The Economist recently ran a lengthy, ominous survey of the state of the U.S. economy and its financial markets. One of the more interesting articles was on the stock market, where they cite Andrew Smithers and Stephen Wright, two British economists who argue that the U.S. remains under the spell of a dangerous bubble. They argue that the Federal Reserve should be willing to try to pop the bubble--but that position is quite problematic, as the article points out.
Looking back, both the aftermath of the 1929 stockmarket crash and the bursting of the Japanese bubble were bad enough to justify paying a high price to avoid a repeat. But in both instances the authorities made glaring policy errors, including keeping interest rates high for far too long and, in Japan, refusing to acknowledge the extent of losses caused by the bubble bursting, let alone cleaning them up. There is no obvious reason why other central banks should repeat these mistakes. Alan Blinder, a former vice-chairman of the Fed, observed a little while ago, when the economy was still looking much bubblier than now: “For the US economy to go into a significant recession, never mind a depression, important policymakers would have to take leave of their senses.”
Discussion Question. If productivity in the United States grows at an annual rate of less than 1.25 percent for the next ten years, are stock prices now a bubble? What if productivity grows at an annual rate of more than 2.25 percent?