Greater Than the Sum

Editor: An underlying theme of this issue of The Region is partnership—it shows up in every article, however subtly. From this bank's involvement with professional journalists, with the University of Minnesota, with economists from around the world, and with the bank's board of directors, this issue discusses policy questions and ideas important not only to this bank, but to other organizations as well. In many respects, this is reflective of any Federal Reserve bank's role—to contribute to both regional and national policy debates. The following piece is a description of an explicit partnership between the University of Minnesota and the Minneapolis Fed; while this type of partnership is not necessarily the norm, it is a model that has worked effectively and is gaining acceptance among other institutions.

Developing good economic policy is a subtle art, a creative process. It requires pulling together the right minds with the proper training, and providing an environment that pushes and focuses thought, yet allows sufficient freedom to follow new directions and develop unexplored relationships. At its best, the environment will be a nexus between theorists and policymakers where the flow of ideas sharpens both theory and policy. In Minneapolis, that creative process is at work in a partnership between the University of Minnesota and the Minneapolis Federal Reserve bank.

For over a quarter of a century, economists and economics graduate students have shuttled back and forth between the Federal Reserve bank in downtown Minneapolis and the economics department on the West Bank campus of the University of Minnesota. The physical commute is hardly a mile, but over the years, these economists have covered theoretical ground spanning from early papers on rational expectations to current debates over stock market valuation.

During this history, the Minneapolis partnership has been fertile, both in the development of solid economic theory and in moving that theory into the public arena. It is, observed Mark Yudof, president of the University of Minnesota, "a classic engagement of the university in the polity." And while at its surface this "engagement" might be viewed as a simple exchange of expertise, at a deeper level the relationship is one of mutual reinforcement and transformation, a partial merging of interests and identity that has led, fundamentally, to a whole greater than the sum of its parts.

Seeds of collaboration

The parts, from the university's standpoint, are faculty and students who devote a portion of their time to work at the Minneapolis Fed. Of the 26 active University of Minnesota economics professors, 15 are (or recently were) staff, consultants or long-term visitors to the Fed's research department. And at any given time, 10 or so university economics graduate students populate cubicles on the Federal Reserve's seventh floor.

The bank provides modest stipends and assistance to the university students and professors, as well as the invaluable research commodities of time, space and silence. "It's the kind of place," recalled Lee Ohanian, a former University of Minnesota associate professor and Fed visitor, now at University of California, Los Angeles, "where you can walk in the door at 8 o'clock on a Monday morning, decide you want to spend the next eight hours on uninterrupted research and be able to do it. That makes all the difference in the world."

In return, the university scholars collaborate with staff economists at the Fed, focus on current policy questions, discuss macro theory with bank officials and contribute to ongoing debates over the future direction of monetary and fiscal policy. The substantial overlap has borne fruit in the form of research focusing directly and indirectly on Fed policy questions. The Minneapolis Federal Reserve has been cited as one of the Federal Reserve System's leading research institutions, and nearly one-third of its research papers have been authored or co-authored by faculty, graduate students or alumni from the university's economics department.

But the university/Fed collaboration has not always gone smoothly; in fact, the first joint effort succeeded only after it initially failed. The seed of the Minneapolis partnership was a "special studies group" formed in 1970 by John Kareken, then a professor of economics at the university and adviser to the Minneapolis Fed, to build a better mousetrap: an econometric model that was broad enough to capture the key macroeconomic relationships, yet was simple enough to derive optimal policy rules under different economic assumptions.

Kareken brought in Neil Wallace, Thomas Muench and Thomas Sargent, all university economics professors at the time. A year into the work, the group received a draft of a paper from Robert Lucas, then at Carnegie-Mellon University. Because they'd been classmates, said Wallace, he paid more attention to Lucas' paper than he otherwise might have. "It was a difficult paper," he recalled, "very different from things I was used to reading. I tried reading it a couple of times, not sure I'd mastered it immediately, but I knew that it cut away the underpinnings of what we'd been doing."

