The International Origins of the Federal Reserve System 9781501722370

Citation preview

The International Origins of the Federal Reserve System

The International

Origins of the Federal Reserve

System J.

LAWRENCE BROZ

C

Cornell University Press ITHACA AND LONDON

First printing, Cornell Paperbacks, 2009 Copyright © 1997 Cornell University All rights reserved. Except for brief quotations in a review, this book, or parts thereof, must not be reproduced in any form without permission in writing from the publisher. For information, address Cornell University Press, Sage House, 512 East State Street, Ithaca, New York 14850. First published 1997 by Cornell University Press Printed in the United States of America Cornell University Press strives to utilize environmentally responsible suppliers and materials to the fullest extent possible in the publishing of its books. Such materials include vegetable-based, low-VOC inks and acid-free papers that are also either recycled, totally chlorine-free, or partly composed of nonwood fibers. Library of Congress Cataloging-in-Publication Data Broz, J. Lawrence. The international origins of the Federal Reserve System I J. Lawrence Broz. p. em. Includes index. ISBN: 978-0-8014-7595-5 1. Board of Governors of the Federal Reserve System (U.S.)-History. 2. Federal Reserve banks-History. 3· International finance-History. 4· Monetary policyUnited States-History. I. Title. HG2563.B68 1997 332.1' 1' 0973-dc21 97-11932 Cloth printing

10

9 8 7 6 5 4 3 2 1

To my parents, Carmen and Perry Broz

Contents

List of Figures and Tables

ix

Preface

xi

Introduction

1

1

The Federal Reserve Act: Content and Contending Explanations

2

The Economics and Politics of International Currency Use

55

3 The International Economy, Patterns of Currency Use, ·and Domestic Politics

86

4 The Rise of the U.S. Economy and the Banking Reform Movement

132

5 Collective Action for Banking Reform

160

6 The Origins of Other Central Banks

206

Summary, Observations, and Implications Index

245

Figures and Tables

Figure 1.1. Number of national banks, state banks, and trust companies, 1862-1913 Figure 1.2. Total assets of national banks, state banks, and trust companies, 1862-1913 Figure 1.3. Single- and double-name paper as a percentage of total loans and investments, all national banks, 1883-1913 Figure 1-4- Single- and double-name paper as a percentage of total loans and investments, New York City national banks, 1881-1913 Figure 1.5. Commercial paper as a percentage of total loans and investments, New York City national banks and all national bank~ 1886-1913 Figure 4.1. Gold holdings of the U.S. Treasury, the Bank of England, the Bank of France, and the Reichsbank, 1878-1913 Table 1.1. Institutions not changed by the Federal Reserve Act Table 1.2. The Federal Reserve Act's minor institutional changes Table 1.3. The Federal Reserve Act's major institutional changes Table 2.1. Functions of international money Table 2.2. Necessary and supplementary characteristics of international currency countries Table 2.3. International distributional effects of key currency status Table 2.4. Domestic beneficiaries of international currency issue, ranked by intensity of preference

22 23

44 44 45 135 51 52 53 58 71 75 81

ix

x

Figures and Tables

Table 3.1. Merchandise exports of the major trading states, 1872, 1899, 1913 Table 3.2. National export values, 1872, 1900, 1913 Table 3·3· National share of world exports, 1872, 1900, 1913 Table 3-4- National share of world exports by product group, 1872, 1900, 1913 Table 3·5· Destination of national exports, 1872, 1899, 1913 Table 3.6. National export share by area, 1872, 1899, 1913 Table 3·7· Destination of U.S. exports, 1872-1913 Table 3.8. U.S. balance of international payments, 1872-1913 Table 3·9· Changes in the U.S. gold stock, 1890-1910 Table 3.10. Growth and composition of foreign-exchange assets, 1900-1913 Table 3.11. Stability and range of official discount rates in France, Germany, and England, 1878-1909 Table 4.1. Holdings of the U.S. Treasury Table 5.1. Economic consequences of U.S. banking panics

91 94 96 98 100 102 103 1o6 108 114 121 134 166

Preface

F

rom the Civil War to 1913, the United States suffered under one of the worst banking systems in the world. Major panics occurred about every ten years, and seasonal changes in the demand for credit created liquidity disturbances nearly every autumn. To many observers, the panic of 1907 was the last straw, prompting the rise of one of the great organs of American administrative government: the Federal Reserve System. Founded in 1913 by an act of Congress for the expressed purpose of reducing the propensity for panics, the Fed was given a mandate to provide society with one of its most basic public goods: a sound and efficient payments system. This book is an attempt to explain how American society overcame the collective action dilemmas that normally constrain the production of public goods to inadequate levels. In plain English, it is about how the nation produced one of the cornerstones of good government, in the face of disincentives that should have left few people with sufficient motivation to incur the large costs of institutional change. I argue that Mancur Olson's familiar "joint products" model (also known as the "by-products" or "selective incentives" model) provides the key to understanding the voluntary collective action behind the Federal Reserve Act. The model postulates that a public good produced jointly with a private good can yield collective action in a large group setting, because the addition of the private good creates the necessary convergence between the individual and the social costs of collective action. In other words, if a person wants to enjoy a private good, and that xi

