• Cover Story
• Table of
  Contents
• Contents By
  Topic
• Columns
  • Brownstein
  • Cook
  • Crook
  • Rauch
  • Stokes
  • Schneider
  • Taylor Jr.
• Regular
  Features
  • Hotline Extra
  • Inside Washington
  • Insiders Poll
  • K Street Corridor
  • People
  • The Week on the Hill

The good news is that the world economy may be turning the corner. The bad news is that a lot is still wrong with American banks, and U.S. government borrowing seems to be sliding even further out of control. The first development points to a slow recovery at home, the second to a whole new crisis not far down the road.

At a meeting this week of central bankers in Basel, Switzerland, Jean-Claude Trichet, head of the European Central Bank, said that the world economy had probably bottomed out. This was notable coming from Trichet, not one of nature's optimists. The Organization for Economic Cooperation and Development -- the Paris-based club of rich-economy governments -- also said it saw signs of global recovery. At the very least, the pace of decline is slowing. Financial markets have gotten the message. The free-fall scenarios that seemed all too possible several months ago are no longer taken seriously.

Output has even picked up slightly in countries such as France and China -- but not yet in the United States. Whatever happens, U.S. unemployment is likely to keep rising for months. Still, the slower rate of economic decline and the prospect that recovery will begin before the end of the year have revived Wall Street in recent weeks. What matters now, as I argued in this space a month ago, is how strong a recovery we will get -- and whether the coming expansion will steer the economy directly into a new crisis. (See "Obama, Bernanke Duck Specifics," NJ, 4/18/09.)

A brisk recovery is unlikely without healthy banks. Since that previous column, the Treasury Department has announced the results of its "stress tests," an exercise to show how much capital the banks still need to support their lending. The findings, on their face, were reassuring: The tests found banks to be basically solvent, and determined that their capital, after a little refreshment here and there, was broadly adequate. But one needs to be skeptical.

The idea of a stress test is to make pessimistic assumptions -- assumptions with no more than a 15 percent chance of coming true, according to the tests' designers -- and then work through the implications. The assumptions have to be pessimistic, otherwise there is no stress. The problem is, the exercise carried out by the Federal Reserve Board and by Treasury did not consider a seriously bad case. The tests imagine unemployment rising to 10.3 percent in 2010, for instance, compared with 8.9 percent in the base case. But unemployment is already at 8.9 percent and headed higher. In an improbable but entirely possible bad case, unemployment could go well over 10.3 percent next year.

Treasury's scenario barely qualifies as a mildly pessimistic case. It is difficult to take seriously as a rigorous stress test.

The 19 banks examined were deemed to face possible loan losses of $600 billion this year and next taken together. Nouriel Roubini of New York University, a noted pessimist who has been more right than wrong, reckons that loan losses of $900 billion are likely. Treasury's stress tests, in other words, are more optimistic on loan losses than is Roubini's central forecast. The government also expects the banks to generate profits (which can be used to replenish capital) of nearly $400 billion over the two years. Roubini's estimate is half that. All in all, Treasury's scenario barely qualifies as a mildly pessimistic case. It is difficult to take seriously as a rigorous stress test.

The suspicion that the exercise worked backward from political constraints is irresistible. The key thing is the reluctance of Congress, reflecting public opinion, to put any more taxpayer money into helping the banks. To avoid that, the tests had to call for additional capital at a level the banks could hope to raise by themselves, either by issuing new shares, selling assets, or converting preference shares into common equity. And that is exactly what the tests did.

This approach could work, as long as the worst-case scenario that the exercise flinched from examining does not actually come to pass.

But Roubini is right to call it muddling through. Yes, depending on the alternatives, none of them very appealing in this case, muddling through might be the best that Treasury can do. The lack of a more decisive resolution, however, leaves the banks' willingness to lend in doubt.

