about the quality of corporate governance. * * * the struggle to understand developments in the economy and financial markets since the mid - 1990s has been particularly challenging for monetary policymakers. we were confronted with forces that none of us had personally experienced. aside from the then recent experience of japan, only history books and musty archives gave us clues to the appropriate stance for policy. we at the federal reserve considered a number of issues related to asset bubbles - - that is, surges in prices of assets to unsustainable levels. as events evolved, we recognized that, despite our suspicions, it was very committee on banking and financial services, u. s. house of representatives, july 22, 1999. for continuous discounting over an infinite horizon, k ( e / p ) = r + b - g, where k equals the current, and assumed future, dividend payout ratio, e current earnings, p the current stock price, r the riskless interest rate, b the equity premium, and g the growth rate of earnings. the relationship holds for both real and nominal variables. if k is assumed to be 0. 6, the average over the second half of the 1990s ( taking account of payouts made through share repurchases ), a rise in the p / e of the s & p 500 from 15 to 30, with r and b unchanged in real terms, implies an increase in g of 0. 02 in real terms. if earnings are a constant share of output in the long run, then real long - term earnings growth is the product of productivity growth and growth in labor force hours. in this exercise, the growth rate of hours, driven by demographics, is assumed not to change ; hence, the growth rates of earnings and productivity are the same. difficult to definitively identify a bubble until after the fact - - that is, when its bursting confirmed its existence. moreover, it was far from obvious that bubbles, even if identified early, could be preempted short of the central bank inducing a substantial contraction in economic activity - - the very outcome we would be seeking to avoid. prolonged periods of expansion promote a greater rational willingness to take risks, a pattern very difficult to avert by a modest tightening of monetary policy. in fact, our experience over the past fifteen years suggests that monetary tightening that deflates stock prices without depressing economic activity has often been associated with subsequent increases in the level of stock prices. for example, stock prices rose following

causes, or simply forecasts, sharply higher spending on consumer goods and new capital, it may indicate incipient inflationary pressures. policy tightening might therefore be called for - but to contain the incipient inflation not to arrest the stock - market boom per se. the second part of my prescription is for the fed to use its regulatory, supervisory, and lender - of - lastresort powers to protect and defend the financial system. in particular, alone and in concert with other agencies, the fed should ensure that financial institutions and markets are well prepared for the contingency of a large shock to asset prices. the fed and other regulators should insist that banks be well capitalized and well diversified and that they stress - test their portfolios against a wide range of scenarios. the fed can also contribute to reducing the probability of boom - and - bust cycles occurring in the first place, by supporting such objectives as more - transparent accounting and disclosure practices and working to improve the financial literacy and competence of investors. finally, if a sudden correction in asset prices does occur, the fed ’ s first responsibility is to do its part to ensure the integrity of the financial infrastructure - in particular, the payments system and the systems for settling trades of securities and other financial instruments. if necessary, the fed should provide ample liquidity until the immediate crisis has passed. the fed ’ s response to the 1987 stock market break is a good example of what i have in mind. i have expressed these two principles in rather simple terms ; they could be elaborated much further. taken together, they provide a strategy for policy that has a number of advantages : it keeps monetary policy focused on the appropriate goal variables, economic activity and inflation. it is transparent and easy to communicate to the public. it does not require that central bankers be systematically better than the market at valuing financial assets nor substitute policymakers ’ judgments of company prospects for those of investors. finally, and crucially, it is a robust strategy, in that - although it certainly does not eliminate all economic and financial instability - it protects the economy against truly disastrous outcomes, which history has shown are possible when monetary policy goes severely off the track. the opposing view : preemptive strikes against bubbles as i noted at the beginning, however, the framework just articulated is not universally accepted, particularly the aspect that precludes attempts to guide the course of asset prices. instead, a number of critics have argued that monetary policy should be more proactive in trying to