For example, in a 1986 paper in the Minneapolis
Review, Prescott described the state of knowledge about
real business cycles, a line of research to which he and economist
Finn E. Kydland had previously contributed pioneering work. Kydland
and Prescott argued that technology shocks drive the economic system
and that costly policies aimed at stabilizing these shocks are counterproductive.
In that same issue, Lawrence Summers, then professor at Harvard
University and currently deputy secretary of the Treasury, responded
with no uncertain skepticism: "Let me follow Prescott in being
blunt. My view is that real business cycle models of the type urged
on us by Prescott have nothing to do with the business cycle phenomena
observed in the United States or other capitalist economies."
In the same issue, Prescott then followed Summers with a response
of his own, concluding: "My guess is that the reason for skepticism
is not the methods used, but rather the unexpected nature of the
For more on this issueand for a discussion of economic growth,
the wealth of nations and other topicsread on.
The following interview was conducted by Arthur J. Rolnick,
senior vice president and director of research at the Minneapolis
ROLNICK: Ed, over the years you have worked with some of the
best economists in the world. Which ones have influenced your research
PRESCOTT: My thinking has been heavily influenced by
Bob Lucas. I met him
in 1964, which is pretty far back. He was a new professor and
I a new graduate student at Carnegie-Mellon. As a graduate student,
however, he did not influence my thinking much. His impact on
my economic agenda began a few years after graduate schoolbeginning
about 1969when we collaborated on the paper, "Investment
Under Uncertainty." That collaboration along with his seminal
paper, "Expectations and the Neutrality of Money," forced
me to rethink completely how to do macroeconomics. So, when I
returned to Carnegie-Mellon in 1971, this time as a colleague
of Bob Lucas, I decided not to teach macro until I understood
what it was and how to teach it. As a result, I never did teach
macroeconomics at Carnegie-Mellon. I only resumed teaching this
subject when I moved to Minnesota in the spring of 1981.
At that time, the foundations of dynamic economic theory had
been laid, and the task was to figure out how to use this theory
to quantitatively study economic fluctuations. At that time there
was a theory of secular growth and this theory was being used
to address public finance issues. Virtually everyone, including
myself, was certain that this theory, without money introduced,
would not be useful for studying economic fluctuations and assumed
that some other theory was needed to account for the fluctuations
about the secularly increasing trend. Finn Kydland and I developed
practical methods for deriving the quantitative implications of
growth theory for fluctuations. We thought that with some extensions,
in particular longer time requirements to build new factories
and office buildings, that growth theory might provide the mechanism
for the propagation of monetary shocks. When we derived the implications
of growth theory without any monetary shocks, however, we found
to our surprise that business cycle fluctuations are just what
that theory predicted.
These were exciting times, particularly here at the university
and the Minneapolis Federal Reserve bank, where much of the progress
in this research program was made. What we were doing was controversial.
There was a taboo then against doing quantitative theoretical
exercise in macroeconomics. This is no longer the case. Even my
undergraduates at the university run their business cycle experiments
using model economies with people deciding how much to work and
consume, and firms deciding how much to produce and invest in
dynamic environments characterized by uncertainty.
ROLNICK: Is this what the profession calls "micro
foundation of macroeconomics?"
PRESCOTT: That's what some have labeled it, but I think
the labeling is antiquated. Let me explain why. In the '60s the
profession, including myself, thought Keynesian macroeconomics
was a great theory that could be used to eliminate costly economic
fluctuations. Naturally the profession tried to develop the theoretical
foundations for the equations that constituted the Keynesian macroeconometric
models. But, Bob Lucas established that this is impossible. The
assumptions underlying the macroeconometric models were logically
inconsistent with dynamic economic theory. This conceptual problem,
along with the failure of these models in the '70s, resulted in
the demise of Keynesian macroeconomics. With this demise, again
there is just economic theory.
ROLNICK: Over 30 years ago, Milton
Friedman made the argument that we must consider the economy
as a whole. He warned the profession to beware of conclusions
based on partial equilibrium analysis. Why has it taken this long
for macroeconomists to pay heed to his warning?
PRESCOTT: There have been breakthroughs in the way we
model the economy. Dynamic economic theory was not very far advanced
30 years ago. In addition there were neither the computers to
compute the equilibria of dynamic economies with uncertainty,
nor the rich data sets to restrict the models economies constructed.
