Preserve the Exchange Stabilization Fund

A congressional coalition of strange bedfellows has recently attempted, and only narrowly failed in the House of Representatives, to constrain the use of the Exchange Stabilization Fund (ESF) by the secretary of the treasury. On 15 July, the House rejected by 192-228 an amendment offered by Rep. Bernard Sanders (I-VT), cosponsored by eleven others and endorsed by several labor unions and lobbying groups, that would have required explicit congressional approval for loans from the ESF greater than $1 billion. This is the second floor vote in as many years on an attempt to renew temporary restrictions placed on the ESF after the Mexico crisis of 1995.¹

Although those restrictions expired in October 1997, they hamstrung US leadership at the outset of the Asian financial crisis and arguably aggravated the crisis. These legislative efforts are likely to continue. If they succeed, limitations on treasury access to the ESF will slow the US response to future crises, constrain US leadership, and send the wrong message to foreign governments and the financial markets about international cooperation. Representing a step backward in the reform of the international financial architecture intended to inoculate the system from shocks, such efforts should be resisted vigorously.

The secretary of the treasury should
retain broad discretion in the use
of the ESF for stabilization loans
and foreign exchange intervention.

The secretary of the treasury should retain broad discretion in the use of the ESF for stabilization loans and foreign exchange intervention. The treasury should continue to manage the account conservatively, transparency could be strengthened, and congressional oversight can be made more consistent. The treasury can nonetheless continue to administer the account with wide latitude while remaining democratically accountable.

Critics of the ESF raise five objections:² (1) the account is a secretive “slush fund”; (2) the treasury has strayed from the original purposes of the ESF; (3) loans from the account illegally or unconstitutionally circumvent the congressional appropriations process; (4) the mechanism by which the treasury can swap foreign exchange in the account for dollars with the Federal Reserve—“warehousing”— is a subterfuge and undermines the central bank's independence; and (5) stabilization loans create moral hazard.

However, a review of the history and evolution of the ESF and the procedures for reporting and oversight do not support these claims or a case for direct congressional controls over the account. After briefly considering the origin and history of the ESF, we address each of the critics' objections below.

History

The Congress and the Roosevelt administration created the ESF through the Gold Reserve Act of 1934. The basic purpose of the account was and remains the stabilization of exchange rates and the international monetary system. Congress delegated the management of the ESF to the secretary of the treasury and holds the executive branch accountable through its oversight. The Department of the Treasury has used the ESF primarily to conduct foreign exchange intervention; stabilization loans have been an important secondary activity of the account. Congress also provided that all income and profits from its investments and operations remain part of the ESF, which has thus grown over the decades to about $40 billion.

. . . Congress should . . .
leave the ESF alone.

Having labored in relative obscurity for most of its existence, the account was thrust into the spotlight and intense political controversy by the Mexican peso crisis of 1994-95. In January 1995, the Clinton administration asked Capitol Hill to approve an assistance package consisting of $40 billion in loan guarantees for the Mexican government. The new 104th Congress balked, however, and the administration resorted to extending a $20 billion line of credit to Mexico from the ESF.

Upon learning that the Clinton administration had switched to using the ESF in the face of congressional opposition to the loan guarantees, several members of Congress and outside observers charged that the will of the national legislature was being circumvented. The amount and the term of the loan to Mexico were indeed unprecedented in the history of the ESF. Treasury Secretary Robert E. Rubin nevertheless argued that assistance to Mexico was in the US interest, that a rapid response was necessary, and that the Gold Reserve Act gave him sole discretion over the use of those funds.

If it did not now exist, the ESF,
or something like it, would have to be created.

The financial crisis that began in Asia in the spring of 1997 and later spread to Russia and Latin America spawned a second set of financial rescues on the part of the international community. Although the International Monetary Fund (IMF) led those rescues, the contributions of national governments were important to the credibility and success of the stabilization programs. The ESF has remained the principal mechanism through which the United States contributes to such rescue packages, notably the recent package for Brazil, and it has attracted continued scrutiny in that role.

Secretive?

At the beginning of the ESF, when the secretary reported only to the president, and for several decades thereafter, disclosures about the account were indeed minimal. However, the transparency of the ESF has evolved greatly over time, to the point where Congress receives considerably more information about the account than it appears to use.

