113, 2 (Summer 1998):356-57.

The International Origins of the Federal Reserve System by J. Lawrence Broz. Ithaca, NY,

This fine book does, as promised, explain the emergence of central banking in the United States. That's value enough, but beyond that, the book provides leverage for handling an important collective action problem in the rationalist account of the creation of institutions.

Central banks have often been the object of epic political battles whose resolution tells us a lot about the relationship within each country among politics, the emergence of market economies, institutions, and international relations. To explain these battles, Broz turns to the logic of efficient institutions. Central banks emerge because they provide benefits to growing economies; they stabilize payment systems, flatten interest rate fluctuations, and eliminate banking panics; in so doing, they enhance investment, growth, and prosperity. (This view is not without its critics: free banking advocates argue against regulation of any kind, because it causes problems of moral hazard and rent seeking, which provokes a debate reflected in contemporary arguments over the International Monetary Fund at the international level and regulation within countries.)

If central banks provide benefits, we should not be surprised to see them created. A rationalist account of institutions dating back to Thomas Hobbes, John Locke, and Jeremy Bentham argues that political institutions exist to serve specific goals; if they are inefficient, they will not be created or will not survive.

Yet, there is a problem in this account. If central banks are demanded because they provide general benefits, they are a public good, nonexcludable and nonrival in consumption. Who, then, has an incentive to provide them? Even if an institution is efficient, it takes resources to bring it into being--organization, lobbying, politics. If all benefit, who has the incentive to undertake the work? The logic of the motive (rationality) questions the logic of the cause (free riding).

Enter the concept of joint product. That an institution provides public goods to society as a whole may obscure the possibility that it may at the same time provide selective benefits. Some portion of the population may gain a distinct benefit which it can privatize, capturing a substantial share of the benefits. If so, that group will have an incentive to provide the good and thereby overcome the collective action problem.

This, Broz argues, is precisely what happened with the Federal Reserve. Finance interests concentrated primarily in New York sought to make money from having the U.S. dollar become a player in international finance. The dollar could not play this role without stronger domestic foundations to American finance. These interests lobbied to create the Federal Reserve. In so doing, they provided a public good--a stable currency and greater wealth to the United States from that stability and the earnings of a reserve currency. At the same time, as the key players in the new system, they made a handsome profit for themselves. Broz nicely examines the economics of finance before and after the creation of the Federal Reserve and explores the politics that led to its creation. He then extends the argument to some other cases, mostly drawn from earlier periods in U.S. history and the United Kingdom.

The functionalism in efficiency explanations of institutions has always been a weakness, for it cannot explain the microincentives needed for action. Broz's approach provides a key conceptual road map out of that bind. The argument is of very great interest for understanding current battles over financial institutions around the world. And it is of great interest to students of institutional creation and design more broadly.