Origins of the Federal Reserve System: International Incentives and the Domestic Free-Rider Problem Author(S): J

Home , Paul Warburg

Origins of the Federal Reserve System: International Incentives and the Domestic Free-Rider Problem Author(s): J. Lawrence Broz Source: International Organization, Vol. 53, No. 1 (Winter, 1999), pp. 39-70 Published by: The MIT Press Stable URL: http://www.jstor.org/stable/2601371 . Accessed: 13/10/2011 18:16

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http://www.jstor.org Originsof the Federal Reserve System:International Incentives and theDomestic Free-rider Problem J.Lawrence Broz

Fromthe Civil War to 1914,the United States had one ofthe worst financial systems in theworld. The dominantinstitutional feature of thesystem was theabsence of a centralbank, and its most salient performance characteristics were the recurrence of bankingpanics and severeseasonal interest-rate fluctuations. These financialprob- lemswere economically costly; panics were accompanied by sharpdeclines in the moneysupply, reduced economic activity, and increasedunemployment and busi- nessfailures. In 1913 Congresscreated the Federal Reserve System to safeguardthe nationfrom panics and smooth out interest-rate seasonals. In moregeneral terms the FederalReserve was establishedto providethe national public good of financial systemstability. In thisstudy I explainhow American society overcame the collectiveaction problems that normally constrain the production of public goods to inad- equatelevels. In otherwords, the article is aboutthe political effort that produced an infrastructuralcornerstone of the modern U.S. economyin theface of incentives that shouldhave left few people with sufficient motivation to "pay" forthe improvement. I bringto bear a "jointproducts" (selective incentives) argument to explainthe voluntarycollective action behind the Federal Reserve Act.' The lobbyingeffort was aboutsolving the panic problem, to be sure,but because this expected benefit approxi- mateda societywidepublic good, it did not,on itsown, motivate collective action. Instead,the United States faced a secondproblem of financialorganization before 1914, and it was thisproblem that created a privateinducement to lobbyfor the FederalReserve. The structureof thedomestic financial machinery contributed not onlyto instabilityat homebut also to thenear complete absence of the U.S. dollarin globalfinancial affairs. Indeed, the United States was theonly major trading country whosecurrency did not function as an internationalcurrency before 1914. The New

Thisarticle is a revisionof a paperdelivered at the1996 Annual Convention of the Southern Economic Association,Washington, D.C., 23-25 November.I thank Michael Bordo, Marc Busch, William R. Clark, BenjaminJ. Cohen, Barry Eichengreen, Jeffry Frieden, William Keech, Stephen Krasner, Charles Lipson, JamesLivingston, Louis Pauly, George Selgin, Beth Simmons, Richard Timberlake, Daniel Verdier, Eugene N. White,and two anonymous reviewers for very helpful comments. 1. See Olson 1965;and Sandler 1992.

InternationalOrganization 53, 1,Winter 1999, pp. 39-70 ? 1999by The IO Foundationand the Massachusetts Institute of Technology 40 InternationalOrganization

Yorkfinancial elite had themost to gain fromrectifying this situation, since the benefitsof internationalcurrency status are demonstrablyconcentrated and specific to money-centerbanks. However, society at large benefited from the bankers' lobbyingeffort because the private good (internationalizing thedollar) could not practicably be disassociatedfrom the production of thepublic good (domesticfinancial stability).This aspectof theargument is crucialbecause the joint products model hinges on theinseparability of theexcludable and nonexcludable goods. In thisarticle I providea "roadmap" ofthe joint products model and demonstrate empiricallythe supply constraints that bound together the public and privategoods ofthe Federal Reserve Act. Additionally, the inferences of joint production are clearly specifiedand evaluated with respect to an importantcase. Althoughthe main historical findingis thatstudents of the Federal Reserve have not paid sufficient attention to internationalfactors in explainingthe creation of theFed, I also confirmthe wider applicabilityof the joint products model.

The Mechanicsof Joint Production

The jointproducts model provides a simple,elegant, yet powerful explanation of how publicgoods are produced.2The basic intuitionis thatmost collective action situationsyield multiple benefits, public and private.The collectiveaction problem ariseswhenever a desiredgood is public;in suchsituations additional incentives are neededto movegroup members to action.Distinct from the collective aspirations of a group,the added incentives are excludablegoods thataccrue selectively to indi- vidualmembers, contingent on theirparticipation in thegroup effort. Hence, the payoffto contributorsincludes both the nonexcludable public good and theexcludable privategood, but it is self-interestand notcollective interest that leads to the provisionof thepublic good. The basic hypothesisis thatthe extent of freeriding associatedwith the production of a publicgood is inverselyrelated to theproportion ofprivate benefits available to participating members of a group. In some collectiveaction situations, however, the model may be inappropriate. The riskis thatit is all too easy to assumethe existenceof some privatereturn wheneverwe observea publicgood. The crucialrequirement of themodel, often ignored,is thatthe private and public goods in questioncannot be disaggregateddue tosome prevailing supply constraint. Otherwise, the argument is open to the "separate- provision"critique.3 In otherwords, if people contribute to a publicgood because of theselective benefits offered, then an efficientsolution is to disconnectthe private goodfrom the collective good, since it would be cheaperto produce it independently. Jointproduction thus requires that it is difficultor impossibleto realizea private benefitwithout contributing to the associatedcollective good. Yet the failureby

2. See Sandler1992 fora formalrepresentation. For substantiveexamples, applied to interestgroups, populardissent, and internationalalliances, see respectivelyMoe 1980; Lichbach1995; and Conybeare andSandler 1990. 3. See Stigler1974, 360; andSugden 1982. Originsof the Federal Reserve 41 manyresearchers to problematize the technology of supply has createddoubts about therelevance of the model. In summary,the mechanics of joint production requires that three conditions be met.First, a publicgoods problemmust exist. The taskbefore the analystis to identifythe desired public good and define the good accordingto a specificgroup of individuals.The publicgood in questionmay benefit only two specific people or the wholeworld. The pointis thatpublic goods can onlybe definedwith respect to some specificgroup. Second, a privategood must be availableto induce select members of thegroup to participatein thecollective effort. The analystmust identify the desired privategood and definethe good accordingto a specificsubset of thelarger group. Third,a privatebenefit can onlyinduce collective action when it cannotbe enjoyed in isolationof thepublic good. In otherwords, the joint goods cannot be separately produced.The analystmust bind the public and privategoods togetherby way of definingthe supplytechnology that makes it impossibleto disaggregatethe joint goods. The articleis organizedinto three sections. In thefirst section I definethe public goodsproblem with respect to the workings of the U.S. financialsystem before 1914. I furnishnational-level data on the economiccosts of panics and otherfinancial disordersto substantiatethe claim that provision of a morereliable financial system was a publicgood fornearly everyone in thecountry. I also providehistorical back- groundon thelegal andinstitutional characteristics ofthe system that left it prone to suchfinancial disturbances. In thesecond section I definethe private good thatinduced select individuals to contributeto a solution.I beginby showinghow the structure of the domestic financial systembefore 1914 precludeda role forthe dollar as an internationalcurrency-an argumentthat finds support in the literatureon key currencies.I then unpackthe distributional effects of internationalcurrency issue to illustratethat the benefitsare concentratedheavily on money-centerbanks. The mainfinding is that thesebanks earn what are knownas "denominationrents" from global use of the homecurrency-profits associated with enhanced demand for banking services of theissuing country. Finally, I documentlobbying for the Federal Reserve Act and providequalitative evidence, drawn from public and private records, that the political effortof bankers was motivatedby the desire to obtainthis selective benefit. In thethird section I evaluatethe claim that producing the private good (internationalcurrency status) and producing the collective good (domesticfinancial stability)could not be separated.To obtainthe private good required improving the breadth, depth,and flexibility of the domestic financial machinery. Since an interrelationship existsbetween these characteristics and domesticfinancial stability, money-center bankershad incentivesto internalizethe costs of producingthe public good. As evidence,I showthat bankers acknowledged a close relationshipbetween their real- izationof denominationrents and domesticfinancial stability. This sectioncloses withan evaluationof alternativeexplanations of bankerlobbying for the improve- mentsembodied in theFederal Reserve Act. In theconclusion I discussthe implica- tionsof this study. 42 InternationalOrganization

