Aug. 27 (Bloomberg) -- Federal Reserve Chairman Alan Greenspan said time is running out for the U.S. to make the ``increasingly stark choices'' needed to pay Social Security and Medicare benefits as the baby boom generation retires.

``If we have promised more than our economy has the ability to deliver to retirees without unduly diminishing real income gains of workers, as I fear we may have, we must recalibrate our public programs so that pending retirees have time to adjust through other channels,'' Greenspan told a central bank conference in Jackson Hole, Wyoming. ``If we delay, the adjustments could be abrupt and painful.''

The U.S. budget deficit, which the Congressional Budget Office already projects to reach a record $420 billion this fiscal year, will widen ``substantially'' as the percentage of the population over 65 nearly doubles by 2035, he said.

``The most famous economist in the country has just put up a red flag,'' said Christopher Rupkey, senior financial economist at Bank of Tokyo-Mitsubishi in New York. ``The federal budget deficit will explode in the years to come.''

The 78-year-old Fed chairman, who was president of National Commission on Social Security Reform from 1981 to 1983, has made the retirement of the baby boom generation, those born between 1946 and 1964, a cornerstone of his persistent calls for Congress to improve budget planning.

Social Security tax receipts, equal to 12.4 percent of a worker's salary, won't cover the entire cost of outlays starting in 2018, according to the Social Security Trustees' 2004 report. That will ``significantly affect our fiscal situation.'' Greenspan said.

`Red Flag'

Social Security and the deficit are issues in the U.S. during this presidential election year. In his acceptance speech at the Democratic National Convention in Boston July 29, nominee John Kerry suggested he would consider tax increases to close the funding gap. ``As president, I will not privatize Social Security. I will not cut benefits,'' he said.

President George W. Bush, in Las Cruces, New Mexico, yesterday, said that younger workers should be ``concerned'' about the fiscal stability of Social Security, and again pitched private retirement savings. ``I believe younger workers ought to be able to own a personal retirement account they call their own, so they can pass it on from one generation to the next,'' he said.

Snow

``I'm in broad agreement with the underlying sentiments of chairman Greenspan,'' Treasury Secretary John Snow said in Grand Rapids, Michigan, repeating Bush's call for personal savings accounts where part of the withholding is diverted to a private account.

Greenspan has avoided specific endorsements of either party's proposals, and some analysts said today's speech is unlikely to produce a greater sense of urgency in Congress.

``Politicians are shy to embrace these realities because they're not very politically popular,'' said Joseph Chamie, director of the United Nations' Population Division in New York. ``No one's going to get elected on telling people they have to work longer, or pay more in taxes or see their benefits reduced.''

Birth rates have fallen around the world, leaving fewer workers to tax to finance retirement programs. And while the U.S. faces ``increasingly stark choices,'' adjustments will be even more wrenching in Europe and Japan, Greenspan said.

Europe and Japan

``Responding to the pending dramatic rise in dependency ratios will be exceptionally challenging for policy makers in developed countries,'' he told the gathering of central bankers from Europe, Latin America and Asia during the Kansas City Fed's 28th annual symposium titled ``Global Demographic Change: Economic Impacts and Policy Challenges.''

The issue may become even more pressing in middle income, or emerging-market, countries such as India, South Korea and Turkey, said Anne Krueger, first deputy managing director at the International Monetary Fund. Such nations must wrestle with financing public works, schools and social services as well as pensions.

``The challenges facing industrial countries pale besides those that emerging-market economies will encounter,'' she said.

Greenspan said the U.S. is better prepared to deal with the challenges of an aging society than Europe or Japan. Its funding shortfall is smaller, its labor markets are more flexible and better able to adapt to changing demographics, and the country is more receptive to immigrants.

Education, Productivity

Most important, companies are quicker to take advantage of productivity-enhancing technology, he said, and that will help most to close the funding gaps. Programs to encourage more output per worker are important as the labor force shrinks in coming decades.

``One policy that could enhance the odds of sustaining high levels of productivity growth is to engage in a long overdue upgrading of primary and secondary school education in the United States,'' he said.

