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Treasury Secretary Paulson made many important decisions last week in response to the national financial emergency. One of them however—the decision to use the Exchange Stabilization Fund (ESF) to guarantee the assets of money market mutual funds—was a mistake. The size of the ESF, the need to preserve it for other contingencies, and problems with Treasury's existing authority, make its use for this purpose a risky tactic, a stop-gap measure grabbed hastily in the midst of a crisis. There are better ways to maintain confidence in money-market mutual funds. As they design legislation for what has been called the "new Resolution Trust Corporation," Secretary Paulson and the US Congress should shift support for money market assets from the ESF to the new entity.
Deeply concerned withdrawals from money-market funds would exacerbate the financial crisis, Treasury on September 19 announced, "For the next year, the US Treasury will insure the holdings of any publicly offered eligible money market mutual fund—both retail and institutional—that pays a fee to participate in the program." (The same day, the Federal Reserve announced that it would provide non-recourse loans to banks to buy asset-backed commercial paper from money market mutual funds.) Over the weekend, Treasury qualified its announcement, saying that it would not guarantee new investments made in these funds after Friday. Treasury's announcement argued that the secretary had the authority under the legislation that created the ESF to use the fund in this way, emphasizing that "maintaining confidence in the money market fund industry is critical to protecting the integrity and stability of the global financial system." Although markets welcomed the move, on closer inspection it is problematic for several reasons.
First, the resources of the ESF are small compared to the scale of the problem confronting money-market mutual funds. Total assets of these funds amount to about $3.4 trillion, most of which are likely to be covered by the new program. The assets of the ESF, on the other hand, amount to $50 billion. What is more, the ESF is invested mainly in instruments denominated in European euros, Japanese yen and Special Drawing Rights (SDRs) issued by the IMF. Tapping these instruments for defense of money-market funds would require conversion to dollars, which would be problematic. The dollar-denominated investments of the ESF amounted to about $17 billion at the end of August. These numbers are not likely to underpin confidence in the money-market mutual fund industry for very long.
Second, tapping the ESF in this way limits the resources that can be used for international contingencies, such as foreign exchange intervention or international financial crises. US official foreign exchange holdings are limited to begin with; encumbering them with commitments to the money-market industry limits them further. However, although we saw movement into US treasury securities last week, we could easily see sentiment shift against the dollar as players in the market add up the fiscal cost of stabilizing mortgage-backed securities and calculate the ramifications for the US external balance. This crisis is global and before it is over we might well need the ESF for its original purpose, which brings us to next point.
Third, the Treasury's reading of the statute that provides for the ESF represents, to be charitable, an aggressive interpretation of its authority. Treasury argues a link between confidence in the money-market mutual fund industry and international financial stability. But it undertook this action when the dollar was near nine-month highs against the euro and there were strong inflows into US treasury securities. The danger posed by weakened confidence in money market mutual funds is, at best, arguable. The statute authorizes the secretary to "deal in gold, foreign exchange, and other instruments of credit and securities that the Secretary considers necessary," the passage cited in Treasury's announcement. But that passage is embedded in a paragraph and section unmistakably devoted to "stabilizing exchange rates and arrangements." Never before has a secretary construed this purpose to cover a domestic financial rescue and the ESF has never been used in this way.1
Fourth, this action endangers political support for the ESF and its external mission over the longer term. Many members of Congress first learned of the existence of the ESF when Treasury Secretary Rubin announced that he would tap it to address the Mexican peso crisis in 1995. They objected then to the discretion wielded by the secretary over the use of the Fund and Congress imposed constraints for two years thereafter, limitations that were in place at the outset of the Asian financial crisis in 1997. I have argued elsewhere that the secretary acted appropriately in the Mexican case and that the congressional constraints were counterproductive.2 Congressional dissatisfaction with the secretary's autonomy have made the ESF potentially vulnerable to proposals to siphon off its resources for projects and programs that are completely unrelated to international finance. The secretary has vigorously resisted these proposals and Congress has rejected them in the past. But using the ESF to guarantee money-market funds breaches the ring fence that has been successfully maintained for decades and potentially opens the door to irresponsible ideas for diverting the ESF's resources in future.
For these reasons, finally, the Treasury should quickly shift support for the money-market funds guarantee from the ESF to the "new RTC" that is being created. Relieving the ESF of this burden would not affect the overall cost to the US government of supporting money-market funds. Doing so would match resources to the scale of the problem more appropriately. Critically, it would safeguard the ESF for its main purpose of maintaining international financial stability. The secretary should propose that the "new RTC" take over the guarantees for the money-market funds and, if he does not, Congress should insist upon it as a condition for approving his new authorities.
Notes
1. The most complete history of the ESF, its mandate and lending programs is C. Randall Henning, The Exchange Stabilization Fund: Slush Money or War Chest? Policy Analyses in International Economics, no. 57 (Washington: Peterson Institute for International Economics, May 1999). See also Henning, "Preserve the Exchange Stabilization Fund," Policy Brief 99-8, Peterson Institute (September 1999).
2. See references above.