FinancialSystem Stability as a Public Good

The financialsystem is the infrastructureon whichthe functioningof the entire economyrests.4 When a financialsystem is operatingsmoothly, itis almostinvisible. Advancesand transfers of money take place between individuals and firms with little regardto theunderlying infrastructure, facilitating exchange and maximizing aggre- gatesocial welfare.In thissense, financial system stability is literallya publicgood, and thebeneficiaries include nearly all citizensof a nation.The publicnature of financialstability is especiallyclear in itsabsence. When a financialsystem is unreli- able or proneto collapse,people become aware of it because thecosts of its poor organizationare made manifest in forgone everyday exchange. Breakdowns in financial intermediationservices reverberate through the real economy, causing a reduc- tionin economicactivity, higher unemployment, and increased commercial failures.5 Yet simplybecause society at largebenefits from a soundfinancial system does not makeits provision automatic. Provision is problematicbecause any effort to improve theinfrastructure is itself a publicgood and,therefore, subject to thedilemmas of collectiveaction-free riding, undervaluation, and underprovision.The following discussiondemonstrates these points empirically, with respect to the instability of the U.S. financialsystem before 1914. The NationalBanking Acts of 1863, 1864,and 1865 determinedthe basic structureof the U.S. bankingsystem until 1914.6 The legislationhad twomain purposes: to providea uniformnational currency and to raiserevenue for the federal govern- mentduring wartime. Prior to 1863,the national currency supply consisted primarily ofnotes issued by literally thousands of state-chartered banks. The problemwas that thenotes of thesebanks circulated at variousdiscounts from par, depending on the reputationof theissuing bank, the time passed sincethe note was issued,and the distanceto theissuing bank. Determining the quality of a particularnote involved unnecessarilyhigh transaction costs. The nationalbanking legislation substantially reducedthese costs by allowingfor the incorporation of banks chartered by thefed- eralgovernment ("national banks") thatwould issue currency backed fully by U.S. governmentbonds. By effectivelymaking all bankcurrency a liability of the government,and, therefore, risk-free, the bond collateral feature did createa uniformcur- rencythat circulated at par throughout the country.7 Another motive, however, was to createan artificialmarket for government debt. Requiring banks to securetheir note issuewith Treasury securities increased demand for government bonds, and the pro- visionwas thusvalued jointly as a revenue-raisingmeasure during the Civil War. Althoughthe systemsucceeded in establishinga uniformcurrency (and raising revenuefor the government), it did notsolve all thedefects of thefinancial system. Theremaining flaw was thatthe currency was "inelastic"in theshort run, which led

4. Humphrey1990. 5. Bernankeand Gertler 1990. 6. See James1978; andWhite 1983. 7. Cagan 1963. Originsof the Federal Reserve 43 to largeseasonal swings in interestrates and bankingpanics. None of thevarious formsof currency in circulation-nationalbank notes, gold and silver coin, gold and silvercertificates, and greenbacks-could vary much in theshort run.8 Law fixedthe quantityof greenbacks,gold and silvercertificates could be issuedonly if the Trea- suryheld equivalent specie as backing,and theuse of silverwas rigidlycontrolled. The supplyof nationalbank notes, in turn,tended to exhibit"perverse elasticity," contractingwhen it should have expanded. National banks had to obtaingovernment bondsto issueadditional notes, a slow andexpensive process; moreover, they could notissue notesagainst general assets. When bank reserves were low and business veryactive, banks could ill affordto have their funds tied up inbonds and redemption deposits,resulting in a contractionof the note supply. The underlyingcause of thisshort-term rigidity, however, was theabsence of a centralbank. Although the United States had maintained a central bank during much of theantebellum period, the most distinctive feature of the national banking period was theabsence of an institutionwith the power to providefunds at timesof high demandthrough a discountwindow or through open market operations. Other institutions,however, attempted to fillthis void. The mostimportant example was the New YorkClearinghouse Association, which became a quasi-centralbank in the nation'sfinancial center. Most banksin New Yorkwere members of thecity's clearinghouse association becauseof theservices the association offered in settlingpayments between banks. But theclearinghouse evolved to takeon thefunction of poolingmember bank re- servesand issuingemergency currency (known as "loan certificates")during panics.9Although there was no legal mechanismto increasethe supplyof currency quickly,loan certificatesprovided a private,if unlawful,way to freeup a sizable amountof cash.The issueof loan certificatesthus reduced somewhat the need for a centralbank to provideliquidity during crises. But theclearinghouse was notsuffi- cientlypowerful to have majoreffects on thequantity of reserves,and therewere numerouspanics despite the use ofloan certificates. In theabsence of a truecentral bank, short-term rigidity in thesupply of currency causedproblems with respect to seasonalshifts in demandfor currency, arising from theannual agricultural cycle. In thefall, during the harvest season, the demand for currencywas intense,since agriculture still accounted for a largeshare of economic activityand cash was requiredfor many farm transactions.10 With supply held rigid, interestrates were driven upward.11 This deviationof interestrates from their trend level was suboptimalsince it did not ariseto counteroverheated macroeconomic conditions.The extrademand derived solely from the need to "move thecrops." Banks werethus induced to rundown theirreserves in the fall,which left them vulnerableto runs.As JefferyMiron documents, panics occurred with much higher

8. Friedmanand Schwartz 1963, 168-69, 292-95. 9. See Timberlake1993, 198-213; and Gorton and Mullineaux 1987. 10. Eichengreen1984. 11. See Champ,Smith, and Williamson 1996; and Miron 1996. 44 InternationalOrganization frequencyin the autumn,when high interest rates and low deposit-reserveratios prevailed.12 Panicswere the most obvious manifestation ofthe inelasticity problem during the nationalbanking period.13 Major panicsoccurred in 1873, 1884, 1890, 1893, and 1907.14In addition,there were twenty-four lesser panics between 1873 and 1909.15 Althoughthe immediate cause of each panicvaried, ranging from the failure of a specificbank to a stockmarket crash, the most serious panics (1873, 1893,and 1907) endedonly after solvent banks everywhere had suspended the convertibility ofdepos- itsinto currency. The effectsof panics were not restricted to thefinancial sector alone.16 Suspension ofpayments, which lasted from one to threemonths, was one mechanismthat trans- mittedthe shockto thereal sectorof theeconomy. Suspension meant that banks closedtheir doors to firms and individuals needing currency to meet payrolls or make transactions,causing disruptions in economicactivity and increasingthe number of commercialbankruptcies. When banks suspended payments, brokers began buying andselling currency at a premiumto deposits. Such premiums, which averaged 1 to2 percentand ranged as highas 4 percentin 1907,reflected the wealth lost by deposi- tors.In addition,banks were forced to curtailloans and ration credit, due to pressure on theirreserves. Even ifcredit contraction was onlymomentary, the effects on the real sectorwere often severe, since firms relied on short-termloan facilitiesto fi- nancecommerce and temporaryshortfalls. Table 1 providessome evidenceof the economiccosts of major panics during the period. 17 In summary,seasonal interest-rate fluctuations and theshortages of a mediumof exchangeduring panics imposed large costs on Americansociety. These problems werelargely rectified with the establishment of theFederal Reserve, justifying the claimthat the installation of the Fed was a publicgood. The principalreason for the foundingof the Federal Reserve was toassure stable and smoothly functioning financial markets,a functionthat predates the more purely monetary functions of engag- ing in open marketand foreignexchange operations and settingreserve require- ments.Miron shows that the frequency of panics and the size ofseasonal movements in interestrates declined substantially after the founding of the Fed.18 The realization of thesegeneralized and nonexcludablebenefits, however, does notsquare with the narrowscope of thelobbying effort undertaken by New Yorkbankers (discussed later)in therun-up to thelegislation. My claimis thatmoney-center bankers took up thecause becausethey sought a separate,group-specific benefit-namely, the internationalizationof the dollar.As documentedin thisarticle, the nationalbanking

12. Miron1986. 13. Champ,Smith, and Williamson 1996. 14. Sprague1910. 15. Kemmerer1910. 16. Economistsdiffer on how financialdisturbances influence the real economy. For a testof thetwo mainhypotheses, see Bordo,Rappoport, and Schwartz 1992. 17. Fora fulleraccounting, see Grossman1993. 18. Miron1986, 125. Originsof the Federal Reserve 45

TABLE 1. Summaryof the major national banking era panics

1873 1884 1890 1893 1907

Proximatecause Stockmarket Stockmarket Stockmarket Stockmarket and Runon NYC crash/closure crash crash commercial trust failures companies Suspensionof Yes No No Yes Yes payments? Premiumon 1 2 2 currency (% average, during suspension) Liabilitiesof NA 80.7 62.9 389.2 130.4 commercial failures (% change)a Industrial -6.9 -4.0 -2.9 -26.6 -28.5 production (% change)a

Sources:Calomiris and Gorton1991; andSprague 1910. aPercentagechange from the same interval the year prior to thepanic. Panic intervals are: June- December1873; March-August 1884; August 1890-February 1891; April-October 1893; August 1907- February1908. systeminduced financial instability at homeand preventedbankers from realizing theprivate gains of having New Yorkserve as an internationalbanking center.

