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AUGUST 14, 1990
Printed for the use of the Committee on Banking, Finance and Urban Affairs

Serial No. 101-163

33-436 *t

WASHINGTON : 1 9 9 0

For sale by the Superintendent of Documents, Congressional Sales
U.S. Government Printing Office, Washington, DC 20402
Federal Reserve Bank of St. Louis


HENRY B. GONZALEZ, Texas, Chairman
STEPHEN L. NEAL, North Carolina
BRUCE F. VENTO, Minnesota
DAVID DREIER, California
THOMAS J. RIDGE, Pennsylvania
BARNEY FRANK, Massachusetts
TOBY ROTH, Wisconsin
BRUCE A. MORRISON, Connecticut
JIM SAXTON, New Jersey
PAUL E. KANJORSKI Pennsylvania
JOSEPH P. KENNEDY II, Massachusetts
DAVID E. PRICE, North Carolina
NANCY PELOSI, California
JIM McDERMOTT, Washington
RICHARD E. NEAL, Massachusetts
TOM LANTOS, California



Hearing held on:
August 14, 1990
August 14, 1990



Mayer, Martin, author, New York, New York
Meltzer, Allan H., GSIA, Carnegie-Mellon University
Mendelowitz, Allan I., director, International Trade, Energy and Finance
Issues, National Security and International Affairs Division, United States
General Accounting Office
Mulford, Hon. David C , Under Secretary of the Treasury for Internatiional
Schwartz, Anna J., research associate, National Bureau of Economic Research
Whalen, Christopher, senior vice president, The Whalen Company


Prepared statements:
Mayer, Martin
Meltzer, Allan H
Mendelowitz, Allan 1
Mulford, Hon. David C
Schwartz, Anna J
Whalen, Christopher



Miscellaneous newspaper articles


Tuesday, August 14, 1990

Washington, DC.
The committee met, pursuant to call, at 10 a.m., in room 2128,
Rayburn House Office Building, Hon. Henry B. Gonzalez [chairman
of the committee] presiding.
Present: Chairman Gonzalez.
The CHAIRMAN. The committee will please come to order.
I believe that one understands t h a t this is a period of time in
which the House or the Congress is in recess or adjournment, but
we had announced these hearings, and we also are aware of the
fact t h a t Members, especially those t h a t have families, have this
period of time probably before the kids go to school and only this
time, so that was understandable.
However, the fact remains t h a t this should not reflect on anybody not being here. We do expect a couple of Members this morning, but they are going to have homework. We will just send the
homework to wherever they are. That is, all the testimony gathered and transcript of the proceedings.
The relevance and the importance of the issue, plus the issues
that we discussed last week in the two hearings we had, one was
the subcommittee and the other was a full committee hearing, are
of such a nature, and this year being an election year and the brevity of the working days available to us, legislative working days,
makes it imperative t h a t at least a portion of August be devoted to
some formal work and hearings.
This morning's hearing I have called, and perhaps we can consider this as a sort of committee task force endeavor, though it is formally a committee hearing.
The reason I have called it is I and others are very concerned
about several aspects of the Treasury Department's conduct of
international financial policy. This has been true for some time.
It may not have been noticeable, but the record shows that no
sooner was this committee organized last year at the beginning of
the 101st Congress when we had our first hearing on this subject
It is also becoming increasingly clear t h a t the Treasury Department is willing to circumvent the congressional appropriation process called for under the Constitution in order to fund both foreign


currency intervention activities and certain parts, at least up to
now, of the Brady Plan.
The Treasury Department is spending hundreds of millions of
dollars, and these are taxpayer funds, and done behind closed
doors, without congressional authorization, in order to fund certain
aspects of the Brady Plan.
Today the GAO will testify that the Secretary of the Treasury
provides a $192 million subsidy to Mexico as part of the Mexico
commercial banking debt agreement concluded earlier this year.
GAO calls this action poor public policy and a circumvention of
the congressional appropriations process.
Treasury makes the commitment without informing anyone, and
they leave it to Congress, of course, to face paying the bills. Documents obtained by the committee make it clear that certain Treasury officials wanted so badly to make the first Brady Plan deal a
success, they were willing to put aside the best interests of the
American taxpayer by pricing zero coupon bonds, sold to Mexico at
a very favorable discount.
One memo written by a high ranking Treasury official argued
for the Mexico subsidy because, and I quote, "without it the deal
might collapse", end of quote.
Another Treasury memo actually stated, and I quote, "let's not
blow this one for the Secretary of the Treasury", end of quote.
But Congress never authorized this use of taxpayer funds. Treasury did not even notify the Congress about the details of the zero
pricing until after it was too late to stop.
As it now stands, there is apparently no limit on the amount of
taxpayer money the Treasury Department can pour into its LDC
debt initiative. I see little difference between FSLIC's $70 billion
back-door financing scheme, called the Southwest Plan, and the
Treasury Department's zero coupon pricing.
I cannot see how Congress can tolerate such back-door schemes
that can endlessly obligate the taxpayer money without any kind
of review, let alone formal approval.
The taxpayers should also be warned that another aspect of the
Brady Plan is exposing them to huge potential liability by shifting
the repayment risk associated with the debt owed to commercial
banks to the backs of the taxpayers.
The Brady Plan calls for the World Bank and IMF to provide
debtor nations with funds for commercial banking debt relief by
making available $25 billion in loans to debtor nations. In return
for this the debtor countries are supposed to undertake reforms
that will eventually make them credit-worthy and thus able to
repay their debts.
If the debtor nations prove unable to repay IMF and World Bank
loans, the capital of the IMF and the World Bank will be wiped
out, and they will need to be recapitalized. Since the United States
is by far the largest shareholder in these institutions, our taxpayers would be responsible for bearing the brunt of the burden for
bailing them out, no doubt to the tune of tens of billions of dollars.
The Exchange Stabilization Fund is yet another example of the
Treasury Department's willingness to circumvent the appropriations process, using back-door financing in order to engage in massive foreign exchange intervention activities.

There are two troubling aspects of Treasury management of ESF.
First, the Treasury Department, without clear legal authority, has
borrowed $10 billion from the Federal Reserve to fund in foreign
currency intervention activities. Three members of the Federal
Open Market Committee objected to the Federal Reserve making
such monies available to the ESF.
They are quoted in the March 1990 Open Market Committee
meetings as saying, and I quote, "The transactions in question,
which are repurchase agreements that have the characteristics of a
loan to Treasury, could be viewed as avoiding the congressional appropriations process called for under the Constitution", end of
Here again, the Treasury engages in the back-door financing
scheme in order to avoid the congressional appropriations process.
Another troubling aspect of the ESF operations is a complete
lack of public accountability surrounding the use of the funds.
The law actually states that, and I quote from it, "decisions of
the Treasury Secretary as to the use of ESF are final and may not
be reviewed by another officer or employee of the Government",
end of quote.
Now, this, of course, is a 51-year-old provision in the law, and in
order to understand its origin, and its existence even today, we
have to evoke that period of time, 1939, and the war clouds that
hung over the world and our desire to help England where the
Bank of England was intervening pretty heavily at the time, so one
could understand then. The first use of stabilization funds was back
in 1933.
Franklin Roosevelt had, according to his statements, a very limited and differently intended purse at the time. Now, we have tried
to have the fund audited by the GAO. Treasury, of course, appeals
to this provision in the law, and refuses on the basis that they are
not accountable to any other officer or agency of the Federal Government.
I find it indefensible that there is a $26 billion fund in the Government totally free from independent review.
To correct this, I will offer an amendment to H.R. 5153 that will
remove the flagrant, not subject to review, language from the ESF
The amendment will also give GAO audit authority over all ESF
operations and prohibit the Federal Reserve from lending in any
form money to the ESF.
The foreign currency holdings of the U.S. Government have increased from $10 billion in July of 1988 to over $46 billion today.
The need to hold such large amounts of foreign currency raises serious concerns about the effectiveness of foreign currency intervention as well as the risk to the taxpayer from intervention.
We need, of course, a thorough evaluation of foreign currency
intervention, including the cost to the taxpayer, the benefits to the
taxpayer, if any, as well as the risks associated with such operations.
The Congress should and must determine how these operations
will be funded, as well as which government agency should be responsible for this important monetary policy tool. The Treasury Department has repeatedly and inexplicably circumvented the con

gressional appropriations process by using back-door financing
schemes to fund several aspects of its international financing and
official operations.
The American public, which means the Congress, are left to pay
the bill and bear the risk of such actions. This hearing will begin to
explore these operations.
I want to thank our witnesses certainly for being here to answer
some of these questions, and as I said earlier, it is expected that
some of the Members will be arriving a little bit late during the
course of the hearing.
Our first witness is our Under Secretary of the Treasury, Mr.
Mulford, and we thank you, again, Mr. Mulford, for answering our
call, and for the statement which was given to us in time to study
and review, and you may proceed as you deem best.
Of course, as is the case always, your prepared statement will be
in the record as you submitted it.

