~ istributing coin and currency is one of the key responsibilities of the 12 regional Federal Reserve Banks. As part of this process. worn or muti­ lated notes are removed from circulation and destroyed. But that's not the end of the story. Through a collaborative effort by the Federal Re­ serve Bank of Cleveland and a national paper company, roughly 1, 500 pounds of shredded bills once destined for landfills each day are now being recycled into attractive paper products. The cover 2 President's Forevvord stock for this year ~ s 4 Governments and Money annual report contains 70 11 Officers and Consultants percent recycled currency

- 8 fitting treatment to 12 Directors highlight our essay on the 14 Comparative Financial Statement history of governments and money. 16 Business Advisory Council and Community Bank Advisory Council + ~ -::;?/o r~\IV~l!'d

ineteen ninety-five was a year of solid progress for both On the national scene, the economy expanded amid a climate of the Federal Reserve Bank of Cleveland and the Fourth Federal restrained price increases. Through December, the Consumer Reserve District. Although regional economic growth did not Price Index was up 2.6 percent over the previous year, with few match the high levels of 1994, activity remained strong: Capital signs of higher inflation on the horizon. Significantly, consumers goods producers operated at or near capacity, and our financial reported a steady decline in their expectations of future inflation and agricultural industries also turned in a solid performance. -perhaps signaling that the public is becoming aware of the link between low inflation and economic growth. Financial institutions in the region continued to benefit from sound management and a strong asset base. Earnings, asset The President's recent reappointment of Alan Greenspan to quality, and capital levels were all above national averages, and another four-year term as Federal Reserve Chairman bespeaks loan losses remained at or close to their low 1994 levels. confidence in the stewardship of the central bank over the past several years. Both Main Street and Wall Street understand that curbing inflation - protecting the purchasing power of the dollar-is in everyone's best interest. Even Congress is joining the fold: The Economic Growth and Price Stability Act of 1995, proposed by Senator Connie Mack, would make price stability the primary long-term goal of U.S. monetary policy. But such legislative restraint will be effective only if government abides by its restrictions. The essay that begins on page four of this report details the history of attempts to protect the value of money and makes the case that fostering competition among currencies

may be the best way to generate economic growth through price stability.

Internally, 1995 was a year of significant accomplishment for the Federal Reserve Bank of Cleveland. We maintained our focus on technology, quality, and employee involvement to further our goal of providing high-quality, value-added services to our customers. Our Cincinnati and Pittsburgh offices installed a new generation of cash-sorting equipment, enabling them to sort higher volumes of currency more quickly and accurately than before. At the same time, Cleveland's Check Collection Department began offering check imaging services to District financial institutions, which in turn can provide the benefits of A. William Reynolds, chairman; .Jerry L . .Jordan, president; Sandra Pianalto, first vice president; imaging to their individual and corporate customers. and G . Watts Humphrey, .Jr., deputy chairman.

~ tw o We also conducted a comprehensive survey of our customers to Construction of our new Operations Center continued in 1995, determine how they evaluate our services and personnel. The and the building remains on schedule to be occupied in early results have given us a better understanding of our strengths, as 1997. Renovation of our historic main building will begin shortly well as a base for assessing those areas requiring improvement. thereafter. During October and November 1996, those employees We institutionalized our commitment to continuous quality not moving to the Operations Center will relocate to a nearby improvement by appointing a full-time quality officer and estab­ site in downtown Cleveland. lishing a separate Quality Depattment. Partly as a result of these All of the past year's successes have been guided by the 23 and similar initiatives, we saw volume increa es in virtually all directors of OUI Cincinnati, Cleveland, and Pittsburgh offices, of our priced services. as well as by the members of our Business and Community During the year we established a home page on the Internet's Bank advisory councils. I thank them for their hard work World Wide Web, allowing individuals around the globe to and expert counsel. I would particularly like to acknowledge view Bank publications, data, and other printed materials those directors who completed their terms of service in 1995: on-line. This project was conceived and executed by a team Ed Brandon (retired chairman and chief executive officer, comprising individuals from various departments and functions, National City Corporation) for his service on the Cleveland and is an example of the open, cooperative culture we seek to Board; Jerry W. Carey (president and chief executive officer, foster among our employees. Union National Bank and Trust Company) and Eleanor Hicks (president, M.I.N.D.S. International), who served on the The Cleveland Residential Housing and Mortgage Credit Cincinnati Board; and Robert P. Bozzone (vice chairman, Project, launched in 1993, continued to bring together represen­ Allegheny Ludlum Corporation) and Helen J. Clark (chairman, tatives of the residential real estate and mortgage credit indus­ president, and chief executive officer, Apollo Trust Company) tries to seek ways of eliminating potential discrimination in the for their service on the Pittsburgh Board. home-buying process. Plans are under way to launch a similar initiative in the Cincinnati area in 1996. I also extend my gratitude and best wishes to two officers who left the Bank in 1995: Jill Goubeaux Clark, senior vice president The past year saw the Cleveland Bank selected as the site for a and general counsel, and Elena McCall, vice president and head group undertaking important research on behalf of the Federal of the Bank's Human Resources DepaJUl1ent. They were valued Reserve System. The Financial Services Research Group is members of our management team, and their contributions will exploring issues pertaining to the future of the nation's pay­ be missed. We will also miss Jack Wixted, senior vice president, ments system, the impact of technology on the financial services who recently joined the Federal Reserve Bank of Chicago to industry, and the Federal Reserve System's role in the evolving direct its banking supervision and regulation function. payments system. Finally, I want to express appreciation to the officers and The group's work supports the Financial Services Policy Com­ employees of the Fourth District for their creativity and hard mittee, which is part of the Federal Reserve System's new man­ work. Their efforts made 1995 a successful year and will enable agement structure for financial services. This new approach is us to meet the challenges of 1996 and beyond. designed to allow the System to respond quickly and creatively to the needs of the financial services marketplace.