Soon after the creation of the ESF, the secretary's reports were submitted to the Congress as well as to the president, and then later made public. Since the 1970s, the treasury has reported to Congress on a monthly basis and to the public through the Federal Reserve on a quarterly basis. Each loan agreement with a foreign government is reported to Congress under the Case-Zablocki Act of 1972 (widely known as the Case Act). Consistent with this trend, the administrative expenses of the ESF were placed on the budget beginning in FY1980. Under the Omnibus Trade and Competitiveness Act of 1988, the treasury is required to deliver semiannual reports on broader matters of international economic policy and exchange rates, on which the secretary is to testify if called upon to do so, and in which policy matters pertaining to the ESF are discussed. These changes responded in part to the evolving desire for greater transparency of the ESF and accountability of the secretary in past operations while also preserving confidentiality, flexibility, and speed in current operations. Thus, the present-day ESF in no way resembles a “slush fund.”

Wayward?

The ESF has evolved in response to changes in the international monetary and financial systems. Since the 1930s, secretaries of the treasury have used the ESF for both foreign exchange intervention and international loans, most of which went to Latin American countries. The formal objectives of the ESF shifted from stabilizing the dollar in a narrow sense in the early decades to promoting “orderly exchange arrangements” and “a stable system of exchange rates” in a manner consistent with US obligations in the International Monetary Fund today.

A dramatic increase in international capital flows to emerging markets in the 1990s increased the demand for distress financing when those flows reversed, most dramatically in the case of Mexico in late 1994 and 1995. Those loan commitments, and a lengthening of the term of those commitments, thus reflect the increased size, speed, and reversibility of modern private capital flows. (Highly mobile capital could also easily produce large movements in the dollar exchange rate in the future, prompting an increase in the volume of currency intervention.)

The ESF statute, its legislative history,
and decades of practice in the full view
of Congress establish the legality
of loans from the ESF.

Some critics argued that extending medium-term loans to Mexico stretched the legal mandate of the treasury. But the ensuing debate made clear that the secretary had acted within the law. The ESF statute, its legislative history, and decades of practice in the full view of Congress establish the legality of loans from the ESF. Although the president must report and justify to the Congress loans that are longer than six months, neither the statute nor the legislative history imposes any limitation on the term over which funds can be lent from the account. Apart from the two years during which the temporary restrictions (dubbed the D'Amato amendment after its principal sponsor) were in effect, there has been and remains no legal bar to offering medium-term loans to countries stricken by financial crises.

The secretary and the president do not possess, and obviously do not need, unrestricted authority to use the ESF as they please. Although the secretary has broad discretion, the treasury is constrained to use the funds for the purposes of the law. The ESF cannot be tapped for administrative expenses. The secretary cannot use the ESF as a source of “foreign aid,” defined as grants or forgiven or subsidized loans.

Unconstitutional?

Through the Gold Reserve Act of 1934, Congress created the ESF, endowed it with public money, and placed it at the disposal of the secretary of the treasury for the purpose of stabilizing the dollar. The secretary used the account for foreign exchange intervention and stabilization loans during the interwar period, and has continued to use it for these purposes to the present day. These activities are not only approved by Congress through law but also are reported to it and to the public regularly.

. . . the transparency of the ESF
has evolved . . . to the point where
Congress receives considerably more
information about the account than
it appears to use.

During the Mexican peso crisis of early 1995, Congress did not approve the Clinton administration's initial plan to extend loan guarantees from the federal budget. This reluctance clearly indicated that proceeding with loans from the ESF would be politically risky. But congressional inaction in no way removed the treasury's standing legal authority to lend from the ESF at the secretary's discretion.

In many areas of foreign and domestic policy, congressional delegation of authority to the executive branch and independent agencies is extensive. Across a broad spectrum of issues, Congress manifestly prefers to delegate many individual decisions rather than make them itself, and to oversee the executive. The Supreme Court has consistently upheld the Congress's constitutional power to do so. Thus, the delegation of ESF authority to the secretary of the treasury is part of a broad and accepted pattern and is very much consistent with our principles of democratic governance.

Subterfuge?