Mr. MULFORD. Thank you, Mr. Chairman. I am very pleased to
be here today to have the chance to testify before you.
I would suggest that I make a summary statement of the testimony which is rather long and which, as you say, would be fully
incorporated in the record. If I may take about 10 minutes to summarize it, I would be grateful, Mr. Chairman.
The CHAIRMAN. Certainly, sir, without objection, so ordered.
Mr. MULFORD. The Treasury Department welcomes, Mr. Chairman, this opportunity to discuss with you issues relating to U.S.
intervention in the foreign exchange markets and the use of the
Exchange Stabilization Fund to finance Treasury's participation in
these and other foreign exchange operations; and, second, U.S. support of the Brady Plan measures to reduce the debt and debt service burden of debtor countries undertaking economic reforms.
I will first address the issues relating to the Exchange Stabilization Fund, including intervention.
In order to support and give meaning to a nation's international
economic and financial policy, its monetary authorities require a
mechanism to undertake foreign exchange operations. For the U.S.
Government that instrument is the Exchange Stabilization Fund in
the Department of the Treasury.
Globalization of the world economy and financial markets has
changed the nature and scope of strains on the balance of payments adjustment process. There is more latitude for exchange
rates to fluctuate, and indebtedness problems have arisen with serious implications for world financial markets.
The ESF, Exchange Stabilization Fund, is the U.S. Government's
only instrument providing the means for a rapid and flexible response to international financial disruption which can impact adversely on the U.S. economy. The ESF provides a powerful and
flexible means for the Secretary of the Treasury, with the approval
of the President, to support our obligations in the IMF, especially
those concerning orderly exchange arrangements and a stable
system of exchange rates.


The authorizing statute, which dates back to 1934, but which has
been amended several times, gives the Secretary broad authority to
deal in gold, foreign exchange, and other instruments of credit and
securities the Secretary considers necessary.
It also provides that his decisions are final and may not be reviewed by another officer or employee of the government. The history of the ESF reveals that Congress deliberately chose to place
the ESF under the exclusive control of the Secretary and to veil its
operations "in the greatest secrecy", unquote.
This is perhaps why Congress formulated the laws to emphasize
that the Secretary's decisions are final and may not be reviewed,
thereby reflecting congressional recognition of the need to be able
to react swiftly and decisively to international financial developments, including unforeseeable disturbances in the markets.
However, despite the provisions for confidentiality, Congress retains its prerogative for continuing review of the ESF's operations
through periodic reporting and the availability of Treasury officials
for public testimony and for informal briefings.
The statute imposes no limits on the volume or composition of
the ESF's assets, nor on how they are employed other than in a
manner consistent with our obligations in the IMF. Buying and
selling foreign exchange constitutes dealing in foreign exchange
and thus is clearly authorized by the statute. Such transactions
with the Federal Reserve fall in this category.
As specified in his authority to deal in instruments of credit and
securities, the Secretary may also borrow dollars or foreign exchange to the extent necessary to carry out the purposes of the
ESF. However, there is no statutory provision authorizing the Federal Reserve to lend to the ESF.
In this regard, another statute provides explicitly for the issuance by the Secretary of special drawing right certificates to the
Federal Reserve banks in exchange for cash in order to finance the
acquisition of SDRs or other ESF operations.
Secretaries of the Treasury are sensitive to the need to employ
their authority judiciously and to keep Congress informed of their
exercise of it and of the financial condition of the ESF, which is
extremely sound.
The ESF uses funds that were either originally appropriated or
obtained from a source other than the Treasury in accordance with
the basic legislation for ESF operations or other authorizing legislation, thus its operations do not require further appropriations, reflecting their revolving, monetary nature.
The ESF may at times wish to exchange foreign currencies it
holds for dollars. Warehousing entails a sale of foreign currencies
to the Federal Reserve and its simultaneous repurchase of those
currencies for future delivery at the same price. This is not a loan,
but an exchange of assets. The Secretary's basic authority to deal
in foreign exchange extends to warehousing operations. However,
the Federal Reserve is not obliged to agree to warehousing.
The Treasury and the Federal Reserve cooperate closely. The
Secretary is the principal financial officer of the United States, but
the Fed Chairman is closely involved. For instance, he is the alternate U.S. Governor in the IMF and participates in many other

international meetings and has frequent informal meetings with
the Secretary.
Treasury welcomes the Fed's role, both as a participant with its
own funds and as an advisor and agent for our operations. As fiscal
agent for the ESF, the New York Fed is legally obliged to execute
the ESF's operations at our direction. We do not have authority to
require the Fed to undertake operations or to block operations they
wish to undertake.
However, we are confident that various reports, correspondence
and testimony, as well as our experience over the years, provide assurances that the Fed's operations will be fully coordinated with
those of the Treasury.
Intervention is just one element of our broader economic policy.
While the extent of its effect is limited, it can have a positive effect
on market expectations, with important spill-over effects in domestic financial markets. Particularly when it is coordinated with actions by other countries, it can send signals that complement and
reinforce our broader efforts to coordinate economic policies among
the major industrialized countries.
It is not possible to estimate with any degree of confidence a
quantitative relationship between intervention and real economic
variables. Indeed, it is unlikely that a consistent relationship
A key question is whether market participants believe intervention is consistent with fundamental economic variables or signals
willingness to change policies. Prior to the Plaza Agreement in
1985, the dollar was seriously misaligned, rendering important sectors of U.S. industry uncompetitive and giving rise to protectionist
pressures and financial market instability.
The small amount of intervention after this agreement encouraged the exchange market to determine a value for the dollar that
was far more reflective of competitive realities. Since Plaza and
Louvre, intervention has played a role in the effort to maintain exchange rates at levels more consistent with underlying fundamentals.
Greater coordination of economic policies has had a considerable
success. Since 1985, more than 10 million jobs have been added to
the U.S. economy and increased competitiveness has helped reduce
the trade deficit about $60 billion from its 1987 peak.
Intervention sales of dollars when the dollars was under upward
pressure have helped limit or prevent erosion of this enhanced
competitiveness. Purchase of dollars when the dollar was under
downward pressure helped to keep inflation relatively subdued.
We recognize that unusual market forces may at times keep
intervention from being demonstrably successful. We also recognize
that the impact of intervention can dissipate over time and that in
the long run only more fundamental policies matter.
But in the short run, there can be significant dislocations resulting in job losses and distortions of trade and investment decisions.
Failure to intervene may thus impose economic costs.
The table appended to my testimony, Mr. Chairman, shows a
particularly large growth of foreign currency holdings in 1989 and
this year, reflecting intervention sales of dollars to resist upward
pressure on the dollar.


Although our holdings have grown considerably, they are relatively small when judged relative to the size of our economy. They
also constitute a much smaller portion of total international reserves than is the case for other countries.
The risk of substantial valuation losses is relatively small and is
more than compensated by the potential for using them to cushion
the domestic economy against a sharp depreciation of the dollar.
Also, there is no reason to believe that gains are less likely than
losses, and if any losses occur, they are likely to be relatively small
and offset only partly the large recent gains.
The ESF's gains or losses on foreign currencies affect the U.S.
budget only when they are realized as a result of sale of the currencies. The Fed's gains or losses, however, are reflected in the
monthly calculations of income which form the basis for payments
to the Treasury. The ESF's overall impact on the budget, which includes interest earnings and valuation gains or losses on SDR holdings, has been over $1 billion in each of the previous 3 fiscal years.
Congress initially decided, Mr. Chairman, that outside audits of
the ESF would undercut its effectiveness, and has maintained this
view through the many occasions when it has amended the underlying legislation.
Provision for GAO audit of the ESF's administrative expenses for
a period of time, until the Secretary's authority to pay such expenses was terminated, was limited in scope and did not derogate
from the underlying intention to give the Secretary broad and absolute discretion.
ESF audits are carried out by an office within the Treasury, currently the Office of Inspector General, which is independent of the
offices responsible for implementing foreign exchange operations.
The rationale for maintain confidentiality of ESF operations remains valid today. They largely entail transactions with foreign
monetary authorities and could tend to reveal those authorities'
own transactions.
We do provide substantial information about our operations.
Published information includes the report prepared every 3 months
by the New York Fed and the ESF annual report. We also provide
this committee, Mr. Chairman, with confidential monthly reports
on intervention and the monthly ESF financial statements.
We have not received any indication that the Congress finds this
information insufficient. Nevertheless, we will endeavor to respond
in an appropriate manner to any specific requests for further information, subject to the need to protect sensitive details.
The debt difficulties of developing countries, Mr. Chairman,
remain a serious global problem which requires cooperative efforts
on the part of all parties. The approach proposed by Secretary
Brady in the spring of 1989 to strengthen the debt strategy is intended to mobilize more effective external financial support for
debtor countries' efforts to reform their economies and achieve
lasting growth.
The strengthened strategy revolves around two themes, the need
to give greater emphasis to debt and debt service reduction, and
the need for debtor countries to implement sound economic policies
designed to encourage investment and flight capital repatriation.

