Author
"The facts don't speak for themselves; they need all the theory they can get."
Robert E. Lucas, Jr.
Professor of Economics
University of Chicago
When I started working as an editor in the Minneapolis Fed's Research Department six years ago, I thought that very little of the department's research had anything to do with what goes on in the real world. What did rational expectations theory, Bayesian vector autoregressions, or dynamic stochastic general equilibrium models have to do with my day-to-day existence? Could a bunch of brilliant but somewhat eccentric Ph.D.'s in economics have any impact on what goes on outside this Bank? Now, six years later, I'm finally beginning to make some connections.
What's Research Got to do with Reality?
My quest for connections between the department's economic research and the real world began with Preston Miller, the department's vice president and deputy director. I chased him down the hall one day to ask whether the arcane, equation-littered economics I helped edit had the least influence on actual policy decisions made in Washington, D.C.
"Sure it does," he said, escaping into an elevator before I could press for details.
Cornered over lunch the next day, Miller—joined by senior research officer John Boyd and senior economist Dick Todd—informally discussed how the department's work can touch non-economists like me.
Take the savings and loan crisis. In 1983, John Kareken, one of the department's advisers from the University of Minnesota, cautioned that the federal government's deposit insurance system needed to be reformed "before" insured financial institutions were deregulated. Deregulation, he said, was "the cart, not the horse." He warned that "unless insured banks are prevented by regulation from becoming riskier, the result is excessively risky banks." If policymakers had heeded that warning, American taxpayers might have been saved the estimated $250 billion to $500 billion it will now cost to bail out the savings and loan industry.
Once bailed out, what's to prevent the savings and loan industry from taking on too much risk again? One possible solution is a plan for deposit insurance reform, described in the bank's 1988 Annual Report. Proposed by John Boyd and the department's director and senior vice president, Art Rolnick, the plan has been reviewed by the U.S. Senate Committee on Banking, Housing and Urban Affairs in Washington, DC And the American Banker recently listed it among key reform proposals. Under the plan, deposits would be insured 100 percent for only up to $10,000 (rather than the current $100,000), each person could have only one fully insured account (rather than each separate account being covered) and 90 percent of all deposits over $10,000 would be covered by deposit insurance.
Or take one of the Fed's—and the public's—big concerns: inflation. A proposal to reduce inflation to or near zero has been gaining support within the Federal Reserve System. The costs of implementing such a policy—less economic output and fewer jobs—can be minimized if the Fed can commit itself to an inflation-reducing policy that the public will believe. This issue of policy "credibility" is closely tied to an economic theory known as "rational expectations." The theory explains how the public, acting in its own self-interest, reacts to policy changes in ways that unravel the policy's intended effects. In the 1970s, this research on rational expectations was especially nurtured by the University of Minnesota and the Minneapolis Fed, which became known within the System as a hotbed of rational expectation theorists. (For more about this theory, see the interview with one of its originators, Minneapolis Fed adviser Thomas J. Sargent, in the December 1989 issue of The Region.)
What do Economists Do Here?
The Research Department's philosophy, as articulated by Preston Miller, is that "all roads should eventually lead to better ways to formulate and implement policy or ways to reshape institutions that are the objects of policy." But just how do the department's economists—about a dozen staff economists, half a dozen advisers from universities and a steady influx of visiting scholars—go about spanning the gap between economic theory and policy?
Research Pure and Complex . . .
About two-thirds of the economists' efforts are devoted to purely academic research. In fact, the department feels very much like a department at a major university. This is probably because so many of the staff have Ph.D.'s from places like Carnegie-Mellon, Columbia, MIT, Yale and, of course, the University of Minnesota—just a short jog downstream from the Bank. And many of the staff continue to be affiliated with the University of Minnesota and other institutions, such as the National Bureau of Economic Research. The department cultivates these ties to give the Fed access to current academic thinking (and vice versa) and to keep policy debates lively and firmly grounded on sound economic principles.
