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Somehow, 7 of 91 European Banks Fail Fake 'Stress Tests'

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Incredibly, seven of the 91 European banks that underwent "stress tests" somehow failed to pass the tests even though the tests were designed so that every bank would pass them. The tests or "exercise," as the Committe of European Banking Supervisors put it, were conducted over a two-year horizon under -- this is the punchline -- "very severe assumptions."

And just what were these "very severe assumptions"? Losses of 23.1% on Greek debt, 14% on Portuguese bonds, 12.3% on Spanish debt and 4.7% on German debt. As well, as Bloomberg reported this morning, the tests ignored the majority of banks' holdings of sovereign debt since regulators made the decision against testing securities held in their banking books.

But this should not be surprising. Such "stress tests" -- including the one last year on U.S. banks -- are specifically formulated to allow the majority of banks to pass since regulators view the tests as vote-of-confidence formalities during a period of weakened confidence. In other words, as we have seen here in the U.S., banking regulators and policymakers refuse to accept that the underlying economic problem facing financial institutions is too much debt supported by too little real economic activity. All along, both in the U.S. and globally, the financial crisis has been treated as a liquidity crisis as opposed to a debt crisis. The truth is that the seven banks that failed the stress tests are the sacrificial lambs necessary to make the entire process appear as if it is legitimate.

What is happening now is part of the ongoing battle between markets and governments. Despite the best efforts of governments and policymakers, deflation is winning this battle. Deflation is the contraction (reduction) of money and credit. It occurs when the economic system is carrying too much debt to be supported by the level of income generated by economic activity. It occurs because too much debt has been incurred to create unproductive assets that don’t generate income. Deflation is a corrective process, it’s simply the market (you and I) not being able to service debt, so we must forfeit.

Since central banks and accepted economic theory are all about creating debt to grow (artificially) economies, periods of inflation (creating money-debt and credit) last a long time: Debt is accumulated incrementally until there is too much of it. So people don’t really understand the tells of deflation.

Central banks of countries with massive external debt (such as the US) are desperate to create inflation (to keep credit from contracting), but the mechanism to do that is broken (because there’s too much debt). This process occurs in fits and starts and so it is difficult for people to observe as a trend. They see the price of milk go up 15 cents and conclude deflation is not occurring. Or, they see stocks go up for a few weeks and conclude that the market is responding to fiscal and monetary stimulus. But things do not move in a straight line. the deflationary forces at work are secular and will be with us for a long time. This is the third inning, not the ninth.
POSITION:  No positions in stocks mentioned.