President

~ t"ree Governments and Money

e do not pretend, that a National Bank can establish and maintain a sound and uniform state of

curren cy in the country, in spite of the National Government; but we do say that it has established and

maintained such a c urrency, and can do so again, by the aid of that Government; and we further say that no duty is more imperative on that Government, than the duty it owes the people, of furnishing them a sound and uniform currency. " [emphasis added]

braham Lincoln spoke these words, affirming the govern­ challenge remains to devise sustainable institutional monetary ment's ability and obligation to provide a stable currency, in an arrangements that can protect the public from debasement of 1839 speech before the lIIinois legislature. I Even though most the value of its money. prominent U.S. thinkers have clearly recognized the importance In recent years, several nations have taken up this challenge by of a sound currency, the means to ensure that governments legislating price stability as tile sole, or dominant, objective of actually provide it have proven elusive. Convincing evidence can tlleir central banks. Such legislation has already been passed in be found in the somewhat dubious experience of the Greenback New Zealand, Canada, the United Kingdom, and Sweden. period, initiated in 1861 and lasting until 1879, when paper In the United States, a bill to replace central-bank responsibility money issued by the government during the Civil War was made for both low inflation and low unemployment with accounta­ convertible into gold. bility strictly for long-term price stability has been proposed by Today, more than 150 years after Lincoln's admonition, we Senator Connie Mack and others. find ourselves still wrestling with this same issue: [s government While these new initiatives are laudable, it is too soon to tell the solution or the problem when it comes to protecting the whether they will be sufficient to ensure that governments and purchasing power of money? History is replete with examples their central banks consistently deliver price stability. Such of what governments will do when their power of mintage is legislation is but one of many environmental facto rs that may unfettered. The hyperinflations of Germany in the 1920s and contribute to the protection of a nation's currency. Further­ of Bolivia, Argentina, and Brazil in the 1980s are sobering more, legislative restraint on the behavior of monetary policy reminders of the effects of excessive money creation. What can operates only so long as a government chooses to live under be done to ensure that governments and their central banks its restrictions. deliver on their responsibility of protecting money's value? The history of money over the past two centuries shows nations The combination of historical experience and the near-universal groping for lasting institutional structures that provide incen­ evolution to fiat money systems-monetary standards that are tives to limit their own governments' temptation to debase their not supported by convertibility into intrinsically valued com­ currency in order to satisfy shortsighted political objectives. modities, such as gold or silver-has created a widespread The approaches used in the past have stemmed directly from recognition that national monetary authorities will not deliver both the nature of money prevailing at the time and societies' price stability unless careful attention is given to the incentive views about the proper role of government. structures under which they operate. This essay traces some historical attempts to rein in sovereign Nobel Prize winning economist Friedrich von Hayek put it this nations' appetite for excessive money growth. We contend that way: "History is largely a history of inflation, and usually of competitive market forces can provide a strong incentive mecha­ inflations engineered by governments and for the gain of gov­ nism to encourage countries to maintain the quality, or value, of ernments.,,2 What remains uncertain is the mechanism that will their money in much the same way that competition leads com­ prevent such history from repeating itself. More directly, the panies to maintain the quality of their products.

~ rO ll r First issued to help notes vvere issued by finance the North's effort (and thus vvere liabilities in the Civil War, green­ of) individual national Ln other words, perhaps the most innovative and lasting way backs, named after the banks. These notes vvere cheap green ink used t.o printed by the U.S. gov­ countries can achieve stable purchasing power for their monetary manufacture the notes, ernment, however, and assets is by competing against each other in the provision of gave their name to the era vvere backed 111 percent money. Nations that excel at providing a supe ri or standard of that lasted until 1879. by government bonds vvhen the U .S. resumed held on deposit at the value may find citizens in other countries who prefer to import the gold standard. Both Treasury. their currency. Facing such competition, the providers of domes­ the money itself and the The economy of the time era had notable features. tic currencies will have to improve their own products, erect shovved a surprising "trade barriers," or abandon the market. Greenbacks. as a fiat combination of vigorous standard, represented a grovvth and declining hugo break vvith the past: prices. The price level \Nas The government would cut in half over the period, or most of recorded history, government have taken some not convert these notes and despite the long role in providing money to the economy. Ln early times, that role into gold on demand. and recession of 1873-1879, it made greenbacks legal output rose. The popula­ was limited to "authentication"­ The Gold 3taodard tender for private as well tion increased by one­ verifying that coins contained as public debts. These third. vvhile the output of the indicated metals. Even in this limited role, however, the innovations led to severe pig iron, coal, and copper constitutional challenges more than doubled. authorities occasionally violated the public trUSt concerning the about vvhether the gov­ The combination of oundness of money. Citizens' dual reliance on and distrust of ernment could authorize grovvth and declining legal tender that vvas not government with regard to the value of money is an age-old prices is intriguing. With "lawful money," such as freely floating exchange phenomenon. gold or silver. and vvheth­ rates and an open econ­ er greenbacks consti­ omy. the U .S . money sup­ The conviction that, despite all contrary assurances, governments tuted legal tender for ply vvas determined by will eventually abuse their powers led countries to develop insti­ debts contracted before people's demand for they were issued. tutions aimed at limiting a government's ability to print addi­ money (expressed mainly tional money. One such method was the gold and silver standards Greenbacks may have in bank notes). The suc­ followed (on and off) by most countries from 1821 to 1973. hogged the headlines. but cess of fiat money during they were by no means this period vvas largely Specie-backed currency - that is, currency convertible into a the dominant money in due to the competition of circulation. Gold and national bank notes. standardized unit of a nonmonetary commodity-took money national bank notes also Along with the govern­ out of immediate government control. For example, if the dollar circulated. National bank ment's ability to get its were defined as equal to 1120 of an ounce of gold, then the fiscal house in order, this enabled the nation to number of dollars the United States could issue would be con­ deflation. This situation maintain enough credibil­ strained by its holdings of gold reserves. Moreover, if Britain ity to commit to the gold changed dramatically, how­ then defined its currency, the pound, as equal to 5/20 of an standard again. The ever, with the discovery of gold Greenback Era established ounce of gold-as it did before World War I-the dollar/pound in Alaska and South Africa in that despite the high cost exchange rate would be fixed at $5 per pound. If either govern­ in human terms, the Civil the 1890s. The result was ment issued more money than would be consistent with main­ War did not bankrupt the rapid money gro\V1h and infla­ nation financially. taining its va lue in gold-say, to finance a budget deficit-it tion up until World War I. would lose gold reserves to the country with the more stable currency. In this way, the discipline exerted by the potential loss Furthermore, linking currencies to gold (or sometimes silrer) did of reserves strengthen ed a government's covenant with the not completely restrain governments from manipulating the public not to erode the purchasing power of its money. value of their currencies. First, in order to finance expenditure, by printing money, governments would frequently suspend the One problem with a specie standard was that the value of gold standard during times of war. Second, even without offi­ money was only as stable as clle va lue of the specie backing it. cially abandoning gold, ome nations periodically redefined the When gold production was low in the 1870s and 1880s, the value of their currencies in terms of gold. Instead of allowing money supply across the world grew slowly, leading to a general gold or foreign re erves to consistently drain from [heir coffers, they would choose instead to devalue their currencies .