As part of their duties, staff economists are expected to publish at least one article each year in a professional journal and one in the department's own research publication, the Quarterly Review. The economists are also encouraged to hone their research skills by pursuing a variety of professional activities. These include holding seminars for colleagues, organizing and attending conferences sponsored by the Fed, presenting papers at conferences around the country and abroad, refereeing articles for professional journals, and teaching graduate and undergraduate courses at the University of Minnesota.
. . . And Research Applied
For the remaining third of their time, the economists draw on their research interests to perform Fed-related duties. Their responsibilities include analyzing current economic conditions, advising the bank's president and its board of directors about monetary and banking policies, and keeping the public informed about economic thinking and policy issues.
Current Analysis and Policy Advice
The careful analysis of current economic conditions is a crucial Research Department function, for where the economy is now has implications for where it's headed. Careful analysis helps the Federal Reserve set effective monetary policy using its two main tools: adjustments to the nation's money supply and changes in the interest rate the Fed charges on loans to banks (the "discount rate").
The department's current analysis helps prepare Gary Stern, the bank's president, for meetings of the Federal Open Market Committee (FOMC)—the Fed's central monetary policymaking body, which convenes in Washington, D.C., every six weeks. With the exception of the New York Fed, whose president is a permanent FOMC member, the Fed presidents are voting members of the committee on a rotating basis—one year on, two years off. This year, Stern is on.
Preparing the president for the FOMC meeting is known in the department as "briefing." Before each briefing, the department is a flurry of activity as the staff compiles the latest forecasts, analyses and data.
As a part of briefing, the department contributes a report on current district economic conditions for the Beige Book, a collection and summary of the regional reports from the 12 district Feds. To prepare the Ninth District's report, a research assistant telephones firms in the district to ask how business is going. An economist then analyzes the responses and, using other regional data as well, writes the report.
For briefing, the department's technical-support staff runs computer programs for models of the U.S. and Ninth District economies. These special statistical models, known as "Bayesian vector autoregression models," have been developed over the years by the department's economists, and their forecasting record is quite accurate. The national model, which forecasts 46 economic variables, takes about three hours to run on the Bank's mainframe computer at about 50 percent of the computer's capacity. Economists then provide written analyses of the model forecasts for the briefing materials.
Also included in the briefing materials is the most recent version of a summary of national economic conditions written by the staff for the bank's board of directors. The summary is used to help Stern and the directors make recommendations to the Washington Board about setting the district's discount rate.
On briefing day, usually the day before the FOMC meeting, Stern and the economists convene to discuss the current state of the economy, answer his questions about economic developments and advise him on what policy positions might be the best response to current trends.
Besides briefing, the department also helps perform another Federal Reserve function: regulating and supervising the nation's banking system. At the Minneapolis Fed, Research Department economists who are experts in banking and finance assess the applications of local bank holding companies for creating new banks or merging existing ones. In their assessments, the staff weighs factors like existing competition in the area, convenience to customers and the financial needs of the community. The staff's recommendations are forwarded to the Board of Governors, who make the final decision.
Publications
The research department also fills a public service role by informing the public—mainly through its publications—about the Federal Reserve, economics, regional financial developments and policymaking issues. Getting ideas out to the public—including the media—provides the department an additional means of influencing policymakers.
The department's economists write for several publications. The one with the highest profile is the bank's Annual Report, which traditionally contains an essay on a controversial policymaking issue. The research staff usually contributes substantially to that essay. For instance, the 1988 Annual Report on deposit insurance reform (mentioned earlier) was written by the department's director and a senior research officer. And the 1989 Annual Report's essay, on fixing exchange rates, was co-authored by the research director and a senior research officer, Warren Weber.