The PrivateBenefits of Internationalizing the Dollar

Accordingto thelogic ofjoint production, a special inducement is requiredto give rationalagents the motivation to contribute to a publicgood. In thiscase, internation- alizingusage of theU.S. currencywas thespecial inducement for bankers to lobby forthe Federal Reserve. This sectionbegins with information on internationalcur- rencyuse in theera, which reveals the surprising absence of thedollar from global financeprior to 1914.Drawing from the literature on keycurrencies, I then show that (1) theparochial position of the dollar was dueto domestic (supply-side) institutional factors,and that(2) issuingan internationalcurrency would generate concentrated benefits,with most of the gains accruingto money-centerbanks. Together, these findingsmake the point that reforming the U.S. financialsystem offered significant privatebenefits to money-centerbanks. The internationaluse ofa currencyoccurs whenever a nationalcurrency performs thethree functions of moneyoutside the borders of thenation that issues it. As a mediumof exchange, an internationalcurrency is usedto settle foreign trade transac- tionsand to dischargeinternational financial obligations. As a unitof account,it is 46 InternationalOrganization used to invoicemerchandise trade and to denominatefinancial instruments. As a storeof value,it servesas an investmentasset held by privateand officialnonresi- dents.It shouldbe notedthat "money" held as a storeof value is notusually held in theform of moneyat all, butin liquidinterest-bearing assets. This fact will play an importantrole in theargument I later develop. Althoughdata on internationalcurrency use before1914 are sketchy,estimates indicatethe predominance of sterling,a lisingrole for the German mark, some reservecurrency usage of the French franc, and the virtual absence of the U.S. dollarin globalfinancial affairs. Sterling was used to invoicefrom 80 to 90 percentof world tradeby theearly nineteenth century.19 In thesecond half of thecentury, the vehicle currencystatus of sterling declined somewhat, but estimates still range from 60 to 90 percentof worldtrade.20 The markalso made stronginroads as an international mediumof exchangeand unitof account,as did thefranc as a reserveasset.21 The dollar,however, remained insignificant in worldpayments throughout the period. Sterlingremained the primary currency for invoicing and settlingU.S. trade,and sterlingbills formed the basis not only of British trade with the United States but also of U.S. tradewith other regions. "However important the position of New Yorkin domestictrade finance, as a capitaldistributing center, and in settlingdomestic balances,its position was unimportantin financing foreign trade."22 As forthe store-of-value function, foreign governments and centralbanks held a largeportion of theirreserves as sterlingassets in theLondon money market by the 1880s.The positionof London as reservecenter slipped after the 1890s as Berlinand Paris became rivalreserve centers. Yet, as Table 2 illustrates,the dollarwas not utilizedas a storeof value by nonresidents.23 Patternsof international currency use before1914 are sufficientlyclear. Although sterlingremained preeminent, its vehicleand reservecurrency roles fell somewhat betweenthe 1870s and 1913,tracking England's relative economic decline. In contrast,the mark advanced significantly, in association with Germany's rapid economic ascenton theworld stage. For these currencies, international usage followed changes in globaleconomic position. The U.S. dollarwas thecrucial exception. Why? Specialistsin globalfinance consider both international and domesticfactors in explainingpatterns of currency use. These factors fall neatly into the basic categories of economicanalysis: the supply-side conditions, which are domesticand institutional,and the demand-side factors, which involve the relative position of nations in theglobal economy.24The evidencepoints to supply-sidefactors, namely, the ab-

19. See Morgan-Webb1934, 53-54; andWilliams 1968, 268. 20. Thehigher figure is fromWhitaker 1919, 555; thelower from Williams 1968, 268. 21. See Tilly1991; Hertner 1990; andLindert 1969. 22. Beckhart1932, 253. See also Carossoand Sylla 1991. 23. However,$142 millionof the"other currencies" held by privateinstitutions in 1913 consistedof theU.S. dollarassets of Canadian banks. Absent the close tiesbetween Canadian banks and the New York moneymarket, itis unlikelythat the dollar would have served any reserve currency role before 1913. See Lindert1969, 17, 22. 24. The terminologyis from Tavlas 1991and 1992.See also Mundell1989, 189-210. Originsof the Federal Reserve 47

TABLE 2. Growthand compositionofforeign-exchange assets, 1900-13 (in millionsof dollars)

End of1899 End of1913 Change 1913 index(1899 = 100)

Officialinstitutionsa 246.6 1,124.7 878.1 456 Knownsterling 105.1 425.4 320.3 405 Knownfrancs 27.2 275.1 247.9 1,010 Knownmarks 24.2 136.9 112.7 566 Othercurrencies 9.4 55.3 45.9 590 Unallocatedb 80.7 232.0 151.2 287 Privateinstitutions 157.6 497.8 340.2 316 Knownsterling 15.9 16.0 0.1 100 Knownfrancs Knownmarks Othercurrencies 62.0 156.7c 94.7 253 Unallocatedb 79.7 325.1 245.4 408 Allinstitutions 404.2 1,622.5 1,218.3 401 Knownsterling 121.0 441.4 320.4 365 Knownfrancs 27.2 275.1 247.9 1,010 Knownmarks 24.2 136.9 112.7 566 Othercurrencies 71.4 212.0 140.6 297 Unallocatedb 160.4 557.1 396.7 347

Source:Adapted from Lindert 1969, tab. 3, 22. aCentralbanks and treasuries. bForeignasset figures not broken down by currency. c$142million of this total were U.S. dollarassets held by Canadian banks in New York City.

sence of broad,deep, and resilientdomestic financial markets, as thehindrance to widerusage of the dollar before 1914. Takingthe global, demand-side factors first, the basic logicis thata nation'sposi- tionin worldeconomy affects the attractiveness of itscurrency. Demand for a cur- rencyreflects the relative size of marketsin it,and it is thecurrencies of countries thatloom large in worldtrade and paymentsthat are demanded.In thisrespect, the choiceof an internationalcurrency is muchlike the choice of a worldlanguage: both are "notmade on merit,or moralworth, but on size."25Indeed, a largeand growing shareof world trade has beenshown to increase international use ofa currency.26Yet data on theU.S. positionin worldtrade indicate that global positionwas notthe sourceof the parochialism of the dollar before 1914. Table 3 presentstrade statistics for the largest exporting countries-the industrial nationsof Western Europe, the United States, Canada, and Japan.This is a reason- able substitutefor truly worldwide trade, since the United States and Europe together accountedfor about 80-90 percentof worldtrade in manufacturesand forabout 65 percentof worldtrade in all goodsduring this period.27 The datastrongly suggest a

25. Kindleberger1967, 11. 26. Page 1981. 27. Eysenbach1976, 39, 51-53. 48 InternationalOrganization

TABLE 3. Merchandiseexports of the major trading states, 1872, 1899, 1913 (in millionsof dollars)

Exporter 1872 1899 1913

UnitedKingdom 1,246 1,604 2,556 UnitedStates 492 1,204 2,484 Germany 544 1,002 2,405 France 726 816 1,359 OtherWestern Europea 473 911 1,679 Canada 164 432 Japan 113 315 Total 3,481 5,814 11,230

Shareof total (%) 1872 1899 1913 UnitedKingdom 35.8 27.6 22.8 UnitedStates 14.1 20.7 22.1 Germany 15.6 17.2 21.4 France 20.9 14.0 12.1 OtherWestern Europea 13.6 15.7 15.0 Canada 2.8 3.8 Japan 1.9 2.8

Sources:Kindleberger 1956, tab. 3-4a, 58-59; Maizels 1963,tab. Al, 426-27; andU.S. Department ofCommerce 1975, pt. 2, tab.U317-34, 903-904. alncludesBelgium-Luxembourg, Italy, Netherlands, Norway, Sweden, and Switzerland. Excludes goodsconsigned from the Netherlands. Switzerland and Norway are not included in the1872 figures. risingrole forthe dollar as an internationalcurrency. Note thatU.S. exportsrose from14.1 percentof this "totaltrade" in 1872 to 22.1 percentby 1913, a share virtuallyidentical to thatof Englandand Germany.As earlyas 1899, theUnited Stateswas thesecond largest exporter in theworld, yet the dollar played no rolein short-terminternational finance. Anotherdemand-side consideration is a nation'sbalance-of-payments position. Persistentcurrent account surpluses, offset by capitaloutflows, serve as a "promo- tionalmechanism for the international use ofa nation'scurrency."28 The promotional effectoccurs for two reasons. First, the export of capital induces foreigners to acquire balances,denominated in the capital-exportingcountry's currency, to servicethe obligations.Second, the transfer of liquidityfrom the capital-exporting country to thedeficit country is accompaniedby a transferof goods and servicesin thesame direction,increasing demand for claims in thecurrency of theexporter to pay for importsfrom the surplus nation. In short,the current account surplus/capital outflow patternincreases demand for a currency,since foreigners acquire short-term claims denominatedin thatcurrency to bothservice long-term loans and to payfor imports fromthe surplus country.