-­ .I {"'r + d "he Bre.tton Woods System

The Full Employm.nt Under the Bretton Woods The destabilizing effects and aalanced Growth system, the International of speculation and the Act of 1878-popularly Monetary Fund (1M F) persistent U .S . balance- known •• the HumphreY"" At first glance, it might seem that gold standards imposed no charter stipulated that of-payments deficit were H.wklna l.gl.latlon­ the price of the U.S. dollar seen as the immediate IItIpulated that U.S. real discipline on government behavior, because countries could was fixed in t:erms of gold causes of the system's eoonomlc policy be con­ devalue their currencies at will. However, discipline came from (initially at $35 per ounce) demise in 1973. Because ducted to achl_ full the fact that countries actually could riot contemplate doing so and that all other curren­ the U .S . dollar vvas the .mploym.nt" balanced cies were pegged to the key reserve currency. the growth. a balanced fed­ without suffering a cost.lf it was threatened that a country U .S . dollar. Unless a United States was reluc­ .rel budg.t. .n Improved would devalue its currency, massive speculative attacks would country developed a tant to devalue despite trad. balenca. and reeaon­ ensue as investors attempted to shed themselves of that currency. " fundamental disequilib­ persistent deficits. At the abl. price _bllity. The rium" in its balance of same time. surplus coun­ Federal R.....". R.form Such a country would eventually lose large amounts of reserves payments (usually inter­ tries chose to add to their Act of 1877 .paclflcally (gold and foreign currencies). preted as a "large and dollar holdings rather targ.ted three goala: persistent" deficit or sur­ than to revalue. m.xlmum .mployment" In 1966 and 1967, for instance, Britain -whose currency was plus) and obtained IMF As U .S . deficits persisted. _bl. prlca... nd mod.... approval to change the tied to gold-backed U.S. dollars through the ]944 Bretton the stock of U .S . dollars ate long-term InteNat pegged value of its cur­ held abroad ballooned ret•• • Sinca th..... the _n­ Woods agreement-lost nearly 28 million ounces of its gold rency~ the nation would relative to the need for a tlm.nt that _I blink. reserves when confidence in the value of the pound plummeted. have to maintain the reserve currency. Some can reliably .ngln_r mul­ exchange rate through On a single day (November 17, 1967), it lost reserves valued at countries viewed the Uni­ tlpl. objectlv_ ha. *-oll.n purchases or sales of U .S. ted States as abusing its Into dl_puta. Moat more than $1 billion. dollars. the reserve cur­ privilege to issue reserve eoonomlata now .-pt rency. The creation of the currency and as forCing the nation that the only The common wisdom is that the frequency and destabilizing World Bank and its affili­ other countries to finance _Inablelong-term effects of such speculative attacks caused the Bretton Woods ates to make longer-term persistent U .S . deficits. obJectlv•• of monetary loans is also considered system, and thus the last vestige of a gold standard, to be aban­ Eventual increases in the policy are tho_ Involving part of the Bretton dollar price of gold and the purch•• lng pow.r doned in 1973. While this is correct on a superficial level, the Woods system. Shorter­ the refusal of Germany ofmon.y. underlying cause was that the ultimate anchor of the Bretton term loans were available and Japan to revalue from the IMF. On Beptambar 21. 188•• Woods system was not gold, bur U.S. dollars. Although these their currencies were the __or Connie Mack dollars were supposedly backed by U.S. gold reserves, nothing final blows. However, the (R-Fla.) Introducad the in the system constrained the Federal Reserve from issuing fiat fundamental flaw in the Economic Growth and Although the discipline im­ system was that interna­ money (money that is not backed by specie) as long as Congress Prlc. Stability Act of posed by the EMS system of tional liquidity considera­ 188•• which would r.peal was willing to remove successively weaker statutory requirements tions encouraged foreign fixed exchange rates was far the 1878 law and atlpu­ tying dollar issues of central-bank money to gold. Eventually, central banks to hold U .S . lat. prlc. _blllty a. the from immediate or complete­ dollars. but also hindered the modified gold standard of Bretton Woods could be su tained primary long-term goal several realignments of these other nations from reval­ of U.S. monetary policy. only if the United States actively pursued monetary policies con­ uing their currencies to rates have occurred since its S.nator M.ck·. bill Wa. sistent with price stabiliry, or if other governments were willing eliminate their balance­ motivated by the finding inception - the dynamics of of-payments surpluses. to accept the inflation rates generated by the Federal Reserve. In that -the multlpl. policy the process have led to an Ultimately. confidence in goal. of [the central bank] the end, neither condition was realized. the dollar as a reserve have created unc.rtalnty ever-increasing integration currency had to suffer. about the aim. of mon.­ of monetary policy across the tary policy. which can add I countries of the European to volatility In economic he worldwide inflation experiences of the 1970s and Economic Communiry. [f nations within the Community permit eotlvlty and financial 1980s that followed the disintegration of the Bretton Woods marketa. coating work­ pure "free trade" in the use of their currencies, a single European system ha ve left na tions ere Job. and harming Alternative Monetary central bank and currency could someday emerge. If one nation economic growth.- groping for alternatives that Arrangements does specialize in currency provision for the Community, it will might return credibiliry to Th. Economic Growth gain seigniorage (revenue from printing money) and the other and Prlc. Stability Act their pursuit of a stable purchasing power of money. The domi­ nations will achieve monetary stabiliry. would require that the nant role of West Germany in the European Monetary System Federal R.....". -1) _b­ lIeh an .xpllclt numerical (EMS), created in 1979, clearly reflects the fact that the mark definition of the t.rm was widely considered to be (and in fact is) the most stable of ·prlc•• tabllltY: and the participating countries' currencies. 2) maintain a monetary policy that eft.ctlvaly promotIB. long-t.rm price atablllty.- Congr••• ha. yat to act an S.nator Mack'. propo_l.