ROLNICK: So are you saying that economists now have the
tools that allow us to solve dynamic general equilibrium models
tools that we did not have 30 years ago?
PRESCOTT: Yes, but even today, Friedman and many others
of his generation do not think in terms of dynamic equilibrium.
ROLNICK: But in fairness to Friedman, he didn't have
PRESCOTT: That's true.
ROLNICK: Who else has influenced your work?
PRESCOTT: Another person that influenced my thinking
a lot is Robert Townsend. He was a graduate of the University
of Minnesota. He came to Carnegie-Mellon, around 1976, as an assistant
professor. He introduced me to some of the ideas at Minnesotain
particular to mechanism-design theory, which can be used to study
economic situations where there are contracting problems. This
is proving to be increasingly useful in constructing models with
financial intermediation. Such models are needed to understand
issues such as bank regulation. The Minneapolis Fed has been,
and is, a leader in this important development.
Let me elaborate further. In much of economics, we abstract
and study idealized worlds where people can write any type of
contract and where people honor their contracts. In fact, for
some issues, this does not provide a reasonable abstractionin
particular issues concerned with financial intermediation. There
are moral hazard and adverse selection problems. Borrowers from
intermediaries, for example, do not always take the promised action
and may be less than honest as to the riskiness of the projects
they want to fund. There are events which result in borrowers
not being able to honor their contracts. Introducing features
such as these into applied general equilibrium is proving difficult
but progress is being made. Only with their introduction can we
assess whether there is a market failure and if there is one,
what intervention will mitigate it.
ROLNICK: Is there anybody else you want to add to your
list of people that have influenced your views on economics?
PRESCOTT: There are two other people for whom I have
incredible respect for making economics better. These two people
have been associated with the Minneapolis Federal Reserve bankTom
Sargent and Neil Wallace. They along with Lucas were the ones
responsible for the use of dynamic economic theory to study macroeconomic
phenomena. I, of course, was influenced by the writings of Arrow,
Debreu and McKenzie, the great general equilibrium theorists,
but they being pure theorists were not concerned with macroeconomics.
ROLNICK: With regards to your views on the research programs
of Tom Sargent and Neil Wallace, I'd like you to go back in your
career to when you started at the University of Minnesota in 1980-81,
and your affiliation with the Minneapolis Fed's Research Department.
How did these programs, along with your own, evolve and influence
each other? What were the biggest changes?
PRESCOTT: Under Tom Sargent's leadership, in the mid-
and late-'70s, the Minneapolis Fed and the university were at
the lead in the rational expectations revolution. I am sure that
rational expectations would have eventually dominated, as it has,
but Tom made it happen much sooner than it would otherwise have.
Tom, however, did not change my views. I was already convinced
when I came here.
When I came here, the University of Minnesota had the only graduate
program that trained students in the use of dynamic economic theory
in the study of macroeconomic phenomena. Neil Wallace and Tom
Sargent were responsible for this. I like working with students,
and having students trained in dynamic theory made Minnesota a
very attractive place for me. The Minnesota graduates in macroeconomics
have had a major influence upon economics and many are now in
positions of leadership in the other top economics departments.
When I came here, Neil Wallace was leading a program to lay
theoretical foundations for monetary economics. In the late '70s
this was a controversial research program, with which I was sympathetic.
Neil clearly had a major but indirect influence upon my thinking.
His research program of laying theoretical foundations to monetary
economics was controversial, as was Sargent's research program.
It implicitly said that there was no hope for the old, largely
empirical approach to money. The old research program was to use
balance sheets to construct some monetary aggregates and then
to examine the statistical relation between these monetary aggregates
and real output. The weakness of that research program was the
lack of theoretical mechanisms. You always worry or hesitate to
rely on just empiricism when you can't run experiments.
ROLNICK: When you say you worry about just empiricism,
are you worried about drawing implications from empiricism about
PRESCOTT: Yes. With the monetarist research program,
the appropriate monetary aggregate was the one that was highly
correlated with output and led the cycle. That one was assumed
to cause output fluctuations with a "long and variable"
lag. I want a mechanism by which these monetary aggregates have
consequences for output. At a deeper level, all that we can hope
for is a theory of the equilibrium process of the economy given
the rule by which the money supply or interest rates are selected
now and will be selected in the future. We can say this monetary
policy shock did this or that. But, we can't say what the effect
will be of a particular policy action. All that dynamic economic
theory can do is to predict how the economy will behave given
the rules by which policy will be selected in the future.
