05/21/2009 05:12 am ET | Updated May 25, 2011

Confidence Game

Some time in the next two weeks, the Treasury will report on the result of "stress tests" conducted on 19 major banks. But you don't have to wait to learn the results. It's already clear that no major bank will be declared insolvent. The administration's economic assumptions about the worst conditions banks will face err on the side of rosy. In fact, much of the stress testing will be done by the banks themselves. There is no army of examiners poring over bank books. At worst, some banks may be asked to raise additional capital or accept additional aid from the government.

The difference between a "stress test" and the process of a government receivership is that the former allows the government to disguise how bad things are, while the latter forces the issue and gets on with the cure. But receivership is what the administration hopes to avoid. Hence the need for rosy test results.

Originally, the stress tests were billed as rigorous examinations of the balance sheets of the banks, under various possible scenarios. The idea was to see whether additional government capital was needed, and to determine whether any of the major banks might be deemed too weak to continue in its present form. But taking banks into government receivership has been ruled out in advance. Instead, government will string along the weakest banks with dollops of aid -- risking a needless prolonging of the crisis.

Contrary to the implication, the stress tests are not true comprehensive, rigorous bank examinations to determine the condition and value of the banks' balance sheets. Any such exercise just became a lot more difficult, since the Financial Standards Accounting Board gave in to political pressure and rescinded its rule requiring assets to be marked down to their current market value. So in principle toxic securities can now be carried on banks' books at whatever valuation the bank chooses while it waits for markets to revive -- a revival that may never come. If we truly believe that the big banks actually booked normal profits in the first quarter, as all of them claimed, then we have learned nothing from the era that began with Enron.

The stress tests are best understood as part of a broad confidence-building offensive, one that may well be premature. Ever since the stress-test exercise was first announced, Treasury has kept moving the goal posts, rather like states or school districts that dumb down proficiency tests so that they can get high rankings under No Child Left Behind.

Some weeks ago, it dawned on the Treasury that if a couple of large banks, say Citigroup and Bank of America, were given failing grades, there would be hell to pay. Treasury might have to go back to Congress for more bailout money. Congress might start asking nosy questions about how Treasury has spent the $700 billion that Congress gave it last fall. And the government might have to take one or two banks into receivership.

The Treasury, rather, hopes to release as few details as possible, lest markets gain information at odds with the increasingly rosy scenario that the administration, the Fed, and the banks themselves are painting. In recent days, both the government and financial analysts affiliated with banks have been on a concerted campaign to talk up the economy.

Last week, I attended the annual conference held every year on honor of the late economist Hyman Minsky, the man who presciently warned that a market economy, absent strong government regulation, is vulnerable to period bouts of financial excess and collapse. The conference included dozens of eminent economists and other experts on finance, ranging from Nobel Laureate Joseph Stiglitz to analysts Henry Kaufman and Martin Mayer, as well as senior officials of the Federal Reserve. For the most part, the appraisals of the condition of the nation's banking system were sober, if not dour. But when it came time for the representatives of the banks to present, you'd think there was only sunshine ahead.

Bruce Kasman, the chief economist of Morgan, saw housing starts improving, the corporate bond market and the commercial paper market returning to normal, pent up consumer spending picking up, and a recovery starting in the second half of this year, with unemployment peaking at 9.4 percent. James Paulsen, of Wells Capital Management, had an even rosier assessment, seeing 3 percent economic growth in the second half of this year. "We have lacked not stimulus, but patience," he told the conference.

I'd sure like a hit of whatever these people are smoking. The fact is that the entire financial economy is still on life support from the government. And the government is asking precious little in return.

While it's true that the Fed's policy of keeping short term interest rates at zero, and trillions of dollars ladled into financial markets by the Fed, plus $787 billion in legislated stimulus spending, and a budget deficit that will be around 12 percent this year, cannot fail to have some impact, the whole economy will still be dragged down by wounded banks. Nearly every responsible economist projects the economy to lose jobs at the rate of at least half a million jobs a month for much of 2009. The authoritative OECD projects that the unemployment rate will still be in excess of 10 percent in 2011.