Indeed it did. Lucas' paper, "Expectations and the Neutrality of Money," soon followed by his "Econometric Policy Evaluation," together laid out a fundamental critique of economic modeling, positing that the effects of changes in economic policy couldn't be accurately predicted on the basis of past performance because, by changing the rules of the economic game, policymakers would also alter the expectations and behavior of players in the game. For example, if policymakers announced a new policy that would allow extraordinary investment tax credits during a recession (because businesses in the past responded positively to investment tax credits), businesses might reasonably postpone investments today, and thereby bring about a recession.

In other words, rational people and firms will react to policy changes in ways that can't be extrapolated simplistically from their behavior prior to those changes. Indeed, how people and firms behave under one set of policy rules may tell us very little about how they will behave under a new set of rules.

It was a powerful critique of existing theory and methodology, and in the spring of 1973, the research team scrapped its Keynesian macroeconometric model-building. "We were stunned into terminating our long-standing Minneapolis Fed research project," Sargent later wrote. And the researchers immersed themselves in rational expectations, generating a flurry of academic papers in the early- and mid-1970s that would later be termed a "revolution" in economic theory.

But without the university's link to the Federal Reserve, theory might not have reached practice for decades. "The literature [on rational expectations] began well before our partnership did," noted Arthur Rolnick, senior vice president and director of Research at the Minneapolis Fed, referring to work by John Muth, Edmund Phelps and Milton Friedman, as well as Lucas, "but it likely would not have gotten into the policy arena as quickly as it did if this research weren't going on here, if it had been left in the universities." In a sense, the partnership was a catalyst that facilitated the process of "product" development, bringing the theory of rational expectations to the marketplace of ideas and policymaking with remarkable speed. "We started promoting [the research on rational expectations]," said Rolnick, "and then translating these ideas into advice for Federal Reserve policy."

Bruce MacLaury, president of the Federal Reserve Bank of Minneapolis at the time, began to introduce the concept into Federal Open Market Committee (FOMC) discussions. Describing FOMC deliberations in a September 1975 speech in London, MacLaury noted that the efficacy of monetary policy predicated on a Phillips curve trade-off had apparently disappeared. One explanation: "In effect, the public has wised up," said MacLaury. "Repeated experience over the post-war period has taught more and more people (rightly or wrongly) to associate stimulative policies with higher rates of inflation. ... As a result, employers and employees are probably reacting (in wage demands and price markups) more rapidly to signs of policy stimulation." And the policy message: A simple rule prescribing steady monetary growth is probably optimal.¹

The theory of rational expectations and its implications for policymaking were the subject of considerable debate. After all, it seemed to imply that short-term fiscal interventions were ineffective, even counterproductive, an assertion that directly contradicted policy prescriptions derived from the dominant Keynesian paradigm that had guided policymakers since the Great Depression. In the latter half of 1975, Fed and university economists held a series of seminars in Minneapolis to hash out the issues and reach preliminary conclusions.² The Fed's Preston Miller later wrote that a winner to the debate had been found: "The contest for determining which economic model to use for policy deliberations would seem to be won by the natural rate-rational expectations model on grounds of default. There are no serious rivals."

While not all economists would agree with Miller's conclusion, MacLaury's successor, Mark Willes, was immediately intrigued by rational expectations and its implications for Fed policymaking. In FOMC meetings, economics conferences, press interviews and speeches, Willes promulgated the theory taught to him by university professors Sargent and Wallace, as well as Lucas from the University of Chicago. "People cannot be systematically fooled by policy," wrote Willes, in a 1979 Wall Street Journal op-ed piece titled "The Rational Expectations Model." This was the central hypothesis of the new model. Given the failure of econometric models, and the not-yet conclusive empirical tests of rational expectations theory, "the best course of action ... is prudence and caution. ... The Federal Reserve Bank should keep the money supply growing at a steadier—and preferably low—rate of growth." Willes' input to FOMC deliberations didn't immediately sway all listeners, but it has had substantial influence over time.