As I said, the problem in monetary theory is the mechanism by
which money has real consequences. In the 1890s and 1900s, which
is prior to the creation of the Fed, there were financial crises
followed by steep declines and rapid recoveries in real output
and employment. Subsequent to the creation of the Fed, the economy
has not been characterized by that type of crisis, or at least
not as frequently.
ROLNICK: The Great Depression aside?
PRESCOTT: The Great Depression is another matter. I also
was hedging my statements a little bit because of the 1937 experience.
In that year there was a large, sharp decline in output and a
very rapid recovery that was associated with a temporary large
increase in the reserves that banks were required to hold. And
then there was a similar but much less dramatic event in the first
half of 1980.
I think the evidence strongly indicates that Fed actions can
cause sharp declines by taking actions that result in a credit
crisis or by failing to take an action that would avoid a credit
crisis. Before the creation of the Fed there were a number of
financial crises with each being followed by a large decline in
output and a rapid recovery.
ROLNICK:We have talked about how people have influenced
your thinking and research agenda, but your work in turn has been
very influential. I'd like to turn to some questions about your
own work, partly to get you to expound on the nature of that work
and partly to get you to respond to some of your critics. It was
the fall of '86 that we devoted an issue of our Quarterly
Review to your research on real business cyclesresearch
that has attracted considerable attention from both the media and
academia. While much of that attention has been laudatory, some
has been critical.
You are associated with the view that technology shocks, those
affecting production opportunities, are the major driving force
behind business cycles, accounting, according to your estimates,
for about 70 percent of these fluctuations. How would you respond
to the following observations: There seems to be overwhelming
evidence that the Great Depression and many of the major recessions
in U.S. history had monetary origins and that monetary factors
were very important in determining the depth of the downturns
as well as their length. How does that observation square with
your 70 percent estimate? Second, it is very hard to identify
specific technology shocks that have coincided with economic fluctuations.
PRESCOTT: First, the 70 percent number is for the post-World
War II period. This is a period for which we have pretty good
measures of the inputsin particular the labor inputand
for that matter, quarterly measures of output. Such data are needed
to carry out such an analysis. I suspect that the estimate would
be different for the pre-World War I period if the needed data
were available to carry out the accounting exercise.
With regard to the Great Depression, I have not studied it in
detail. I don't know of anybody well-versed in modern dynamic
economic theory who has looked at it carefully. You have to be
a pretty good historian as well as a good theorist to do this
task. My own view is that printing a little bit more money would
not have been the solution. Third World countries have tried without
success to avoid depressions by printing money. With regard to
why there was a Great Depression in the United States in the '30s,
I just haven't seen the evidence that points the finger to the
monetary side. Canada had the persistent and big decline in outputevery
bit as big as the United Statesbut not the bank failures.
ROLNICK: And Canada experienced a much smaller decline
in its money supply. Of course, some would argue that Canada's
economy was so closely tied to the U.S. economy that the decline
of ours spilled over to theirs. In other words, Canada's experience
over this period does not represent an independent experiment.
The emphasis you put on intermediation may some day provide an
answer. There was a significant upheaval in financial intermediation
during the Great Depression. Something real was lostsome
information was lost and that possibly could have turned a typical
recession into a depression.
PRESCOTT: My own speculation would have something to
do with the unstable political times. I have looked at the time
series of factor income shares. Labor's share of total income
or, equivalently, of total output, was more or less constant up
to the beginning of the Great Depression, at which time it jumped
about 5 percent. Subsequently it has remained at that higher level.
This strongly suggests there was a big change in the rules of
the economic game that occurred just after the beginning of the
Great Depression. Incidentally, there was a large drop in total
factor productivity, which matches well with the technology shock
story. I emphasize that technology shocks are changes in the total
productivity of the business sector. The nature of the rules of
the game that govern business activities have consequences for
total factor productivity.