Warehousing is the spot sale of foreign currency from the ESF to the Federal Reserve along with a parallel repurchase at some specified date in the future. It is designed to replenish dollars in the ESF when they have been sold or swapped for foreign currency. The treasury last availed itself of this facility in 1989 and 1990. When warehousing was first instituted in the early 1960s, the General Counsel of the Federal Reserve issued an opinion articulating its legal basis. Congress authorized the Federal Reserve in 1980 to purchase foreign securities, an affirmative action meant to facilitate the Fed's holding of foreign exchange. The counsel opinion, the 1980 law, and 35 years of practice disclosed to the Congress, would seem to consolidate the legal basis for warehousing.

. . . temporary restrictions placed on
the ESF after the Mexico crisis of 1995
. . . hamstrung US leadership at the
outset of the Asian financial crisis and
arguably aggravated the crisis.

Should the issuance of dollars to the ESF cause an undesired expansion of the money supply, the Federal Reserve can easily offset the liquidity effect through standard open market operations. Moreover, the Federal Open Market Committee decides on matters related to warehousing, such as the limits to be set on the facility. In the event that warehousing became so large as to complicate sterilization, the FOMC could refuse further drawings.³ It is therefore difficult to foresee any realistic scenario under which warehousing could undermine the independence of the Federal Reserve or domestic price stability.

Moral Hazard?

The problem of moral hazard is very real, of course. International financial stabilization shares this problem with many other areas, such as fire and consumer protection and insurance. But most reasonable people would not argue for the abolition of fire departments because homeowners could become complacent. The appropriate solution is to balance the costs of complacency against the costs of fires and to limit moral hazard through fire codes. Using the ESF sparingly, requiring the equivalent of collateral, and making ESF loans conditional on policy reform—combined with oversight—provide safeguards against moral hazard while maintaining an effective capacity to fight financial “fires.”

Conclusions

Foreign exchange and international financial markets are imperfect, suffering from incomplete information, multiple equilibria, and problems of enforcement and cooperation among lenders, among other things. They are often driven, as a result, by herd behavior rather than rational expectations and produce speculative bubbles and liquidity crises rather than exchange rate and financial stability.

With loans from the ESF, the US government can provide liquidity to borrowers that are fundamentally solvent, preventing excessive downward overshooting of their currencies, smoothing their balance of payments adjustment, and reducing output and employment losses. By doing so, US authorities also reduce the adverse shift in the trade balance and associated output and employment losses in the United States. Currency stability and international liquidity foster open trade and investment policies around the globe, from which the United States and the rest of the international community benefit.

In legislative terms, the Congress should therefore leave the ESF alone. The secretary of the treasury should retain sole authority and wide latitude in the use of the account. Congress should resist any impulse to constrain the secretary's authority over or access to the ESF. In particular, Congress should not impose any new constraints on the use of the ESF for international financial rescues, including for medium-term credits when those might be necessary.

However, the secretary should also continue to manage the account conservatively by observing several basic principles of emergency finance, and should increase the transparency of the ESF, an area in which progress is currently being made. Congress should maintain consistent oversight of the secretary's administration of the ESF, a process facilitated by thorough reporting by the treasury on the account.

The ESF has remained the
principal mechanism through which the
United States contributes to rescue packages . . .

Six principles should guide the use of the ESF, most of which are already being largely implemented:

• First, loans from the ESF should be issued sparingly. The treasury should make the account available only after borrowers have exhausted their access to the private financial markets and, preferably, other official creditors.
• Second, loans should be conditioned on policy reforms within borrowing countries to correct economic problems and facilitate international adjustment.
• Third, large medium-term loans should usually be made in parallel with programs administered by the IMF, which should continue to take the lead in negotiating policy conditions. The IMF is often better positioned to determine conditionality and has greater legitimacy in insisting on policy reform.
• Fourth, ESF loans should be backed by a reasonably assured source of repayment and generally receive an interest rate premium, relative to the precrisis market rate.
• Fifth, loans from the ESF should be effectively senior to the borrower's obligations to previous creditors.
• Sixth, US officials should do their utmost to persuade private lenders and investors to also contribute to rescue packages—through some combination of debt relief, rescheduling, and new money—so that official financing does not simply substitute for private financing.