Top officials of the Obama administration, meanwhile, hit the Sunday talk shows to crow that they would not need more money from Congress, because some banks will be paying back the government ahead of schedule. White House Chief of Staff Rahm Emanuel told George Stephanopoulos Sunday that the Treasury had the resources to provide any financial aid.

EMANUEL: We believe we have those resources available in the government as the final backstop to make sure that the 19 are financially viable and effective.

STEPHANOPOULOS: Without coming back to Congress?

EMANUEL: Right. The resources that we have on hand, we believe -- and it's not just that, George, is that we have those resources; we have a facility to buy these troubled assets off their banks. If they need capital, we have that capacity.

Emanuel added that "we have a facility to buy these troubled assets off their banks. If they need capital, we have that capacity," and that the Treasury would proceed without any need for "nationalization."

The administration's plan for the banks might be described as "kick the can down the road." If we can just disguise the truly dismal condition of major banks' balance sheets for a few months, until more of the stimulus and the Fed's trillions kick in, maybe we can wish them back to life. Suspending accurate accounting helps. So does the kind of creative accounting that allowed even the most wounded banks to report profits for the first quarter. Treasury Secretary Tim Geithner's latest plan allows investment banks and hedge funds to gamble in distressed securities, in the hope that a massive amount of government subsidy will bid up their value.

The trouble, however, is that some things just cannot be disguised. On Monday, the Wall Street Journal did its own calculation of bank lending between October 2008 and February 2009, and found that lending was continuing to fall.

The financial press has also identified the heroic bookkeeping that allowed some of the most damaged banks to claim a return to profitability. (Curiously, the original headline on Eric Dash's NYT piece was "Sharp Pencil Lets Citigroup Declare Profit." By the time the piece made it onto the Times website, the headline was softened to, "After a Year of Losses, Citigroup Finds a Profit.")

As long as unemployment continues to rise, and even people who have not yet lost jobs worry about becoming jobless, consumer spending will not power a recovery. And while the stimulus package spends a lot of money, state and local governments are continuing to lose revenue at about three times the rate that Washington replaces it.

At the heart of this mess is the severely impaired banking system. Administration officials go out of their way to disparage a more direct and orderly way of recapitalizing the financial system, deliberately using terms like "nationalization," and contending that the government is not very good at running banks. But the fact is that ever since the Reconstruction Finance Corporation was originated (not by FDR but by Herbert Hoover), and the Resolution Trust Corporation of the 1980s was legislated to clean up the Savings and Loan mess (under that Bolshevik Ronald Reagan), government from time to time takes over failed banks, replaces management, and recapitalizes them with public funds. The FDIC does it several times a year.

This process, known as resolution or receivership, is not the same thing as long-term nationalization. And it is just what the government is planning when it comes to the auto rescue. The same Treasury department did not hesitate to fire GM chief Rick Wagoner. But it seems determined to keep zombie banks and their zombie managers intact at all cost. And all cost, in this case, could be trillions.

(Watch for two important Tuesday hearings. Tim Geithner will testify before the Congressional Oversight Panel, and leading critics Joseph Stiglitz and Simon Johnson will appear before the Joint Economic Committee.)

Ironically, the administration seems to keep bumping into its own contradictions. In a story carefully fed to the New York Times, unnamed senior officials Monday declared that they would need no more money from Congress because they could always convert the government's existing investment in zombie banks into common stock. However, as the story by Ed Andrews points out, this would leave the government as the largest shareholder -- in other words nationalization by another name.

Little is accomplished by putting a happy face on what is likely to be as difficult period, except prolonging the agony. Of course, it does save a lot of bank executives' jobs, and it does pump up the bank stocks, at least in the short run. Cynics might be forgiven for suspecting that this is the true intent.

Robert Kuttner is co-editor of The American Prospect and a senior fellow at Demos. His book is "Obama's Challenge: America's Economic Crisis and the Power of a Transformative Presidency."