The early '30s were not politically stable times. Even in peaceful,
lovable Minneapolis there were some serious conflicts. Teamsters
struck and shut down businesses. The police not being able to
handle the situation deputized a citizen army. In subsequent conflicts
between the truck drivers and the police, many people were injured
and a few killed. In neighboring states farmers were setting up
private armies to block the export of agricultural products in
the hope of raising the price of agricultural products. These
were politically unstable times.
ROLNICK: So, that's what you mean by some political instability?
PRESCOTT: There also were movements throughout the world
that must have worried people, namely the rise of fascism and
of communism. In economic terms fascist Italy and communist Russia
were perceived as doing well. The fear that such systems would
be adopted in the U.S. must have deterred investment. The fear
of changes in the rules of the game can have large real consequences.
ROLNICK: Part of your response to your critics, therefore,
is that your 70 percent estimate is for the post-World War II
period. What about the recession of 1980-81?
PRESCOTT: Here I've looked at the data carefully. Central
to the business cycle is how many hours are worked per adult in
the market sector. This time-series started a large decline in
the fourth quarter of 1979, which is significantly before the
1980-81 recession, and bottomed out in the third quarter of '82.
The 1980-81 recession was a small blip down, associated with the
temporary institution of certain reserve requirements. But, the
recession had started before the tightening of monetary policy
and the decline is consistent with technology shocks being the
There were probably some disruptions due to uncertainty. Some
people bet wrong about interest rates. There were a lot of bankruptcies
during that period. Mortgage markets did not function as well
as they normally do. Some of these factors probably contributed.
I only claim about 70 percent of business cycle fluctuations are
induced by technology shocks. That leaves 30 percent for other
ROLNICK: So you concede that monetary factors can explain
some real fluctuations in the economy?
PRESCOTT: Yes. The question is how much.
ROLNICK: Second observation: It seems difficult to point
to specific technological factors that led to each of the several
recessions and recoveries during the post-World War II period.
Yet, economists who emphasize monetary shocks can easily point
to many recessions and many recoveries that seem to be caused
by specific monetary shocks. How would you respond?
PRESCOTT: First, the finding is that recessions or economic
fluctuations are the result of the sum of many random causes.
We don't have a theory of what causes economywide productivity
to change. We can measure how big the changes are, and we can
use dynamic theory to predict the consequences of these random
changes. Now, the question is: Can we identify specific shocks?
My answer is no. We can't even identify why today total productivity
of labor and capital is four or five times higher here than in
India. Given this, how can we hope to identify why this productivity
grew by 2 percent less than expected over some two-year period?
Such an occurrence is all that is needed to induce a recession.
Let me try to explain better what I mean by business cycles
being the sum of random causes. If you take a coin and flip it
repeatedly, assign a one to heads and a minus one to tails and
sum up the values of the last 15 flips, the resulting time-series
will display cyclical fluctuations, that is fluctuations that
look a lot like cycles. This is Eugene Slutsky's (Russian economist
and econometrician) observation in his famous 1927 paper: that
cycles can be the sums of random causesa translation of
which appears in the 1937 Econometrica. With real
business cycle models, a given shock's effect declines only 5
percent per quarter. This implies after three and a half years,
the shock still has half its effect. The current state of the
business cycle depends upon things that have happened over the
last four years.
Returning to your question of what are the factors leading to
technology change, new knowledge is only one factor. I think from
the point of business cycles, changes in our legal and regulatory
system are the big factor. Some of these changes are good because
they permit an industry to develop, which in turn increases the
business sector productivity. Other changes may be good even though
these reduce productivity because they lead to a smaller externalitysay
less pollution or more safetybut, they are still negative
shocks. Others may be bad because they result in resources being
allocated to unproductive type activities. Having a theory of
these shocks is tantamount to having a theory of international
ROLNICK: The other point your critics have raised is
related to measurement errors in estimates of productivity. A
major piece of evidence that you cite in favor of your view of
technology shocks is that labor productivity is procyclical. But
your critics note that measurement error is biased in your favor.
Consider the following example: Sales services provided by a sales
clerk in a store that is open eight hours a day go up or down
depending on how many shoppers show up, if the sales clerk's recorded
hours are more or less the same, all of the increased sales activity
shows up as movements in productivity, even though there is no
change in technological opportunities. Further, empirically possible
factors like monopolistic competition, increasing the terms to
external economies and overtime labor can explain the observed
degree of pro-cyclicality in labor productivity while attributing
much less importance to technology shocks. In other words, how
do we know this evidence you cite on productivity is in fact evidence
in favor of technology shocks?