The IMF and World Bank, as part of the new approach, now
allow a portion of these loans to be redirected to support debt and
debt service reduction by commercial banks and provide limited interest support for these transactions. Such funding is made available under legal authority found in Article V, section 3(a) of the
IMF Articles of Agreement and Article III, section 4(VII) of the
World Bank Charter. As a safeguard, such operations are subject to
detailed objective criteria developed and approved by the executive
boards of both institutions.
IMF and World Bank support has helped to encourage the successful conclusion of several debt and debt service reduction agreements with individual debtor countries. Six countries—Mexico, the
Philippines, Costa Rica, Chile, Venezuela and Morocco—have
reached agreements with commercial banks. These countries account for approximately 46 percent of the total commercial bank
debt outstanding of the major debtor countries.
The strengthened debt strategy also envisaged the use of zero
coupon bonds as collateral to back debt and debt service reduction
transactions. By statute, Congress has delegated the authority to
borrow money on the credit of the United States to the Secretary
of the Treasury with the approval of the President. Mexico purchased zero coupon bonds from several sources which included the
United States, Japan, Germany, Switzerland, France, Canada, and
the Netherlands.
The Treasury pricing decision for the zero coupon bond for
Mexico was based on a number of factors, including the size of the
Mexican transaction and the precedent of the 1987-1988 Mexican
purchase of zeros.
The earlier Mexican deal was priced off the coupon rate because
the strips market was deemed to lack sufficient depth to provide a
basis for pricing a transaction of that size. The 1990 Mexican transaction size of $30.2 billion equivalent was even larger relative to
the strips market.
The specific pricing formula for the 1990 Mexican transaction involved the average 30 year U.S. Treasury coupon borrowing rate
for the 3-day period ending January 5, 1990, plus a fee. The other
countries which sold Mexico's zero coupon bonds followed similar
pricing formulas.
Use of zero coupon bonds has not been an element of all the
agreements reached to date. We cannot predict the actual demand
for such bonds, since that will be driven by the timing of banking
agreements, the options available in those agreements, and banking interest in collateralized instruments.
The emphasis on debt reduction within the debt strategy has encouraged renewed vigor on the part of a number of debtor countries in undertaking difficult but needed reforms. Commercial
banks are actively engaged in debt and debt service reduction to
ease the burdens on debtor countries. Public resources to support
this process are being provided on a limited and efficient basis.
While much remains to be done, we are confident that we have a
strategy with the flexibility needed to meet the challenge facing us.
Thank you, Mr. Chairman.
[The prepared statement of Mr. Mulford can be found in the appendix.]

Mr. GONZALEZ. Thank you very much, Mr. Mulford.
You know, when we talk about intervention, I recall 1970, 1971, I
believe it was August 15, when President Nixon took us off of the
so-called gold exchange and, in effect, devalued the dollar by about
10 percent. Currencies and interaction between currencies were allowed to float.
I remember the justification as if it were today that the free
market would establish the value, but now why all of this intervention? You all have turned out to be the biggest interventionists in
the so-called free market so that obviously some of the discordant
voices of that day, which were pretty much subdued, were raising
those questions on the possibilities, but there is no getting around
The absence of congressional questions in the past is no justification for an allegation or a conclusion that there hasn't been concern about intervention. There has been.
It just hasn't been expressed from the levels that were noticeable. There have been concerns expressed all along.
Regarding the Mexico zero coupon bond pricing, there is no question that concerns were raised even in your inner circles. I have
copies of memorandums here directed to Acting Secretary Robson
from Robert R. Glauber, on the subject of pricing, to get down to
the specifics on the Mexico deal, pricing Mexican zero coupon
In discussions on Thursday, January 4, 1990, Mr. Glauber stated,
"We were essentially told by Mr. Mulford, if the Treasury bonds
were priced below 7.9 percent, the whole transaction would fall
apart. We have not independently verified this.
"Asssuming that you, therefore, wish such bonds to be priced at
7.9 percent, we wish the pricing to be explained as coupon less Vs
percent rather than based off strips, as you referred, as it will necessitate a much less defensible position of strips plus 10 basis
He went on, "Nevertheless, we have certain grave concerns that
remain: Market analysts, newspaper reporters and politicians, and
I guess that means some of us, can be expected to discern that such
pricing represents a contribution by the American taxpayer to
Mexico, and some might even characterize it as an unauthorized
appropriation. Treasury pricing and subsequent Brady Plan transaction must be done earlier in the process so we are not faced with
a virtual accomplished fact that is not fully responsive to financial
market realities. Accordingly, we expect to be included in such
transactions before any verbal understanding or definitive documentation is achieved."
So here we have the very people on the inside of Treasury. Now,
how can you expect Congress, after the fact, to be fully cognizant of
what has even happened after the fact and anything it would want
to do, even if it wanted to do it, but here you have in your innercouncils these voices that are high-placed voices, and I continue to
quote, this is not a deal done in a closet. It is done in public. There
is truth in the world. The market will calculate the difference between the market price and what we charge Mexico if we sell the
zeros to Mexico below market price.

The amount of concession enhancement or subsidy, call it what
you will, will be known to all.
The Secretary and you will have to explain to the press and to
Congress why Treasury gave U.S. taxpayer money to Mexico. There
may be good global political reasons, but they will have to be fully
explained against the size of the subsidy.
We realize the sensitivity of the political aspect, but the central
issue here is far more important and outweighs, and that is exactly
what the fundamental question is confronting our Nation, the continuing basic question still unanswered is what we have seen so
sadly in the case of the so-called S&L crisis now.
Just a few weeks ago we thought we had a crisis, judging by the
sustained interest in approaching some resolution, why you would
think there was no crisis, but that is still the question that I feel is
Otherwise, we can get ourselves all we want to, but we do not
have a viable constitutional system of checks and balances. How
could an agency such as the Home Loan Bank Board have committed the Treasury to $55 billion without going through the authorization and appropriation process?
The President can't do it except in this case where he gives his
approval premature to the Treasury's action.
The Congress can't do it. That question has to be answered
sooner or later.
It hasn't been.
Now, what was happening then when all the deals were being
done in that area?
All the Congress got until January 10, 1989, were press releases,
and this is pretty much what you get when you announce the
Mexico deal. Now, the experts raise a question, and then some in
the Congress are asked those questions, and this is what we are
trying to do.
We are trying to see how we can answer them. Now, how important was the Mexico deal? That is, to do it in the manner and in
the form that it was done, to the success of the Brady Plan in your
Mr. MULFORD. The Mexican deal was a very important deal in
and of itself because Mexico is a very important country. The resolution of Mexico's debt problem is very important for Mexico, for
the United States, and in general for the world financial system.
The financing package was an important transaction, and Mexico
has been an important participant in the debt strategy since its
problem first arose in 1982. problem, Now it looks like Mexico is
making reasonable progress as a result of its commitment to basic
economic reforms to improve its situation very substantially.
The CHAIRMAN. Well, but still in all, given the fact, of course,
Mexico is important but you have a series of nations right behind
Mexico, some of them I would say relatively important. Are we
going to handle them and this debt restructuring in the same identical manner?
Mr. MULFORD. AS I mentioned in my testimony, there have been
six countries which have reached agreements with banks using elements of the so-called Brady Plan in their negotiations. The main

point, Mr. Chairman, is t h a t each of those deals is structured differently.
We don't expect deals to be identical. We expect them to be
either very different from one another or in some cases relatively
similar, but not identical. It depends on each country's circumstances, the profile of the debt situation, and the views of the
banks. There will be some deals t h a t are similar to the Mexican
deal, but so far there has only been one other deal t h a t involves
the use of zero coupon bonds issued by the Treasury—Venezuela.
The other four transactions do not make use of zero coupon
bonds at all, but they do make use of the other elements of the
Brady Plan.
The CHAIRMAN. Not thus far, but now, isn't Venezuela asking
pretty much for the same treatment as Mexico got?
Mr. MULFORD. We have had no request from Venezuela as yet
t h a t I am aware of about the zero coupon bonds. We do know from
their negotiations with the banks, which are nearing conclusion,
they plan to use zero coupon bonds. Presumably when t h a t deal is
finally agreed and all the banks in the syndicate have returned to
the Venezuelans with their responses to the proposal that has been
agreed between Venezuela and the lead banks, we would then
expect the Venezuelans to indicate to us their plans for using zero
coupon bonds.
The CHAIRMAN. You use Mexico, intending to mean Venezuela
just awhile ago. You said when Mexico
Mr. MULFORD. I am sorry.
The CHAIRMAN. I was sure t h a t is what you meant, but I wanted
to corroborate.
Mr. MULFORD. That is right.
The CHAIRMAN. A S I see it, it would be difficult to expect debtors
not to seek the same relief sooner or later, but in the meanwhile,
you also create an anomaly t h a t I think, again, Mr. Glauber pointed out in another memorandum in which he says, as background
for today's meeting, I want to provide some additional data and
emphasize a few important points, one, pricing terms for Mexico
more favorable t h a n those accorded domestic entities for similar
tailor-made securities. That is to our States.
Our States would love to get the same kind of terms as Mexico
got, wouldn't you say? But they are not.
Mr. MULFORD. A S I understand it, you are referring to what we
call the SLUGS Program for States and local governments. Those
are securities with coupons. They are not zero coupon securities in
those cases.
The CHAIRMAN. I know that.
Mr. MULFORD. It is a different transaction.
The CHAIRMAN. Well, it may be, but I am sure they would love to
have the same benefits as the Mexico deal.
Mr. MULFORD. I don't think it is really relevant in their case, Mr.
The CHAIRMAN. Well, I will give you another example.
This is from, I believe, the Wall Street Journal. It looks like January 12, S&L bailout agency asked to be treated like debtor nation,
dateline, Washington.

