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Interview with Neil Wallace

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Interview with Neil Wallace Neil Wallace thinks about money a lot. That might be true of all economists, of course, but Wallace is widely considered the father of money’s “microfoundations,” which is to say, its very essence—how families and firms conceive of and use it. Without that base, many believe, macroeconomic theory and policy stand on unsteady ground. But once solid micro-level fundamentals are established, predictions about the impact of change at macroeconomic levels can be made with greater certainty. Wallace began working on monetary microfoundations in the early 1970s after reading a paper by former classmate Robert Lucas, an early proponent. The so-called Lucas critique, says Wallace in the following interview, “essentially broke down the barrier between microeconomic theory and macroeconomic theory.” Ever since, he has been building crucial monetary bridges from one to the other. In his early years at the University of Minnesota, often in partnership with the Minneapolis Fed, Wallace collaborated frequently with Tom Sargent. They, with Chris Sims and Ed Prescott, were soon anointed the “Four Horsemen” of Minnesota economics and viewed as leaders of a new wave in economic theory. Prescott, Sargent and Sims recently won Nobel awards for research begun at Minnesota. Wallace is far more modest about the value of his early work, pioneering though it was. “I learned all my serious economics very slowly at the University of Minnesota. And I’m still learning. I started at such a low base,” he jokes, “and I’ve been pretty lazy.” Few agree with that assessment, of course, and the following conversation gives a glimpse of the range and insights of his prodigious research, from analyses of government guarantees and risk-taking to the impact of quantitative easing and why foreign currency markets are different from all others. SEPTEMBER 2013 PHOTOGRAPHS BY PETER TENZER 28 13 DECEMBERSEPTEMBER 2013 2013 THE INFLUENCE OF LUCAS ’72 Fed at that time. We were engaged in a number of projects to try to, you might That Lucas paper, “Expectations Region: In the early 1970s, you were say, bring some sort of rigor into the and the Neutrality of Money,” working with Tom Sargent at the Univer- making of monetary policy. had a major impact on our work. sity of Minnesota to build better models John’s vision involved building a mod- for deriving optimal policy rules under el of the macroeconomy that would be Even aside from its very varying economic assumptions. And useful to policymakers. Well, the Phillips important role as a counterex- then you got an early draft of Bob Lu- curve and how to build a relationship in ample to thinking of a Phillips cas’ 1972 paper on rational expectations. a model to account for it, and then to say Several years ago, you told me, “That pa- whether this relationship is exploitable curve correlation as invariant per cut away the underpinnings of what or not through policy—that was clearly to policy interventions and, we’d been doing.” at the heart of any such model. Tom and therefore, exploitable, it changed I were working on it, and doing nothing Wallace: Right. very different from what was standard at the standards for how we do the time. macroeconomics. It said you’ve Region: How did that paper influence And then I came across this working got to think about the econo- your work? In what fundamental ways paper by Bob Lucas. did it change your thinking about eco- And had I not known Lucas from hav- mies of dynamic systems. It also nomics and macro models? And perhaps ing been a classmate, I probably wouldn’t essentially broke down the barrier the course of your career since then. have read the paper. But knowing him between microeconomic theory and having a high opinion of him, I did Wallace: Bob Lucas and I had been fellow try to read the paper. Although it was and macroeconomic theory. grad students at the University of Chica- a pretty hard paper, I could quickly see go, and we both took Milton Friedman’s what the main message was, and I real- price theory course at the same time. This ized that it undercut what we were do- ing and that we ought to reorient our was two quarters of two, two-hour ses- move on to the next date. But it was re- research endeavor in a major way. sions a week, so it’s a lot. And Friedman ally just solving the model one date at a was well known for giving take-home time. Region: It was that convincing to you at exams, which were very open-ended That’s what Keynes did, and almost that point? questions—like, “This is a mystery; how everything up until that time, pret- do you think about it? How do you ex- ty much everything that grew out of plain it?” Those were the exams. Wallace: Yes, it was. Because I kind of Keynes’ general theory, was like that. Although this was microeconomics, believe that some of the best econom- And yet, all macroeconomic phenom- called “price theory” at Chicago, he gave ics consists of counterexamples. People ena inherently involved many dates. For us a question about the Phillips curve, a think A is true, and someone builds a lit- instance, people are making decisions negative association between inflation tle model whose ingredients don’t seem about how much to save and consume. and unemployment. He had briefly talk- particularly weird and it implies not A. Well, if they’re saving, it’s for the future, ed about this in class, but the take-home And so you’ve got to confront that. so they obviously have to be thinking exam question was basically, “How does about the future. this correlation come about?” I have no Region: These are theoretical counterex- Tom and I had been struggling with recollection of what I wrote. amples, not necessarily empirical? how to put these notions about the fu- ture into models. Tom had already done Region: This was the early ’60s? Wallace: Well, for me, yes, and certainly some of this in his Ph.D. dissertation at that paper was a theoretical counterex- Harvard several years earlier, but we were Wallace: This was the winter of 1961. Bob ample. And people had varying reac- struggling with trying to do this kind of Lucas was in this class, as I said, so may- tions to it, but Tom and I bought into it. thing in complete economy models. At be this was the start of his eight, nine, 10 And, in part, we bought into it because the time, my mathematical tools weren’t years of work on this question. Now, in macroeconomics at the time was emerg- good enough to do this. the early 1970s, Tom and I were work- ing from what we call static models. Such ing together under the general auspices models take conditions at a date and try Region: But as you and Tom developed of John Kareken, who was economic ad- to sort of figure out what is going to hap- the math, how did it focus your future viser to the president of the Minneapolis pen at that date and then, based on that, research? DECEMBER 2013 14 Wallace: Well, that Lucas paper, “Expec- to have. But economists are not satis- tations and the Neutrality of Money,”— fied with that easy acceptance and have When two people meet, it’s often which, by the way, I’ve heard Lucas say developed a number of theories about the case that one has something at a conference, speaking publicly, that its existence and utility, as a measure of that the other person wants, he regards as having been a waste of his value, medium of exchange and so on. time—had a major impact on our work. As a monetary theorist, you’ve studied but not vice versa. And without Even aside from its very important money far more deeply than most. Many money, nothing can happen. role as a counterexample to thinking of a economists consider you the intellectual Trade will not occur. Now, this Phillips curve correlation as invariant to father of money’s microfoundations. policy interventions and, therefore, ex- When you introduce this topic to story is incomplete. ploitable for policy, that paper did other students, how do you discuss the issues things. involved? Maybe it makes sense here to It changed the standards for how we quote from your 2008 discussion of fiat do macroeconomics. It not only said money in Palgrave, where you wrote, you’ve got to think about the economies “Money is helpful when there are ab- Aristotle have this absence-of-double- of dynamic systems and solve for the sence-of-double-coincidence difficul- coincidence notion? Probably not. But whole path of outcomes, not thinking ties that cannot be easily overcome he finds someone named Paulus, a Ro- about solving it just one date at a time, with credit; and a good money has de- man jurist in the second or third century but it also essentially broke down the sirable physical properties—recogniz- A.D., who said something like, when barrier between microeconomic theory ability, portability and divisibility.” two people meet, it’s often the case that and macroeconomic theory. [See Wallace 2008.] one has something that the other person I don’t know if that’s a good starting wants, but not vice versa. And without Region: Which is why establishing mi- point, but … money, nothing can happen. crofoundations became crucial. Wallace: It’s a reasonable starting point.
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