28. Tavlas 1991,11. Originsof the Federal Reserve 49

Table 4 reportsthe evolving balance-of-payments position of theUnited States between1872 and 1913.During this period the U.S. changedfrom running persistent currentaccount deficits, financed by capital inflows and occasional gold outflows, to runningpersistent current account surpluses, financed by capitaloutflows and gold inflows.Although surpluses generally prevailed in merchandisetrade from as early as 1875,it was notuntil after 1896 thatthe country reversed its overallpayments position.American investors then began to extendlong-term credit overseas to fi- nancethe growing discrepancy between the nation's exports of goods and services andits imports. From the mid-1890s to 1905,the United States was a consistentnet capitalexporter. After 1905, it reverted to beinga netcapital importer, but at a level well below thelevels reached in the 1870s and 1880s.Although the United States remaineda netdebtor until 1914, it lessenedits dependence on foreignsavings and developedinto a largeexporter of its own funds.29 The constraintson dollarusage apparentlydid not involvethe nation'sglobal position.In areasknown to influencedemand for international currencies, the U.S. dollarwas poisedto playa largerole before World War I. The implicationis thatthe constraintson dollarusage before 1914 were on the supply-side, involving the domesticfinancial attributes of the United States. Transactioncosts are the overriding consideration on thedomestic, or supply-side, of internationalcurrency issue. "A currencyis used as a vehiclecurrency when the transactionscosts (e.g., thecosts of information,search, uncertainty, enforcement, andnegotiation) involved in usingit are less thanthe transactions costs involved in usingother currencies."30 More generally, "The microeconomicsof money, whether domestic or international,is fundamentallyabout frictions.... Frictions-costs of transacting,costs of calculation-cause agentsto use nationalmonies as interna- tionalmedia of exchange, units of account, and stores of value."'31 Chiefamong the supply-side factors affecting transaction costs is thecharacter of theissuer's domestic financial markets. Specifically, "a countrywhose currency is usedinternationally should possess financial markets that are broad (i.e., with a large assortmentof financial instruments traded), deep (i.e.,including well-developed secondarymarkets), and substantiallyfree of controls (such as . .. capitalcontrols)."32 Broad,deep, and open short-termfinancial markets are requiredto supplyassets appropriatefor international currency use (suchas treasurybills, commercial paper, andbankers' acceptances), reflecting foreigners' preference for liquid and safe short- termfinancial instruments. Hence, "the more liquid and diversethe national capital markets,including the short-term money markets, the more attractive is thenational currencyas a storeof value and transactions medium."33 Although the United States keptcapital controls low throughoutthe period, breadth and depth were certainly not characteristicsofits financial markets before 1914.

29. Lewis 1938. 30. Tavlasand Ozeki 1992,2. 31. Krugman1984, 262. 32. Tavlasand Ozeki 1992,41. 33. Henning1994, 32. 50 InternationalOrganization

TABLE 4. U.S. balanceof international payments, 1872-1913 (in millionsof dollars)

Currentaccount Capitalaccount

Unilateral U.S. capital Foreigncapital Changesin Balance transfers, flows,net flows,net monetary Errors on goods net(to foreign (outflow (outflow goldstock and and countries offunds offunds (increase omissions, Year services [- )a [-])b [-])C [-) net

1872 -246 4 242 1873 -181 14 167 1874 -61 -11 82 -11 1875 -99 -14 87 27 1876 20 -11 2 -10 1877 102 -13 -57 -33 1878 218 -11 -162 -44 1879 202 -8 -162 -44 1880 114 -4 30 -140 1881 137 -5 -41 -91 1882 -55 -13 110 -42 1883 -12 -22 51 -17 1884 -59 -24 105 -23 1885 12 -27 34 -19 1886 -77 -28 137 -32 1887 -157 -28 231 -46 1888 -226 -30 287 -30 1889 -166 -44 202 -30 1890 -150 -45 194 1 1891 -90 -50 136 4 1892 -20 -54 41 33 1893 -119 -44 146 17 1894 98 -54 -66 22 1895 -127 -55 137 44 1896 43 -49 40 -25 1897 132 -41 -23 -68 1898 444 -44 -279 -121 1899 427 -68 -229 -130 1900 507 -95 -143 -75 -91 -103 1901 438 -104 -212 -33 -61 -28 1902 258 -105 -105 -30 -71 53 1903 340 -115 -41 20 -71 -11 1904 279 -137 -109 59 -25 -67 1905 298 -133 -139 56 -71 -11 1906 296 -147 -46 114 -171 -46 1907 296 -177 -65 136 -154 -36 1908 427 -192 -135 89 -44 -145 1909 26 -187 -112 171 18 84 1910 46 -204 -90 345 -71 -26 1911 274 -224 -123 171 -90 -8 1912 257 -212 -209 232 -81 13 1913 374 -207 -165 252 -25 -229

Source:U.S. Departmentof Commerce 1975, series U168-92, 564. aPrivateand government. bPrivate(direct investment and other long-term) and government. cLong-term. Originsof the Federal Reserve 51

U.S. financialmarkets were largely concentrated in NewYork City and functioned in thesame impersonal manner as theydo today,although both the variety and the volumeof securitiestraded were much smaller. At thelong-term end of themarket, privatesecurities (such as railroadsecurities) were actively traded on thestock exchange,whereas public issues (such as governmentand statebonds) accounted for onlya smallportion of securitiestransactions.34 More importantly,no short-term Treasurysecurities, such as notesand bills,were outstandingat any timebefore 1914.35Funds available to themarket on shortterm found outlets in call (demand) loansmade on stockexchange collateral or in commercialpaper.36 Of thesealterna- tives,call loans carriedless defaultrisk and formedthe primary liquid outletfor temporarysurplus funds. Much of the credit extended by banks was to stockmarket brokers,and such call loanswere "considerably more important than the commercial papermarket" in New York.37Call loan rateswere generallylower (by about 1 percentagepoint) than those on commercialpaper. Although commercial paper was bought,endorsed, and sold by bill brokersand commercialpaper houses from the 1840s,the secondarymarket was verythin, since interbankrediscounting of commercialpaper was extremelyrare.38 Most important,there were no primaryor secondarymarkets in bankers'acceptances, the era's maininstrument of short-term internationalfinance. This conditionseriously compromised the dollar in worldaf- fairs. Bankers'acceptances are instrumentsthrough which banks act as intermediaries betweenimporters and exporters, by guaranteeing to makepayments to theexporter on a specificdate. The purposeof the bankers' guarantee is tolower transaction costs ininternational exchange. By addinga bank'screditworthiness tothat of the less well knownimporter, bankers' acceptances reduce the informational costs of short-term cross-borderfinance.39 Hence, "a well-developedbankers' acceptance market in a countrycontributes to theamount of tradefinanced in itscurrency and, thus, to the amountof trade invoiced in that currency."40 But U.S. banksdid no acceptingbefore 1914 due to regulatoryrestrictions. Banks "wereeither legally forbidden or (what amountedto thesame thing) lacked specific authorization to acceptdrafts or bills of exchange."'41Since theNational Banking Acts did notexplicitly authorize banks to acceptbills, the courts repeatedly refused to legalizethe activity.42 The UnitedStates was therebyunable to offerthe very instrument that, due to low transactioncosts, was usedto financetrade and settle short-term obligations between nations.

34. Gray1978, 34-35. 35. Studenskiand Krooss 1963. 36. James1978. 37. Goodhart1969, 20. 38. See Davis 1965,355-99; Greef1938, 304-305; andJames 1978, 153. 39. LaRoche 1993. 40. Tavlasand Ozeki 1992,41. 41. Carossoand Sylla 1991,53. 42. Forthe specific rulings, see Laughlin1912, 93-94. 52 InternationalOrganization

In London(and Berlin),by contrast,banks bought, sold, and rediscountedbills andbankers' acceptances, and secondary markets in these instruments were deep and articulated.43"A veryhigh proportion of internationaltrade among countries other thanBritain was financedby sterlingbills drawnon importersby exporters,which weredue in 90 daysor 6 months.If thesecommercial bills were guaranteed against defaultby an acceptancehouse, exporters, in turn,could freelysell thesesterling billsto a Londonbank (discount house) at theworld's lowest open-market rates of interest."44More succinctly, "London without its specialized discount market would be Londonwithout its greatness."45 Althoughdepth and breadth are important, resilience-the ability to accommodate shocks-is anotherdomestic characteristic ofkey currency countries. When nonresi- dentshold working assets as a storeof value, they need to be certainthat such assets will alwayshave a readyhome market. To thisend, a centercountry usually main- tainsa reliablerediscounting facility of last resort. Business firms or financial institu- tionsdo nothold substantial balances in a foreignmarket without the assurance that theseassets can be rediscountedat any time.Indeed, before gold or convertible currenciescan be obtainedand repatriated,it is firstnecessary to convertworking balancesinto the local currency.A corefunction of central banks is to provideresil- ience to themarket during periods of stress.According to BarryEichengreen, the "London discountmarket's attraction was its safety,and it was safe because the discounthouses could turn in thelast resort to theBank of England."46 By contrast, theabsence of a rediscountmarket for acceptances and other short-term instruments suchas was facilitatedby thecentral banks of otherleading nations obstructed U.S. participationin internationalshort-term finance. A comparisonof interest rates in theUnited States and England provides evidence in supportof this supply-side view. At thelong end ofthe market, the United States generatedinterest rates that were as low as thosein Londonbefore 1914 (Figure1). Yieldsto maturityon long-termU.S. governmentbonds fell below yields on British consolsas earlyas 1882,and remainedthere until 1914, with the exception of four yearsin themid- 1890s. Foreigners, as indicatedearlier, took advantage of low long- termU.S. interestrates and floated securities in theUnited States. At the short end of themarket, however, U.S. rateswere usually above the London discount rate before 1914 (Figure2). Call loans,of course,were not equivalent to three-monthLondon bankers'acceptances, but even three-month U.S. commercialpaper rates were con- sistentlyabove theLondon discount rate before 1914. The reasonwhy U.S. short- termrates were not competitive was "institutionalrather than purely economic."47 AlthoughU.S. financialmarkets produced long-term rates lower than London's, the "lackof a centralbank and a discountmarket for bankers' acceptances meant that the

43. By 1913 theannual turnover in acceptancesin theLondon discount market was about$1 billion. King1936, 265-82. 44. McKinnon1979, 84. See also Williams1968, 269. 45. King1936, 321. 46. Eichengreen1987, 9. See also Eichengreen1992, 42-43. 47. Carossoand Sylla 1991,53. Originsof the Federal Reserve 53

5.0 English consols, 3% - --- English consols, 2 3/4% ...... 4.5 Englishconsols, 2 1/2% U.S. bonds,5% of 1864-74 ---- U.S. bonds,4% of 1907 4.0 U.S. bonds,2% of 1930

3.5

B3.0

2.5

2.0

1.5

1.01.0 I I I I I I I to I I I CIA \I CIAI I CI AI t IN CI AI t 1

oo oo oo 00 oo oo 00 oo oo oo oo oo oo oo oo a, N CN N CN CN O

Source: Homerand Sylla 1991.