If they do it for Mexico, why not the savings and loan industry?
The Resolution Funding Corp., REFCORP, set up by Congress to finance the savings and loan industry bailout wants to buy zero
coupon bonds from the Treasury at the same cut rate price the
Treasury gave to Mexico.
Quote, "We have asked them to give us the same deal, said
Austin Dowling, Chief Operation Office of the Corporation. It certainly doesn't seem fair to us for Mexico to pay a lower price. You
can't get around that." Those are the sort of anomalies t h a t arise
when we kind of bend things. Of course, I think t h a t when you
have accountability, those questions are asked before, not after the
fact, and this is the reason for the basic concern t h a t some of us
have expressed and continue to express and will in the future.
Now, this debate t h a t obviously was going on between the intraTreasury officials, those arguing t h a t Mr. Glauber and I just read
awhile ago reflecting his position, you obviously would be arguing
the other position, which is what prevailed, is that correct?
Mr. MULFORD. Mr. Chairman, may I just take a moment and ask
for some guidance from you?
You are making a number of remarks here t h a t show very clearly t h a t we are talking about a very complex issue in technical
The CHAIRMAN. That is right.
Mr. MULFORD. And maybe it would be helpful if I gave you a
brief run-through of t h a t issue so t h a t your questions can be put in
t h a t context.
Would t h a t be helpful if I did t h a t or do you want to proceed on
a basis where
The CHAIRMAN. I think you are being condescending there.
Mr. MULFORD. I am not being condescending, Mr. Chairman.
The CHAIRMAN. I think you are.
I think this subject matter isn't t h a t esoteric. I think the simple
facts are t h a t we had a very special arrangement here. The beneficiary was the Republic of Mexico, and the payee, the payor was the
U.S. Treasury or the U.S. taxpayer.
Now, I don't think we have to get involved in financing jargon to
say t h a t it is t h a t complicated to be unperceived. I think the basic
facts are there, they are established, they have been reported.
We have had quite a number of reports in the press and in the
financial pages of some of the outstanding financial newspapers of
our country, this isn't a seminar or a briefing.
This is a hearing in which we are seeking and eliciting testimony
in order to form judgment as to how to legislate and the need for
It is our intention to offer an amendment, and even though we
had supporting testimony, the purpose of these hearings is to lay
the predicate on a knowledgeable basis for legislation, not financial
knowledge, knowledge of financial intricacies.
Mr. MULFORD. Mr. Chairman, may I then respond in simple
The CHAIRMAN. Absolutely.
Mr. MULFORD. Let me just make two statements.
The CHAIRMAN. Please feel free to do so. I didn't want to cut you


I just wanted to make sure that I didn't get into a seminar.
Mr. MULFORD. Well, I wasn't proposing to conduct a seminar.
Let's stay off the technical issues for a moment, but let me make
some simple points. The first simple point is that there was no subsidy to Mexico in the pricing of the zeros.
The second simple point is that the U.S. taxpayer enjoyed a substantial advantage from the pricing of the Mexican transaction
compared to the cost at which that money which Mexico invested
in the United States would have been raised in the market by the
Treasury. Those are two simple points that show you that there are
other opinions and judgments than the ones that you have read to
The CHAIRMAN. Well, I see here that we have a very, very fundamental
Mr. MULFORD. We do.

The CHAIRMAN. Difference as to interpretation as to what has
happened here. You insist that Mexico received no subsidy.
Mr. MULFORD. That is correct.
The CHAIRMAN. Even though Mexico didn't go to the market.
Why not?
Mr. MULFORD. Well, Mexico
The CHAIRMAN. Why this sweet deal?
Mr. MULFORD. Well, Mexico didn't go to the market for reasons
that are rather technical. I would like to go through those reasons
this morning if we could. There are good reasons Mexico didn't go
to the market.
Maybe it would be useful if I took a moment and summarized the
points that are relevant here.
The CHAIRMAN. If you feel it is necessary to explain that position, certainly, I will listen.
Mr. MULFORD. On a complex issue of this kind there are differences of opinion, both inside the Treasury, in the markets, among
academics and probably among Members of Congress.
There is a wide range of opinions on this matter because it is
technically complicated. There are a number of possible options
and benchmarks that could have been used.
There are different methods of pricing that could have been applied to this transaction.
I think we have to take that as a given. As long as that is true,
there are obviously going to be different points of view.
I think a key determinant, Mr. Chairman, in making an assessment is to determine what the basis is that you choose for pricing
such an issue. In this case, I would suggest that there were two imperfect benchmarks.
One was the so-called strips market, and the other is the socalled Treasury 30-year coupon market.
I say that neither of these two benchmarks is perfect for the job
of pricing this particular transaction.
If you are governed in your approach by the comparability of the
instrument involved, then you would move towards using the strips
market as the benclpnark.
If you are governed by the actual cost of money, of this money to
the taxpayer of the United States, then you would move towards
the coupon market. Those are two very simple differentiations.

Now, if you choose the comparability of the instrument approach
and move toward the strips market, you have some fundamental
problems to deal with. In our opinion these problems made it unlikely or inappropriate to use that solution.
One problem is that, in the regular Treasury market, there is no
identical instrument to the strips issue or to the proposed Mexican
zero issue. The reason is that there is not in the regular Treasury
market a zero instrument that is issued directly by the Treasury.
The only instruments out there are strips that are a derivative of
a market operation.
In other words, their price in the market is affected by their cost
of production, the way in which those instruments are developed.
The Treasury issues a 30 year coupon and the market strips them
into one corpus piece, and in this case, 60 coupon pieces. Those instruments are all out there in the market, and the relationship between the various pieces of paper influences, in this case, the value
of the long-term 30 year corpus. That is a problem that presents a
distortion in the strips market that is very significant.
Second, there was the great size of the Mexican transaction. The
size of the Mexican transaction, at about $30 billion, represented a
substantial amount that was almost half the total size of the zero
market outstanding in Treasury securities. As anybody in the financing business knows, you cannot bring a new issue into a
market whose size is about half the volume of all the paper outstanding.
That is simply not possible to do effectively without affecting the
price. That is the second problem.
A third problem is that the Mexican zeros have limitations on
them that are not found on Treasury strips. The Mexicans are not
free to use those bonds as they wish.
They don't have full liquidity, and, therefore, they are different
from the Treasury strips outstanding.
Finally, and I think this is a very, very compelling point, it is
widely agreed that if the Treasury itself were to issue large
amounts of zero coupon bonds directly into the market as a part of
its regular financing program, the yield differences between the
strips and the Treasury coupons would disappear for all practical
purposes. Therefore, you wouldn't have the anomaly between the
two benchmarks.
So if you look at the strips market, you are looking at a market
which has major distortions, major shortfalls as an appropriate
If you turn to the 30 year coupon market, that has limitations as
well, because that instrument is different from the zero coupon
bond. It is a different instrument. We acknowledge that.
However, the advantage of using the 30 year coupon market is
that this is the market the Treasury uses to raise 30 year money.
When Mexico is buying our Treasury securities, we forget that
Mexico is investing $3 billion of cash in the United States.
We weren't just doing a transaction for them. They were investing approximately $3 billion of cash in the United States. That enabled us to avoid raising that money in the regular Treasury
market. From the taxpayer's standpoint, the Treasury in this case,
instead of paying 8.05 in the coupon market to finance our deficit,

picked up over $3 billion at 7.92. Therefore, the taxpayer obtained
an advantage in excess of $100 million in comparison to what it
would have cost the Treasury to raise that $3 billion in the market.
On that benchmark, you have a very sound basis for saying that
the taxpayer is getting an advantage. He is not giving a subsidy
because the rate at which financing would normally be raised
would have been done at 8.05, and the Mexican deal was done at
Now, this doesn't satisfy some people of a technical bent who are
troubled by the fact that the two instruments are not, strictly
speaking, identical instruments. As I have already said, none of the
possible benchmarks are quite identical anyway.
And the other argument ignores the market—the practical
market fact that you simply cannot say to the Mexicans, go into
the market and try to do the transaction yourself. You would completely disrupt the market, whether it was a Mexican transaction
or any other transaction of that size.
Finally, Mr. Chairman, I think it's relevant that we sought the
views of other governments on how they would approach the pricing of their zero coupon bonds in their currencies. All had a similar
view about the pricing, namely to price against coupon securities in
their market.
Frankly, that was the view we got from most investment bankers
we spoke to. My point here is to say it was a highly complex transaction. There are differences of opinion—differences of opinion in
the Treasury; and in the end, the Secretary of the Treasury made
the decision himself.
I think it's possible to isolate what his key considerations were,
and I would be happy to do that later if you wish. That, I think,
gives the background more broadly than is presented, for example,
in the Wall Street Journal, which is just one side of the story, or in
the General Accounting Office testimony, which is inadequate in
several respects and very selective in its use of information.
Chairman GONZALEZ. Well, you will pardon me for saying so,
either way you go, strip or zero, been stripped and zero means goes
against, in my jargon; taxpayer didn't benefit as you are trying to
picture it.
You may very cavalierly dismiss GAO, but I think the facts
speak for themselves. And you can involve yourself in the intricacies and difficulties and the maze of financial jargon, but you still
have to come back to simple arithmetic.
Mr. MULFORD. Yes, Mr. Chairman, the simple arithmetic is the
taxpayer got an advantage of Vs, and Mexico didn't get a subsidy.
That is the simple rendition.
Chairman GONZALEZ. Well, I'm certainly not in a position to try
to persuade you to change your interpretation. The fact is that our
oversight arm, the GAO, tells us that the Secretary's decision, the
price of zero is based on the coupon bond rate resulting in an effective subsidy of Mexico of about $129 million as compared to the
price for the zero based on the yield for strips.
You can get the statistics, and you have your options. We have
them here. Mexican shortfall given yields at key dates. One strip
or coupon minus V* of 1 percent. Mexican date deal July 23, 7.9.

