about the prospects for the specific companies that make up our broad stock price indexes. if episodic recurrences of ruptured confidence are integral to the way our economy and our financial markets work now and in the future, it has significant implications for risk management and, by implication, macroeconomic modeling and monetary policy. probability distributions that are estimated largely, or exclusively, over cycles excluding periods of panic will underestimate the probability of extreme price movements because they fail to capture a secondary peak at the extreme negative tail that reflects the probability of occurrence of a panic. furthermore, joint distributions estimated over periods without panics will misestimate the degree of correlation between asset returns during panics. under these circumstances, fear and disengagement by investors often result in simultaneous declines in the values of private obligations, as investors no longer realistically differentiate among degrees of risk and liquidity and increases in the values of riskless government securities. consequently, the benefits of portfolio diversification will tend to be overestimated when the rare panic periods are not taken into account. as we make progress, hopefully, towards understanding asset - pricing mechanisms, we need also to upgrade our insights into the effect of changing asset values on gdp – the so - called wealth effect. although many aspects of this issue deserve attention, let me cite a few open questions of particular importance. efforts to differentiate between realized and unrealized gains, and the propensity to leverage both, may afford a deeper understanding of the consequences of asset price change. and differentiating between gains that arise from enhanced profitability and those that reflect changes in discount factors may also be useful. the former may be more likely to be sustained, given the tendencies of discount factors to revert back to historic norms. moreover, it is evident that borrowings against capital gains on homes influence consumer outlays beyond the effects of gains from financial assets. preliminary work at the federal reserve suggests that the extraction of equity from housing has played an important role in recent years. however, stock market values and capital gains on homes are correlated and, hence, their separate effects are difficult to identify. this is an area that clearly warrants further examination. finally, in the business sector, questions remain about the influence of equity prices on investment spending. in particular, do all equity price movements – whether related to fundamentals or not – have the same effect on investment spending? in conclusion, the issues that i have touched on this morning are of increasing importance

ongoing labor compensation charges against corporate earnings. this distortion, all else equal, has overstated growth of reported profits according to fed staff calculations by 1 to 2 percentage points annually during the past five years. similarly, the rise in stock prices, which reduces corporate contributions to pension funds is also augmenting reported profits. these upward adjustments in reported earnings, of course, are a consequence of rising stock prices and, hence, may not be of the same dimension in the future. nonetheless, it is reasonable to surmise that undercapitalized expenses have been rising sufficiently faster than reported earnings to have more than offset the factors that have temporarily augmented reported earnings. it does not seem likely, however, even should all of the appropriate accounting adjustments to earnings be made, that such adjustments can be the central explanation of the extraordinary increase in stock prices over the past five years. however we calculate profits and capital, shifts in the stock market value of firms will doubtless continue to remain important influences on our economies. it is thus incumbent on us to improve our understanding of the process by which projections of future earnings are translated into asset market value. even our most sophisticated analytic techniques have difficulty dealing with the interactions among time preference, risk aversion and uncertainty, and with the implications of these interactions for the risk premiums that are embedded in asset prices. it is our failure to anticipate changes in this discounting process that much of our inability to accurately forecast economic events lies. for example, the dramatic changes in information technology that have enabled businesses to embrace the techniques of just - in - time inventory management appear to have reduced that part of the business cycle that is attributable to inventory fluctuations and, accordingly, may well have been a factor in the apparent decline in equity premiums that has characterized the latter part of the 1990s. whether the decline in these premiums themselves may foster activities that could result in wider business cycles, as some maintain, is an open question. as model builders know, all economic channels of influence are not of equal power to engender growth or contraction. of crucial importance, and still most elusive, is arguably the behavior of asset markets. more broadly, there is an increasing need to integrate into our macro models more complete descriptions of the responses of households and businesses to risk – behaviors that are generally modeled separately under the rubric of portfolio risk management. for example, erik brynjolfsson and shinkyu yang, “ the intangible costs and benefits of computer investments