The department's chief publication is the Quarterly Review, which publishes scholarly research mainly by economists affiliated with the Minneapolis Fed. The review embodies the department's philosophy by presenting economic research that aims to improve policymaking by the Federal Reserve System and other governmental authorities. Much of the pathbreaking research on rational expectations has been published in the review, as well as significant work about real business cycle theory, time series modeling, monetary and budget deficit policies, and the theory and history of money and banking. Currently mailed to about 15,000 readers—economists in academia and business, government workers, bankers and students—the review has a following outside the United States of about 1,500 readers in nearly 70 countries. It is available, without charge, to anyone who asks.
The department contributes regional analysis to two other bank publications. The Agricultural Credit Conditions Survey analyzes results of a quarterly survey of district rural bankers about the financial situation of their banks and of farmers in their areas. And the bank's fedgazette reports the forecasts of national and district models maintained by Research Department staff.
Among the Research Department's occasional publications are its series of Working Papers and Staff Reports. These highly technical papers are works-in-progress whose intended readers are mainly other economic researchers and academics. The department also sometimes publishes proceedings from department-sponsored conferences held at the bank.
Do They Do It Alone?
The Research Department certainly would not be as strong as it is without the efforts of its support staff—technical, library, administrative and editorial.
The department's technical research assistants help the staff economists collect, analyze and present economic data. Some assistants are computer experts who maintain the department's forecasting models, make charts of research data and keep the staff equipped with computers and software. Others are involved in bank regulatory case work. Still others are top economics graduate students at the University of Minnesota.
The library staff maintains the department's research library, which houses an extensive collection of periodicals, economic journals, government documents, and books about economics. Each day the library staff compiles and distributes to the staff a helpful digest of economic news from top national and local newspapers.
The department runs smoothly thanks to its administrative specialists, who daily attend to innumerable details. Their duties include managing the budget, compiling materials for briefing and bank directors' meetings, arranging accommodations for visiting scholars and conference participants, and tracking the flight patterns of staff economists.
Other support staff help the economists get their research into print. The word-processing specialists input complex equations and statistical material without blenching. The editor/writers make Economese read a bit more like English and tend articles from first drafts to the printer. And a publications specialist gets the "pubs" distributed and maintains a computerized mailing list of subscribers.
How Well Do They Do It?
The Minneapolis Fed's Research Department has a reputation for the excellence of its economic research that extends well beyond the Federal Reserve System. Fed adviser Tom Sargent, now a senior fellow at Stanford University's Hoover Institution, recently described the department as "one of the most distinguished in terms of macroeconomic theory and macro monetary policy" and called it "one of the two or three best places in the world" to do research.
Although this bank's Research Department is one of the smaller in the Fed System, the quantity and quality of research produced here is highly regarded. This is evident from a recent, independent study that ranked the System's research departments according to the number of pages of economic research published between 1980 and 1988 in the top four economic journals. The study ranked the Minneapolis Fed, with its staff of then 16 economists, a close second to the Board of Governors, with its staff of about 200 economists. The same study showed that the department's economists increased their output of pages published in professional journals by nearly 140 percent between the five-year periods of 1978-May 1983 and June 1983-1988.
The department's excellent reputation is also evident from other indicators:
- Frequent attempts by academic institutions to hire away staff economists
- The numerous invitations the staff receives to present their work at universities here and abroad
- The interest of respected scholars in visiting the department or joining the staff.
This year the department continues to attract high-quality staff, having recently hired two professors from the University of Pennsylvania's economics department, which is ranked among the top ten in the country.
Economists in general—like lawyers and doctors—have long been the butt of humor. The classic joke about them is attributed to George Bernard Shaw: "If all economists were laid end to end, they would not reach a conclusion." Given the department's contribution to economic policy issues, this sort of abuse is probably undeserved. Still, I can't resist concluding with one of my favorite anecdotes from life among the economists at the Minneapolis Fed:
Early one morning, before my first cup of coffee, I overheard an economist in the next cubicle ask another economist, "Do we have sex?" After my initial shock, I realized he was asking whether the data in their study had been classified according to gender. So much for economists and the real world.