Mexican request on zeroes August 15, 7.91. Even of RefCorp survey,
October 26, 7.64. November 30, 7.65 percent.
Shortfall 44, 4115, 16, 2020, option two, strips minus Vs of 1 percent. Mexican bank deal date July 23rd, 7.78 percent. Mexican request of zero, August 15 of 7.79 percent.
End of RefCorp survey, October 26, 7.51. November 30, 7.5.
Option three, strips minus Vi of 1 percent.
Mexican bank deal July 23, 7.65 percent. On July 23 was the
Mexican bank deal date. Mexican request on zeroes August 15, 7.6
End of RefCorp survey October 26, 7.39 percent.
Yes, these reflect the current estimate of bank choices 44 percent
for bond, 15 percent for new money, and we can use all of t h a t
jargon. The point, I think, is t h a t we have a very, very serious
question t h a t we must resolve. We welcome your interpretation
and your reasons for the decision, but we are going to h e a r from
other witnesses as well.
We will submit specific questions in writing in order not to
unduly tire you this morning.
Mr. MULFORD. Mr. Chairman, if I could say so
Chairman GONZALEZ. Absolutely.
Mr. MULFORD. The question of the subsidy which you touched on
and which the GAO touched on, as I tried to show in my brief rem a r k s here, depends upon the method of pricing t h a t you choose.
So if you choose one method, which in this case was thought not
to be appropriate by the Secretary of the Treasury, then you can
generate numbers that you claim were a subsidy.
You could even generate a third set of numbers t h a t would be in
disagreement with the GAO and make it look like the GAO's proposal produced a subsidy, even greater than the amount t h a t they
mentioned. So the numbers can be made to do various things.
My point here this morning is to explain t h a t from the standpoint of the taxpayer, one has to look at the cost of money to the
taxpayer at t h a t time. And t h a t cost, as I have explained, in the
real world of finance with the Treasury issuing its bonds was 8.05
percent. We took in money from Mexico at 7.92 percent, so it was
an advantage for the taxpayer.
I would just like to point out there is a very significant fact
about the RefCorp deal, which you mentioned in your comments a
moment ago, compared to Mexico. The REFCORP deal was only
$4V2 billion in face value, and as I have said, the Mexican deal was
over $30 billion and represented about half of the amount outstanding in the strips market.
So, obviously, the size of the transactions is an important point
Chairman GONZALEZ. I believe the basic issue t h a t we confront,
regardless of how you can rationalize, it's not the Secretary of the
Treasury's right, only the Congress has the constitutional responsibility to appropriate; and in effect, this was tantamount to an appropriation. That is our basic point.
It's not for the Secretary to decide, yes, in his opinion, given the
circumstances and the political weight of his plan in balance to
make X decisions or Y decisions t h a t call upon outlays. That is the
Congress' constitutional prerogative and responsibility.

Mr. MULFORD. I can assure you, Mr. Chairman, if an appropriation had been necessary for this transaction, we would have come
to Congress to obtain it.
As I said, an appropriation was not required. There was no subsidy, and as the GAO report says, the Secretary of Treasury had the
legal authority to set the price for this transaction.
The Secretary has broad discretion to set price and other terms
of Treasury bonds in order to fund the national debt. That is what
the Secretary of the Treasury did in this case. There was no appropriation necessary. That is why we did not come and seek an appropriation.
Had there been, or if there were appropriations required for
other elements of the Brady Plan, obviously we would come and
seek those appropriations from the Congress.
Chairman GONZALEZ. Then you would have debate, and you
would have delay.
Did Mexico need more money than was originally anticipated?
Mr. MULFORD. You mentioned the question of a shortfall earlier
in your comments. There were many reports during the period
from roughly early September through the end of the year as the
deal was coming together, interest rates were moving around, and
market conditions were changing.
There were many reports of a possible shortfall in the Mexican
transaction. I think the simple fact about all shortfall points on the
Mexican transaction is that in any case shortfalls were generated
by the pattern of demand from the banks for the instruments that
had been proposed in the deal, regardless of the interest rate levels
or cost of money.
The interest rates and cost of money were not irrelevant to the
transaction, but it's not the main source that generated the shortfall concerns. And in the end, Mr. Chairman, those shortfall numbers to the extent they existed were never significant enough to
unhinge the $50 billion Mexican deal.
Chairman GONZALEZ. Well, I will repeat in a certain way, accept
in a different form—how important was the pricing of the zero
coupon bonds to the successful completion of the Mexico restructuring deal?
Mr. MULFORD. What was important was to get them priced—the
level of the pricing was not critical to the success of the deal. The
success of the deal necessitated the provision of the bond, but the
deal did not depend on the pricing of the zero coupon bonds.
The deal coming together was generated by a wide range of other
factors, including the pattern of demand for the various options
available. That is what brought the deal together.
Chairman GONZALEZ. Well, the point is that you obviously have
calculated different pricing options in their relation to the shortfall?
Mr. MULFORD. Certainly, we always calculate the pricing options.
Chairman GONZALEZ. With relation to the Mexican shortfall?
Mr. MULFORD. Not in relation to the Mexican shortfall. We didn't
sit down with the shortfall as the item that had to be resolved by a
pricing decision. But the shortfall that was there, that was being
discussed in the press and by others, was obviously a factor that
could not be resolved until the zeroes had been priced. Then

Mexico and the banks could sit down and sort out whatever shortfalls they had between them.
But the shortfall
Chairman GONZALEZ. I imagine the banks were delighted. We are
talking about the taxpayers. That is where we come from.
Mr. MULFORD. The taxpayers should be very pleased.
Chairman GONZALEZ. That may be your opinion, but we feel a
little bit different, and we are concerned. We think what you have
here is an operation that is still open-ended.
Mr. MULFORD. In what sense, Mr. Chairman?
Chairman GONZALEZ. There is no question we cannot attack your
legal right, but how many times will you resort to that legal right,
without accountability to the Congress and the processes of authorization and appropriation? That is the central issue.
Sure Mexico is important; who says it isn't? It's our next-door
neighbor. I come from a Mexican background, but I never felt that
we had to give the family jewels in order to prove we were good
Mr. MULFORD. We didn't give the family jewels.
Chairman GONZALEZ. I don't see how we can avoid the fact that
we did dip into the Treasury, short of going through the appropriation process, as Mr. Glauber was arguing. I know that his view
didn't prevail, and who am I to judge? That is your decision over
there in Treasury.
What we are most importantly concerned about is the openended necessary possibility to these decisions in the future. The
Congress ultimately is going to have to provide the funding, one
way or the other, and ultimately does this mean that we will end
up in actually subsidizing the banks in their overhang on the debts
they have incurred?
Mr. MULFORD. Mr. Chairman, we have not subsidized the banks.
I really cannot understand why the simple arithmetic is brushed
aside. The United States raised $3 billion in cash from Mexico at
7.92. On that same day, if it had raised that cash in the market, it
would have paid 8.05.
Now that may leave dissatisfaction in the minds of technicians
for the reasons I have tried to explain here. But in the kind of
simple political and financial terms you are talking about subsidies, it's clear the taxpayers benefited to the extent of over a hundred million dollars on that day, over and above what it would
have cost to raise this money in our market at 8.05. That is the
only technique used by the Treasury to raise 30-year money.
So 30-year money, approximately $3 billion from Mexico, in cash,
was raised at 7.92, instead of 8.05 in the market. How can that be a
subsidy? That is impossible. That is an advantage for the taxpayer.
There is no doubt of that in my mind, whatsoever.
Chairman GONZALEZ. Well, you could argue the same way with
the cost of the S&L deals. You could say the taxpayer was a lead
cause; they saved money by entering into all of these deals, instead
of having to bankrupt the insurance fund, pay out, close down, pay
out. What is the difference here? Aren't we kind of gilding the lily
here a little bit, Mr. Under Secretary?
Mr. MULFORD. It's different, and it's a very straightforward proposition. Mr. Chairman, with regard to the future, I have already in

dicated to you that each of the deals done by debtor countries are
different, and obviously, not every deal will use Treasury zeros. Obviously we will look at each transaction on its own merits and price
it accordingly.
We will take into account all the factors that I described here;
the size of the issue, the condition of the market, the type of benchmark that would seem to be appropriate at that time. All this with
the interest of the taxpayer in mind, the interest of Congress in
mind, and certainly not, Mr. Chairman, to produce a subsidy for
foreign governments.
We do not believe in producing subsidies for foreign governments. The entire debt strategy is an indication that our efforts
have been devoted to curing this problem without recourse to taxpayers' funds.
Chairman GONZALEZ. It's far from resolved; I think you will
admit that. And the point is—and I don't want to repeat what I
said in my opening statement, that you have announced plans for
the future in the IMF World Bank mechanism.
As I pointed out in the opening statement, we are the heaviest
shareholders there. So this is where we are coming from. I don't
mean to—I am not being necessarily critical. I understand that you
are rationalizing your position, but you have got to understand
that we are also aware of the statements that have been made as
to future intentions with respect to these other routes.
We have had a difficult time legislatively speaking when it
comes to eliciting from Congress the necessary funds for the replenishment of these institutions, so I don't think any one of us is
necessarily deliberately trying to cheat.
I am saying that these are judgment decisions over which very
reasonable and knowledgeable minds have very serious and conflicting viewpoints and conclusions.
I didn't mean to get into an argument with you, because I think
it's fruitless. Second, it doesn't produce anything that would be of
greater value to our understanding what we have to do legislativelyIt does contribute to the evaluation of the type of legislation that
we could consider. So I have a couple more questions. I think the
reasonable thing would be to submit those in writing as well as
some of the other Members that have informed me, even though
they couldn't be here, they will be submitting some questions in
Mr. MULFOKD. All right, Mr. Chairman.
Chairman GONZALEZ. I don't mean to close you out. If you have
any additional statements to make or questions you want to direct
to me, feel free to do so.
Mr. MULFORD. I would like to touch on just two points before concluding, which came up during the course of your remarks.
One is on the question of the appropriations to the IMF and
World Bank. The IMF and World Bank are co-participants in world
international financial affairs, including development around the
world, and the smooth functioning of international exchange markets.
Also, they are important in the debt problem. But I want to
assure you, Mr. Chairman, and point out to you for your comfort,