Willes had given prominence and clarity to a controversial and technically abstruse body of work, employing the Minneapolis partnership of academic and Fed economists to refine the policy implications of leading edge economic theory. "It turned out that I'd fallen into the hotbed of rational expectations," as Willes later described his arrival at the Minneapolis Fed. "With Tom Sargent over at the university and Bob Lucas in Chicago ... I had a whale of a good time having them kind of tutor me ... [and] I rather happily took on the chore of not only interjecting that into the policy discussions in Washington, but talking about it in speeches and in the press ... all of which was designed to try to get the discussion out of strictly the academic environment into the public domain."³

Beyond expectations

A similar, if less-storied, process of theoretical exploration and policy elaboration describes the process of other collaboration between the university and the Federal Reserve. For example, work by Kareken and Wallace in the late 1970s and early 1980s on deposit insurance and financial intermediaries—a prescient discussion in light of the $150 billion bailout of savings and loans associations in the late 1980s—has provided a theoretic basis for bank policy discussions on moral hazard and market discipline ever since. In the 1980s, university professor and Fed consultant Christopher Sims collaborated with Fed senior economist Robert Litterman in developing vector autoregression (VAR) models, which proved to be uncannily accurate in economic forecasting. Curiously, drawing policy implications from Sims-Litterman VAR models appears to stand at direct odds with Lucas-Sargent-Wallace rational expectations theory, and spirited debates between the two camps have helped refine the strengths of both.

The elaboration of real business cycle analysis by university Regents' professor and Fed research consultant Edward Prescott provided the dynamic general equilibrium model that is now a basic methodology for modern macroeconomics. Moreover, Prescott's message that business cycles are an efficient response to technology disturbances is now gaining increasing attention in light of the remarkable rise of labor productivity and economic growth without inflation in the late 1990s. And time-consistency theory developed by Prescott, V.V. Chari, Finn Kydland and Patrick Kehoe—all current or former professors at the university and advisers to the Fed—helps guide current Minneapolis Fed commitments to low inflation policies.

As it did with rational expectations, this joint work by partnership economists informs their ongoing dialogue with Fed policymakers. "What I find particularly valuable in discussions with these economists—our staff and those from the university—is their willingness and ability to challenge the conventional wisdom effectively, and to bring a fresh perspective to significant policy issues," observed Gary Stern, president of the Minneapolis Fed. "Moreover, because they are at the cutting edge of research, I know I'm not going to be blindsided by a new theoretical development."

By any other name

Joint venture, strategic alliance, cooperative affiliation, symbiosis—any of these terms might be used to describe the collaboration that the university and the Fed have sustained since 1970. But the work of Harvard Business School professor Michael Porter suggests another. Porter describes geographic concentrations of similar businesses as "clusters"—think filmmakers in Hollywood, auto manufacturers in southern Germany or shoe designers in northern Italy. Proximity of companies and institutions, and repeated exchanges among them, fosters coordination and trust.

"A cluster of independent and informally linked companies and institutions represents a robust organizational form that offers advantages in efficiency, effectiveness, and flexibility," argued Porter in a recent Harvard Business Review article. Clusters stimulate interconnection, growth, output and further concentration. Organizations with similar interests tend to interact frequently if they're physically close, and that frequency of interaction fuels productivity. As opposed to a merger, which might squelch innovation and diversity, a cluster or informal linkage can call forth the resources and strengths of each participant while preserving the fundamental autonomy of all involved.

It's "eminently reasonable" to think of the university/Fed partnership as a cluster, said Porter, who suggested that demand conditions may play a role. "Proximate local needs can spur progress, especially when those needs are distinctive and demanding," he explained. "The close contact between the Minnesota economics department and the Fed may have given the economists there an edge in perceiving and puzzling over 'real world' problems of importance, compared to a typical department focused primarily on the academy."

Many economists who have been part of the partnership highlight precisely that advantage. "Economics lives on applied problems," noted Thomas Sargent, now a professor at Stanford University and senior fellow at the Hoover Institution. "In terms of infusing the macro part of the department with interesting policy questions, [the bank] is just a gold mine." Christopher Sims, who left the University of Minnesota in 1990 for Yale and is now at Princeton University, observed that "the way the consultant group was connected to policy discussions in the Fed [was] an important part of why [it] was productive and influential. They weren't thinking in a vacuum; they were regularly being asked to brief the president, asked to write [Quarterly Review] articles that had something to do with policy or attending Fed conferences related to policy."

