What's the Exchange Stabilization Fund, and don't we need it for something?

Answers to your questions about the news.
Sept. 26 2008 3:00 PM

What's the Exchange Stabilization Fund?

A pile of cash that can be used for whatever.

Read more about Wall Street's ongoing crisis.

The U.S. Treasury announced last week that it would provide insurance for money market fund holders using $50 billion from the Exchange Stabilization Fund. What's the "Exchange Stabilization Fund," and what will happen now if we need it to, um, stabilize exchanges?

It's an emergency reserve fund rarely used for its original purpose. Congress created the ESF with profits from the nationalization of gold—and adjustment of the gold standard for the dollar—in the early 1930s. With the passage of the Gold Reserve Act, the government stash increased in value by $2.8 billion; most of that money was then diverted into a new fund to help the Treasury manage the exchange value of the U.S. dollar in times of crisis by buying and selling foreign currencies without congressional approval.

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Since then, the government has used the ESF to give stabilizing loans or credit lines to troubled foreign governments. The intent is to counter disorderly conditions in the foreign exchange market by propping up foreign currencies. Past administrations have extended loans or lines of credit to China, Brazil, Ecuador, Iceland, and Liberia. In 1995, the Clinton administration Treasury used the fund to extend a $20 billion line of credit to Mexico in order to stabilize the peso.

But the Treasury doesn't have to use ESF funds solely for foreign exchange. The statute as amended in 1970 states that the secretary can, with the approval of the president, use the money to "deal in gold, foreign exchange, and other instruments of credit and securities." The use of the Exchange Stabilization Fund to insure money market accounts fits under that expanded definition.

Don't we need that ESF money in case we need to stabilize the dollar exchange rate? Ideally, the government will still have the $50 billion, as it's serving only as a guarantee to depositors in case of default. In any case, the Treasury hasn't used the ESF since the late 1990s, as empirical evidence suggests that interventions have had little effect in influencing exchange rates, anyway. Although legislators and other detractors grumble that the ESF serves as a "slush fund" for the Treasury, few have been particularly committed to get rid of it. In the unlikely event that the Treasury needed the ESF for foreign exchange and lacked sufficient funds, it could always borrow some more from the Federal Reserve.

Got a question about today's news? Ask the Explainer.

Explainer thanks Michael D. Bordo of Rutgers University, Mark Gertler of New York University, and Anna J. Schwartz of the National Bureau of Economic Research.

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