with the passage of time since 1982 when the debt crisis first
emerged, neither the World Bank nor IMF have rescheduled or
rolled over their debt in the way commercial banks have been
forced to do.
The resources provided as capital by the United States to those
two institutions are being used in a broad range of programs in
those institutions. Among those programs are those that relate to
the debt strategy, but they are not exclusively aimed at tje strategyIn those cases, what we have done is redirect the use of certain
resources that would have flowed to these countries anyway more
creatively to help support negotiations with the banks to reduce
debt and debt service.
This is, I think, a sound use of those resources, and it does result
in the banks taking losses. So the banks are not being bailed out,
as you suggested. They are being placed in a position where they
have to negotiate, and they take some pretty uncomfortable losses
in the process.
So I hope that by testifying and by being willing to come visit
you and other members of the committee privately, we can assure
you that although there are differences on very complex issues, we
can find a basis for broad understanding.
My second point, Mr. Chairman, refers to a comment—a question
I thought I heard you ask at the very beginning with regard to
intervention. You indicated your view on intervention and suggested that this is something that has materialized in a growing fashion since 1971 and is in some way doubtful or suspicious, at least,
not appropriate.
I want to assure you that—as I said in my testimony, intervention is an appropriate tool. It's an important tool. It's sometimes
overemphasized—too much attention is given to it among all the
other economic policies. It's but one policy among many, that we
use in the international policy coordination area, but it's an important policy.
It has its limitations, as I said; but it has its uses. You will hear
a wide variety of opinions this morning, some of them very negative. It's, we think, a very useful instrument.
I want to point out it was in use before 1971, in the monetary
system. It's been a normal part of the system for many, many
years; and second, I wanted to draw your attention, Mr. Chairman,
to the 1988 Trade Bill, which has in it language which I just would
like to read on the question of intervention. It s very short.
It's in Title III, Subtitle A, paragraph marked number 9. It
says—and this is the law, the trade law, "Under appropriate circumstances, intervention by the United States in foreign exchange
markets, as a part of a coordinated international strategic intervention effort, could produce more orderly adjustment of foreign
exchange markets and in combination with necessary macroeccnomic policy changes assist adjustment toward a more appropriate
and sustainable balance of current account."
So, that is a very strong preference expressed by the Congress for
us to intervene within a coordinated pattern as a part of our overall economic policy coordination process, and I didn't want to leave
the impression here that we are off on our own.

We think that we are responding to congressional views on this
issue and that we are conducting policy coordination exercises, reporting regularly to a subcommittee of this committee on foreign
exchange markets and intervention, and I think it's been a constructive exercise.
I just wanted to get that out before you, because we appreciate
the opportunity to have that kind of liaison with the committee.
Chairman GONZALEZ. The 1988 act you referred to was one that
was involved in the reconciliation process. And it involved some
other committees that had much more of a contribution in that respect, than even the Banking Committee.
However, be that as it might, if you have the time, I would like
to now address your seriatim. I think you first discussed the question of intervention or was that the second point?
Mr. MULFORD. The second point I made was on intervention.
The first point was about the contribution of capital to the institutions and the debt strategy.
Chairman GONZALEZ. With respect to the first—we will go seriatim, the institutions. I think you are well acquainted with the fact
that there has been some concern about diverting from the basic
intent and purpose of the World Bank, precisely along these lines—
diverging it from economic into financial arm, the IMF was supposed to be exclusively in operation, so that there has been some
concern expressed about how the World Bank has diverted from
it's original economic improvement and and so forth, infrastructures and so forth.
With respect to the second, on intervention, I did mention the
very serious question raised by three Members of the open market
committee, and the reasons they gave, and that is that they questioned the usefulness of that tool in today's world.
Now, these are not politicians. These are not untutored minds
like mine. These are guys sitting there in the open market committee making financial policy, determining among other things what
Treasuries will be worth. So there is—you must admit, basis for
very serious concern and very serious difference of opinion that has
emanated only in the last few years.
Also, I think you will accept the fact that from the level of about
some $10 billion in foreign currency reserves, just about 2 years
ago—maybe less, you now have better than $46 billion in foreign
currency reserves, in a very unstable world in which our holdings
can appreciate or depreciate as the will of the whim of these currency markets dictate.
So I wanted to make the point that these are not any kind of
demagogic efforts—also, anybody will tell you that there is no political mileage in this. If there was, you would see about half of these
seats filled.
I was chairman of the subcommittee on what was then known as
the international finance, for 10 years, and I became chairman because the fellow ahead of me said, Henry, I am going to pass it up
because there is no political mileage in all of this.
But to me, the fact that we would have an exposure of the Treasury in a manner that is not consistent with the law, the Constitution, is vital enough political mileage if we are going to be worthy

of discharging this trust t h a t has been placed upon us by the
people we represent.
So I just wanted to remove any doubt t h a t there would be any
personal or political or reason for the questions raised or the
reason for the hearings.
We have been exposed enough over the course of years to some
of this where we have some appreciable—not an expertise or an expert's knowledge, but some appreciable factor—and above all, we
are very conscious of the trust and the responsibility t h a t rests
upon us, when there is or there isn't political mileage.
I think the facts also revealed—and we had testimony last year
and earlier this year—in which we are not out of the woods in the
so-called foreign debt. I think t h a t there has been a profound and
fundamental overlooking of history in this cavalier m a n n e r in
which our chief banks went into this so-called sovereign debt considering sovereign debt sacrosanct or very safe.
History will show you t h a t has been t h e most vulnerable. Those
are the debts that have not been paid back, sovereign debts. You
have to review the history of all the span, French and European
And so there is reason for concern. It's not a temporary or an
evanescent thing with us. And there are other Members t h a t are
equally concerned. I am not trying to say I am the only one.
I wanted to t h a n k you, though, and you are entitled to our gratitude to our response fco your invitation under these circumstances.
And I can assure you every Member will have a copy of your testimony, and they will have a copy of the transcript for their study.
And we will hope and look forward to a continued and sustained
communication—line of communication, and we welcome that.
Also, if you would be kind enough to convey our sincere thanks
to the Secretary.
Mr. MULFORD. I will do that.
Thank you, Mr. Chairman. I appreciate being here, and I do
think the dialogue we have with you and your subcommittees has
been very useful these past few years.
Obviously, these are issues t h a t are very complex. There are
wide ranges of opinion, it's quite clear. It's important to keep discussing these things. I hope we have continuing access to you and
your colleagues.
Thank you very much for allowing me to appear this morning.
Chairman GONZALEZ. Thank you.
Our next panel or witness is Mr. Allan Mendelowitz, who is the
Director of International Trade, Energy and Finance Issues, the
National Security and International Affairs Division of the U.S.
General Accounting Office.
Thank you very much, Mr. Mendelowitz. Once again, you have
been helpful. I know you have appeared before the subcommittee.
Of course, we are sitting as a full committee this morning, but we
want to t h a n k you once again.
We wanted to t h a n k you for your statement, which we have had
with plenty of time to read once again, and it will be incorporated
in the transcript as you gave it to us, and you may proceed as you
deem best.

Mr. MENDELOWTTZ. T h a n k you, Mr. Chairman. I will be delighted
to read a shortened statement orally and submit the full statement
for the record.
Before I begin, I would like to introduce Mr. Berel Spivack, who
is at my left, who is the Senior Economist in charge of the work we
undertook at your request.
Chairman GONZALEZ. Thank you very much.
Mr. MENDELOWTTZ. We are happy to be here this morning to discuss our review of Treasury's pricing of zero coupon bonds t h a t
were sold to Mexico in March 1990.
In addition, we are also commenting on proposals to extend
GAO's auditing authority to the Exchange Stabilization Fund.
The Treasury sale of zero coupon bonds to Mexico was part of
the restructuring of Mexico's commercial bank debt under the
"Brady Plan." The sale was a private placement to Mexico; that is,
the bonds were sold directly to Mexico at a negotiated price. A zero
pays all interest and principal, together in one payment at maturity, and thus it's sold at a deep discount from its face value.
To date, Treasury issued zeroes only five times. In contrast, a
coupon bond has multi semi-annual interest payments in addition
to the principal payment. The sale of coupon bonds at auction is a
usual way in which Treasury borrows medium and long-term.
However, dealers who trade Treasury securities have created an
equivalent to a zero called "strips." They create strips by separating coupon bonds' interest payments from each other and from the
bonds' principal and selling the rights of these payments straightly.
The United States encouraged negotiations between Mexico and
its commercial bank creditors t h a t culminated in the recent rescheduling. United States also encouraged the World Bank, the
International Monetary Funds, and others to lend Mexico funds.
Mexico received assistance in the following ways: Most of the
commercial banks exchange their Mexican loans for two types of
new Mexican Government bonds. One type had a face value that
was 35 percent lower t h a n the principal of the loans they replaced.
And the other types replaced the original loan's variable interest
rate with a lower fixed interest rate of 6.25 percent.
A few commercial banks provided new loans to Mexico, equal to
25 percent of their outstanding medium and long-term Mexican
The U.S. Treasury zeros discussed above are being used as collateral to secure the principals of new Mexican Government bonds.
Mexico can exchange these new bonds for about 93 percent of the
debt owed to foreign commercial banks.
The restructuring agreement also called for 18 months bond interest to be guaranteed by funds placed in an escrow account by
However, Mexico was to receive interest earned on this account.
When the agreement in principle was made on July 23, 1989, the


