Why are the options for fixing the global economy so lousy?

By Dan Alamariu

The results of recent stress tests of European banks were all but a foregone conclusion. The assumptions on which the tests were built were not severe enough to potentially undermine the still-recovering EU financial sector. The similarity to the stress tests that were performed by U.S. authorities in spring of 2009, when the top 19 U.S. financial institutions were tested, are striking: In neither case did the tests assume the (not-all-that-unlikely) worst-case scenario.

Why bother with a stress-test then? This question raises a quandary that goes to the heart of government responses to the financial and economic crisis: How do we balance the need for stability that restores near-term confidence with the need for increased transparency to ensure it doesn’t happen again? There’s no easy answer, but it’s a crucial part of all the fiscal and regulatory responses to the 2008-2009 financial meltdown. In choosing between the policies emphasizing stability and those leading to transparency, which over the short-term can be mutually exclusive, governments face a tragic choice worthy of Sophocles: neither option is likely to produce a happy outcome in the next couple of years, and neither is sure to solve the long-term problem. Both contain tragic flaws.

Start with stability. When faced with the evident meltdown of the global financial sector in 2008, the U.S. government intervened on a massive scale — via the Troubled Asset Relief Program (TARP), guarantees to the money market, and a number of measures that may well have saved the U.S. financial system from complete collapse. In Europe, similar measures, including virtual nationalizations of weakening financial institutions in Britain, France and elsewhere have arguably stabilized the system.

But emergency support hasn’t solved the larger problem. Large financial institutions have carried on, but their liabilities and the value of their assets remain uncertain. The causes of the financial crisis have not been addressed, and massive government interventions have added the new problem of moral hazard — "Why should I learn the lessons of past mistakes when the real lesson is that governments will bail me out of any serious trouble I create."

To prop up falling asset prices, governments have moved beyond moral hazard to change the rules of the game. Accounting standards come to mind, primarily the application of mark-to-market rules, where during 2008-2009, enormous pressures from U.S .and European lawmakers forced independent accounting standards boards to relax their rules.

The EU and U.S. stress tests have served the same purpose: To rebuild confidence and stability in the system. They were designed to restore confidence (however misplaced) and to create soft landing conditions that would allow banks to recover over time. That choice gives false confidence that the kids are alright.

How sustainable can a recovery of the financial system and the economy be if the political class simply changes the numbers and standards? The financial system can’t function without the confidence of investors and without real price-discovery (i.e. transparency). Changing accounting standards to match the circumstances, restricting the ability of investors to short-sell (as some developed states have done) and running weak stress-tests are all fueled by the same reasoning that led Soviet bloc planners to inflate annual pig-iron production numbers. The analogy is exaggerated — EU and U.S. regulators have little else in common with Soviet-era apparatchiks — but it reminds us that there is a price to be paid whenever governments favor short-term stability over longer-term transparency.

There’s no guarantee that wishful thinking will eventually become a benign self-fulfilling prophecy. The government officials on both sides of the Atlantic who ran the stress tests may well have reasoned that they won’t be around to take the blame if the structure begins to buckle. The true value of assets will remain uncertain, and markets will continue to price political support into investment decisions. Injecting political calculation into market rules is no more likely to produce sustainable economic growth now than when Soviet bureaucrats were crafting five-year plans.

But the alternative-allowing markets to price financial assets transparently over a short period of time-is dangerous in a different way. The long-term sustainability of financial institutions and markets certainly depends on transparency — even when the added information undermines near-term confidence. In theory, recovery from financial crisis and the rate of recovery depends on the political courage to let some banks fail and the value of assets fall in line with liabilities. By this logic, the U.S. government and the EU states should have let more banks sink beneath the rising tide of investor panic in 2008 and early 2009.

But the costs of that policy would have been enormous — in economic, political, and human terms. Would the value of market discipline have justified the risk of Depression? Would it now? It’s a lot safer and easier to oppose bailouts after they’ve happened.

That doesn’t change the fact that transparency, accurate financial reporting and pricing of assets remain the ultimate goals. Even with the significant regulatory reforms now underway in the United States and Europe, investors will always police markets much more actively and effectively than regulators can. They have better incentives and are often less stretched than regulators, as the Bernie Madoff saga has shown in spades. Ongoing reforms in the United States and EU may help investors do just that. If they work — that’s a big if — they could allow corporations, investors and regulators to have a much better view of how financial products and institutions should be priced. But that will take time, as the reforms will be implemented over a period of two years or longer. 

In the meantime, the conflict between transparency and stability will not abate. Most governments will try to muddle through between these two less-than-ideal options: Enforce transparency and risk depression or promote stability and create a "zombie" financial system that yields a prolonged economic malaise, as Japan has experienced since the 1990s.

But these are the choices we face. It would help if politicians and policymakers leveled with us. At the very least, they should acknowledge that both choices come at a significant cost and are likely to create more drama of their own.

The hard truth is that we sometimes have to cope with problems before we can solve them.

Dan Alamariu is an analyst in Eurasia Group’s Comparative Analytics practice.