These principles are designed to maximize the likelihood that the financial operation will effectively stabilize markets, assure repayment to the treasury, encourage an early return to private capital markets, and minimize the moral hazard effects of official lending. They cannot be imposed rigidly on the credit activities of the ESF. The principles require flexible application in light of prevailing economic and perhaps political circumstances. Nevertheless, the secretary must respect the spirit of these principles when using the ESF for stabilization loans.

The ESF has been an important part
of the financial architecture in the past and
remains critical to any future set of arrangements.

When conducting oversight, members of Congress should ensure that these principles are respected. The Congress, and the banking committees in particular, have a litany of treasury reports and multiple opportunities to question the secretary and other treasury officials privately and publicly, and thus possess the tools necessary to exercise oversight relating to the ESF.

Three measures would nonetheless further strengthen transparency and oversight. First, the many reports that the treasury issues regarding the ESF and international monetary and financial policy more broadly could be streamlined, thereby economizing on scarce time of the treasury staff and provide “one-stop shopping” for Congress and the public. Doing so would require amending each of the several statutes that require the existing reports. Second, it would be desirable for the treasury to release ESF balance sheet information more frequently. The department could release monthly balance sheets with a few months' lag.

Third, more important, credit agreements with foreign countries, such as the 1998 agreement with Brazil, renegotiated in March 1999, should be released to the public. Such agreements are often classified out of deference to other creditors or to the borrower. Releasing these agreements should be part of the transparency agenda of the finance G-7, the IMF, and other international bodies.

. . . the present-day ESF in no way
resembles a "slush fund."

Disclosure to Congress is part and parcel of the broad delegation of authority to the treasury to manage the ESF. For its part, Capitol Hill must also recognize the substantial costs in staff time of reporting to Congress and strengthening transparency and should provide for them in budgetary appropriations for the administrative expenses of the treasury.

The United States, other leading countries, and the international financial institutions are searching for solutions to the global financial crisis and mechanisms to prevent and contain future crises. Former treasury secretary Rubin and current secretary Lawrence H. Summers have advocated designing a new international financial architecture that could lend greater stability to the international system. The ESF has been an important part of the financial architecture in the past and remains critical to any future set of arrangements.

In the absence of the ESF, international cooperation and US participation, let alone leadership, in international financial support operations would suffer considerably. Market confidence that governments could handle crises would decline. Governments of emerging-market economies would be tempted to backtrack on external liberalization. The intensification of international financial instability in recent years requires that the ESF be maintained rather than constrained. If it did not now exist, the ESF, or something like it, would have to be created. Truncation, or abolition, of the ESF at this point would convey a very negative signal both to markets and to other governments concerning the global economic role of the United States.

Notes

1. In July 1998, the House rejected by a slightly narrower margin a similar bill cosponsored by Rep. Sanders and Rep. Spencer Bachus (R-AL) that would have prevented the treasury from tapping the ESF for any international loan greater than $250 million. In the Spring of 1999, Rep. Jim Saxton (R-NJ) proposed that congressional approval be required for international stabilization loans greater than $1 billion and reiterated this proposal recently through the Joint Economic Committee. See Joint Economic Committee, “Transparency and U.S. Dollar Policy,” study by Robert E. Kelleher, July 1999.

2. These criticisms are contained in, among other places, floor statements by members of Congress (Congressional Record, 15 July 1999), Joint Economic Committee, op. cit.; statements by Lawrence Lindsey, Allan H. Meltzer, and Charles Calomiris before the Joint Economic Committee, The International Monetary Fund and International Policy, hearing, 24 February 1998, pp. 67-71; Anna J. Schwartz, R. Christopher Whalen, and Walker F. Todd, Time to Abolish the International Monetary Fund and the Treasury's Exchange Stabilization Fund (Charlotte, NC: Committee for Monetary Research and Education, Inc., 1998); and the debate between the author and Allan Meltzer, “The U.S. Exchange Rate Stabilization Fund: Sleazy Slush Fund or Safety Net for the World Economy?,” The International Economy, July/August 1999, pp. 47-51, 63-64. With respect to the latter, see also C. Randall Henning, “Response to Prof. Meltzer,” The International Economy, September/October 1999.

3. In March 1990, for example, Vice Chairman Manley Johnson and Governors Wayne Angell and John LaWare argued against raising the warehousing limit, but were overruled by a majority of the Federal Open Market Committee. FOMC transcript, 27 March 1990.