parties to negotiations expected that the principal and interest arrearages and guarantees would cost Mexico $7 billion.
During the 5 weeks preceding the pricing decision, the U.S. Department of Treasury had an intense and internal debate over the
proper pricing of the zeros that would be sold to Mexico. Central to
the debate was a disagreement over whether to base the price of
the zeroes on the strip rates or on the Treasury coupon bond rate.
The price of the zero is determined by its interest rate. The lower
the interest rate, the higher the price.
And during this time period, the yield on strips was about 25
basis points lower than the yield on coupon bonds. One side of the
debate called for selling the bonds at a price that was based on the
yield on strips. Similar bonds traded on U.S. markets arguing in
part this was the closest to a market price for the private placement.
The other side called for selling the zeroes at a lower price based
on the yield for 30-year coupon bonds arguing in part. In addition,
this side argued pricing the zeros based on the yield on strips
would endanger the restructuring agreement.
At a Treasury meeting on January 4, 1990, proponents of couponbased pricing argued that a price with a yield under 7.9 percent
would cause the whole transaction to fall apart. At a lower yield,
Mexico would not have the resources to complete the restructuring.
On January 5, 1990, the Secretary decided to price the zeroes
based on the 30-year coupon bond yield. Treasury used the interest
rate prevailing in the market on January 3 to January 5, 1990, less
Vs of 1 percent accommodation fee, which equaled 7.925 percent.
We have no official documents from the Secretary explaining the
rationale for his decision.
On March 28, 1990, the Treasury sold Mexico $30.2 billion in
zeroes at face value for $2.99 billion. A Treasury official told us
even after they were priced at 7.925 percent Mexico needed approximately $311 million more than had been expected when the
agreement in principle was reached in January-July 1989.
This shortfall arose because interest rates had declined, thus increasing the price of the zeroes and the bank chose a different mix
of options than had been expected.
Mexico covered this shortfall by contributing slightly less than
$100 million in additional reserves and by funding the escrow account somewhat differently than originally called for.
Considerable controversy has developed concerning the pricing of
these zero coupon bonds. As you requested, we reviewed the issue
and concluded that Treasury set a price for the bonds that involved
an effective subsidy of approximately $192 million.
In our view, the interest rates used to set the price of the zeroes
was indicated by comparable rates of interest which lowered the
price of the private placement.
We believe the Secretary of the Treasury had the legal authority
to set this price for the transaction under review. The Secretary
has broad discretion to set the price and other terms of Treasury
bonds in order to fund the national debt.
However, while it was in the Secretary's legal authority, we
think that the pricing decision was neither appropriate nor good
public policy. The Secretary's decision to price the zeroes based on


the coupon bond rate resulted in an effective subsidy of Mexico of
about 192 million as compared for the price of zeroes based on the
yield on strips.
I have to point out at this point, Mr. Chairman, we reviewed all
documents associated with this transaction based on Treasury providing us the information and ensuring us we had, in fact, seen all
We brought the necessaru analytical talent to bear to complete
the work, and I believe the estimate of 192 million of effective subsidy is both accurate and probably the only disinterested and unbiased number you are going to hear today.
There may be credible arguments that can be made to support a
U.S. Government financial contribution to the solution of the less
developed country debt crisis, and it's not clear whether the Mexican restructuring would have succeeded without some such contribution.
Nevertheless, we believe if Treasury wished to help Mexico, the
correct way would have been to obtain congressional approval
through the authorization and appropriations process rather than
with an effective subsidy provided to the underpricing of zeroes.
In the long run, this decision could set a precedent that would
cost the United States many times more than the 192 million. The
Mexico deal was the first in many agreements anticipated under
the Brady Plan. Foreign governments and commercial banks may
well expect the U.S. Government to contribute resources so that
their own concessions can be reduced.
Again, such contributions may be in our national interest, but
they ought to be funded through explicit congressional authorization.
Regarding the Exchange Stabilization Fund, we understand the
Treasury is concerned with the confidentiality with respect to the
information related of the transactions. We believe we can maintain that confidentiality as provided in law and as provided in legislation recently introduced, and which support the extension of
GAO's audit authority to also include the activities of the Exchange Stabilization Fund.
This concludes my summary comments, and would be happy to
try to answer any questions you might have.
[The prepared statement of Mr. Mendelowitz can be found in the
Chairman GONZALEZ. Well, first I must thank you most sincerely.
I happen to have unqualified admiration for the GAO generally,
and you specifically, for competency.
But you were here, I am sure, a while ago, and you heard the
Secretary say—I agree with you, what is tantamount to a subsidy
in effect was not, that actually the taxpayers benefited.
Apparently, as I gathered it from what he was explaining, the
Secretary was saying that you ignored the financial benefit of
Mexico's investment—I think he said what was 3 billion?

would Mexico invest if it's a debtor
nation and by all definitions was broke, unless the United States
loaned the $3 billion to begin with or somebody else did?
I wonder if you could elaborate on that?


Mr. MENDELOWITZ. Well, I think—and as everyone knows, Secretary Mulford is a fine financial analyst, but I must say his comments about accessing the pricing of the zero coupon bonds did
nothing to enhance that well deserved reputation.
I would say it was rather disingenious to try to turn the discussion of an effective subsidy of $192 million into a claim the American taxpayer benefited by about a hundred million dollars.
Let me give you what I think is an intuitive explanation with
what went on with respect to the pricing of the zeroes.
Take a car dealer who sells Chevrolets day in and day out, the
trucks arrive and deposit Chevrolets in the sales room. One day a
truck arrives and offloads a Cadillac. He looks at it and says, it's a
car, but it looks a little different. What should I sell if for?
And one of his salesmen stands up and says, a car's a car; let's
sell it for what we sell all our other cars, namely price it like a
Another salesman stands up and says, it's not a Chevrolet; it's
really something different. Let's go out and see what the world
charges for this different thing, for this Cadillac, and let's price it
the way the world prices it.
Well, basically, that was the argument in Treasury between pricing the zeroes on the coupon bond yield versus pricing the zeroes
on the strips yield. Our judgment is they used the inappropriate
measure and, as a result, underpriced the bond.
Second, with respect to the issue of the benefit to the American
taxpayer, the first thing—and Mr. Mulford knows how the national
debt is financed—the Treasury does not set out to find the national
debt with some fixed proportion of different maturities of debt.
They have a very sophisticated and very complex process in which
they are always looking at the market.
They are always looking at the yields on different maturities of
bonds, and they determine the maturity structure of new offerings
in a way that minimizes the cost to the American taxpayer.
Therefore, just to say that because Treasury was able to borrow
30 years at Ye of 1 percent less than the coupon yield means the
U.S. taxpayer received a benefit is not analytically defensible because Treasury would not have as an alternative gone out and necessarily borrowed 30-year coupon.
That is number one—if I can go back to number one, for example, on the same day Treasury was borrowing for Mexico at 7.925,
they could have borrowed 1 year at 7.905 and had an even lower
cost of borrowing. That is just an example of the point I was trying
to make.
Second, the sale of the zeroes was an accommodation for Mexico.
The United States obviously has a very strong interest in the success of Mexico restructuring. The United States had an interest in
moving along, helping out if it could, but the reality was we
weren't looking to lend or to borrow—excuse me—we were not
looking to borrow $3 billion at 30-year zero coupons. We have no
such instrument, other than specially tailored offerings to accommodate a specific need.
Mexico's alternative to having the Treasury accommodate their
need for the zero coupon bonds would have been to go to the strips'

market and buy strips that were comparable to the zero coupon
Now, if Mexico had done that, t h a t would have represented a tremendous increase in demand for zero coupons or strips. The price
of strips would have been bid up and Mexico would have paid substantially more t h a n it had paid or, in fact, would have paid if it
had used the strips price to buy the zero coupons from the Treasury.
For example, one estimate t h a t I saw predicted if Mexico went to
the strips market, it would have raised the price of strips to the
extent t h a t the yield would have fallen by a hundred basis points
over the then prevailing market price.
That means t h a t Mexico would have had to pay almost a billion
dollars more t h a n it paid to buy comparable instruments in the
strips market.
So I think that—we stand by our assessment, t h a t in fact there
was in effect a subsidy. We stand by our assessment t h a t the Treasury did not appropriately price the bonds. And we stand by our assessment t h a t the American taxpayer did not receive a benefit
from this transaction.
Chairman GONZALEZ. In other words, Treasury sold a Cadillac for
the price of a Chevrolet.

Chairman GONZALEZ. And call it what you will, by any standard
of definition, it amounted to a subsidy of 192—approximately.
Mr. MENDELOWITZ. That is our conclusion.
Chairman GONZALEZ. I had read some quotes from other Treasury officials in which obviously they deal with of paramount importance to some viability of the Brady Plan.
I think the Secretary answered their particular decision to financed as they did was essential to the successful—what they consider the successful completion of the Mexico restructure.
But where he, I think, kind of shaded things was where Mexico
was coming from. That is, did Mexico have or not have a shortfall
as it was entering into the negotiations, because then it would
seem to me t h a t whatever the U.S. did would have to be tailored to
that exigency, and this is where I think he didn't really give me a
very clear answer.
Mr. MENDELOWITZ. The time period between the agreement in
principle between Mexico and the banks and Treasury's decision
with respect to pricing the zeroes was about 6 months.
There was another period of about 3 months between Treasury's
decision on how to price the zeroes and the actual sale and the closing. We are dealing with a world in which financial variables are
constantly changing. Mexico's foreign currency reserves go up and
down with changes in the price of oil. They go up and down with
changes in repatriation of flight capital.
For example, the needs—the financial needs to close the deal
change depending upon what interest rates were prevailing in the
market at the time and how the banks ultimately chose to choose
amongst the menu of options they had with respect to granting
concessions for Mexico.


