(Summer 1998):80-81.

by J. Lawrence Broz

Reviewed by JEFF FRIEDEN

The Federal Reserve is the United States' most powerful economic policymaking institution. It is watched carefully by decision makers in government, business, and labor, because its decisions affect economic activity around the globe. Yet the reasons for Fed action remain mysterious, not least because the Fed itself has been quite successful at making it hard for the markets to predict its policies.

J. Lawrence Broz's new book is an important step toward understanding the institutions of US monetary policy. In The International Origins of the Federal Reserve System, Broz proposes a convincing new argument about the founding of the Federal Reserve in 1913. The book is suggestive of broader explanations for the making of US monetary policy, and of monetary policy in general.

Broz brings international factors squarely to the center of his discussion of how and why the Fed was created. In so doing, he provides an important correction to traditional views and suggests how important the world economy has been and remains to a full understanding of US economic policy-making.

The traditional interpretation of the founding of the US central bank emphasizes the desire of public-minded policymakers and others to stabilize financial and monetary conditions, especially in the aftermath of damaging bank crises. But Broz points out that the United States had endured many bank crises over the course of more than a century without having given rise to a movement for a central bank; the country had even decided twice (in 1811 and again in 1832) to close down its existing central bank. Furthermore, there were many ways to avoid bank panics other than the complex machinery of the Federal Reserve.

Indeed, the fact that a central bank could have improved US economic performance gave no guarantee that it would be created. Many economically efficient policies are never undertaken. This is especially the case where such policies give rise to problems of collective action: if the policy benefits everyone, no one person or group has an incentive to exert the effort necessary to get the policy adopted. In the standard story, central banking is a classic public good-it makes everybody better off, including those who do nothing to help obtain it-which raises the question of why and how it came about when it did.

Broz's answer to this puzzle is that while the Fed did provide a set of public goods that improved the functioning of the US economy, it also provided an important private benefit to a powerful group of US citizens. International bankers and exporters of complex manufactured goods stood to gain disproportionately from the creation of the Federal Reserve, and it was in fact their exertions that made the Fed possible.

The International Origins of the Federal Reserve System points out that supporters of the Fed's founding were especially interested in the impact it would have on deepening the country's financial system. This had many effects, but foremost among them was to give US banks and exporters a stronger position in international competition. The weakness of the US monetary and financial systems made it impossible for the US dollar to play a global role. This, by extension, made it very difficult for US banks and corporations to compete with those from countries whose currencies, such as the British pound and the French franc, were central to world trade and payments.

Groups in the United States who wanted to increase their international business were hampered by the underdeveloped nature of the country's money and finance. It is not coincidental, Broz argues, that these groups were the central supporters of the movement for a new central bank, and that their ideas dominated discussions of this crucial institutional change in the years before 1913.

In other words, Broz sees the founding of the Federal Reserve as the result of two forces: the general desirability of a central bank, and the specific self-interested goals of US international banks and businesses. The former was insufficient to push the plan through the political system. Indeed, it was the special interests of New York bankers and their allies that provided the muscle, brain, and money to convince politicians to create a powerful new monetary institution.

This "joint products" model, in which the public good was provided to all only because it served to supply private benefits to some, helps to answer some of the theoretical and empirical puzzles of the founding of the Fed. Broz backs up his convincing logic with suggestive evidence from statistical records, private and public archives, the public and legislative debates, and the contemporary press. He fills out the case with extensions to earlier US debates over central banking, and to the founding of England's pioneer central bank in the seventeenth century.

The International Origins of the Federal Reserve System makes a convincingly argued and supported case for a new understanding of the sources of American central banking. Its implications are of broader, and less purely historical, interest. Broz's point about the interaction of special and general interest in monetary affairs is applicable both to the founding of central banks elsewhere and to the making of monetary policy in general.

Broz's insistence on the centrality of private financial interests in the establishment and reform of monetary institutions is relevant to the many instances today in which countries are debating the appropriate role of central banks in society. For example, most of the member states of the European Union will soon share a new European Central Bank for their new single currency. Broz's historical examples suggest that understanding the source of Economic and Monetary Union in Europe requires us to look not only at its general impact on the region's economic development, but also at the special interests that would stand to gain most from this historic innovation.

The same is true of ongoing efforts to set up new central banks in many developing and transitional countries. Supporters typically present central bank formation and management as the unselfish actions of public-spirited technocrats. Broz's US story suggests that there may also be important private spirits involved, and this serves as a powerful corrective to those who see central bank establishment and reform as purely technical issues.

The historical perspective that Broz brings to bear is also relevant to understanding today's US monetary policy. After all, it is no less true today than it was 90 years ago that monetary policy can have both broad public-interest and narrow special-interest effects. The International Origins of the Federal Reserve System suggests that contemporary Fed policy may be the result not only of the needs of the US economy in general but also of the desires of such particular interests as the financial community. If Wall Street was able to bend the United States' monetary institutions to fit its needs in the founding of the Federal Reserve System, there is reason to believe that it may be able to affect Fed policy similarly today.

J. Lawrence Broz has written a book of historical and contemporary interest, with broad implications for understanding monetary policy and economic institutions. The International Origins of the Federal Reserve System is a model of the application of rigorous theory to historical and current problems, and a demonstration of how important understanding the past can by to thinking clearly about the present.