.., 5fX L--1he European Monetary System and European Monetary Union

Throughout its post-World Implicitly, hovvever, the War II drive for economic arrangement required integration, the European each country to adopt Currency boards represent a similar institutional constraint Community has consis­ a monetary policy similar tently regarded monetary to that of Germany, the that can be adopted by countries that lack an established or union as necessary in member country vvith credible reputation for maintaining the purchasing power of order to realize the full the most credible lovv­ their money. The essence of a currency board arrangement is benefits associated 'With inflation policies. free movement of goods, Betvveen 1978 and 1991, that domestic money is issued against a foreign reserve currency capital, and labor within the ERM was remarkably at a fixed exchange rate. Under a currency board, a country's its borders. In December successful. European 1978, the European money stock behaves much as it would under a gold standard, inflation rates converged Community entered into tovvard the lovv German except that instead of contracting and expanding with gold a series of agreements­ rate, and surprisingly reserves, the money stock responds to the government's holdings collectively referred to as fevv official parity adjust­ the European Monetary of a foreign reserve currency. ments took place. In System (EMS)-to stabilize 1992 and 1993, hovvever, European exchange rates Arrangements such as currency unions and currency boards are, a series of economic and minimize the signifi­ shocks, including a reces­ ultimately, still fiat monetary systems, and as such rely on the cance of the U .S . dollar in sion in England and the monetary performance of the governments involved. Currency European monetary deci­ effects of German reunifi­ sions. The EMS defined boards, for instance, are probably best described as small boats cation, forced countries central parity rates for either to suspend their that tie themselves to a large ship. As in the Brerron Woods participating countries, participation or to adopt experience, there is not much to keep the smaller boats from articulated rules for largely irrelevant (15 per­ defending a currency. drifting if the large ships themselves are not firmly anchored. cent) parity bands. established institutions to finance intervention. and Encouraged by the rela­ encouraged monetary tively early success of policy cooperation. n the era of pure fiat monies, the primary approach to the EMS, the European Community agreed to keeping governments "honest" has been to remove the power to The centerpiece of the a monetary union at program vvas the Ex­ inflate from those with the Maastricht.. the Nether­ Competing Currencies: change Rate Mechanism lands, in December 1991. most incentive to do so. (ERM), vvhich effectively Private Competition The European Monetary This is achieved by building established a series of Union (EMU) advocated exchange rates and in a high level of independence between the central bank­ the adoption of a single required each member pan-European currency which has the power to inflate-and the Treasury-which has country to defend these issued by a single Euro­ the incentive to inflate. Charging the central bank with independ­ rates vvithin a 2 .25 per­ pean central bank by the cent band (6 percent in ent responsibility for monetary policy is meant to serve as a way end of the decade. With some special cases). for a government to commit to lower rates of inflation than an independent central would be realized without the existence of a separate monetary bank directed tovvard maintaining price sta­ authority. This institutional structure is not a panacea, but has None of these developments, bility, the EMU ideally proven especially useful: Studies have shown that, on average, however, goes as far as the could lovver the costs of economic transactions countries with more independent central banks have lower rates more radical mechanism for in Europe. of inflation.3 price stability proposed by Hayek, who suggested that Despite central-bank independence, the high-inflation era of the governments be removed altogether from the provision of 1970s showed us what central banks can do when left to their money.4 Although private issuers of fiat money also have an own devices, freed from fixed exchange rates and dollar con­ incentive to finance expenditures by creating monetary liabili­ vertibility into specie. An increasing number of countries are ties-by collecting the seigniorage on their money creation­ now moving toward more explicit central-bank accountability Hayek contended that as long as private monies were allowed for protecting the purchasing power of money - witness the to circulate freely, competition would keep the value of these previously mentioned price-stability mandates enacted in New currencies constant over time. If any issuer attempted to collect Zealand and other nations, as well as the Mack proposal in the too much seigniorage by inflating away the value of its money, United States. consumers would substitute into a competing money. Thus, currency issuers would have an incentive to remain honest and not devalue their product through excessive money creation.