PRESCOTT: Yes, it is possible that due to mismeasurement
of the labor input, productivity may not be as pro-cyclical as measured,
or it may be more pro-cyclical than measured. One way to challenge
our finding is to introduce some feature of reality from which we
abstracted and establish that the answer changes. Some researchers,
including Finn Kydland (Carnegie-Mellon) and I, have introduced
features such as a variable workweek length for the production units,
monopolistic competition and factors that result in idle capacity
in equilibrium. The estimate has stood up to these challenges. Researchers
are restricted as to how they introduce these features by theory
and by micro observations as well as by macro observations. Probably
the key macro observation is the small correlation of the cyclical
components of the labor input and labor productivity. There is one
study that introduced a feature that gave rise to labor hoarding
in equilibrium. This study found that firms must commit their employment
levels for ridiculously long periods for this feature to matter.
At the time these challenges were articulated by Larry Summers in
a 1986 Quarterly
Review paper, the studies I refer to had not been carried out. In responding
to his challenge a lot was learned.
ROLNICK: So I take it that you are not swayed by the
labor hoarding explanation?
PRESCOTT: When times get hard, there are a lot of people
out there who would take a job. Workers worry about keeping their
jobs. I suspect, if anything, they work harder and are absent
less in bad economic times.
Let me review some history. Economists, since the late '30s
or maybe earlier, have been trying to make the case that there
is labor hoarding in bad times. This is because they were bothered
by the fact that when output was low, labor productivity was low
rather than high, as standard production theories predict. They
rationalized this observation by hypothesizing an error in measuring
the labor input. In the ensuing years no measures of the amount
of labor hoarding were provided that show how it varies with the
There is a problem with the labor hoarding story on the theoretical
side as well. Theoretically, labor hoarding results in response
to temporary and not to permanent shocks. Technology shocks that
induce business cycles are highly persistent. Cyclical variation
in the intensity with which workers work hasn't panned out.
ROLNICK:Other research of yours that has received a lot
of attention and has intrigued me personally is your joint work
with Finn Kydland that appeared in the Journal of Political
Economy in 1977, titled "Rules Rather Than Discretion:
The Inconsistency of Optimum Plans." It has been cited by
the Economist as one of the 10 modern classics in
economics. What is the thesis of that work and what implications
do you think it has for the Federal Reserve in our search for
an optimal monetary policy?
PRESCOTT: Finn Kydland and I began working on the optimal
policy problem within the framework of dynamic equilibrium theory.
Once we worked out the logic of it, we found that there was a
fundamental problem. The problem in a nutshell is as follows:
The best policy plan has the property that after following the
plan for a while, everybody agrees that there is a better alternative
then to continuing the original plan. But, if a group of people
cannot commit to its original plan, the ex ante best plan is not
The problem comes up in the design of the legal system. Suppose
the best policy is to punish people who take certain actions and
that punishment is costly to society. The best plan, which is
time inconsistent, is to punish people who take the action in
the future. But the time consistent solution is not to punish
in the second period of the plan those who took the action in
the first, as costly punishment will not deter actions already
taken. The solution to this problem is to have rules or laws and
to follow them. The same logic holds for fiscal policy. It is
always best to tax the returns on past investments but not on
new investments. But with the passage of time, the present becomes
the past. This is why constitutional provisions that make it possible
for the government to commit to not taking property without full
compensation are desirable. A big problem facing many Third World
countries is their limited ability to so commit.
One problem is that sometimes the environment changes and the
old rule no longer works well, which necessitates a change in
the rule. But such changes should be made only after a lot of
discussion with past commitments being honored as much as practical.
Credibility of policy permits much better outcomes to be achieved.
A secondary implication of this is that the Fed should not try
to trick people. It should stick to rules, and I think implicitly
it has over a considerable period of time now, since the Volcker/Greenspan
era. There has been some important subsequent work in this area,
some of which is done here at the Minneapolis Federal Reserve
bank by V. V. Chari and Patrick Kehoe on sustainable plans. Using
the language of modern mechanism of design, they examined the
entire set of policy plans that are sustainable, that is plans
with the property that people will not want to change the plan
subsequent to instituting it. And then they looked at which plan
is the best within that set.