FIGURE 1. Yieldon governmentbonds in England and theUnited States, 1870-1913(annual average)

UnitedStates could not compete on thefield where the contest of international short- termfinance was played."48

DistributionalAspects of International Currency Status My claimis thatglobalizing the U.S. currencythrough improvements in domestic institutionsoffered selective benefits adequate to motivatecollective action. The ar- gumenthinges on whetherinternational currency issue yieldsbenefits that are con- centratedon selectagents. In thissection I drawon theinternational finance literature to demonstratethat money-center banks derive such benefits. Following the analyti- cal discussion,I documentbanker lobbying on behalfof domesticfinancial reform andpresent evidence that internationalizing the dollar motivated these efforts. Since othershave plowedthis ground before, I also consideralternative explanations of bankerlobbying.

48. Ibid. 54 InternationalOrganization

16 - Three-monthbankers' bills, London ------Three-monthcommercial paper, New York 14 - ---- Call loan rate,New York

I' I' 12 _ i

_ 8 _1

; 6 .1 1 *%,.,~~~~~~~~~~~AI 1/\

Source:Homer and Sylla 1991.

FIGURE 2. Short-terminterest rates in England and theUnited States, 1870-1913 (annualaverage)

The distributionalimplications of internationalcurrency issue are typicallydis- cussedin terms of the gains and losses accruing to issuingversus nonissuing nations. Yet, withrecognition that the nationalbenefits are not distributedsymmetrically amongdomestic residents, this analysis can also serveas thebasis fora systematic evaluationof thedomestic distributional effects. These effects,in turn,suggest the possibilityof collective action in supportof internationalizing a currency.49 Economistsidentify three main benefits conferred on nationsthat issue internationalcurrencies: seignorage, reduced foreign exchange costs and risks, and denominationrents.50 For simplicity, I treat the first two benefits as distributionallyneutral in thedomestic context and ignorethem here.51 The thirdbenefit, however, is directly

49. Forsimilar approaches, see Frieden1991; andHenning 1994. 50. Cohen1977, 70-73. 51. Seignorage-thegain associated with the difference between the value of the money issued and its costsof production-accruesto thegovernment of theissuing country. Hence, any local distributional effectsare determinedby extanttransfer mechanisms. Similarly, the exchange-rate benefit-the gains associatedwith no longer having to deal inforeign currencies or hedge against exchange-rate fluctuations- Originsof the Federal Reserve 55 relevantto theanalysis. The termdenomination rents connotes the profits earned by thebanking sector of issuingnations. Inasmuch as thebanking sector of thecenter countryhas an effectivemonopoly over the issue of monetary liabilities denominated in thevehicle currency, expansion of suchliabilities to meetthe needs of nonresi- dentsmeans that the banking sector earns profits that it would not have received had itsliabilities been denominatedin anothercurrency.52 In other words, "the average level of profitsof thebanking system of an issuingcountry will tend,other things equal, to be higher[due to theextension of themarket] than that of thebanking systemsof othercountries."53 As theinternational use of currencyexpands, loans, investments,and purchasesof goods and serviceswill increasinglybe executed throughthe financial institutions of theissuing country. Thus, "theearnings of its financialsector are likelyto increase[relative to thefinancial sectors of nonissuing nations]."'54These extraearnings include not only the commissions charged for the increasedvolume of foreignexchange transactions but also the fees chargedfor investmentservices, such as theplacement of foreignsecurities and the purchase of domesticfinancial assets for foreign accounts. In additionthey include the interest earnedon thehigher total of foreignloans and investments.55When a nation'scur- rencyis used internationally,there is simply"more business for the country's banks andother financial institutions." 56 Denominationrents are also unevenlydistributed within the issuer's banking sector,since not all banksprovide international banking services. The averagebank in thehinterlands does littlebusiness that gives rise to foreigntransactions. Instead, a smallgroup of large, specialized firms located in thenational money center typically handlethe foreign short-term financial business of theentire nation. Money-center financialfirms should thus have intense preferences for installing the domestic institutionsthat underpin international currency status. Not only do theyearn the commissions,fees, and interest associated with financing world trade and payments, but also use of thehome currency as a reserveasset brings large inflows of fundsinto the centralmoney market, thereby increasing demand for banker services. Money-centerbankers thus benefit directly when the national currency serves as an internationalcurrency. "International bankers perceive a strongbusiness interest in wide acceptanceof thenational currency. That acceptance favors not only their individualbanks, but their national financial center, such as Londonor New York,as an internationalfinancial center."'57 My claimis thatearning denomination rents was theprivate inducement that led New Yorkbankers to internalizethe costs of reform- ingthe national banking system. accruesto all domesticresidents involved in worldtrade and payments.For an analysisincorporating thesegains, see Broz 1997. 52. Swoboda 1968,105-106. 53. Ibid.,106. Swoboda shows how the rise of the Euro-dollar market eroded the monopoly position of U.S. banksand distributed denomination rents to banksof other countries. 54. Tavlas 1991,12. 55. Cohen1971, 37. 56. Frankel1995, 11. 57. Henning1994, 23-24. 56 InternationalOrganization

Lobbyingfor the Federal Reserve Giventhe poor performance ofthe national banking system, political officials respon- siveto national constituencies (that is, presidents, cabinet officials, and party leaders) mighthave assumedleadership of the reform movement. Yet the historical record is richwith evidence that large bankers were the principal protagonists.58 As one con- temporaryexpressed it, 'bankers had directed the discussion, bankers had financed it, andbankers had keptit alive.'59Although there is debateabout this lobby's motivation,it is clearthat a subsetof society shouldered the costs of institutional change.60 I recountthese efforts and documentthe role that internationalizing the dollar played in thelobbyists' incentive structure. Money-centerbankers drafted the initial reform legislation and funded an expen- sive publicrelations campaign aimed at securingmass supportand theapproval of Congress.A key eventtook place in 1910 whena groupof bankersconvened at J.P. Morgan'sduck-hunting club to drawup prospectivelegislation. Paul Warburg (Kuhn,Loeb & Co.), FrankVanderlip (National City Bank), Henry Davison (Bank- ers' TrustCompany), Charles Norton (First National Bank), A. PiattAndrew (Har- vardeconomist), and SenatorNelson Aldrich (Rhode Island) attended.61The plan thisgroup produced-the "Aldrich Plan"-was based largelyon thework of War- burgand served as theblueprint for the Federal Reserve Act.62 Afterthe meeting,the groupmobilized to rallybroad political support for the AldrichPlan. To Warburg,"it was certainbeyond doubt, that unless public opinion could be educatedand mobilized,any soundbanking reform plan was doomedto fail."63To thisend, the bankers formed and financedthe National Citizens' League forthe Promotion of SoundBanking,64 a nationwide public relations organization, intendedto "carryon an activecampaign of education and propaganda for monetary reform,on theprinciples ... outlinedin SenatorAldrich's plan."65 Although the league appearedto springfrom grass roots in 1911,it was fromthe outset "practi- cally a bankers'affair."66 Great pains weretaken to keep New York'srole in the leaguehidden, given prevailing populist prejudice against Wall Street. Warburg rec- ognizedthat "it wouldhave been fatal to launchsuch an enterprisefrom New York; in orderfor it to succeedit would have to originatein theWest."67 NationalCitizens' League officialsestimated that it wouldcost $500,000 to carry outthe program of publiceducation. A quotaof $300,000was assignedto theNew Yorkclearinghouse, $100,000 to theChicago clearinghouse, and the balance appor-