Under the government's assumptions, banks will need the capital they have, and more, to even support their current levels of lending. In almost any scenario, their capacity to expand their lending is constrained. So nobody should count on a vigorous growth of credit -- or a strong credit-fueled recovery in the wider economy.

If economic growth, once it resumes, is slow, the outlook for public borrowing is correspondingly worse. Pressure on public spending will be higher and tax receipts lower than the White House has planned. Its plans, of course, already include heavy medium- and long-term borrowing, even with the administration's rosy economic assumptions.

On this front, the past few days have seen several disturbing developments. The White House released new deficit projections, significantly worse than the ones in its budget of just weeks ago. The fiscal 2009 deficit is now forecast at $1.84 trillion, 5 percent worse than before, and the deficit in 2010 at $1.26 trillion, 7 percent worse than earlier. Peter Orszag, the administration's budget chief, called these technical revisions: They do not reflect new tax or spending proposals. But if the recovery is slow, more such revisions will come. Technical or otherwise, they push the same way.

Fears about long-term fiscal viability may already be coming to the fore, and the recovery has not even started yet.

No sooner had the administration released this bad news than the Social Security and Medicare trustees issued their annual report. Again because of revenue shortfalls, both programs are running down their assets faster than expected. According to the new projections, Social Security's trust fund will be gone by 2037, four years sooner than in the previous report, and Medicare's by 2017, two years sooner than projected. Admittedly, the trust-fund structure of these programs is a bookkeeping fiction.

In economic terms, Social Security and Medicare are really just enormous pay-as-you-go programs, financed out of current taxation. The disappearance of the funds has no economic significance. The point is simply that at present levels of payments and receipts, they are adding faster than before to projected fiscal deficits.

President Obama's budget projected a long-term deficit of more than 3 percent of gross domestic product, despite strong sustained growth, and despite taking credit for spending cuts and tax increases that likely will not happen. Take carbon cap-and-trade, for instance. Obama penciled in the sale of permits to emit greenhouse gases to raise nearly $80 billion a year, with the proceeds earmarked to the administration's "making work pay" tax cut (intended to offset the impact of cap-and-trade on utility bills for lower-paid workers) and subsidies for renewable energy.

During the election campaign, Obama promised that all such permits would be auctioned. This week, Congress was debating how many of them to give away -- half, or more, was how the discussion seemed to be going. If cap-and-trade passes in any form, by no means certain, given bipartisan opposition in the Senate, it will raise much less money than hoped. The administration says that, if so, it will roll back its tax cut proportionately, leaving the deficit unaffected. We will see whether Congress goes along with that. In any event, cap-and-trade represents another big revenue shortfall.

Obama pushed back against these unhelpful fiscal developments first by calling, with quite some fanfare, for his Cabinet chiefs to cut $100 million from their departments' budgets. Hard to say why this announcement was not saved for use with all the other jokes at the recent White House Correspondents' Dinner. With a projected deficit approaching $2 trillion, savings of $100 million are offered as "a signal that we are serious about changing how government operates"? Good one.

Later, announcing the fleshed-out version of his budget for 2010, Obama called for new spending cuts of $17 billion -- a not-quite-as-comical number, but still less than 0.5 percent of the projected $3.5 trillion in spending. The president also announced an agreement with health care providers on voluntary efforts to contain costs, which would curb some Medicare outlays. That was encouraging in one way -- it showed that the health care industry does not expect to be able stop Obama's reform efforts in their tracks. At the same time, voluntary cost control has been promised countless times before, never to materialize.

The task is not to bring the 2010 deficit down. Next year, a strongly expansionary budget is still needed to prop the economy. The danger lies in high projected deficits in the years beyond, a prospect baked into the administration's long-term budget planning.

Last week, the bond market hesitated when it was asked to absorb a new tranche of government debt. Fears about long-term fiscal viability may already be coming to the fore, and the recovery has not even started yet. Sooner rather than later, the White House will have to start talking about serious spending cuts, serious tax increases, or both.