Stress among the stress testers…and its benefits…

As many including myself have often written, the Obama administration’s economic team contains some really exceptionally smart and talented individuals. This tends to mean that they are capable of being highly effective and also of knowing where they are falling short. Sometimes the press suggests that the “administration’s” views are monolithic, underplaying the broad range of debates that underlie every action. This is healthy and inevitable, for it’s often these internal doubts and the second-guessing of senior policy makers that provides the impetus for future programs and initiatives that complete or refine current undertakings. Recent conversations I have had with friends on the inside have underscored the nature of some of those lingering questions and are worth considering.

“They didn’t want to write down the worst case scenario.” Those were the words that lingered in my mind after one such conversation with a senior economic official. My friend explained that “these guys (his colleagues in the economic team) take behavioral economics very seriously” and they wanted to avoid taking steps that might negatively impact markets by virtue of their structure or parameters. In other words, if the scenario was too nasty and it leaked, markets then might conclude that such a scenario was actually what the administration thought was possible, and adjust their outlook and strategies accordingly. Nonetheless, he noted, there were those in the administration arguing…sensibly, if you ask me…that since under-estimating risks got us here in the first place, it might be the one thing we should avoid going forward. 

He agreed that the one area in which it could be convincingly argued that the tests do not really plumb accurate predictions (even in a fairly likely scenario) has to do with the potential for a crisis in the commercial real estate market. He felt that provisions for consumer credit losses at 20 percent a year for a couple of years were so far above historical levels that they were sufficient for the purposes of the test. Noting that while there was no desire for a quarterly stress test process, his feeling was that undertaking such tests was useful (as argued for by Sebastian Mallaby in today’s Washington Post.)

Earlier today, I also spoke to Harvard’s Niall Ferguson about this and mentioned the conversation. His reaction:

While I’m glad they recognize their own vulnerabilities to leaks, the reality is the next stress test is going to be administered by the economy and it would be disastrous if after passing the theoretical test they fail the real one. There are real disasters in waiting out there including in particular commercial real estate. I can’t think of another more serious stress to the solvency of the big banks than (commercial real estate) and if they soft-peddled it in their models I can’t think of anything that would render the stress test effort more worthless. Overall, the behavioral approach creates a certain circularity in the way policy is addressed and opens the door to cynical efforts focused more on shaping public opinion than on meeting practical objectives and as a consequence opens the door to a certain real vulnerability.”  

Several other folks with whom I’ve spoken acknowledged that there was some reluctance to move forward on domestic and international regulatory reform carried too high a perceived political cost. One insider said that even among those who supported more aggressive efforts on reform there was a sense that looking around the world at countries that might be seen to have more robust regulatory schemes or better institutional structures, performance in the crisis was not necessarily better. He gave the U.K. as an example.  

A friend offered a wonderful analogy about our macro situation: It’s as though we had all been on a plane bound for Charlotte from LaGuardia, that it had taken off and 45 seconds into the flight taken a couple of bird strikes to the engines, that we had spent two minutes (the past several months) thinking we were going to die and that somehow the plane was landed in the river and that we now find ourselves standing on the wing euphoric that we had lived. The problem is that soon we will realize that although we have lived, we are still in New York and that we will soon have to get back on another plane to get to Charlotte. His point: new problems and challenges will soon replace the ones we have grappled with thus far. Of these, the greatest will be restoring growth to the U.S. economy at levels approaching those to which we have been accustomed. Even assuming no secondary near-death experience, the supreme political and economic challenge for the Obama Administration for much of the remainder of this term (assuming all continues to go fairly well in containing the most acute dimensions of the crisis) may be trying to nudge U.S. growth rates above comparatively minimal levels. It may end up being the one economic issue on which they are judged come the mid-term or next presidential election cycle. The Republican critique could well turn on what could be seen as prolonged “stagnation,” a “Japan problem” a la their generally losing economic battles of the past decade or so.

A common theme was what is seen as Washington’s “schizophrenia” on this issue: we want a recovery in financial markets, that many see it as a prerequisite for recovery elsewhere, but that we don’t want to be seen as rewarding or supporting Wall Street. That the conundrum is that by fixing the problem you look like you are helping the ones who caused that problem. This will certainly come up again soonish as some financial institutions come out from under the TARP and rather than being hailed for their quick-turnarounds, the administration will take fire for sending the wolves back into the herd and for enabling them to get an unfair competitive advantage over banks still in the government program. (It’s my view that being more forward leaning on regulatory reform would have the dual benefit of being good policy and also good politics, offsetting the soon to be deafening critique that the administration is just resetting the table for Wall Street fat cats.)

Frankly, I found talking to these insiders very encouraging because it reinforced the idea that the policy formation process within the administration involved extremely robust analysis and debate…as it should…and that this in turn was producing a constructive and on-going evolution of views and policy prescriptions.

Scott Olson/Getty Images