58. See Kolko 1963;Laughlin 1933; Reed 1974;West 1977; White 1983; andWiebe 1962. 59. Willis1915, 33. 60. See, forexample, Kolko 1963; andLivingston 1986. 61. See Stephenson1930, 373-79; Lamont1933, 96-102; andChemow 1991. 62. See West1977, 52-66; and Chemow1993. Warburg's publications and speechesare collectedin Warburg1930. 63. Warburg1930, 1:68. 64. See Welton1922; andLaughlin 1933, 56-69. 65. Warburg1930, 1:569. 66. New YorkTimes, 6 July1911, A4. See also Laughlin1933, 59-61. 67. Warburg1930, 1:68. Originsof the Federal Reserve 57 tionedamong clearinghouses in othermajor cities. The New Yorkclearinghouse formeda specialcommittee to look aftermember bank contributions. This committee based thecash contributionof each bankon its size, measuredby capitaland surplus;the specific formula was $.32 per$1,000 of capital and surplus.68 Withthe funds, the league published and distributed15,000 copies of a currency primer,"Banking Reform."69 It establisheda fortnightlyjournal, also namedBank- ingReform, with a circulationof 25,000-mainly newspaper editors. The league also published950,000 free pamphlets of pro-AldrichPlan statementsand speechesand providednewspapers all overthe country with "literally millions of columns"of copy.70In manyinstances, newspapers and newspaper chains published the league's pre-writtengalleys with no editingwhatsoever.7' The leaguealso suppliedspeakers forgatherings of variousinterest group organizations and sponsoredmass letter- writingcampaigns to Congress. In thefinal analysis the league probably accomplished its task of creating popular acceptanceof the need for reform along the lines of the Aldrich Plan.72 The Aldrich Plan,however, died in committee shortly after it was introducedin Congressin 1912 forreasons that are not directly relevant to thisanalysis (see thethird section, "Limi- tations").Its political liability was thatit placed monetary policy control too much in thehands of bankers.73 In addition,when the Democrats won the presidency and the Senatein the electionof 1912, a reformmeasure that bore Aldrich's name-the politicianmost closely associated with Wall Street-hadlittle chance in Congress. Nevertheless,the bill that finally emerged as theFederal Reserve Act, though bearing theimprimatur ofthe Democrats in termsof the monetary policy control issue, very closelyfollowed the Aldrich Plan blueprint-a"near identity" according to Milton Friedmanand Anna Schwartz.74This reflectedthe league's workin buildingmass supportfor a financialsystem modeled on Europeanpractices. In speakingof the FederalReserve bill, whichhe co-sponsored,Senator Carter Glass statedtersely, "No league,no bill."75 Throughoutthe campaign, Warburg and otherbankers emphasized that financial reformwas neededif the dollar was tocompete more effectively with sterling and the markas internationalcurrencies. Although financial reform was couchedin termsof thenational interest, Warburg explicitly tied it to improving the international position of thedollar. In so doing,he gave theNew Yorkbanking community private incentivesto assumeleadership of the reform effort.

68. NewYork Times, 7 December1911, A7. See also NationalCitizen's League, Organizational Report, 15 June1912, James Laurence Laughlin Papers, Manuscript Division, Library of Congress. 69. Laughlin1912. 70. Welton1922, 36. 71. Forexamples of the league's newspaper copy, see theNational Citizen's League files, James Laurence LaughlinPapers, Manuscript Division, Library of Congress. 72. Warburg1930, 1:76. 73. Timberlake1993, 214-34. 74. Friedmanand Schwartz 1963, 17 In. Foran item-by-itemcomparison of the two bills, see Warburg 1930,vol. 1,chap. 8, 9. 75. Welton1922, 36. 58 InternationalOrganization

Warburg'sanalysis consisted of comparingAmerican financial structures with Europeansystems. He advocatedthe developmentof a European-styleddiscount marketfor acceptances supported by a centralreserve-holding agency that would standready to absorbthe surplus stock of eligibleacceptances from the market. In advocatingacceptances, Warburg showed how bills of exchangethat were guaran- teedby well-known banks served as thebasis ofdiscount markets in Europebut had onlya smallposition in theAmerican system due to restrictivelegislation. His point was thatthe addition of thebanker's endorsement turned commercial paper into an instrumentwith much greater security, negotiability, and liquidity.76Moreover, the transactioncosts advantagesof bankers'acceptances were crucial to international exchangeby virtueof thedifficulty in securingforeign credit information. For this reason,bankers' bills were employed as a basis forinternational short loans as well as forholding foreign exchange reserves. Lawrence Jacobs of NationalCity Bank madethe point with respect to sterlingacceptances: Obviouslythe guaranty of a bankerof high standing adds an importantelement of securityto billsof exchange as a basis forthe lending or investmentof bank funds.It is an additionalassurance to theforeign exporter that he can discount his billsat a low rateso thathe can affordto makea favorableprice to theEn- glishbuyer. It makesthem all themore satisfactory investments for foreign bank- inginstitutions.77 Becauseof the absence of such bills, the United States was excludedfrom participating in financinginternational commerce. To Warburg,the problem was notsimply thatnational banks were forbidden from accepting bills of exchangearising out of foreigntrade. Equally important was thatacceptances, supported by shippingand insurancedocumentation, were not used to any significantextent even withinthe UnitedStates. Nonresidents rarely invested in U.S. commercialpaper because it was toodifficult for them to judge itsquality and the reputations of the local commercial paperhouses that gave it theirseal of approval;in otherwords, commercial paper carriedhigher default risk than acceptances. For thesereasons, America's short-term financial markets were "as backwardas Europeat thetime of the Medicis, and Asia, in all likelihood,at thetime of Hammu- rabi."78 A discountmarket in bankers' acceptances and other two-name paper simply did notexist, and theconsequence was thatforeigners found the dollar unattractive as an internationalcurrency: New Yorkis in a class by itself.Without bank-accepted bills, it can haveno discountmarket. Without a discountmarket, funds cannot move to it as theydo be- tweenfinancial centers of Europe, because there are no bank-acceptedbills in whichforeign banks can invest.Our commercial paper is notsuitable. Foreign bankswill not purchase it because they are not acquainted with, or sureof the ratingof miscellaneous mercantile establishments, and because such paper could

76. Warburg1930, 1:186. 77. Jacobs1910, 38. 78. Warburg[1907] 1930,9. Originsof the Federal Reserve 59

notbe readilydisposed of in case itbecame necessary or profitable to withdraw fundsfrom New Yorkfor remittance elsewhere.79 Money-centerbankers thus understood that the creation of an Americandiscount marketwas a prerequisitefor developing the dollar as an internationalstore of value and mediumof exchange.They also anticipatedthe denomination rents that would accompanythe rise of thedollar as an invoicingand reservecurrency. Warburg's manyreferences to "forgoneprofits" and "tribute"paid to Londonresulting from the"dependence" on sterlingacceptances shows cognizance of the rent-earning pos- sibilitiesof issuing international money.80 Casting the situation in terms of both rents and prestige,he wrote:"It is impossibleto estimatehow largea sumAmerica pays everyyear to Europe by way of commissionsfor acceptingsuch documentary bills ... butthe figure runs into the millions. The annualtribute to Europeresulting fromour primitive financial system is notmerely a wasteof money, but reflects upon thedignity of a nationof the political and economic importance of the United States."'8' NationalCity Bank, the most ambitiously international New Yorkbank, estimated thatEnglish banks earned $150 millionper year in commissionsjust from financing U.S. exportsbefore 1914.82 Such figures do indeedsuggest a strongprivate motiva- tionfor bankers to absorbthe costs of financial reform.83 My pointis thatinternationalizing a currency confers large gains on a restricted segmentof society.Money-center banks are theprimary beneficiaries, since they earnrents from the globalization of thedomestic currency. Collective action by this groupin supportof domesticinstitutions that underpin international currency status is thusrational and predictable.This, however, raises one finalissue. If New York bankerswere primarily interested in globalizing the dollar, why did they also contribute to themuch larger effort to improvethe stability of theU.S. financialsystem? Boththe Aldrich Plan andthe Federal Reserve legislation certainly had widerobjec- tivesrooted in domesticfinancial problems. Yet bankerslobbied for the entire (and morecostly) package. Even politicians hearing testimony on theFederal Reserve bill werepuzzled. During a sessionwith a New Yorkbanker, one exasperatedsenator exclaimed:"Most of ourexperts who come hereare moreinterested in theforeign bankingbusiness than in ourdomestic banking business." 84

The Inseparabilityof Jointly Produced Goods

The keychallenge for the joint products model is to demonstratethat the public and theprivate goods cannot be disassociated.Otherwise, agents would seek to discon-

