The results of American banking ?stress? tests have arrived amidst speculation that the economy is improving. Indeed, many public figures have given reassuring signals in recent weeks. Barack Obama and Ben Bernanke both hinted that the worst is behind us. In a meeting with credit card executives, Larry Summers was photographed in a sleep so tranquil that it would put Deve Gowda to shame. And on American television, Jim Cramer, the infamous financial guru, recently declared the depression over.
Yet, there are many reasons to remain sceptical, not least of which is that Cramer made a similar announcement last summer. The data are still ambiguous. The good news is that consumer spending is up and equity markets are no longer abysmally low. The bad news is that urban housing prices have continued to decline, manufacturing is shrinking, credit remains unavailable and stock prices are volatile.
The stock volatility was partly driven by concerns about the stress tests, which estimate how much capital banks must hold to survive a deepening recession. The US government has made the somewhat encouraging announcement that only ten of 19 large banks need to raise more capital. However, a positive stock market reaction should not be taken as a sign of an improved economy. After all, the test results were based on the Federal Reserve?s guess about the worst-case scenario, a guess that has proved wildly inaccurate in the past.
To make a pronouncement on economic recovery, we need to observe slightly longer-term trajectories, not just of stock prices but also of more tangible measures like industrial output and unemployment. Matters are complicated by the fact that we are no longer sure what a healthy trajectory is. Clearly, we cannot expect growth rates to rebound to pre-crash magnitudes since those were symptomatic of a dysfunctional global economy in the first place.
Of course, it might make sense for the US administration to declare the recession over even if it isn?t. One of the jobs of the government is to coordinate expectations. This is particularly important in environments where an individual?s behaviour depends on her expectation of others? behaviour. For example, a government?s announcement that cash was worthless would lead to the collapse of cash payments. While a reversion to barter might sound appealing to some atavistic utopians, imagine carrying a palm tree into your butcher?s shop to pay for a kilo of mutton.
To the extent that well-functioning credit markets rely on positive expectations, the government?s optimistic declarations could be self-fulfilling. But there remain deeper problems that require more active restructuring, especially in manufacturing and financial market regulation.
The government is trying to fix these structural problems, but it is difficult to predict the impact of interventions that have never been tried before. For example, the Treasury Department?s plan for the sale of toxic assets could easily backfire. Under this plan, the government will not only subsidise, but also insure private purchases of toxic assets. What this effectively means is that taxpayers are providing insurance without being paid an insurance premium in return. If these assets turn out to be truly toxic, the already huge debt burden on future citizens will expand further.
It is in the world?s interest to see the US economy back on its feet. The international economic system is not a zero-sum game, and countries rely on each other for investment and trade. It is reassuring that Indian manufacturing grew in April after several months of contraction. But exports fell a staggering 33% over the last year. This is strongly linked to the US recession, and is a reminder that India is insufficiently diversified in its trading partners. Also worrying for India is that cross-border lending is showing no signs of recovery.
However, the weather is a source of hope. After a long winter, it is spring in the US. If the economy is driven by what Keynes referred to as ?animal spirits?, it is possible that young men?s fancies will turn to thoughts of stocks. At present, half the large banks (and, one might add, Mr Summers) have passed the stress test. It remains to be seen if the rest of the country follows suit.
The author is a post-doctoral fellow and instructor in economics at the University of Chicago