~ selJe tJ Revenue

nting Money

A gDII'e,"m.nt oe" ft__ 1t8 ependlng In ttw.e ~I 1) through ..... 2) bv bottowl.,. Hayek's proposal, written 20 years ago, has historical precedent. money or in any currency provided by a monopoly. 1n other frotn the public. or ., by prtntlntl ~. The So-called "free banking"-well-known examples being the words, governments have powerful incentives ro tax private _nue ... Ieed thlaUgh eighteenth and nineteenth century experiences of the United money out of existence in order to become the sole provider of the prlntI.,. of ~ I. States, Canada, and corland - tested the idea that money need legal tender.1ndeed, according to Hayek, "it might ... prove to be CMII ...... " __".- s from the .....nc .. _reI not be provided by the central government. Under free banking nearly as impossible for a democratic government 1I0t to illterfere ..",...,r• • ,..,.. 1 lord. arrangement, private banks competed again t each other to with money as to regulate it ensibly" [emphasis addedl.- In th. MIddI. Agee. the provide the public with currency (albeit under varying degrees lord 0""'" the .-U"'" rttlht ... _In mo.,.y on hJe of government regulation). menor. 'IbcIe,. tN. right eft unanswered in Hayek's proposal is what might make belo.... to Critics of traditional private money system have often cited .--rtry". governments less inclined to intervene now than in the pa t. --...1 gDII'efftment. Gresham's law to argue that money must be provided by Furthermore, converribil- governments and not by private banks. This famous dictum Competing Currencies; The.~to"""" itl' of private nore issues mon., .11_the..--.~ states that bad money will always drive good money Out of Competition among into specie was taken as a mentto ...I .. ~ circulation- in effect, it argues that onl y monies with the worst Governments "--.the coet of pta­ given in all hi torical free- inflation rate would circulate. This led many to believe that a dualntlthe lItO1M\' ..... Ie banking regimes. What incentives do governments have to forgo fer I_then the gIIIIIWIt- government monopoly on printing money is necessary. me"". ___lid -.... the seigniorage opportunities inherent in their provision of fiat puroheM of goode eiId However, as Hayek poinred out, "Gresham' law will apply money and rerum to the world of privately issued monies that ~..... ollly to different kinds of money between which a fixed are ultimately redeemable in specie? exchange rate i enforced by law. With variable exchange rate, We argue that with the advent of flexible exchange rates, the inferior quality money would be valued at a lower rate and, Hayek 's vision of competition among currencies that can effec­ particularly if it threatened to fall further in value, people would tively regulate the quantity of notes may become a reality. try to get rid of it as quickly as possible. The selection proce s Privately issued monies may not be allowed to compete, but would go on towards whatever they regarded a the be t SOrt competition among different national currencies may serve the of money among tho e i sued by the variou agencies [or coun­ arne purpo e. Even without allowing private companies and tries[, and it would rapidly drive out money found inconvenient banks to i sue their own money, such competition can also work or worthless. "6 to keep government monetary authorities honest. With variable exchange rates, the exchange value of i uer lia ­ 1nternational currencies are increasingly competing to become bilities will fall (depreciate) if an issuer attempts to print an the currency of choice. The rapid "dollarization" in Eastern exce sive amount of money, because cautious consumers will Europe, the former Soviet Union, and Latin America shows how ub titute into a competitor's product with a more stable pur­ a foreign currency can become a legitimate substitute for a chasing power. The offending monies, ceasing to circulate as domestic currency that has failed to maintain its value. Even in media of exchange, will be replaced by money that has more currency-board countries like Argentina, individuals' ability to stable value. Competing money issuers, who gain seigniorage hold dollar accounts encourages the government to maintain the from the use of their liabilities, will have an incentive to protect integrity of its monetary system. the purchasing power of their money. Thus, the same seigniorage motives that have historically provid­ De pite the po ibiliry that private companies and bank could ed perverse incentives for governments to inflate make it desir­ compete in the provision of money, it is not clear that such pri­ able for them to circulate their domestic money as an interna­ vate arrangement are su tainable a a practical matter, given the tional medium of exchange. However, the fact that such "market eigniorage opporrunities inherent in government-controlled share" is contestable-alternati ve currencies being readily avail­ able to supplant any currency that is losing value tOO rapidly­ acts as a natural restraint on central-bank misbehavior. f' / -;'e Free Banking Era

Until the Civil War, the Between the charters use of paper money in of the First and Second the United States largely Banks of the United nce the United States and the rest of the world broke away developed outside the States (1812-181S) and direct control of the fed­ after the expiration of the from the anchor provided by the gold standard, inflation rates eral government. As Second Bank's charter almost universally trended banks vvera chartered by (183S), the natural con­ Some Barriers to upward and, in some cases, states and established straint on bank- note iss ue International around the country, they was tested. Banks wishing spun rapidly out of control. Competition in Money began to issue their own to take advantage of the Recently, the Federal Reserve circulating liability notes rules of the circulating has made great progress in reining in inflation from the clearly and deposits to their cus­ bank- note regime placed tomers. These liabilities themselves at long dis­ unacceptable experience of the 1970s and early 1980s. Unfortu­ vvere implicitly backed by tances from financial and nately, our current commitment may seem fragile to many gold and silver held at the commercial centers and issuing bank and could issued much larger vol­ market participants because there appears to be no clear insti­ be redeemed for such by umes of notes than their tutional safeguard to prevent a return to the past. the bearer or depositor. reserve of specie other­ Also, the First and wise would have war­ Though a price stability mandate would help to shift the focus Second Banks of the ranted. However. when of monetary policy away from short-term fine-tuning to long­ United States issued cir­ bank notes and deposit term price stability, such legislation cannor be viewed as a culating notes that were liabilities circulated to also receivable for federal places far from their point panacea in the absence of clear incentive structures thar remove taxes at par, as long as of issue. potential recipi­ the government's tempration to violate rhe mandate. However, they were redeemable at ents often demanded dis- in light of the increasing integrarion of world markets, we pro­ par in gold or silver. counts commensurate vvith the difficulty of State-chartered banks pose that the same competirive forces thar have served marker sending the notes back vvere constrained by mar­ economies so well may ultimately constrain the excessive money for redemption or of col­ ket forces in their a bility lecting a check. Market creation that has been problematic for fiar money regimes in to issue notes and depos­ forces, in effect. " priced" its. The likelihood that the the past. the value of each bank's demand liabilities would note. Why might competition among sovereign nations in the provi­ be redeemed at the bank for specie- gold and The U .S . banking system sion of money prove to be sustainable where private competition silver coin - constrained showed great promise in did not? The answer lies in the vety same seigniorage possibili­ a bank's ability to issue its ability to formulate ties that induce governments to undermine private competition notes. Under norma l cir­ private market solutions in the first place. Unlike the case for the domestic economy, cumstances a nd market for the problems associ­ pressures. then, each ated with a maturing individual countries have no power to legislate their own mone­ bank had to be careful to financial system and tary monopoly in the global economy. Short of a war declaration, reserve an appropriate economy. By the 1850s, the U.S. dollar will circulate as a medium of exchange in foreign amount of specie in rela­ the banking system was tion to its issue of bank far from perfect, but it countries only if it is considered superior in value to other notes- 8 tricky endeavor. displayed enough stabil­ national currencies. In other words, the United States, or any ity and efficiency so that counrry, will enjoy the benefits of seigniorage ourside irs borders there was no real political impetus to change the only if ir wins rhe comperitive bartle in rhe monetary market­ This competitive mechanism system until the Civil War. place. Furthermore, this battle will be won only by maintaining for protecting the value of a relatively stable purchasing power for the nation's money. money can be enhanced by changing existing protectionist laws to foster more effective Why would a sovereign nation willingly give up its seigniorage competition among currencies. We should heed Hayek's argu­ to a "competing" coumty? The answer comes from considering ment that countries around tile world should abolish "any kind rhe mutual advantage of trade, wherein narions benefir from of exchange control or regulation of the movement of money comparative advantage. A nation should be willing to import a between countries ... " and provide "the full freedom to use any competing currency when it needs a stable payments medium to of the currencies for contracts and accounting." Further, there undergird a developing market economy. If a nation's monetary should be "... the opportunity for any bank located in these credibility is weak, importing a standard of value may enhance countries to open branches in any other on the same terms as wealth within the country, and thus tax receipts, by more than established banks ... 8 the revenue gained from seigniorage.

lilli e + I...( L d~. -Cash.

