The International Origins of the Federal Reserve System

Published by EH.NET (June 1999)

J. Lawrence Broz. The International Origins of

the Federal Reserve System. Ithaca: Cornell University Press, 1997. xiii

+ 269 pp.

$35,ISBN: 0-8014-3332-0.

Review for EH.NET by David C. Wheelock, Federal Reserve Bank of St. Louis.

Why was the Federal Reserve System established? The common view is that the

Fed was established as a public good to correct deficiencies in the U.S.

banking and payments system that made the system inefficient and prone to

crises. Reform proponents blamed crises on the nation’s “inelastic currency”–

stocks of currency and bank reserves that did not adjust with seasonal or

cyclical fluctuations in demand, let alone in response to bank runs. Other

proponents of reform pointed to the difficulty of making inter-regional

payments, citing long delays and high costs associated with the clearing of

checks and drafts. Still other reformers decried the concentration of bank

reserves in the central money markets and the investment of correspondent

balances in stock market call loans. A less import ant goal of reformers, the

traditional view argues, was to promote use of the dollar in international

trade and finance.

J. Lawrence Broz argues that the goal of promoting the dollar as an

international currency was in fact the primary consideration of reform

proponents, and that reform was achieved only by alignment of strong private

interests for promoting international usage of the dollar with the general

public interest of improving the stability of the U.S. payments system. The

establishment of the

Federal Reserve System thus fits a “joint products” model, in which

institutional change produces a public good, but occurs only because of the

efforts of a narrow interest group seeking private gain.

The United States’ share of world exports, particular ly of manufactured goods,

rose during the last decades of the nineteenth century, and by the early

twentieth century the Untied States enjoyed an increasingly persistent current

account surplus. Despite these gains, the dollar was not used widely in inter

national commerce because, Broz contends, U.S. banks were prohibited from

issuing bankers acceptances to finance international trade and the U.S. lacked

a central bank with the power to create liquidity as needed by re-discounting

commercial paper. Because the dollar was not an international currency,

American exporters faced exchange risk and high transactions costs, while

American banks were largely shut out of the market for financing international

transactions. A coalition of leading bankers and manufacturers thus developed

with the goal of enhancing the dollar’s role as an international currency by

reforming American banking laws and institutions.

For the dollar to be acceptable to international markets, the stability and

efficiency of the U.S. banking and payments system had to be enhanced.

Thus, the interests of large U.S. banks and exporters aligned with the public

interest generally. The creation of the Federal Reserve System, Broz argues,

was an institutional reform that was consistent with both sets of interests.

Various alternatives for improving the domestic payments system, such as

adoption of nationwide branch banking, were insufficient to meet the interests

of internationally-oriented bankers and businessmen, and hence failed

to inspire a

strong coalition to push for their adoption.

Broz points to two features of the Federal Reserve Act that were crucial for

gaining acceptance of the dollar for international payments. First, the act

permitted U.S. banks to issue bankers acceptances to finance foreign trade.

Second, the act established facilities to re-discount acceptances and other

commercial paper, thereby adding depth and liquidity to the U.S.

money market. Other features of the legislation directly benefiting large banks

included a reduction of reserve requirements and authority for banks with

capital of at least $1 million to establish foreign branches. The legislation

thereby solved, apparently, the problems of an inelastic currency and an

inefficient payments system, while promoting the dollar’s use as an

international currency.

While the fundamental reforms embedded in the Federal Reserve Act provided the

key ingredients for promoting the dollar as an international currency,

specific features of the Act reflected give and take among various private and

public interests. Banks outside the central money market, for example,

were strong proponents of a currency backed by commercial paper, while New York

City bankers by and large preferred a currency backed by government bonds.

Banks

outside New York City also favored a decentralized system that limited the

ability of New York City banks to dominate. Bankers in general and many in

Congress favored a system controlled by banks themselves, but the Wilson

Administration, and especially

William Jennings Bryan, pushed for strong public oversight in the form of a

Federal Reserve Board. The Federal Reserve System was the product of compromise

at every stage and detail.

Broz supports his study of the origins of the Federal Reserve by examining how

well the founding of other central banks fit his joint products model.

The central banks he considers are the Bank of England, and the First and

Second Banks of the United States. In contrast to the Federal Reserve, each of

these banks was created

in part for government revenue. In exchange for providing loans on favorable

terms to the government, the owners of the banks were granted certain monopoly

privileges. The Bank of England was given a monopoly over note issuance, while

the First and Second Banks of the United States profited as the government’s

fiscal agents, as well as from their unique ability to branch nationwide. Broz

argues persuasively that the Bank of England survived, while the two U.S. banks

did not because in the United States federalism created a potent political

opposition that could be exploited by private enemies of the central bank.

While Andrew Jackson’s militant “hard money” philosophy explains his opposition

to the Second Bank, Wall Street bankers also sought to kill the

Bank on the grounds that its monopoly position as the government’s fiscal

agent gave the Bank advantages that state-chartered banks did not have.

I find little to quibble with Broz’s explanation of the origins of the Federal

Reserve System. Clearly the

most ardent proponents of establishing a central bank, especially the New York

bankers, sought to establish a major international money market in the United

States and to promote the dollar in international commerce and finance. There

was, however, strong

opposition to the establishment of a “central bank,” particularly one dominated

by New York bankers, and key players in shaping the Federal Reserve Act, such

as Carter Glass, William Jennings Bryan and Woodrow Wilson, sought to limit the

influence on the

System of New York banks.

Nonetheless, Broz has persuaded me that establishment of the Federal Reserve

required the ongoing support of leading banks and others who sought to firmly

establish the U.S. dollar as an international currency. I highly recommend

this book for anyone interested in either the history of the Federal Reserve or

other central banks, or for those interested in the origins of institutions and

institutional change more broadly.

David C. Wheelock is Assistant Vice President and Economist at the Federal

Reserve Bank of St. Louis. His research interests are the history of the

Federal Reserve System and other monetary policy institutions, and the

regulation and performance of commercial banks.