SYNOPSIS: Assuming stock markets are nuts, what should the Fed do? Answer: Hope for a prick in the bubble, but any action might make things worse.

  It was a time of unprecedented prosperity. And it was also a time of soaring stock prices, a time when the market became a national obsession. As more and more ordinary Americans began buying stocks, many responsible people became worried. True, some market gurus argued that changed fundamentals made the higher price levels reasonable--and those optimists had, of course, been right so far. But still there was a sense, almost a consensus, among sober heads that this was a classic bubble.

   Even if stock prices had gone crazy, however, what if anything should be the policy response? Should the Fed raise interest rates and pop the bubble? Or would this simply bring on a recession? Anyway, if consumer prices are stable, should the central bank even care about asset inflation?     Like most debates in which nobody really knows the answer, one became peculiarly intense and bitter. Those who wanted the bubble popped accused the other side of irresponsibility, warning that continued financial excesses would inevitably lead to a painful hangover. Their opponents argued that as long as there were no signs of inflation, to raise interest rates would be an act of pure spite and would itself bring on a gratuitous recession.

   So even in times of prosperity, a central banker's lot is not a happy one. The funny thing is that 70 years later the great debate about the market and monetary policy, the one that raged in 1928 (bet you thought I was talking about current events--well, those too) remains unresolved. What, if anything, should the Fed do when it thinks the market has gone mad?    You can tell that this question has gotten Greenspan upset: He's so worried that he's become--it scares me to say this-- comprehensible. Everyone knows he believes stock prices are too high. But the market is no more convinced now than it was the first time he warned about "irrational exuberance," back when the Dow was around 6500. So he can't seem to talk it down. Should he do more?    The answer, I'm almost convinced, is no: leave the economy alone. But I'm not totally sure, so let me give both sides.    To start, let's assume Greenspan is right, that this is a bubble-- that it isn't just the Internet stocks with infinite P/E ratios (because they haven't got, and may never get, any E) but stocks in general that are way out of line. Eventually the bubble will burst, and the "wealth effect" of that burst will pull down consumer spending. At that point we will have a recession if the Fed either doesn't or can't cut interest rates enough to keep the economy going.    Now, we know Greenspan will be fast on the trigger if it looks as if a recession is brewing, so the main danger is a collapse in consumer spending so deep that interest rate reductions are ineffective--sort of what happened to Japan. You might think that the big question, then, is whether this is at all likely for the U.S.

   Actually, that's the wrong question. Say you're worried that after the Big Meltdown, Americans will be so discouraged that even zero interest won't keep them spending. That still doesn't mean things would necessarily have been better had the Fed raised rates when the market was high.

   The thing to understand is that a stock market boom is not like a boom in physical investment--say, a boom in condominium construction. That kind of boom depresses future spending because it leaves behind a landscape littered with unsellable condos. But that isn't quite what happens when stocks surge: When the market value of doubles, that doesn't mean there will be an overhang of vacant dot- coms weighing down rental rates two years from now. It's paper gains today, paper losses tomorrow; who cares?

   Advocates for pricking the market bubble have a few favorite scenarios. First, there's the "harder they fall" hypothesis: The higher stocks go now, the lower they will go--or the lower consumer spending will be for any given level of stock prices--when people return to reality. But that's more amateur psychology than serious analysis, and a poor basis for economic policy.

   Ah, they say, but what about debt? Shouldn't Greenspan act to counter the defaults that could accompany a market crash? If consumers go deeply into debt to buy stock or to buy consumer goods because their market gains make them feel rich, this could depress spending later on. But really bad debt overhangs come when businesses (especially real estate developers) overborrow, which is not, as far as I can tell, a big problem in America right now.

   Perhaps the most seductive argument for Greenspan's intervention in the market is the lesson that the past would seem to teach us: Didn't America's bubble in the 1920s, and Japan's in the 1980s, prepare the way for the economic crises that followed? Maybe--but it turns out that in both cases the central banks raised rates in an attempt to let the air out of markets, and thus may have helped precipitate the very slumps they feared.

   So what should Greenspan do? Probably what he does best--i.e., nothing--and deal with the bubbles if and when they burst. Oh, and I wish he wouldn't worry so publicly: It makes me nervous when I understand what he's saying.