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
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
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
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
More About the Partnership Participants
and Their Work
The partnership between the University of Minnesota economics
department and the research department at the Federal Reserve
Bank of Minneapolis is a fluid and sometimes informal affair.
Throughout the year numerous Fed economists and university
economics faculty and graduate students share their time between
the two institutions.
To learn more about these economists, their special areas
of study and the work they have produced, go to the following
Many articles by the economists mentioned in the accompanying
article are available on the Web; however the following seminal
works are not.
"Expectations and the Neutrality of Money," Robert E. Lucas
Jr., Journal of Economic Theory, 4 (April), 103-124
"Econometric Policy Evaluation: A Critique," Robert E. Lucas
Jr., The Phillips Curve and Labor Markets, Karl
Brunner and Allan H. Meltzer, editors, Carnegie-Rochester
Conference Series on Public Policy 1: 19-46, Amsterdam: North-Holland,
The Rational Expectations Revolution: Readings from
the Front Line, edited by Preston J. Miller, Cambridge,
MA: MIT Press, 1994.
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
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
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 ...
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 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
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.
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