So, the well-meaning civil servants have dutifully ground through the numbers and their politically-attuned Treasury/White House managers have signed off on the "stress tests" of 19 major shareholder-owned financial institutions. (Notice that the Social Security System and major public employee pension funds - e.g. the State of California's mega fund Calpers - have not had to undergo similar scrutiny.)
What do we know now that we didn't know yesterday? Not a great deal more. The regulators took these institutions' current balance sheets, posited a set of assumptions about future economic conditions and loan losses, and let the Excel spreadsheets generate a set of numbers and ratios. These purport to estimate the "capital buffers" each institution has to have to weather a more severe economic downturn. A fairly simple exercise for any reasonably competent MBA.
The Reality. What has been the true purpose of this exercise? The answer can be found in John Maynard Keynes' "The General Theory of Employment, Interest, and Money." But it has all to do with "confidence" and nothing to do with spending and fiscal stimulus.
The answer is in Chapter 12, "The State of Long-Term Expectation." Long term expectations, Keynes pointed out, do not depend solely on forecasts, but also depend upon "the confidence with which we make this forecast." The state of confidence, in turn, is critical to determining the appetite for investment and enterprise. I suspect that more than a handful of Federal Reserve governors and staffers, and a few Treasury Department types, have been re-reading this classic essay in recent weeks.
In other words, since the rating agencies have been shown to be close to useless in such matters, and the credit default swap market had been so bad-mouthed by politicians and journalists, and the regulators themselves were shown to have been clueless, a hopefully credible alternative had to be immediately established.
Washington's "stress tests" have been one in a series of actions designed to restore confidence in the financial system and among bankers. This is to ensure that depositors and other lenders are comfortable in entrusting their funds to such institutions, who in turn will be able to extend credit.
The Politics. The results of the stress tests rest on fairly credible assumptions: the "more adverse" stress simulation assumed a two-year loss rate of 9.1% of total loans (the highest rate in at least 90 years) and the highest unemployment rate since the 1930s. Ten of the 19 financial institutions evaluated were seen as needing to augment their "Tier I" capital to cope with such a downturn, but the initial reaction in the market is that this should be feasible without a major problem.
As I have suggested in this corner before, "modern money is magic." Destroy my confidence in my bank - any bank - and you destroy money, as represented by that bank's deposits, as I withdraw my deposit and turn it into currency, gold, or some other borrower's liability (Treasury bills?). The stress tests, originally announced in February, were designed and orchestrated primarily to restore confidence in major financial institutions.
In short, the entertaining saga of the "stress tests" has more elements of a long-running, elaborate Japanese noh drama than technocratic public policy - but that doesn't mean we can't congratulate the dramatists for a useful script.
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