Krugman: Will The Fed's "Stress Test" Be Stressful Enough?

The the so-called “stress tests” the Fed plans to use to measure whether banks are sufficiently capitalised played a large role in Fed chairman Ben Bernanke’s testimony to the Senate banking committee today. No one knows exactly what the stress tests will consist of, but we’re starting to get an outline. Unfortunately, it looks like the Fed is still way too optimistic to realistically measure the capitalisation of banks.

Here’s how the New York Times describes the tests:

The stress tests will use computer-run “what if” situations to estimate what would happen to each bank under Depression-like conditions, with unemployment surging to 10 or 12 per cent, for example, or home prices dropping 20 per cent further, Treasury and Federal Reserve officials said.

Fed officials emphasised that these hypothetical events were “highly unlikely” to occur.

Highly unlikely? No wonder the government keeps describing the banks as well capitalised. It just doesn’t think home prices will drop much further or the recession will get much deeper.

But don’t take our word for it. Paul Krugman does a great job of cutting right through this rose-tinted eyeshade nonsense of the government accountants:

Um, quite a few private forecasters expect unemployment to top 9 per cent, which makes 10-plus a reasonable possibility. Meanwhile, using today’s release of the Case-Shiller price index and the BLS measure of owners’ equivalent rent, I get this for housing:

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The price-rent ratio is still 15 per cent above its 2000 level, and why shouldn’t it overshoot given the excess supply right now? Oh, and rents are falling.

Bottom line: that “highly unlikely” case seems all too possible to me. Maybe not the most probably outcome, but hardly a black swan.

 

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