The Fed Chairman told the US Senate’s powerful Budget Committee that America’s government borrowing was on an “unsustainable path” in which deficits would cause interest rates and interest payments to rise in a dangerous spiral.

His criticism of the burgeoning deficit marked a toughening of earlier warnings to the Bush Administration and Capitol Hill over budget policy.

Wall Street brushed aside Mr Greenspan’s blunt comments, however, to seize upon a batch of positive results for US companies and an upbeat manufacturing survey as an excuse to buy back into shares after last week’s plunge by American markets.

The Dow Jones industrial average closed up 206.24 points, or more than 2 per cent, at 10,218.6.

In his stark assessment earlier, Mr Greenspan said that rising interest payments threatened to keep the budget deficit growing as a proportion of US national income. “Unless that trend is reversed, at some point these deficits would cause the economy to stagnate or worse,” he said.

Raising a question mark over President Bush’s pledge to cut the $400 billion (£210 billion) budget gap in half by 2009, Mr Greenspan said the latest projections from the Administration and the independent Congressional Budget Office “suggest our budget position is unlikely to improve substantially in the coming years unless major deficit-reducing actions are taken”.

He said that the approaching surge of Americans due to retire added urgency to the problems.He also said that growing economic pressure would compel China to alter its policy of pegging its currency to the dollar at some point. “The sooner they move off this fixed (rate), the better off for China’s economy,” he said in comments that put his weight behind the Administration’s increased pressure on Beijing to drop the peg.

The Fed chairman dismissed fears that the US economy might lurch into 1970s-style “stagflation” in which growth founders but prices keep soaring. “It certainly doesn’t seem that way,” he said.