Word Matching the “Deadly Sins”: #1

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 on the left, and we’ll play word match with the two columns. Each of the topics is related to government finances.  As we work through them, we’ll see a pattern that doesn’t bode well for our financial future.

We’ll cover the topics in a series of seven articles, one match at a time, beginning with “Economic scenarios.”

From medical tests to banking to economic scenarios

In the 1970s and 1980s, doctors developed procedures to examine smelly 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 required to test their financial strength at least once a year. Federal Reserve Bank Governor Daniel Tarullo, who helps oversee the tests, summarizes their role as follows:

Stress testing is a key tool to ensure that financial companies have enough capital to weather a severe economic downturn without posing a risk to their communities, other financial institutions, or to the general economy.

Now, there are many problems with bank stress tests, but I’ll set those aside and ask a 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, such as the public sector?

Our government’s financial strength is also important to the health of “communities,” “financial institutions,” and “the general economy,” to echo Tarullo’s concerns about our largest banks. Therefore, you might argue that government financial projections should follow similar standards to those required of banks. They should also be tested against a “severe economic downturn.”  Let’s see if they are.

How stressful are the government’s projections?

Three governmental entities are especially relevant:

• 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 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 shorter 10-year projections released in February.

Like the Social Security trustees’ projections, tests for banks rely on three different economic scenarios. The least favorable of the three is the most important and the only one that’s included in results disclosed to the public. For the latest round of tests, it was based on a hypothetical recession beginning in late 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% (which is what happened in 1957-58, 1973-75, 1981-82 and 2008-09).

Have a look at the assumptions for economic output for this recession, compared to the projections from the Social Security trustees, OMB and CBO:

And here are the 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 financial projections, and they don’t consider the possibility of even a mild slowdown.

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 scenario. Notice, though, that the adverse Social Security scenario (which is also used for Medicare) is a walk in the park compared to the downturn that banks are required to test. Unless they’re setting guidelines for the private sector, government analysts simply don’t test their projections against a true recession.

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 answer on the giant gap between the government’s standards for the private sector and the standards it applies to itself. And I’ll call it hypocrisy.

Check back tomorrow for topic #2: Unexpected events.