Are The Stress Tests Not Stressful Enough

One persistent criticism of the “stress test” process has been the argument that the scenarios being envisioned aren’t nearly pessimistic enough. Dean Baker makes the case:

2) Unemployment — in their negative scenario, the stress tests assumed a year-round average unemployment rate of 8.9 percent for the 2009 and 10.3 percent for 2010. The economy is on track to have a much higher unemployment rate, as it is likely to hit 9.0 percent in April. My best guess for a year-round average would be 9.4 percent for 2009 and probably around 10.5 percent for 2010. (These numbers assume no second stimulus, but of course Congress will not sit back and just let the unemployment rate go through the roof.)

3) House prices — the negative scenario assumes that house prices, as measured by the Case-Shiller 10-City index fall 22.0 percent in 2009. Prices in this index have been falling at a 24 percent annual rate in recent months. Given the massive inventory of unsold homes, It is reasonable to expect that this rate of price decline could continue at least through 2009.

I think Dean is probably too pessimistic about house prices. Still, to be as pessimistic as he is wouldn’t be unreasonable for an “adverse scenario” forecast. But the real trouble here is on the unemployment side. The evidence suggests that loss of income — primarily through job losses — is actually the main driver of home foreclosures. Home prices factor into the picture because price declines mean that those who otherwise might have been able to avoid foreclosure by selling their house may not be able to do. But the driver is on the jobs side. And the “stress test” employment forecasts seem way too optimistic. That said, it’s worth emphasizing that the Fed’s estimates of bank capital needs is pretty close to the IMF estimate so it’s not as if Ben Bernanke just made this up out of thin air.

That said, I’m not totally clear on how significant this will be. The stress tests are part of a strategy where it’s clear that regulatory forbearance and letting banks recapitalize themselves out of operating profits are playing a big role. Or in non-technical terms, as Paul Krugman says we’re going to be trying to muddle through. The results of the stress tests represent the limits of the extent to which pure muddling through will be allowed. But I think the right way to understand this is as a regulatory fiat — “forbearance will be extended to all those who do x, y, and z” — rather than as a proclamation about objective reality. If unemployment winds up much higher than the stress tests are forecasting, that will be a problem because so many people will be unemployed, not because the test will be “wrong.”

The question is how well can muddling through really work? If you’d asked a year ago, the conventional wisdom was that muddling through was a disaster for Japan and a catastrophic error that policymakers would never again make. But the deeper America’s waded into crisis, the better and better muddling through has come to look to politically constrained policymakers.