Plunging computer chip form of a string of spa- prices and advances in the cially encrypted digits. In esoteric science of cryp· either case, buyers could Specific U.S. laws could be changed. For example, federal law tography may novv permit transmit their e ~ cash to affordable and secure merchants on the Internet currently states that "United States coins and currency (including forms of electronic cur­ in exchange for various Federal Reserve notes ... ) are legal tender for all debts, public rency ~ or He -cash," to products. With products charges, taxes, and dues. Foreign gold and silver coins are not become not just a curios­ that can be shipped elec­ ity. but a significant mar­ tronically, such as infor­ legal tender for debts. " 9 This law might be altered so that con­ ket reality. E-cash offers mation, consumers vvould tracts written in terms of foreign or alternative domestic mone­ the prospect of added benefit from rapid deliv­ tary units, including specie, could compete with those based convenience and security ery and merchants vvould in everyday. small- dollar­ receive good funds. on dollars. value transactions. Per­ A number of policy ques­ haps more important, tions arise from the use Legislation requiring that the courts enforce "specific perform­ a - cash could enable the of e~cash . First, advances ance" would also increase the opportunity for currency compe­ cybermarkets novv emerg­ in computer science or ing on the Internet to tition. Currently in most countrie of the world, when there cryptography could com­ flourish. is a dispute involving a contract that is stated in terms of a cur­ promise even seemingly rency or unit other than the national currency (s uch as gold), Many different types of e ­ impregnable systems. cash have been proposed. Security is a moving courts do not require performance in the stated unit, bur only For everyday transactions, target, so care must be require an "equivalent payment" in the national currency, weak­ smart cards (credit cards taken to ensure that ening the power of competition among national currencies. vvith embedded computer security practices are chips) could be loaded kept up to date. Second. \Nith value by transferring what laws should be in funds using compatible place to protect con- learl y, important goals are within reach. Inflation is low, and ATM machines, tele­ sumers? Currently, Fed­ phones, or even " elec­ eral Reserve Regulation E price stability is beginning to be recognized as the predominant tronic wallets. " Once gives consumers specific long-term monetary policy loaded. the cards could rights. but just hovv this A Market objective of the Federal Reserve. be used to make a variety statute should be imple­ Approach to of purchases-provided mented in this market Flexible exchange rates, coupled Currency Provision the merchant has com­ has not been determined. with more-open capital markets, patible equipment. Finally, hO\N much privacy should consumers be per­ are enabling international currencies to compete with one In cyberspace, e-cash mitted? Currency offers could reside either on a another. Central banks cannot be complacent, however, because consumers near- complete smart card placed in a new challenges will surely arise. Just as fiat money replaced anonymity. Should its special reader or, as some electronic replacement specie-backed paper currencies, eleCtronically initiated debits proposals envision, on the offer the same? All of user's hard disk in the and credits are likely to become the dominant pa yment modes in these issues require the future. The concept that money is like any other good and careful consideration. that competition among issuers can best guarantee its value should not be forgotten . I ndnotes

With the fall of communism, the lesson that market economies I. Abraham Lincoln, "Many Free Countnes Have Lost Their Liberty," ASpeech on the can best provide a country's goods and services is being affirmed Subtreasury, Springfield, lIIinois, December 26, 1839. 2. Friedrich A. von Hayek, DenallollollSlltioll of MOlley: An AnalySIS of the Theory alld around the world. That same wisdom may also be applied to PractICe of Concllrrent umenctes, London: Institute of Economic Affairs, 1976, p. 27. the provision of currency. A nation's economy does not fare as 3. See Albeno Alesina and Lawrence H. Summers, "Central Bank Independence and well without competition in the marketplace. Similarly, the value Macroeconomic Performance: Some Comparative Evidence," jOlmral of Money, Credit, alld 8ankmg, vol. 25, no. 2 (May 1993), pp. 151-62. of a nation' currency may not be optimal without competition . 4. See especially Hayek, DelratlOllalisatloll of MOlley, op. cit. It is probably only with such competition that we ma y finall y 5. Free bankmg experiments are common throughout world hiStory. Countries With live up to Lincoln 's challenge of fulfilling "the duty [government] banking systems exhibiting various degrees of private, competitive currency issue owes the people, of furnishing them a sound and uniform cur­ include Bolivia (1835-5 1), Rhodesia (now Zimbabwe, 1892-1939), Thai)and (1888- 1902 ), and many others. See Kurt Schuler and Lawrence H. White, "Free Banking: rency." Fo tering such competition ma y prove the sure t way History," In Peter ewman, Murray Milgate, and John Eatwell, cds., The New Palgrave to guarantee that central banks meet their responsibility to DICtiOlrary of Malley alld Flnallce, London: Macmil)an Press, 1992, pp. 198-99. generate maximum sustainable growth through price stability. 6. Hayek, DenatlOnalisallon of Malley, op. Cit., p. 35. 7. Ibid., p. 74. 8. Ibid., p. 17. 9.31 U.S.C§5i03 (1983).