Noting that theory developed by university economists tended toward the abstract, Sims pointed out that "without the pressures connected to policy issues, it might not have been formulated in such a way that it was useful." Indeed, Fed economists have helped university economists both in shaping research questions and testing the answers. S. Rao Aiyagari and John Bryant at the Fed, for example, worked closely with Neil Wallace at the university in his development of theories of money and price discrimination, just as Fed economist Litterman's expertise helped hone Sims' forecasting models.

And it clearly isn't a one-way street. "There have been immense benefits to the management of the bank," said Sargent. "The bank president gains access to world-class macroeconomists that he can talk to on a day-to-day basis, just by walking down the hall." Or as University of Minnesota President Yudof put it, "I'd like to think that some of the time it runs in the other direction, that sometimes our economists can engage in some conceptualization of issues or constructs" to aid Fed policymaking.

"A group of capable people in close contact stimulate each other," noted Porter. "[They] advance more rapidly, and in some cases are pressured to differentiate themselves from each other, which also fosters innovation. Such concentrations of talent also often attract other talent from other locations."

It seems clear that the first-tier macroeconomists in Minnesota have exerted a gravitational pull on talented students and distinguished economists from around the world. "Grad student magnet" is how some refer to the university/Fed economics partnership. And others note that the decisions of Nobel Laureate Robert Lucas and eminent economist Nancy Stokey, both of the University of Chicago, to spend a recent sabbatical in Minneapolis is a compelling imprimatur. "Lucas and Stokey, well, they could have gone anywhere in the world," observed Ohanian, "and they chose to come to the Minneapolis Fed. That speaks volumes."

Other banks in the Federal Reserve System have developed similar relationships. The St. Louis Fed was one of the first to establish a research department with ties to academia, and in the last decade other banks have created affiliations of various sorts with university scholars. The Chicago Fed, for example, has ties with economists at Northwestern University and the University of Chicago. The Richmond Fed has a longstanding connection to the University of Rochester in New York. The Cleveland Fed has a rich variety of research alliances, conferences and projects involving scholars and universities both locally and around the country. The New York Fed pulls in academics from Princeton, Yale, New York University and Columbia University, and the Atlanta Fed invites university economists for intense multi-day sessions roughly once a year.

But while these research departments share some characteristics with the Minneapolis partnership, the Minneapolis Fed is unique in the length and depth of its association with a single university's economics department, an association that has survived several department chairs, four bank presidents and not a few bank buildings.

"[The Minneapolis Fed's] reputation is one of [having] an outstanding research department and it's a well-deserved one," said Mark Sniderman, director of research at the Cleveland Fed. "And its ability to work with the university has been a key element of that." Sniderman also noted that the Minneapolis partnership helped pave the way for other Feds to broaden the scope and method of research in the Federal Reserve System. "The Minneapolis Fed research department ... showed that there's room in the Federal Reserve System for people to take a different perspective and 'add it to the portfolio,' if you will, and see whether or not it bears fruit over time," he said. "In the case of the Minneapolis program, it clearly did bear a lot of fruit and the whole system has benefited from it." Speaking to the Cleveland experience, Sniderman said the Minneapolis model "has had a real positive effect on our willingness over time to address issues in different ways, to experiment. It helped us see that as a viable way to do research."

Burdens of intimacy

"Joined at the hip, in many ways," said V.V. Chari, former chair of the university's economics department and long-time Fed adviser, when asked to describe the relationship between his department and the Fed's research unit. "The partnership has produced phenomenal synergies." But there are downsides, as well. To the degree that students and faculty spend time at the Fed, rather than the college campus, they are unavailable—physically and intellectually—to their colleagues at the university. "The physical separation does have some cost," concedes Wallace. But as university Regent Michael O'Keefe noted, it's a challenge inherent in any university engagement with the community at large, "one that I believe both unavoidable ... and manageable."

