I offer a challenge that requires vocabulary and reasoning skills and may bring back memories of elementary school. And it's not talking your way out of detention. In the diagram below, seven sins are listed in the column on the right, seven topics in the column on the left, and we'll play word match with the two columns. It won't be an especially tidy word match, since each of the topics brings to mind multiple sins. But I'll offer my choices for the best matches and why. I'll do this in a series of seven articles, one match at a time, beginning with topic #1: "Government economic scenarios."
Government economic scenarios
In the 1970s and 1980s, doctors developed procedures to examine places where problems aren't otherwise found until it's too late. That's right, I'm talking about colonoscopies and prostrate exams. Today, we have the same thing in the business world - bank stress tests. All U.S. banks with greater than $10 billion in assets are now required to stress test their financial strength at least once a year. Federal Reserve Bank Governor Daniel Tarullo, who helps oversee the tests, summarized their role as follows:
Stress testing is a key tool to ensure that financial companies have enough capital to whether a severe economic downturn without posing a risk to their communities, other financial institutions, or the greater economy.
Now, there are many problems with bank stress tests, but I'll set those aside for now and consider a more general question. The question is this: if we're thoroughly examining one sector of the economy that's been reducing its financial leverage for the past four years, shouldn't we also examine the parts of the economy that are increasing their leverage; the public sector, perhaps? Our government's financial strength is also important to the health of "communities," "financial institutions," and "the greater economy," to echo Tarullo's concerns about our largest banks. Therefore, you might argue that projections of government finances should follow similar standards to those required of banks. Let's see if they do. Three governmental entities are especially relevant: (1)
- The Board of Trustees for the Social Security Trust Fund publishes 75-year projections using three different economic scenarios: intermediate, low cost and high cost.
- The White House's Office of Management and Budget (OMB) publishes 10-year projections based on a single economic scenario.
- The Congressional Budget Office (CBO) publishes 25 year projections, also using a single set of economic inputs. (Although the charts below are based on the shorter ten year projections released yesterday.) (2)
For banks, stress tests are based on three different economic scenarios, just like the Social Security trustees' projections. The least favorable scenario is the most important and the only one that's included in results disclosed to the public. For the next round of stress tests, it's based on a hypothetical recession beginning in the fourth quarter of 2012 and continuing until early 2014. The recession is "severely adverse," which the Fed defines loosely as a worsening of the unemployment rate of between 3% and 5% (such as those that occurred in 1957-58, 1973-75, 1981-82 and 2007-09). Have a look at the assumptions for economic output for this recession, compared to the worst of the three Social Security trustees' scenarios and the single scenarios of the OMB and CBO (calculated using data from the documents listed at the end of the article).
And here are the assumed unemployment rates in the same four scenarios:
Clearly, the charts mix apples and oranges. The Fed (bank stress tests) and Social Security trustees' scenarios represent the worst of three different sets of inputs, while the OMB and CBO each use a single scenario. And this is exactly the problem. The OMB and CBO are the main places to look for government debt projections, and they don't even consider the possibility of recession. Ironically, the health of the Social Security program is largely insensitive to the economy's growth rate, and yet, this and Medicare are the parts of the budget that are tested against an adverse economic scenario.
Notice, though, that the Social Security trustees' adverse scenario is a walk in the park compared to the recession that banks are required to test. The government simply doesn't test its financials against recessions - a practice that's been reserved for the private sector. In other articles in this series, I'll have more to say about the perpetually stable economy assumed by the OMB and CBO. But I'll base my word match choice on the giant gap between the government's standards for the private sector and the standards they apply to themselves. And I'll call it hypocrisy.
- Board of Governors of the Federal Reserve System, "2013 Supervisory Scenarios for Annual Stress Tests Required under the Dodd-Frank Act Stress Testing Rules and the Capital Plan Rule," November 15, 2012.
- The Board of Trustees, Federal Old-age and Survivors Insurance and Federal Disability Insurance Trust Funds, "The 2012 Annual Report of the Board of Trustees, Federal Old-age and Survivors Insurance and Federal Disability Insurance Trust Funds," April 25, 2012.
- Office of Management and Budget, "Fiscal Year 2013 Budget of the U.S. Government."
- Congressional Budget Office, "The 2012 Long-term Budget Outlook," June 2012.
- Congressional Budget Office, "The Budget and Economic Outlook: Fiscal Years 2013 to 2023," February 2013.
(1) The Government Accountability Office (GAO) also makes long-term debt projections, but it borrows economic assumptions from the CBO and the Social Security trustees. The Social Security trustees' economic scenarios are also used by the Board of Trustees for the Medicare trust funds.
(2) In its long-term budget outlook, the CBO acknowledges that it's unwise to base debt projections on economic scenarios without also considering the reverse effects of future changes in debt on the economy. It analyses these reverse effects, but without altering its primary debt projections and without publishing the results in a form comparable to the Fed's bank stress tests.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.