~ t e 1J (!fficers and Co suit

As of December 31.1995

.Jerry L .Jordan David E A1tig Terry N Bennett .James W Rako\Nsky President & ChIef Executive Officer Vice President & Economist Assistant Vice President Assistant Vice PresIdent Monetary Policy & Macroeconomics Cash Automation Sandra pianalto

Fi~t Vice President & Andre\N.J Bazar .James A Blake Kimberly L Bay Chief Operating Officer Vice President Consultant Assistant Vice President Automation Automation Check ColleCIlOn, Marketing Charles A Cerino Pittsburgh Office Senior Vice President .Jake D Breland Raymond L Brinkman Cincinnati and Columbus Offices Vice President Assistant Vice President David ERich Cash, SecuritieslFiscal, Custody Control Automation, Building, Cash, ProteCIlOn Consultant .lill Goubeaux Clark Pittsburgh Office Automation Senior Vice President & General Counsel Andre\N C Burkle .Jr Corporate Communications & Vice President Michael F Bryan .John P Robins Community Affai~ Banking Supervision and Regulation Consultant Consultant Research Banking SupervIsIon and Regulation Samuel D Smith La\Nrence Cuy Sentor Vice President Vice PresIdent William D Fosnig Terrence J Both Facilities, FinanCIal Management, Banking SupervISIon and Regulation Assistant Vice President & AsSIstant Vice PresIdent Protection, Informanon Security Assistant General Counsel Marketing Rayford p Kalich Mark S Sniderman Vice President Robert.J Gorius Robert B Schaub Senior Vice PresIdent & Banking Supervision and Regulation, Assistant Vice President Assistant Vice President DireCIor of Research Credit Risk Management, Data Services General Services, Mail Accounting, General Services, Fiscal, Securities Harold.J SMlart R Chris Moore Eddie L Hardy Pittsburgh Office Senior Vice President Vice President Consultant Pittsburgh Office Quality Banking SuperviSIon and Regulation William.J Smith Assistant Vice PreSIdent Donald G Vincel Robert W Price .Joseph G Haubrich Human Resources Senior Vice President Vice PresIdent Consultant Automation, Cash, SeruritiesIFiscaJ, Check ColleCIlon, ACH, Funds Transfe~ Research Gregory L Stefani Custody Control, EEO Officer Electronic Delivery ServICes Consultant Barbara H Hertz Banking upervlslon and Regulation Robert F Ware Ed\Nard E Richardson Assistant Vice PresIdent Senior Vice President Vice President Facility/Automation ServICes, CashlFiscal, Ed\Nard.J Stevens Check Collection, ACH, Funds Transfe~ Marketing ProteCIion, Registered Mail Consulrant Marketing, EleClrontc Delivery Services Cincinnati Office Financl3l ServICes Research Group Susan G Schueller .John .J Wixted .Jr Vice President & General Auditor David P .Jager Henry P Trolio Senior Vice President Assistant Vice President Assistant Vice President Banking Supervision and Regulation, .James B Thomson ACH, Funds Transfer, EleClronic Automation, Deputy EEO Officer Credit RIsk Management, Data Services Vice President & Economist Delivery Services Financial Services Research Group Darell A Wittrup Kevin P Kelley Assistant Vice President .Joseph C Thorp Assistant Vice President Accounting, Billing Vice President Budget, Expense, Financial Planning Building William.J Major Collsllitants are IlIghly sktlled employees Robert Van \lalkenburg Assistant Vice PresIdent who contribute to attammg the Bank, Vice President Check ColleCIion gOdls through the" speClallUd professIOnal Accounting, Budget, Expense, or techmcal skIlls. Fmancial Planning, Purchasing Laura K McGowan Assistant Vice President & Corporate Andre\N W Watts Secretary, Community Affai~ Officer Vice President & Regulatoty Counsel Corporate Communications &

Charles E Williams Community Affai~

Vice President Wilmer M piper Automation, Check ColleCIion, Consultant Marketing, Accounting Automation CinCinnati and Columbus Offices

~ eleven . I'

. rj irectors

As of December 3 1. 1995

leveland Chaimzalt & Federal Reserve Agellt A. William Reynolds

Chief Executi~ Old Mill Group Hudson, Ohio

Depllty Chain""" G. Watts Humphrey. Jr.

Edvvard B . Brandon I.N. Rendall Harper. Jr. President & CEO American ~ticrographlC' Co., Inc. ____---' ...... _ ~.k Monroeville, Pennsylvania

David S. Dahhnann Alfred C. Leist Chainnan, President & CEO The Apple Creek Banking Co. Apple Creek. Ohio "--'=-- --

Robert v . Farrington Michele Tolela Myers Executive Secretary-Treasurer Prc.ident Ohio State Building and Construction Trades Council Denison University Ohio Granville, Ohio

Thomas M. Nies President Cincom Systems, Inc. CinCInnati, Ohio

Federal Advisor), COlllleil Represelltatwe Frank V. Cahouet Chainnan, PresIdent & CEO Mellon Bank, KA. Pittsburgh, PennS)'h'ama

~ tll'elve OJamnQII Incinnati John N. Taylor, Jr. ChainNn & CEO KIIIl-Kasch, Inc. Dayton. Ohio

Jerry W. Carey PrtSidcnr 8c CEO

Judith G. Clabes Eleanor Hicks

Phillip R . Cox Pmident Cox FllllnciaI Corporation CinciMati, Ohio

Ittsburgh ChamllQ" Robert P . Bozzone

Randall L.C. Russell Pmidert 8c CEO Ranbar Technology. Inc. Glmshaw. PeruISVI,ania

Thomas J. O'Shane John T. Ryan, III Prnidmt 8c CEO

Sandra L. Phillips Schack ExtCUhve Dineror Pinshurgh Partmnbip for tighborhood DevdopmaIt Pimhurgh, PeMsj'I"ania !'.nnsylvania

til/rlull 1 ' I" ,",!