An independent Fed, I think, is something that is a valuable
commitment technology for Congress, for the same reason an independent
judiciary is a good arrangement.
ROLNICK: Let me go to your third area of influence on
the profession. That's your more recent workyou touched
on this earlier but I'd like you to elaborate a little bit more.
In the spring of '93 we published your joint work with Steve Parente
(Northeastern University) in our Quarterly
Review. This is your work on understanding changes
in wealth of nations. This work has also received quite a bit
of attention and there's been a considerable amount of additional
work since the '93 piece. In your mind, what have we learned from
this work, and again, what policy implications, if any, have you
PRESCOTT: I think the question, "Why isn't the whole
world rich?" is the most important question facing economists.
I think we've learned that just accumulating more capitalthat
is more machines, factories, and roadsis not sufficient
to become rich. Accumulating more human capital, as well, is not
sufficient either. Both are important and essential but, given
the economywide productivity parameter, these factors of production
will be accumulated. As I see it, what we need is a theory of
this parameter, and I expect that the rules of the game a country
sets up will account for the big difference in this number across
ROLNICK: That parameter being ...
PRESCOTT: The parameter is total factor productivity.
In rich countries the same quantities of the inputs produce more
output. This parameter summarizes the technology level of a country.
ROLNICK: Is this what is left over after you take account
of infrastructure and human capital?
PRESCOTT: Yes, differences in this parameter is what
is left over after accounting for differences in all the inputs.
ROLNICK: And you're saying that "Why isn't the whole
world rich?" is the paramount question for economists?
PRESCOTT: Yes, I think that is the question. We may not
be any more successful this time around than the development economists
were in the '50s. I hope we are.
ROLNICK: Are you saying that answering this question
is more important than, say, finding better policies for smoothing
the business cycle?
PRESCOTT: Yes, I think we found out that these fluctuations
are not costly to society, and that the response of the economy
to these shocks is approximately optimal. What we should be worrying
about is increasing the average rate of increase in economywide
productivity and not smoothing business cycle fluctuations.
ROLNICK: I understand that your son Ned has recently
been hired by the Research Department at the Richmond Fed. What
type of research is he doing and does he ask you for advice on
PRESCOTT: One thing he's made a point of throughout his
life was never to ask his father for advice. I offered it for
free. We never discussed economics and he was annoyed when in
college he found that he liked doing economics. He is doing some
research at the Richmond Fed that appears quite interesting in
the area of theory of financial intermediation and theory of the
ROLNICK: We should let the readers know that Ned was
a graduate of the University of Chicago, studied under Robert
Townsend and graduated in 1995. Let me finish with one last question
that a lot of people wanted me to ask. I have been told, mostly
by you, that you were a pretty good football player in college
and that your bowling average was close to 170. Some say you are
no longer the athlete that you once were. Do you accept that view
or do you think you still have a few good years left?
PRESCOTT: Well, I just made a big decision: I'm going
to start playing golf.
ROLNICK: In other words, no. Thank you, Ed.
More About Edward Prescott
In June 1996 Prescott was named a Regents? Professor at the University
of Minnesota, which is the highest honor bestowed on a member of
the university faculty; he joined the University?s Department of
Economics in 1980. He is also a senior consultant in the Research
Department at the Federal Reserve Bank of Minneapolis, which he
also joined in 1980.
Walras-Pareto Lecturer: Barriers to Riches, University of
Fellow, American Academy of Arts and Science, 1992.
Prescott has held visiting professorships at the Kellogg
Graduate School of Management, Northwestern University, the
university of Chicago and the Norwegian School of Business
and Economics. He has also held positions at Carnegie-Mellon
University and the University of Pennsylvania.
Recent papers include: "Real Returns on Government Debt:
A General Equilibrium Quantitative Exploration," with J.
Diaz-Gimenez, European Economic Review, forthcoming; "The Discipline
of Applied General Equilibrium," with T.J. Kehoe, Economic
Theory, June 1995; "Economic Growth and Business Cycles,"
with T.F. Cooley, Chapter 1 in T.F. Cooley, ed., Frontiers
of Business Cycle Research, Princeton University Press,