79. Jacobs1910, 9. See also Warburg[1908] 1930,43. 80. See, forexample, Warburg [1910a] 1930,187-88; andWarburg [1911] 1930,227-28. 81. Warburg,[1910a] 1930,187-88. 82. NationalCity Bank 1920,5. See also Mayer1987. 83. See Moyer1907; and Abrahams 1976. 84. JosephBristow (Kansas), U.S. Senate1913, 1394. For the source of Bristow's puzzlement, see the testimonyof Charles Conant, Fred Kent, Frank Vanderlip, and James Cannon. 60 InternationalOrganization nectthe private good from the collective good, since it would be cheaperto produce theselective benefit separately. New Yorkbankers, for example, could have lobbied foronly the institutions affecting the position of the dollar, leaving others to deal with theweaknesses of thefinancial system that gave riseto panics.The reasonthey did notwas thatproduction of the two goods involved a supplytechnology in whichthe privateoutput (international currency status) could not feasibly be separatedfrom the associatedcollective output (domestic financial stability). Recallthat the causes of the parochialism of the dollar before 1914 weredomestic andinstitutional. To internationalizethe dollar, the nation needed to broaden, deepen, andmake more resilient its short-term financial markets. Yet these same characteris- ticswould also improvethe stability and efficiency of the domestic financial machinery,almost by definition! Consider, for example, the concordance between the supply- siderequirements ofinternational currency issue and the general goals of the Federal ReserveAct. Accordingto its preamble,the act was created"to providefor the establishmentofFederal reserve banks, to furnish an elasticcurrency, to affordmeans ofrediscounting commercial paper, to establish a moreeffective supervision of bank- ingin theUnited States, and for other purposes." In otherwords, its main objective was to improvethe resilienceof the financialsystem through a depth-enhancing systemof reservebanks, rediscounting a broad range of eligibleacceptances and commercialpaper. This equivalence with the needs of the dollar suggests that bankers,lobbying for the private good of denomination rents, had incentives to contribute to theproduction of thecollective good, since doing otherwise would have meant thatthe private good was notthen available. More directevidence is thatbankers understoodthat the institutions required to enhancethe international standing of the dollarpresupposed the production of domestic financial stability. In thelobby's literature, the banker-specific benefits of making the dollar an internationalcurrency were tied explicitly to attaininga diversifiedand resilientinternal financialsystem. In otherwords, bankers clearly understood that building a modern discountmarket involved joint benefits. "It wouldbe a greatnational achievement in itselfto bringabout . . . thecreation of an importantworldwide discount market, whichin turnwould have, as a consequence,the turning into a broadbill marketof the manymillions that now floodand overfloodWall Street."85Note the mutual dependenceof the joint goals expressed in thefollowing passage: Bills willbe drawnon Americanbanks and bankers, instead of on London,Paris, orBerlin, and instead of being financed by others we maygradually become the "financiers"of others.... Once we establishthe modern banking bill in the UnitedStates, its use willgrow and our own banks will reap the tremendous ad- vantageof being able to investtheir deposit money in assetsupon which they can realizeat homeand abroad.As theuse ofthis modern paper increases, so willthe financialsafety of the banks and the business community.86

85. Warburg[1913] 1930,559. 86. Warburg[1910b] 1930, 132. Originsof the Federal Reserve 61

To be sure,the development of a modemdiscount market was onlypart of the reformagenda. Even thoughbills carryingthe endorsementof reputablebanking firmsrepresented the most marketable form of short-termcredit, at timeseven this papercould not be resoldby banks.87When a runon a singleinstitution spreads for lack ofstabilizing expectations, throughout the banking system accepted bills would be no moreliquid than any otherasset. The existenceof thediscount markets of Europepresupposed the liquidity guarantee inspired by thecentral bank rediscount window.Bankers expressed the dependence of a discountmarket on a centralbank, arguingthat a discountmarket could notdevelop in New Yorkunless foreign and domesticpurchasers of acceptanceshad confidencethat they could liquidatetheir assetsat anytime. Warburg constantly referred to theinstitution that provided this confidencein Europeansystems-the central bank-and arguedfor the necessity of establishingone on Americanshores: In orderto makeour paper part and parcel of the means of the world's interna- tionalexchange, it needs, however, as a preliminarycondition, to becomethe foundationon whichour own financial edifice is erected.It mustalways have a readyhome market, where it can be rediscountedat anymoment. This is insured in nearlyevery country of the world claiming a modemfinancial organization, bythe existence of somekind of central bank, ready at all timesto rediscountthe legitimatepaper of the general banks.88 This referenceto the "preliminarycondition" for internationalizing the dollar reflectedthe dual and inseparablegoals of theFederal Reserve Act: increasingthe liquidityof the financial system through a system of rediscounting reserve banks was a prerequisiteto making the dollar an internationalcurrency. The joint products inter- pretationof U.S. bankingreform is particularlyclear in thefollowing passage: Americancommercial paper will not be considereda quickasset and will not takethe place ofthe stock-exchange call loan unlessthe purchasers-both local andforeign-know that there will be a possibilityof rediscounting a safe propor- tionof their holdings, if need be, witha centralinstitution. While as a matterof factthe actual rediscounting by centralinstitutions may be unimportantin nor- mal times,the existence of suchinstitutions creates the ultimate basis ofconfi- dencewithout which a discountmarket cannot be developed.No law can createa discountmarket without a centralreserve.89 In summary,the societywidebenefits of thebankers' political entrepreneurship wereexternal to their drive to internationalizethe U.S. bankingsystem. The bankers' coreobjective was to advancethe dollar as an internationalinvoice, payments, and reservecurrency, and thereby to allowNew YorkCity to become a worldwidefinan- cial centercommensurate with the position of the economy in theworld system. Yet theirinstitutional agenda also enhancedthe nation's economic welfare by addressing

87. Tallman1988, 2-2 1. 88. Warburg[1907] 1930,12-13. 89. Warburg1930, 1:560. 62 InternationalOrganization

extantfinancial shortcomings (such as insufficientliquidity in panicsand seasonal creditmarket pressures). This general benefit, however, was a by-productcreated by theinseparable and complementary nature of the joint products. Improving the depth, breadth,and flexibility of the national financial system was boundto complement the productionof domestic financial stability.

AlternativeExplanations The politicalentrepreneurship ofNew Yorkbankers in lobbyingfor the Federal Re- serveAct has been the subject of several other studies. Some analysts adopt a carteliza- tionframework, whereas others tend toward a "privilegedgroup" explanation of bankersupport for reform. These arguments are unconvincing. One view is thatbankers wanted the Federal Reserve Act because it offeredthe privatebenefit of cartelizingthe banking industry to theadvantage of Wall Street.90 The proliferationof trustcompanies and statechartered banks, operating under less restrictiveregulations than New York's nationally chartered banks, supposedly posed thecompetitive challenge. As in myview, the public good of stabilizing the financial systemdid not provide the primary impetus for banker lobbying. However, this alter- nativejoint products argument falls victim to the"separate-provision" critique. Al- thoughthe Federal Reserve Act did allow nationalbanks to enterthe trust banking business,this restriction was a minorregulatory change that could have been effected withoutthe massive financial restructuring ofthe Federal Reserve Act. Moreover, the argumentignores the empirical evidence that the largest and most powerful "competi- tors"of Wall Street were actually owned and operated by Wall Streetnational banks themselves.9'As JohnJames notes, "One responseto thethreat posed by thetrust companieswas combination,so thatit was notuncommon to see a nationalbank and a trustcompany operated and controlledby the same stockholders, frequently in the samebuilding."92 That New Yorkbanks innovated around the legal restrictionsim- posedby theirnational charters further undermines the notion that cartelization mo- tivatedbankers to organizeand lobby. Bankerlobbying might also be understoodby way of the "privileged group" model, whichrelaxes the condition that a publicgood providesuniform, symmetric benefits.93If thegains of collective action are distributed unevenly within a community, thebenefit going to one or several members may be sufficienttojustify this subgroup providingthe public good single-handedly,even if otherbeneficiaries free-ride.94 JamesLivingston implicitly adopts a privilegedgroup framework, arguing that bankers and membersof thecorporate elite organized for political action, not because

90. See Kolko 1963;and Rothbard 1984. 91. Neal 1971,51. 92. James1978, 40. 93. See Olson 1965;and Stigler 1974. 94. Althoughhe does not directlyaddress the originsof the FederalReserve, Thomas Furguson's "investortheory" of politicsis a variantof theprivileged group model in whichlarge bankers figure prominently.Furgeson 1983. Originsof the Federal Reserve 63 theywould gain a distinctprivate benefit, but because they would benefit dispropor- tionatelyfrom provision of the public good of financial stability.95 Livingstonties the origins of the Fed to theemergence of the modem corporation in the 1890s.He assertsthat the new corporateclass was verysensitive to financial instability,not only because panics meant short-term losses butalso becauseof the potentialfor "economic anarchy and political unrest, if not revolution."96 The argu- menthinges on whetherfinancial instability is moredebilitating to a corporate economyor to an economyorganized around smaller firms. To Livingstona corporateeconomy fares much worse, although from an industrialorganization perspec- tiveit is easyto infer just the opposite. In an economycomposed of many small firms withfew formal ties witheach other,a reliablefinancial system is probablymore essential,since the largenumber of arms-lengthtrades requires an equallylarge numberof credit transactions and money transfers to settlepayments. In contrast,in a corporateeconomy, characterized by a smallnumber of large integrated firms, many transactionsare internalizedwithin the firm, reducing the need for money transfers altogether.In otherwords, market transactions that would otherwise require credit and paymentsare takeninside the corporation, thereby reducing the importance of financialsystem stability to suchfirms. Lacking a morecareful specification of the disproportionategains accruing to bankersand the corporate class, Livingston's ac- countfalls victim to faultyinference.

