Stressful testing for economy

The stock market has been lurching upward, with the Dow Jones Industrial Average recently crossing the 8,000-point threshold. Many pundits and commentators have interpreted this sign as the beginning of a recovery. This assumption is based on the belief that the stock market is a leading indicator of economic growth. While it is true, historically speaking, that the trough of the stock market has preceded economic recovery, it is still premature to declare that we have reached the trough. There are several reasons to believe that the current uptick may not herald the recovery we all hope is around the corner.

The International Monetary Fund recently released reports that estimate total bank losses on bad loans and decreases in asset values to be roughly $3.6 trillion. The report estimates approximately $1.6 trillion lost in loans and another $2 trillion of lost asset value. Before this report, pessimistic estimates were on the order of $2 trillion. Needless to say, this is quite a shock and reveals just how poor the state of the financial industry really is. It also means that the government, meaning the taxpayers, will be forced to take additional steps to recapitalize the banks. These measures will ultimately come from the Treasury Department and Treasury Secretary Timothy Geithner. The recent decision by Federal Reserve Chairman Ben Bernanke to purchase $1 trillion in long-term government securities will not help the under-capitalized financial institutions. The securities, which the Federal Reserve is buying, are not undervalued. Sales of these securities to the Federal Reserve will provide additional liquidity but will not improve the balance sheets of these firms.

The Treasury Department has been recently running a series of so-called "stress tests" to evaluate how well individual banks and financial firms can weather further economic downturn. These tests are being run for 19 of the nation's largest banks, although the exact identities of these banks have not been made public. The tests are designed to determine which financial institutions will require an additional influx of public capital, which will be converted into common stock. These tests have considered a "baseline scenario" and a "more adverse scenario." Each scenario provides a hypothetical annual gross domestic product growth rate, unemployment rate and housing prices for each quarter of 2009 and 2010. Nouriel Roubini, a professor of economics at the Stern School of Business at New York University, rightly criticizes the hypothetical scenarios created by the Treasury Department for the stress tests. Their main problem, he argues, is that they do not reflect reality. Consider the unemployment rate: for the first quarter of 2009, which just ended, the baseline scenario estimated an unemployment rate of 7.8 percent and the adverse scenario estimated an unemployment rate of 7.9 percent. The true unemployment rate for March 2009, based on figures released by the Bureau of Labor Statistics, is 8.5 percent — which is worse than the worst-case scenario considered by the stress tests. Advanced estimates of first quarter GDP growth have not yet been released, but many independent analysts predict it to be on the order of the adverse scenario estimate of negative 6.9 percent. Goldman Sachs has estimated first quarter GDP growth to be an annual rate of negative 7 percent. As far as housing prices are concerned, the baseline estimate is that housing prices will drop 14 percent during 2009, while the adverse scenario estimate is that housing prices will drop 22 percent over 2009. Independent estimates predict that the actual decline in housing prices for 2009 will be around 20 percent. The Case-Shiller Composite 10 Index, which is an index of housing prices in 10 cities across America, released data for January 2009. The numbers released by the Case-Shiller Index are almost identical to the declines estimated by the adverse scenario estimated by the stress tests.

The baseline scenarios considered by the Treasury Department look meaningless — they are exceptionally optimistic estimates of the future that are not shared by independent analysts. The adverse scenario estimates are more in line with what is actually occurring in the world. It must be noted that the stress tests are only meaningful when applied at the adverse scenario conditions; to apply the baseline scenario estimates would be misleading at best. The majority of these stress tests have been completed, yet the results are being kept secret. The reason for this, as explained by federal regulators, is to present all the results at once at the end of April in order to protect the banks that failed the test from a market that will seek to punish them and reward the banks that passed. It is possible that many of the banks tested have failed the stress test; after all, when has the government ever waited to announce good news?

This column is not meant to be a dour note on the state of the economy. It is safe to say that all reasonable people wish for an economic recovery. We must be aware the current state of affairs is not as positive as many media commentators would have you believe and that big challenges would require innovative solutions may still lay ahead of us.

Alexander Draine is a Rutgers College senior majoring in economics. His column, "Draine on Society," runs on alternate Tuesdays. He is a contributing writer to the Johnsonville Press.

Alexander Draine

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