Reports from the Economic Front

a blog by Marty Hart-Landsberg

The Stress Test

A problem banking system is one of the main factors driving our economy deeper into recession.

Most analysts believe that several of our major money center banks are technically bankrupt. Treasury Secretary Geithner believes otherwise and wants to convince investors that the banking system is fundamentally sound–there might be a few problems, but these can be addressed through some government stock purchases or loans.

He has ordered the Treasury to conduct “stress tests” on the biggest 19 U.S. banks to see how they would fare assuming a continuing deterioration in the economy. Though the tests have not yet begun, Geithner has publicly ruled out any nationalization, claiming that any problems that might emerge can and will be handled through some form of public subsidy.

This position has not reassured many investors or economists. They also don’t find the standards to be used in the test reassuring either. The tests are supposed to determine each banks likely financial health under two different economic scenarios — “baseline” and “more adverse” — covering this year and next.

The “baseline” scenario assumes that GDP growth will be -2% in 2009 and +2.1% in 2010, the unemployment rate will be 8.4% in 2009 and 8.8% in 2010, housing prices will fall 14% in 2009 and 4% more in 2010.

The “more adverse” scenario assumes that GDP will be -3.3% in 2009 and +0.5% in 2010, the unemployment rate will be 8.9% in 2009 and 10.3% in 2010, and housing prices will fall 22% in 2009 and a further 7% in 2010.

This sounds pretty bad—except for the fact that most people think it will be far worse.  Speaking about the baseline scenario, Simon Johnson (former chief economist of the IMF and now professor of economics at MIT) asks:

How exactly do we get growth over 2 percent in 2010 (and after)? The global economy is getting worse, consumer and business confidence is weak everywhere (tell me if you know different). There is no sign of housing turning around, consumers are cutting back, and large organizations are all planning to trim costs for the next financial year. Our policy response so far: moderate fiscal stimulus, underfunded housing policy, and small potatoes for the banking system.

Dean Baker, one of the sharpest analysts around, has the following to say about the assumptions underlying the scenarios:

Okay, unemployment will almost certainly reach 8.0 percent and possibly 8.1 percent in February. It might cross 8.5 percent in March. The worst case scenario is that it hits 8.9 percent by the rest of the year?

Remember, this is the same crew that told us that there was no housing bubble. When it became clear that there were serious problems, they assured us that they would be contained in the subprime market. After Bears Stearn collapsed they told us that they didn’t see another Bear Stearns out there.These stress tests indicate that our economic policy makers are still in a serious state of denial. Why isn’t the media ridiculing them and telling the public that the folks making economic policy still don’t understand the economy.

And if you have any doubts—Doug Henwood, author of the always insightful Left Business Observer, shared the following on his blog:

It was predicted in this space just two weeks ago: “Obama to coddle bankers.” Now we’ve got official confirmation of this from one of the prime coddle-ees: Citigroup. An analysis of the Treasury’s plan produced by two Citi analysts, Ryan O’Connell and Jerry Dorost, begins with this headline: “New Treasury Stress Test Guidelines Do Not Appear Onerous” and continues in this vein.

Even the conservative London-based Economist magazine appears to have thrown in the towel—after grudgingly accepting the need for nationalization, it ended one of its recent editorials as follows: “[Nationalization] is hard to swallow in a country that likes its capitalism red in tooth and claw. But better a temporary ward of the state than a permanent zombie.”

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