Limitations AlthoughI have soughtto providethe underlying rationale for money-center bank interests,this study is limitedin two important respects. First, I makeno claimsabout theoptimality of the Federal Reserve Act as a solutionto thenation's financial problems.There is a normativeliterature claiming that laissez-faire in theissuance of notesand deposits by private, competing banks ("free banking") is superiorto centralbanking as a meansof insuring a stablefinancial and monetary environment.97 In thissense, there was nothinginevitable about the creation of theFed. Furthermore, empiricalstudies attribute the weaknesses of thepre-1914 U.S. financialsystem not to marketfailure, but to extantgovernment regulations, such as theprohibition on branchbanking.98 Congress, however, did not elect to create a freebanking system in 1913. Since thisstudy is an exercisein positivepolitical economy, I have triedto explainwhat Congress actually did, not what it should have done. Second,I do not directlyaddress the monetarycontrol features of theFederal ReserveAct. Creating a centralbank meant vesting some group of people with mon- etaryauthority, and therewere fierce battles over just whichgroup should have this authority.Republicans, big bankers,and northeasternbusiness interests wanted a centralbanking system with only a fewreserve banks topped by a centralgoverning

95. Livingston1986. 96. Ibid.,27. 97. White1993. 98. Calomirisand Gorton 1991. 64 InternationalOrganization boardunder private (banker) control. Centralization and privatecontrol were ex- pectedto improvethe prospects for low inflation.Democrats, agricultural interests, andrural bankers favored a decentralizedsystem with as manyas fiftyreserve banks and a centralgoverning board controlled by politicalappointees. Decentralization and politicalcontrol reflected populist distrust of concentratingmonetary power in thehands of groupsmost inclined toward hard money. In the finalcompromise, Congresssettled on a maximumof twelvebanker-controlled reserve banks and a governingboard that was entirelypolitically appointed.99 The conflictleading up to thismonetary compromise belies thenotion that the FederalReserve Act was a publicgood, pure and simple,since it wouldhave faced no opposition.These battles,however, were over monetary policy and who would controlit, an issuethat is conceptuallydistinct from financial system stability, which is literallya publicgood. Althoughthe distributional aspects of thepolicymaking structureof the Federal Reserve Act are surely important, I have ignored them here in orderto focus on thebroad allocative aspects of the Act.

Conclusionsand Implications

Before1914 theUnited States faced two major problems of financialorganization. On theone hand,it experienced panics and severeseasonal interest-rate fluctuations long afterother nations had foundsolutions to theseproblems. Indeed, the nation experiencedpanics in a period"when they were a historicalcuriosity in othercountries."'00 On theother hand, the dollar lacked international currency status, and major U.S. banksdid notparticipate in financinginternational trade. Domestic institu- tionsand regulations not only failed to producestabilizing expectations at homebut also keptthe dollar a purelynational currency, even as thenation's advancing global positiongenerated worldwide demand for dollar-denominated financial services. Froma nationalwelfare perspective, domestic financial instability involved wasted resources,since panics and largeseasonal fluctuations in interestrates rebounded negativelyon financialintermediation services and on real economicactivity. Yet simplybecause society would benefit from a betterfinancial system did not make its provisioneasy or automatic.Provision was problematicbecause any effortto improvethe system was itselfa publicgood and,therefore, subject to thedilemmas of collectiveaction. Fortunately, New Yorkbankers were willing to expendresources lobbyingfor the improvements contained in the Federal Reserve Act. Why this group workedto makeall of societybetter off is explainedby thejoint products model. Internationalizingthe dollar and reducingdomestic financial instability were two distinctbut interdependent goods that differed in "publicness"-theformer offered excludable,localized benefits, whereas the latter presented diffuse, general benefits. Nationalwelfare was advancedbecause the production of theconcentrated private

99. Fora treatmentfrom the "time-consistency" perspective, see Faust1996. 100. Bordo1985, 73. Originsof the Federal Reserve 65 benefitsrequired production of the general public benefits. Hence, it was rationalfor the small groupseeking the private international benefit to designand lobbyfor institutionsthat simultaneously advanced the provision of both goods. Withthe establishment of theFederal Reserve, the domestic financial system became markedlymore stable, notwithstanding the banking crisis of the 1930s.101In additionthe dollar began to competeseriously with sterling as an internationalcurrency,and New Yorkbegan to challengeLondon as an internationalbanking center.'02By 1916 thedollar had largelyreplaced the pound as themeans of payment, notonly for U.S. exportsand imports but also formost of Europe's trade with Latin Americaand Asia. By 1919 thetotal volume of dollaracceptances outstanding had reached$1 billion,approximating London's prewar level.'03 The New Yorkdiscount marketeroded London's dominant position as reservecenter by offeringrelatively cheapcredit facilities for borrowers as well as reliableinvestment opportunities for foreignersseeking a stablestore of value. In shortthe United States emerged as a nascent"world banker," providing dollar-denominated liquidity to theinternational system.Nonresidents accumulated dollar balances to maintain liquidity and/or under- take investment,to pay forimports invoiced in dollars,and to serviceloans for capitaldevelopment that were denominated in dollars.America's halting, tentative firststeps as financial"hegemon" in globalaffairs date from this period. Animportant implication of this study is thatthe literature on therise of the United Statesin globalfinancial affairs has paidinsufficient attention to the role of domestic institutionsinthis transition. For most analysts, World War I was theshock that upset theinternational economic hierarchy. Although the war greatly accelerated the pace ofAmerica's economic ascent in theworld system, the institutional innovations of theFederal Reserve Act surelyfacilitated the transformation. By allowingnational banksto acceptbills of exchange,and by establishingthe Federal Reserve banks to give acceptancesand othershort-term paper a readymarket of last resort,the act helpedestablish the kind of discountmarket on whichBritain's position as world bankerhad rested.The outbreakof thewar and the establishmentof theFederal ReserveSystem tended to reinforceeach otherin thisrespect: the war enhanced the attractivenessof theNew Yorkmoney market and thedollar just whenthe institu- tionalfoundations for global banking had beenput in place. In short,"if theWorld Warprovoked the expansion, it is also truethat the American banking reforms permit- tedit, granting our banking institutions full freedom to enter the foreign field without thoselegal restrictions to whichthey had previously been subject." 104 A currentanalog is theprocess of economic and monetary union (EMU) inEurope. If theprocess remains on schedule,the creation of a new currency,the euro, may pose a seriouschallenge to the position of the dollar at thecenter of the international financialsystem. The shareof globaltrade and paymentsresulting from EMU will increaseto encompassthe trade and paymentsof all membernations adopting the

101. See Miron1986, 125-38; and Schwartz 1986. 102. See Abrahams1976; and Beckhart 1932. 103. Beckhart1932, 310. 104. Phelps1927, 132. 66 InternationalOrganization euro,producing a suddentransformation in the global financial hierarchy not unlike the"disturbance" created by World War I. Therewill be vastlymore traders, investors,and officialagents transacting either directly or indirectlywith euro nations, implyingjust thekind of demand-sidenetwork externalities that enhanced global demandfor the dollar. 105 On thesupply side, however, there are reasons to be skepti- cal aboutthe displacement of the dollar by the euro. If substantialeuro balances are to be held by privateand officialagents, there must be a convenientmedium for holdingthem. In thisrespect a principalreason for the predominant role of the dollar is thesize, depth,and liquidityof U.S. financialmarkets, particularly the Treasury billmarket. As RichardCooper notes, "there is nothingcomparable to this market on theEuropean continent, or in Japan,and thereis not likelyto be fordecades to come."106 The developmentof a deep and liquidgovernment securities market in Europe,with bonds and bills denominatedin euros,will requiredomestic-qua- Europeanlegal and regulatory changes not fundamentally unlike those introduced by theFederal Reserve Act. Inasmuchas domesticfinancial institutions remain important to internationalcur- rencyuse, thepolitical analysis of thisarticle has continuedrelevance. To put it generally,global financial capability does notarise naturally or automaticallyfrom internationalforces, as in hegemonicstability theory.107 The capacityto issue an internationalcurrency and serveas a worldbanker also hingeson domesticinstitu- tionaland policychoices. This bringsdomestic politics into the foreground. In this articleI have provideda causal mechanismby whicha nascenthegemonic power adjustedits domestic institutions in accordance with its rising international position. Atthe core of this mechanism bridging the international and domestic environments arerational, maximizing individuals. Here, I employinternational currency economics to extrapolatethe stakes involved in theissuance of internationalmoney and to deriveexpectations regarding collective action in respectto domesticfinancial mar- ketinstitutions. My chiefclaim is thatmoney-center banks have private reasons for internalizingthe costs of improvingthe depthand liquidityof domesticfinancial markets,an argumentthat should carry over to othercontexts, such as contemporary Europe. Thebroadest implication of my argument concerns the production of public goods. The findingthat an institution,like the FederalReserve, that provides collective benefitsfor society can arisefrom the self-seekinginterests of thefew is starkly counterintuitive.The coreinsight of the rent-seeking literature is thatspecial interest lobbyingis inherentlywasteful: a formof "directlyunproductive, profit-seeking" behavior.108However, when inseparable joint products are at stake,rent seeking can yieldsocial improvements. The originof central banking more generally follows this pattern,109as does theformation of other national and international institutions."I0 In

105. See Pratiand Schinasi 1997; and Bergsten 1997. 106. Cooper1998, 12. 107. Fora review,see Lake 1993. 108. Bhagwati1982. 109. Broz 1998. 110. See Lowry1997; Gradstein 1993; Gilligan 1997; Conybeare and Sandler 1990; and Sandler 1993. Originsof the Federal Reserve 67 thecase of theFederal Reserve, financial system reform made everyone better off, butit was theconcentrated distribution of thegains from international banking that gavemoney-center bankers incentives to payfor it.

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