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In the Nation's Interest

Financial Crises and Business Cycles: A Movie With Many Sequels

New Book Brings Back 2008 Crisis and Recession

Former Treasury Secretary Geithner’s first book, Stress Test, brought renewed attention to the 2008 financial crisis and to the ensuing recession.  The commentators failed to highlight one fact:  Financial market reversals and economic downturns are, unfortunately, regular occurrences in  American free enterprise.  The societal toll of these phenomena is quite severe, which opens the system up to legitimate criticism.

Moderating, or preventing, these events remains a real challenge for the government and the business community, because there appears to be no self-correcting mechanism.  The repeated nature of the events indicates the challenge is pressing.

Recessions and Financial Crises Are Old Stories

Since 1970, the United States has experienced seven recessions (an average of one every six years), defined by the National Economics Research Board (NBER) as “a significant decline in economic activity spread across the economy, lasting more than a few months…” Over the same period, we have seen five steep financial market reversals, where stocks declined 30% or more, with real estate prices falling as well.  Direct government support of the financial sector was evident in the 2008 crisis, and noticeable in a late 1980s predecessor, when the government bailed out the savings and loan (S&L) industry at tremendous cost.

At times, the two phenomena – financial market decline and economic recession – are coincident, and Wall Street troubles spill over into the regular economy.  This was certainly the case in 2008, and the 2001 recession had links to the 2000 dot-com stock market collapse.

Financial Economy and Regular Economy

The U.S. financial markets get high marks for efficient capital allocation and innovation.  Their organization is widely emulated around the world.  That being said, financial firms have unique attributes.  Unlike manufacturing or other service businesses, the tangible assets in the firms immersed in the “financial economy” are almost entirely pieces of paper, most of which are contractual in nature, such as:

  • Loans
  • Stock certificates
  • Derivatives

In contrast, many Americans (and businesses) associate the  “regular economy” (what economists would call the “real economy”) with more tangible goods and services, like a haircut, smartphone or restaurant meal.  The firms in this economy work with the financial players for funding and support.

The contracts – or pieces of paper – in the financial economy comprise the preponderance of the balance sheet assets of the major banks, investment banks, and insurance companies.  Federal regulators (and state regulators in the case of insurers) have an acute interest in receiving accurate contract values, so problem links in the chain can be addressed quickly, before the regulator must step in directly.  Nonetheless, financial instruments can be complex, and it can be hard for outsiders to verify that the banks have not made mistakes.

Financial Assets Can Be Tough to Value

The valuation of financial assets relies on two methodologies:

  • Fundamental value
  • Comparable value

Both approaches have problems.

Fundamental value relies on (i) the estimated future earnings power of the business issuing the security; and (ii) the appropriate rate, given the asset’s risk, at which to discount that firm’s earnings power to the present day.  It’s theoretically valid, but hard to put into practice:

  • Projections are uncertain
  • The equity discount rate for a stock (or the yield for a bond-oriented  instrument) is hard to pinpoint, particularly as you advance past government-type obligations

Furthermore, 95% of the projections I have seen in investment banking/private equity deals ignore the likelihood of a future recession, so the issuer’s results move steadily upward, even if a recession would interrupt the trend and disrupt the deal.  This custom also damages the fundamental approach’s validity.


  1 2 3 4 5
Typical Forecast 100 110 120 130 140
Reality (recession, year 3) 100 110 90 100 120

The comparable approach isn’t perfect either.  Here, the investor evaluates a stock or bond price by considering similar securities.  If Safeway is trading at 20x earnings, for example, then that price-earnings multiple is a guidepost for other supermarket chains.  One problem is many public firms (or bonds and derivatives) lack true comparables.  Another issue is the loss of credibility when the entire sector is inflated, such as the dot-coms in the late 1990s (and some say the social media space today).  By way of illustration, if a social media stock trades at 100 times earnings, and this price-earnings multiple is consistent with similar equities, the comparable analysis concludes the stock is fairly priced.  This result can conflict with common sense.

Residential Real Estate Values

Comparable analysis dominates residential real estate.  Appraisers look at nearby property sales to gauge the fair price of a home.  The property’s future rental income takes a back seat, even though annual rental income is a good fallback position for estimating a home’s worth from a purely monetary angle.  Mortgage lenders who depend principally on comparable-based appraisals to set “loan on fair-market value” ratios – a critical component of residential credit approvals – are thus in danger of overheating a residential market.  The lenders’ new financing for home buyers can set up a spiral of upward trending purchase prices.

Regulators, Business and Balance Sheets

The sentiment on a financial firm’s true asset value is thus the result of competing forces, many of which have a subjective element.
Regulators have tried to get ahead of the valuation puzzle in the past, to forestall panics and follow-on recessions.  Financial firms have committees – armed with institutional responsibilities – to monitor asset valuations as well.  As Stress Test tells us, neither tactic had success in 2008.  As history warns us, another blow-up may be lurking around the corner.