xii

Preface

enjoyment is contingent on the production of a public good, he or she will have incentives to contribute to an effort to produce both goods. The Federal Reserve Act was a case of joint production, as it produced at least two important "goods." It was about solving the panic problem, to be sure, but, because this expected benefit approximated a pure public good, few people would invest in efforts to change the system, when they could enjoy any improvement for free. The Act also offered the means to fully internationalize the U.S. dollar and the operations of money-center banks, a benefit restricted to a far smaller segment of society. The New York financial community stood to gain the most, and the profits made possible through the attainment of international currency status created the necessary overlap between the private and social costs of institutional change. Bankers could not earn the rents associated with issuing an international currency without contributing to the overall effort to improve the general operation of the payments system. Moreover, the stimulus behind the entire process of institutional change was the rapidly advancing position of the United States in the world economy, a post-187os trend that gave large bankers some incentives to absorb the expenses of domestic institutional innovation. In short, to its most ardent and organized proponents, the Federal Reserve Act was first and foremost a response to new international opportunities, previously unattainable because of the deficient organization of the domestic payments machinery. This book began its life at the University of California, Los Angeles. UCLA offered a rich and stimulating environment for political economy research, and I am indebted to all those who attended presentations and commented on early drafts, especially Mark Brawley, David Lake, Karen Orren, and Ron Rogowski. Intellectually, I owe the most to my adviser and colleague, Jeffry Frieden, who diligently reviewed many drafts and uncovered numerous errors of commission and omission. Without his help and encouragement through every phase of the project, I doubt I could have completed it. Ken Sokoloff also conveyed sound advice on the full manuscript and introduced my project to other leading economic historians. Lance Davis was the most generous of this group, providing many pages of detailed evaluation and data on one of my presentations. I also thank my colleagues at Harvard University for guidance and advice on parts of the manuscript. Marc Busch, Joel Hellman, Robert Keohane, and Lisa Martin offered important suggestions. Other scholars gave valuable counsel: Michael Bordo, William R. Clark, Benjamin J. Cohen, Barry Eichengreen, William Keech, Stephen Krasner, Charles Lipson, James Livingston, Robert Paarlberg, Louis Pauly, Frances Rosen-

Preface

xiii

bluth, George Selgin, Beth Simmons, Daniel Verdier, and Eugene N. White. I also had useful conversations with Vincent Carosso, Gary Gorton, Alex Leijonhufvud, Stephen Schuker, and Richard Sylla. Two anonymous reviewers provided first-rate advice, for which I am very grateful, and Roger Haydon deftly guided the manuscript to publication. Xenia Busch, Melissa Freeman, and Ilya Somin compiled the index and proofread the manuscript. I received financial assistance from the National Science Foundation (grant no. SES-8819707), and UCLA's International Studies and Overseas Program. Research for this book was done while at the Center for International Affairs, Harvard University. The following institutions provided access to their libraries and archival assistance: The Rare Book and Manuscript Library of Columbia University, the Archives Division of the Federal Reserve Bank of New York, the Research Library of the Board of Governors of the Federal Reserve System, the Special Collections Department of the University of Virginia Library, the Archives Department of the Baker Library at Harvard University, the U.S. National Archives, and the Manuscript Division of the Library of Congress. Lastly, I thank my wife, Chris, and children, Adrian and Marina, for all their love and encouragement.

J. LAWRENCE BROZ Cambridge, Massachusetts

The International Origins of the Federal Reserve System

Introduction

W

hen Congress passed the Federal Reserve Act in December 1913, it established a new set of institutions governing the relationship between banks and credit markets and between banks, the government, and the production of money. The official rationale was to imbue the payments system with greater "elasticity," by way of central bank rediscounting facilities. Before 1913, there was no public-sector agency charged with management of the system in times of crisis, and private-sector remedies often proved inadequate to the task. Recurrent periods of shortage of a medium of exchange and severe banking panics were the result. Since the 1930s, no major disruption to the banking and payments systems has occurred, and scholars are virtually unanimous in attributing much of this success to prompt and aggressive interventions on the part of the Federal Reserve.1 To explain the origins of the Federal Reserve System in terms of society's need for a credible lender of last resort-a desired institution that approximates a societywide public good-misreads the incentives that compelled the institutional changes. In this book, I argue that the rapid international advance of the American economy after the 187os 1 See, for example, Anna J. Schwartz, "Real and Pseudo-Financial Crises," in Financial Crises and the World Banking System, ed. Forrest Capie and Geoffrey E. Wood (London: Macmillan, 1