• • _ • ~. • .'. ~. ~ • : I I

t-Yi omparative Financial Statement

C/tatement of Condition

For years ended December 31

1995 1994

ASSETS

Gold certificate account $ 621,000,000 $ 660,000,000 Special drawing rights certificate account 584,000,000 556,000,000 Coin 23,652,072 16,694,902 Loans and securities: Loans to depository institutions -0- -0- Federal agency obligations bought outright 151,844,053 229,245,239 U.S. government securities: Bills 10,556,220,428 11,181,316,977 Notes 8,705,577,919 9,086,293,278 Bonds 2,540,458,668 2,710,415,171 Total U.S. government securities $ 21,802,257,015 $ 22,978,025,426 .,.. .. Total loans and securities $ 21,954,101,068 $ 23,207,270,665 Cash items in process of collection 265,371,685 268,936,471 Bank premises 66,429,296 45,580,606 Other assets 1,999,292,948 1,977,994,674 Interdistrict settlement account 220,361,503 -1,332,449,195 . . .. ,' ...... TOTAL ASSETS $ 25,734,208,572 $ 25,400,028,123

LIABILITIES Federal Reserve notes $ 23,524,410,275 $ 22,542,394,720 Deposits: Depository institutions 1,161,144,879 1,813,652,367 Other Federal Reserve Banks 10,000 - 0- Foreign 9,858,331 9,266,587 Other deposits 39,750,755 40,656,808 Total deposits $ 1,210,763,965 $ 1,863,575,762 Deferred availability cash items 231,941,721 222,309,262 Other liabilities 249,559,011 256,692,279

TOTAL LIABILITIES $ 25,216,674,972 $ 24,884,972,023

CAPITAL ACCOUNTS Capital paid in $ 258,766,800 $ 257,528,050 Surplus 258,766,800 257,528,050

TOTAL CAPITAL ACCOUNTS $ 517,533,600 $ 515,056,100

TOTAL LIABILITIES AND CAPITAL ACCOUNTS $ 25,734,208,572 $ 25,400,028,123

9 (O llrt ee ll frYn~~~~ an" E""cn

For years ended December 31

1995 1994

CURRENT INCOME Interest on loans $ 231,626 $ 137,807 Interest on government securities 1,400,033,105 1,227,039,616 Earnings on foreign currency 54,586,655 58,356,750 Income from services 47,415,071 45,499,574 All other income 438,272 401,259 Total current income $ 1,502,704,729 $ 1,331,435,006

CURRENT EXPENSES Current operating expenses $ 89,140,676 $ 83,758,408 Cost of earnings credits 13,122,316 12,381,212

CURRENT NET INCOME $ 1,400,441,737 $ 1,235,295,386

PROFIT AND LOSS Additions to current net income Profit on foreign exchange transactions $ 70,243,911 $ 159,216,132 Profit on sales of government securities 267,913 -0- All other addjtions 13,175 33,927 Total additions $ 70,524,999 $ 159,250,059 Deductions from current net income Loss on sales of government securities $ -0- $ 1,510,117 Post-employment benefits-FAS 112 2,890,248 -0- Compensated absences-FAS 43 1,192,327 -0- All other deductions 8,270 5,063 Total deductions $ 4,090,845 $ 1,515,180 Net additions or deductions $ 66,434,154 $ 157,734,879 Cost of unreimbursable Treasury services 2,183,009 1,964,554 Assessments by Board of Governors Expenditures 11,216,100 9,693,400

Federal...... Reserve currency costs 21,874,736 21,583,556 Total assessments by Board of Governors $ 33,090,836 $ 31,276,956

NET INCOME AVAILABLE FOR DISTRIBUTION $ 1,431,602,046 $ 1,359,788,755

DISTRIBUTION OF NET INCOME Dividends paid $ 15,514,258 $ 14,283,474 Payments to U.S. Treasury (interest on Federal Reserve notes) 1,414,849,038 1,311,506,031 Transferred to surplus 1,238,750 33,999,250 Total distributed $ 1,431,602,046 $ 1,359,788,755

., fifteen William H Braun James D Kiggen Gerald M Miller President Chairman, President & CEO Chairman & Managing Parmer Custom Rubber Corporation Xtek, Incorporated Miller-Valentine Group Cleveland, Ohio Cincinnari, Ohio Darron, Ohio

Margo E Broehl Norman Klass Jeanette C prear Owner President & Owner President & CEO Brochl & Waldron Anomeys Agri Supply Company, Inc. Day·Med Health Maintenance Plan, Inc. Wooster, Ohio Leipsic, Ohio Dayton, Ohio

Ronald B Coben Cheryl L Krueger Steven C Thomas Senior Pamler President & CEO President & CEO Cohen & Company Cheryl & Company Mulach Steel Corporation Cleveland, Ohio Columbus, Ohio Bridgeville. Pennsylvania

Glenn R Jennings Pre ident & CEO Delta Narural Gas Company, Inc. Winchester, Kentucky

~~Jaraun~t______B.enjaDJin T Pugh ebilip S S_ope President & CEO CEO President & CEO The Second National Bank of Warren Premier Financial Bancorp, Inc. Chippewa Valley Bank Warren. Ohio Vanceburg, Kentucky Rinman , Ohio

EdlNin P c..cnt.e1r______Ronald L Solomon Carlos E Watkins President President. Director & CEO President & CEO Commercial National Bank of First We t Virginia Bancorp, Inc. First-Knox Bane Corp. Westmoreland Coumy Wheeling, West Virg,"ia Mr. Vernon. Ohio L1trobe, Pennsylvania WilliaDl....C....s..nn.taa...­ Robert W zaplL___ _ J..ean R Hale Ptesident & CEO President & CEO President & CEO The First National Bank of Slippery Rock The Bank of Boone County, Inc. Pikeville National Bank & Trust Company Slippery Rock, Penns)'lvania Florence, Kentucky Pikeville, Kentucky

, sixteen ~Ieveland 146 , Street Cleveland, OH 44114 (216) 679 2000

~inCinnati 15 Cincinnati, OH 45202 (613) 721-4787

~ittsbUrgh

71 treat Pittsburgh, PA 15219 (412) 261 7800

~OlurnbUS 9 rkway Columbus, OH 43229 (614) 846-7494

,

This annual report was prepared by the Corporate Communications & Community Affairs Department and the Research Department of the Federal Reserve Bank of Cleveland.

For additional copies, contact the Corporate Communications & Community Affairs Department, Federal Reserve Bank of Clevelend, P.O . Box 6387, Cleveland, OH 44101, or call 1 -800-543- 3489 (OH, PA, WV) or 216-579-2001 .

The annual report essay is also available electronically through the Cleve­ land Fed's home page on the World Wida Wab: http:/ / www.c/ev.frb.org.

Design: Micheel Galka Executive Portreit: Bill Peppes