Annual productivity gains averaged 2.5 percent from 1996 to 2001, an acceleration from the 1.6 percent average in the previous two decades. Last year and in 2002, productivity rose 4.4 percent. It was the first time since record-keeping began in 1947 that productivity exceeded 4 percent in consecutive years, according to Labor Department statistics.

Foreign investment has helped pay for much of that, Greenspan said, with the U.S. current account deficit reaching a record $144.9 billion in the first quarter.

Given that, Congress must encourage national saving, ``because it is difficult to imagine that we can continue indefinitely to borrow saving from abroad at a rate equivalent to 5 percent of U.S. gross domestic product,'' Greenspan said.

Medicare

Data show retirees save at a higher rate than had been thought, and if the baby boom generation continues that pattern, achieving a higher rate of national saving ``is not out of reach,'' Greenspan said.

``Even so, critical to national saving will be the level of government, specifically federal government, saving,'' he said.

Increased saving and higher immigration won't be enough to maintain the outsized productivity gains of recent years, he said, and that will necessitate ``difficult policy choices.''

That's particularly true of Medicare costs that will ``almost surely be much larger and much more difficult to address, he said. Medicare spending is surging with an aging population that wants the latest technologies and medicines.

Outlays are expected to more than double to $570 billion in 2010 from $280 billion last year, according to 2004 Trustees report, with expenditures beginning to exceed income in 2011.

Retirement Age

Raising Social Security and Medicare payroll taxes would suppress economic growth and tax receipts, and likely create incentives for workers to retire early ``by diminishing the returns to work,'' he said. Better would be policies ``promoting longer working life.''

In testimony last February the Fed chairman suggested Congress should consider indexing the retirement age to longevity. As an overall budgetary cure, he recommended that Congress return to a system whereby new spending programs are paid for by spending cuts or revenue increases. Today, the Fed chairman didn't endorse any specific proposals, saying only Congress must be careful in making decisions.

``How these deficit trends are addressed can have profound economic effects,'' he said. ``Changes to the age for receiving full retirement benefits or initiatives to slow the growth of Medicare spending could affect retirement decisions, the size of the labor force, and saving behavior.''

Stakeholders

Critics, including Kentucky Republican Senator Jim Bunning, say the chairman, now in his fifth term, should steer away from fiscal policy questions and keep his comments focused on monetary policy. Bunning opposed Greenspan's nomination to a fifth term objecting to Greenspan voicing opinions on subjects such as tax and budget issues that Bunning said are outside of the Fed's jurisdiction.

That is not how Fed officials see it and is why demographic change is the theme of this year's meeting in Jackson Hole.

Central bankers from around the world view themselves as stakeholders in the issue because governments are more likely to boost deficits than raise taxes to pay for retiree benefit programs.

Rising deficits might destabilize an economy by boosting the cost of capital for businesses and the cost of loans for consumers. Legislatures may also exert pressure on central banks to ease up on inflation so the real cost of the debt declines.

``Every central banker around the world will tell you we should not let that happen,'' Federal Reserve Governor Edward Gramlich said in an interview with Bloomberg News last week. ``I think we should speak out on this but I don't think we should get involved in the politics of it.''

Peril

The bond market's reaction to the looming fiscal challenge is something both traders and economists find difficult to explain. Ten-year note yields of 4.21 percent do not as yet reflect the possibility of higher deficits.

``The Fed chairman has put out a warning that the markets ignore at their peril,'' Rupkey said. ``The graying of America could force interest rates up substantially with the Fed powerless to respond.''

For Greenspan's audience in Jackson Hole, the challenge could arrive even sooner. An aging workforce is already placing demands on government resources in countries such as Italy, which spends about 14 percent of gross domestic product on pensions.

``I wish he could give that speech to both the Democratic and Republican conventions -- that's really the defining economic issue of this century,'' Robert Bixby, director of the Concord Coalition, a non-partisan budget-monitoring group based in Arlington, Virginia, said in an interview. ``This election is going to determine the first president of the senior boom, and Greenspan's remarks articulate the main challenge that the winner will face.''

To contact the reporters on this story: Craig Torres in Jackson Holet ; ctorres3@Bloomberg.net

Last Updated: August 27, 2004 18:03 EDT