Former GAO Head Warns of Impending Deficits.--

John Fund interviews former GAO director David Walker:

David Walker sounds like a modern-day Paul Revere as he warns about the country's perilous future. "We suffer from a fiscal cancer," he tells a meeting of the National Taxpayers Union, the nation's oldest anti-tax lobby. "Our off balance sheet obligations associated with Social Security and Medicare put us in a $56 trillion financial hole—and that's before the recession was officially declared last year. America now owes more than Americans are worth—and the gap is growing!" . . .

"We have four deficits: a budget deficit, a savings deficit, a value-of-the-dollar deficit and a leadership deficit," he tells one group. "We are treating the symptoms of those deficits, but not the disease."

Mr. Walker identifies the disease as having a basic cause: "Washington is totally out of touch and out of control," he sighs. "There is political courage there, but there is far more political careerism and people dodging real solutions." He identifies entrenched incumbency as a real obstacle to change. "Members of Congress ensure they have gerrymandered seats where they pick the voters rather than the voters picking them and then they pass out money to special interests who then make sure they have so much money that no one can easily challenge them," he laments. He believes gerrymandering should be curbed and term limits imposed if for no other reason than to inject some new blood into the system. . . .

What kind of reforms would Mr. Walker hope the commission would endorse? He suggests giving presidents the power to make line-item cuts in budgets that would then require a majority vote in Congress to override. He would also want private-sector accounting standards extended to pensions, health programs and environmental costs. "Social Security reform is a layup, much easier than Medicare," he told me. He believes gradual increases in the retirement age, a modest change in cost-of-living payments and raising the cap on income subject to payroll taxes would solve its long-term problems.

Medicare is a much bigger challenge, exacerbated by the addition of a drug entitlement component in 2003, pushed through a Republican Congress by the Bush administration. "The true costs of that were hidden from both Congress and the people," Mr. Walker says sternly. "The real liability is some $8 trillion."

That brings us to the issue of taxes. Wouldn't any "grand bargain" involve significant tax increases that would only hurt the ability of the economy to grow? "Taxes are going up, for reasons of math, demographics and the fact that elements of the population that want more government are more politically active," he insists. "The key will be to have tax reform that simplifies the system and keeps marginal rates as low as possible. The longer people resist addressing both sides of the fiscal equation the deeper the hole will get."

FHA Adopts Countrywide's Business Model and It's Not Working . . . Again.--

Nick Timiraos and Deborah Solomon at the Wall Street Journal have an excellent report on problems at the FHA (Federal Housing Administration).

"They're probably going to need a bailout at some point because they're making loans in a riskier environment," says Edward Pinto, a mortgage-industry consultant and former chief credit officer at Fannie Mae. " . . . I've never seen an entity successfully outrun a situation like this." . . .

Before the boom, the FHA wasn't a big player in the housing business because it didn't follow private lenders in loosening its standards. Borrowers had to fully document incomes and insured loans were capped at $362,000. Congress increased those limits last year to as high as $729,750 in the most expensive markets. In August, the FHA and the U.S. Department of Veterans Affairs backed 40% of loans for all home sales. . . .

While most private lenders have raised lending standards and now require minimum 20% down payments, the share of borrowers who are able to make down payments of less than 10% hasn't changed in the last two years, largely because of the FHA, says Mr. Pinto . . . .

Marketwatch summarizes the problem:

The government seems to have taken over Countrywide's business model, and it's not working out much better the second time around.

The Federal Housing Administration may be next in line for a government bailout because it's losing a lot of money on bad mortgages, according to a report in the Wall Street Journal.

When the subprime mortgage industry self-immolated a couple years ago, the staid FHA was ordered into the breach to try to stabilize a market in freefall. As the bubble expanded earlier in the decade, the FHA hadn't relaxed its lending standards, unlike its swashbuckling counterparts in the private sector.

But once the housing market started to collapse, the government decided the FHA should try to prop up the market. The FHA loosened its standards a bit, though not as far as the subprime sharks had. FHA guaranteed loans with a down payment as small as 3.5% and let borrowers take a lot of cash out of refinancings. Congress also doubled the maximum loan to $729,750 [in some areas].

The federal agency, which guarantees loans made by private companies, also briefly allowed sellers to finance down payments.

The result was predicable, at least to anyone who was paying attention to the way the housing bubble collapsed. The FHA increased its market share from 3% to about 23%, and more of its loans began to go sour.

The Congress, not just the FHA and the Veterans Administration, have been trying hard to reinflate what's left of the real estate bubble. This reminds me of the successful efforts of the Hoover and FDR administrations in the 1930s to prevent wages in manufacturing from dropping to their market-clearing level, actions that helped create and then lengthen the Great Depression. The quicker housing prices reach their market-clearing level, the sooner a strong housing recovery can start.

Could a Government Regulator of Systemic Risk Avoid the Next Economic Meltdown?--

One of the goals of proposed regulatory changes of the financial industry is — as President Obama has argued — to create "a 21st century regulatory framework to ensure that a crisis like this can never happen again":

1. [L]et's put in place some financial regulations to make sure that this doesn't happen again.

2. My job is to help the country take the long view, to make sure that not only are we getting out of this immediate fix but we're not repeating the same cycle of bubble and bust over and over and over again . . . .

We're going to put forward some regulatory architecture that ensures that we don't see these kinds of systemic risks again.

Yet can a government — whether run by Republicans or Democrats — really anticipate future bubbles or meltdowns? And if it could, would the government have the political will (or political power) to prevent future meltdowns?

As David Walker has argued, "Our off balance sheet obligations associated with Social Security and Medicare put us in a $56 trillion financial hole—and that's before the recession was officially declared last year. America now owes more than Americans are worth—and the gap is growing!"

Even if the problem is only a half or a third of the size that Walker identifies, it still constitutes a huge systemic risk. At some point in the future -- perhaps quite suddenly a decade or two hence — it is likely that the purchasers of the government's massive debt will decide that they won't buy it without a huge increase in interest rates. As Alistair Thompson said in August 2007 as the credit crisis first hit, "Liquidity can just be turned off, and essentially it is a confidence game."

Indeed, the last time that we had a recession as deep as the current one was in 1980-82 when a Federal Reserve induced credit crunch caused short term interest rates to reach about 19%.

So if today we had an all-powerful systemic risk regulator who could act to prevent a future melt-down, she might consider taking bold steps to:

Reduce government spending dramatically, especially in the future;

Prevent cap-and-trade from passing;

Stop any expensive health care reforms (and favor cost-cutting measures);

Stop dangerous lending practices at the FHA and the Veterans Administration;

Cut the future costs of Social Security, Medicare, and Medicaid;

Finance much of the existing federal debt with 30-, 50-, and 100-year bonds while interest rates are low; and

Begin orderly sales over the next decade of substantial unused lands owned by the federal government ("It's time for America to start an annual yard sale of stuff for which the government has little use. This has the ancillary positive effect of reducing excessive government power over its citizens and resources. Does the government really need to own 45% of the state of California?").

That would be my list to consider. David Walker, the former head of the GAO, has a somewhat different list, but like my ideas, only a few of his proposals are likely to be implemented.

If Walker and a slew of financial commentators are right, our profligate spending is threatening the long-term health of the economy. Excessive borrowing is highly likely to lead eventually to another big credit crunch in a decade or two, and another deep recession.

My point is this: if there were a systemic risk regulator today, very few of the steps she should favor to prevent a future crisis would be supported by the current administration and many would also be opposed by Congress, the last administration, and the American people. I just don't see how even a reasonably far-sighted super-regulator would be able to do much to reduce the systemic risks that our current policies are fostering.