The No Stress Stress Tests?

OK. It seems as if the objective of the so called stress tests being applied by the Treasury department to our failed banks doesn’t include a whole lot of stress. Paul Krugman both reports and laments here:Not much stress – Paul Krugman Blog

So what’s the deal?

Bernanke, in his testimony before Congress today, toed the party line: yes the recession looks pretty ugly this year, but by 2010 everything will be just fine and the medium term trend line for GDP will snap right back to its pre-downturn average of around 2.5% to 3% a year. All this with unemployment topping out at just over 10.0%.

So where’s the stress?

I thought a ‘stress test’ was designed to put a balance sheet through the wringer with more extreme problems. You know: apply actual stress. With unemployment up around 15% for instance. The Treasury’s use of about 10% for unemployment is pretty much the consensus number and not an ‘outlier’ at all. Didn’t anyone down there read Roubini’s book last Fall? What happened to the ‘fat tail’ hypothesis we were all working on back in November?

I smell a rat.

For the record: I now think that the Treasury is doing its damnedest to ensure that the big banks squeak by these tests. The belief seems to be that the recovery is not so far away that we need to take any harsh remedial action [a.k.a. nationalization]. After all if the economy kicks back to life those toxic assets go up in value and the losses now sucking the life out of the banks simply fade away. And no one has to do the dirty deed.

I hope I am wrong. But this looks like the fix is in.

The problem stems from the fact that all the folks involved were brought up to believe the same economics creed. They just don’t seem capable of thinking beyond the borders of that creed. Which is infuriating to say the least.

It was the wrong headed theory promulgated by people like Milton Friedman and his heirs at the University of Chicago [Robert Lucas in particular comes to mind]; along with the financial economists like professors Black, Scholes, and Merton from MIT who laid the intellectual groundwork that both led to the surge within the derivatives market and shaped the ‘free market’ anti-regulation ideology of the Reagan years. Geithner, Bernanke, and Summers are so tied to this theory that they simply cannot break free.

That’s why these ‘stress’ tests appear to be rigged in favor of the banks. We wouldn’t want our precious theory to be exposed as a fraud would we?

Well, guys, to use the words of Karl Popper: your hypothesis has been falsified. We have acquired significant knowledge. We now know for certain that markets sometimes fail from within.

We shouldn’t be using trillions of taxpayer money to cover the embarrassment of academic economists whose theory is defunct.

Move on.

And trying applying a little stress in those ‘stress tests’.