that it should reduce the risk of hitting the zero bound, but we should recognize that under some circumstances extra action may actually exacerbate the problem. to see this, suppose that a speculative bubble has emerged and that a central bank, operating under a conventional strategy, has raised interest rates to keep the projected output gap closed and expected inflation at its desired level before the bubble bursts. now the central bank contemplates taking extra action. in a low - inflation environment, such a step would be a bad idea if, after averaging across all the possible outcomes weighted by their likelihoods, the predicted moderation in the bubble from tighter policy is small. in this case, the expected weakening in real activity after the bubble bursts would be only marginally less severe under extra action, but inflation would be substantially lower because the extra action policy would have generated persistent economic slack beforehand. with inflation having already started out at a low level, such a decline would be extremely dangerous because the zero bound would now be much more likely to constrain monetary policy after the bubble see alan g. ahearne, joseph e. gagnon, jane haltmaier, and steven b. kamin ( 2002 ), " preventing deflation : lessons from japan's experience in the 1990s, " international finance discussion paper series 2002 - 729 ( washington : board of governors of the federal reserve system, june ). bursts. under these conditions, extra action would therefore worsen expected economic performance, not improve it. another purported benefit of extra action is that, by raising the cost of capital to firms and households, it helps reduce overinvestment fostered during speculative booms, thereby making it easier for the economy to recover after the bubble collapses. however, we should be careful not to exaggerate the macroeconomic importance of such capital mis - allocation. true, the u. s. high - tech boom led to overinvestment in some sectors, wasting resources and creating lingering difficulties while capital overhangs were eliminated. but it is hard to see much of a cost in terms of diminished aggregate productivity, given the robust growth of output per hour over the past few years. furthermore, even if tighter monetary policy would have damped the enthusiasm for dot - com firms in the late 1990s, higher interest rates would have also led to less housing and less business investment outside the high - tech sector, where valuations were not obviously out of line with fundamentals. thus, mitigating

of such effects. however, without the onset of deflation, how large is this risk? in recent history, the health of the u. s. financial system remained solid after the collapse of the high - tech boom, despite the bankruptcy of dozens of telecom and dot - com firms, the loss of more than $ 8 trillion in stock market wealth, and stress in the nonfinancial corporate sector. moreover, the financial sectors of most other developed economies also weathered the worldwide drop in corporate equity values fairly well. of course, the nonlinear risks associated with a collapsing bubble may depend on the initial health of the financial system, and under some circumstances we could be worried about the potential for significant financial distress to accompany the bursting of a bubble, should that bubble expand further. even in such cases, however, i wonder whether good prudential supervision in advance and prompt action to clean up any lingering structural problems afterward would not be better ways to deal with this possibility. certainly, closer oversight of banking systems during the 1980s, including the united states, would have left many economies in a stronger position during the early 1990s. this lesson has been absorbed by supervisory authorities around the world, as evidenced by our successful efforts to strengthen bank capital and our financial systems. i do agree that market corrections can have profoundly adverse consequences if they lead to deflation, as illustrated by the united states after the 1929 stock market crash and the more recent experience of japan. but it does not follow that conventional monetary policy cannot adequately deal with the threat of deflation by expeditiously mopping up after the bubble collapses. in japan, deflation could probably have been avoided if the initial monetary response to the slump in real estate and stock market values had been more aggressive ; in addition, macroeconomic performance would have been better if the government had dealt more promptly with the structural problems of the banking sector. 6 as for the great depression, the federal reserve actually worsened the situation by allowing the money supply to contract sharply in 1930 and 1931, after unwisely attempting to prick the stock market bubble in the first place. rather than demonstrating the need for preemptive extra action to restrain emerging bubbles, these examples are object lessons concerning the wisdom of central banks'easing promptly and aggressively following market slumps when inflation is already low, so as to head off the threat posed by the zero lower bound. by doing so, policymakers should be able to avoid the severe nonlinear dynamics of deflation. proponents of extra action often argue