies put in place," Kohn said. "If the fiscal path does not change, unless private savings rise considerably to compensate, interest rates will be higher than they otherwise would be to ration scarcer savings, and we will have slower growth in the capital stock and in the number of houses and autos," he said. Fed Chairman Alan Greenspan last year raised a similar red flag in a speech to a securities association in Florida, but said spending curbs, not tax hikes, were the best path to budget health. The U.S. budget and trade gaps have been a growing source of concern for many economists. While the current account gap has been financed by foreign investors willing to invest in U.S. assets, Kohn said this trend may be waning. "If we do not increase our saving, investment will have to be cut back," he said. Answering questions from the audience following his speech, Kohn said there were things the government could do to stimulate spending but added that it was a complex task. The Fed governor did not assign blame for the current account gap, however. "We did not seek to run a current account deficit, nor did we make policy mistakes that brought it on," he said. Instead, faster U.S. economic growth in the past made U.S. investments more attractive to global capital. "But although the U.S. economy continues to be far more vigorous than most others, foreign investors may be becoming less willing to finance the gap between what we spend and what we produce," he said, adding that this shortfall was reflected in "a significant drop" in the dollar since early 2002. "To date, this adjustment process has not been a problem for the United States," he said, largely because of idle capacity in the American economy. Kohn later waded into the controversial subject of China's currency peg to the U.S. dollar, saying "at some point" the country would need more currency flexibility. "You've got a country undergoing this huge change of production and productivity," Kohn said. "When you have this sort of thing, you can't fix ... the price a currency trades with another currency. At some point, the forces in the two countries are going to diverge and those exchange rates have to become more flexible," he added. Kohn said that while China's financial system and its heavy load of bad debts posed a problem for the rapidly developing economy, "at some point as they develop, they need to have flexibility in their exchange rate."//