A second criticism: University and Fed economic research is often too abstract, too complex and too divorced from the real world to be of immediate value. Director of research at the Fed since 1985, Rolnick accepts the criticism, but only to a point. His development of the Fed's public affairs department as a means to translate and disseminate research findings represents a serious effort to make cutting-edge economic research accessible to the general public and policymakers.

And a considerable amount of the partnership's research is directly relevant to very real world issues. A few recent examples: analyzing the impact of state tax and labor policies on business location; measuring the welfare effects of the North American Free Trade Agreement; examining the consequences of taxing capital income; evaluating the level of stock market "exuberance" or lack thereof.

But, said Rolnick, the criticism also reflects a misunderstanding of the purpose of basic research. Without an understanding of underlying economic theory, real-world predictions and policy prescriptions are based on sand. And while not all basic research has direct policy implications, he conceded, enough strong, relevant concepts emerge to make such research not only worthwhile, but essential. "We're not going to hit a home run every month, maybe not every year," he said, "but if we get one or two really good ideas that influence regional, national or international policy, that's a significant contribution." And a powerful way to ensure that policy prescriptions are academically solid is by maintaining constant, ongoing interaction between university and Fed economists. Added Minneapolis Fed President Stern, "I think the relationship has demonstrably worked to the advantage of both the university and the Fed."

The future

The Minneapolis partnership has helped to generate path-breaking theory and cogent, informed policy. Academics have moved beyond the ivory tower, and policymakers have had the benefit of their insight. And it's fair to say that neither institution would have been as innovative or influential had it not sustained the relationship over the last three decades. "Since I'm removed from it now, I can offer this opinion," said Wallace, who left Minnesota in 1994 and is now at Pennsylvania State University. "Between the bank and the university, you have a collection of people in macroeconomics that's rather unrivaled anywhere. And neither place could do that on its own."

Where will the partnership be in a decade? In nearly 30 years, it has generated a solid body of work and created an enviable network of world-class economists. But any research alliance—no matter how successful—faces challenges, and one of the most important is competition for talent.

"My concern is that it's going to be very hard to maintain this quality level that we have today because the field is so competitive," observed Rolnick. "Our people are getting offers all the time." But speaking as one who got a better offer, Sargent points out that competition comes with the turf, and the Fed has always been able to draw the best and the brightest. "[The Fed] loses people to very good universities," he said, "but then they hire people away from universities that are very good. Any research organization is fragile because it requires an infusion of new young people. You can never rest on your laurels."

From the university's perspective, it seems, the partnership should endure. "I would hope the relationship will expand," said Regent O'Keefe. Added Regent David Metzen, "If the Fed weren't in Minneapolis, if this relationship didn't exist, the university would be all the poorer for it. This is precisely how government, business and education ought to work together."

The Fed remains committed as well, and Rolnick has clear ideas about how to sustain the partnership that has produced valuable advances in scholarship and policy. It's important to maintain a strong connection between research and policy, he said. "If it's too disconnected, you get bad policy and you don't get enough research aimed at important policy questions." And in order to attract leading scholars, the Fed creates an academic environment that mimics an economics department at a top university, "meaning that the incentives, the rewards, are for publishing, for doing basic research."

Rolnick's approach sounds deceptively laissez-faire. "Now having said that," he continued, "you also create an environment in which policy issues are constantly raised, and people just through osmosis start to get interested in the types of questions that the bank is interested in. You don't really have to direct research, you just have researchers sit around at lunch, talk with the president, talk with senior management, and policy questions come up; people get interested in these issues and the research follows."

"Everyone in this community shares a vision," said Ohanian, of the research environment, "that what we're doing there is attacking really important problems and using the best economic theory to do so. Very serious and very supportive."

About the future of this partnership, Rolnick is optimistic, though cautious. "Five years ago I thought it couldn't get better, and it has," he observed. "I guess I think the same today."

Regional economist Tobias Madden contributed research and interviews to this article.

Endnotes

¹ "Monetary Policy in Uncharted Waters," an article based on MacLaury's speech, appeared in the Minneapolis Fed's Ninth District Quarterly in April 1976 and can be found at www.minneapolisfed.org/research/quarterly-review.

² See research books for proceedings of these seminars.

³ See interview with former Fed president Mark Willes.