Creeping trade protectionism and ballooning budget deficits pose a risk to the United States’ long-term economic vitality, Federal Reserve Chairman Alan Greenspan warned Friday.

“The developing protectionism regarding trade and our reluctance to place fiscal policy on a more sustainable path are threatening what may well be our most valued policy asset: the increased flexibility of our economy, which has fostered our extraordinary resilience to shocks,” the Fed chief said in a speech to an economic conference here, sponsored by the Federal Reserve Bank of Kansas City.

Maintaining economic flexibility is especially important, Greenspan said, to deal with what he called some of America’s current economic imbalances: the swollen current account trade deficit, which surged to a record US$668 billion last year, and the housing boom.

Greenspan also worried in his speech about what will occur with the ending of the recent sustained period of low interest rates and low risks for investors. “History has not dealt kindly with the aftermath of protracted periods of low risk premiums,” he said in his remarks.

Greenspan warned that investors shouldn’t count on the paper wealth of inflated prices for homes and stock, which can evaporate if economic conditions deteriorate rapidly.

“What they perceive as newly abundant liquidity can readily disappear,” he said. “Whether the currently elevated level of wealth-to-income ratio will be sustained in the longer run remains to be seen.”

Stock prices and house prices are factors that Fed policy-makers are increasingly needing to consider when setting interest-rate policy. “Our forecasts and, hence policy, are becoming increasingly driven by asset price changes,” Greenspan said.

Commenting on Greenspan’s speech, BMO Nesbitt Burns, notes that Greenspan indicated that balance sheet considerations must be given greater emphasis as the structure of the economy changes.

“This is oblique shorthand for: Consumers are behaving as never before; debt-to-income ratios are at record highs, savings rates are at record lows, and people are accepting increasingly lower levels of compensation for risk. Household net-worth-to-income ratios are rising (though they are down from the stock-bubble peak in 2000 in the U.S., while at record highs in Canada) and people are cashing in some of that wealth to pay for current spending; they are assuming that economic stability will last indefinitely,” BMO Nesbitt explains. “Conclusion: Watch out! Think again and reduce risk in the management of your money, business, career, and balance sheets.”

National Bank Financial also zeros in on the same theme from the speech, saying, “Lowered risk [premiums have] resulted in rising prices for stocks, bonds and homes that have pushed the net wealth-to-income ratio well above its historical average. Since much of this rise has been financed by debt, Mr. Greenspan now wonders whether this vast increase in market value of asset claims has not rendered investor’s too complacent about its permanence.”

NBF adds that, “He warns that, ‘any onset of increased investor caution that would elevate risk premiums could very well lower asset values and promote the liquidation of the debt that supported higher asset prices’.”

“In plain English, Mr. Greenspan is increasingly worried about the current imbalances and housing exuberance financed by record debt accumulation,” NBF explains.

BMO Nesbitt extracted a couple of other nuggets from his speech too, noting that he suggested, “With the rise in globalization and technological change in the past decade, it is impossible to use traditional econometric analysis using historical data to predict the future.”

“Conclusion: Don’t believe point estimates or forecasts of anything; there is far more risk in the economic and financial outlook than ever before; so, therefore, the Fed will base policy decisions on a ‘risk-management approach’, which looks at the spectrum of risks (the loss function) and minimizes the risk of events with the most serious negative consequences, even if they have a low probability of happening,” it says. “Basically, the Fed sees its major role as ensuring financial stability. This is very different from other central banks, which see their major role as to keep inflation at target levels.”

Finally, BMO Nesbitt reports that he called on policymakers to, “maintain flexibility in the economy to allow for sufficient price, interest rate, and exchange rate fluctuations to correct imbalances reflected in the fiscal deficit, the housing boom, and the current account deficit. Do not rely on protectionism or other anti-globalization governmental policies to stem the effects of competition on employment, output, and incomes.”