Basically, what analysts at Treasury determined after 6 months
had passed, following the agreement in principle, was that more resources would be needed by Mexico to close the deal.
Second, how large that shortfall and available resources was
could be very seriously affected by how we choose to price the
As I stated in my testimony, even pricing the zeroes off the
coupon bond yield left Mexico with a shortfall of about 300 million.
They were able to cover that shortfall by dipping a little bit more
into their national reserves and by changing the way in which they
met their escrow obligations for the interest payments.
However, it's unclear if, for example, we had priced off the strips
and the shortfall had jumped from about 300 million up to 500 million that Mexico would in fact had the resources to close the deal,
and it's unclear whether restructuring could have been successful.
Chairman GONZALEZ. The essential question, though, I think is
what you were addressing, and I think that is where we also come
from, and that is that as much as the Secretary has the legal ability, the methods and means and actions derived from those—from
that pattern, in effect, amount to a lack of accountability to the
Congress in the expenditure of actually public funds.
Is that a fair way to describe it?
Mr. MENDELOWITZ. I think that captures the spirit of the comments that we provided today. Basically, as I concluded in my
statement, while we believe the Secretary had the legal authority
to do what he did, it doesn't mean that he should have done it, and
it doesn't mean that it's good policy.
It doesn't mean that it should be done again in the future.
Chairman GONZALEZ. And it's a policy matter that should be inherent in the national policy making body, which is the Congress.
Mr. MENDELOWITZ. I think that is correct. The Constitution
places with the Congress the authority to appropriate funds. While
the Secretary had the legal authority to do what he did, the effect
of what he did was to provide a benefit to a foreign country or the
banks, depending on what incidents the benefits was determined to
And because we, in effect, provided this benefit, we think it's appropriate for the Present or the Secretary to come to the Congress
to receive approval for such undertakings.
Chairman GONZALEZ. The testimony to the effect that there is
some form of accountability by reports issued or reports available,
would you say that that was at best a most disingenous response
Mr. MENDELOWITZ. Considering with respect to the Mexico restructuring deal, if you receive a report from the Secretary in
which he tells you the American taxpayer received a net benefit,
and that is his report, I would say that is not a very effective way
of—for the Congress to receive information on which to conduct
oversight of such activities.
Chairman GONZALEZ. YOU are precisely right. Certainly we are
most grateful for GAO.
I have a couple of other questions, but actually they are not of
such consequence they have to be asked at this moment. I will
follow through and submit them.

[The information referred to can be found in the appendix.]
Chairman GONZALEZ. I wanted to thank you very much for your
constant help and cooperation, particularly with our staff. You
have been invaluable.
Mr. Spivack, do you have any observations or points that you
think ought to be made for the record?
Mr. SPIVACK. Nothing additional to add.
Chairman GONZALEZ. Thank you very much, sir.
If you have any additional comment, we will be glad to hear it.
Thank you very much.
Our next panel is composed of Professor Allan Meltzer, GSIA,
Carnegie-Mellon University; Dr. Anna J. Schwartz, National
Bureau of Economic Research; Martin Mayer, Author, New York,
New York; and Christopher Whalen, the Senior Vice President,
The Whalen Co..
Ladies and gentlemen, thank you very much. We are deeply
grateful. Particularly the testimony you gave us was most comprehensive, and it was given to us again in sufficient time to have
read it overnight and looked at it and analyzed and educated ourselves.
I understand, Mr. Meltzer, you have a plane to catch at 1:00 p.m.
Mr. MELTZER. I have an appointment at 1:30 here in the city. I
would like to be able to leave no later than 1.
Chairman GONZALEZ. IS there any objection if we recognize Mr.
Meltzer first? If not, then Mr. Meltzer, we will recognize you.
Mr. MELTZER. Thank you, Mr. Chairman.
It is a pleasure to appear again before this committee. Although
the issues today appear to be narrow and technical, in my judgment, they are not. Today's hearing touches on basic issues in economics, public policy, accountability, and the use of public funds.
In the past 2 years, and particularly in 1989, the amount of exchange market intervention has increased substantially, and the
balances held by the Treasury's Exchange Stabilization Fund and
by the Federal Reserve have reached unprecedented levels.
Part of the increase in the holdings of the Exchange Stabilization
Fund has been financed by loans from the Federal Reserve. These
loans are outside the budget process and have not been subject to
review or congressional authorization. Indeed, the business of intervention and its financing has, until today, proceeded without the
benefit of congressional authorization or oversight.
No public purpose has been achieved by recent exchange market
intervention that could not be achieved otherwise. Studies of exchange market intervention by virtually all economists and analysts show that exchange market intervention has no effect on exchange rates unless accompanied by a change in monetary policy.
This finding, replicated many times, has led analysts to distinguish between sterilized and unsterilized intervention. Sterilized
intervention is simply an exchange of domestic for foreign assets
on the Federal Reserve's balance sheet.

Unsterilized intervention occurs if the central bank increases or
decreases bank reserves and money as a consequence of its exchange market intervention.
The practical point to the distinction between sterilized and unsterilized intervention is this: The Federal Reserve can achieve in
its ordinary operations whatever can be accomplished by foreign
exchange market intervention. Unsterilized intervention differs insignificantly from domestic open market operations that change reserves and money; interest rates, exchange rates and money stock
will not be noticeably different if the same volume of reserves is
injected or removed by operations in the foreign exchange market
or in the domestic government securities market.
The operations in the exchange market are redundant for such
goals of policy as employment, output, or inflation. Nor does sterilized intervention alter our balance of trade or payments with foreigners.
If you compare the patterns in recent years, you reach three conclusions: First, intervention in the foreign exchange market
achieves nothing that cannot be achieved by domestic monetary operations. The monetary expansion that contributed to the devaluation of the dollar in 1986 was achieved principally by domestic operations.
Second, the principal way in which foreign exchange operations
and domestic monetary operations change the value of the dollar is
by changing the anticipated inflation rate.
If market participants believe that U.S. monetary policy has
become more inflationary relative to inflation in major countries,
the dollar falls. If they believe that monetary policy has become
less inflationary, the dollar rises.
Third, there is no close or reliable relationship between the size
or frequency of foreign exchange operations and changes in the
value of the dollar. The relatively large net foreign exchange purchases of 1989 had little effect on the dollar's external, value. The
much smaller net foreign exchange purchases of 1986 or 1985 were
accompanied by substantial dollar devaluation.
The committee's letter asks whether intervention has raised or
lowered the rate of inflation. My answer is that the excessive monetary growth of 1986 to reenforce the devaluation of the dollar
begun by market forces in March 1985 is a leading cause of the
higher inflation experienced in 1989 and 1990.
The growth of money at first drove down the value of the dollar.
With a lag, devaluation raised prices of imports and stimulated exports.
I might add that if it didn't do that, then it wouldn't do anything, With a lag, faster money growth encouraged domestic expansion also. Under the stimulus of monetary expansion and devaluation, growth of real output remained well above its trend rate of
growth in 1987 and 1986.
With a somewhat longer lag, monetary expansion and devaluation spilled over into a more rapid increase in consumer prices
and in unit labor costs in 1989 and in early 1990.
The Federal Reserve responded to the excessive money growth in
a timely way to avoid a return to a high inflation regime. Their

actions have now brought the economy to the edge of recession and
perhaps beyond.
The long-term effects of exchange rate changes on output, employment, standards of living and trade balance depend on whether
the exchange rate change is monetary or real.
Real exchange rate changes affect standards of living. A familiar
example is the increase in the Japanese standard of living as their
economy has grown and their exchange rate has appreciated
against virtually all currencies in the world.
Treasury and Federal Reserve operations in the foreign exchange
market would have no long-term real effects if inflation were
always neutral.
There are many reasons why inflation is not neutral in either
the short or the long term. The October 1987 stock market crash is
an example of a short-term real effect of unsterilized intervention
and exchange rate policy on the economy and the public.
Exchange rate policies are not the sole cause of the stock market
decline. I doubt that anyone will identify all of the causes, but exchange rate policy contributed importantly by creating conditions
under which interest rates rose and stock prices declined.
These conditions could have been avoided by permitting the exchange rate to adjust to market forces in 1986 and 1987. Intervention did not prevent the adjustment. It delayed it and increased the
The 1987 experience produced a dramatic result. The main lesson
should not be lost. Attempts to control or influence exchange rates
have been costly. The goal of relatively stable, noninflationary
growth does not require exchange rate manipulation or foreign exchange intervention.
No one knows the level of the exchange rate that is consistent
with noninflationary growth. Even if the rate were found, it would
not remain constant. Intervention and exchange rate manipulation
can be costly, as the inflation of 1989 and the 1987 market break
Congress should eliminate or severely restrict both intervention
and efforts to control the exchange rate. Questions 7 and 8 of the
committee's letter can be answered together. The level of the foreign exchange rate depends on interest rates, anticipated and
actual rates of inflation, real growth of productivity and labor
force, tax rates, regulations, and tariffs at home and abroad.
The exchange rate is a price, the price of domestic money and
other assets in terms of foreign money. In a free market economy,
operating as our economy does, the current price is determined by
the decisions of buyers and sellers acting in the marketplace.
As I have indicated, there is not a single unchanging correct
price for our currency. The historically high value of foreign currency holdings by the Treasury and the Federal Reserve, $46 billion at the end of March, will increase in value if the dollar declines and rise in value if the dollar appreciates.
No one can predict reliably which of these two events is more
likely. The Treasury and the Federal Reserve are in the same position as speculators who have invested heavily in foreign currencies.
If the dollar appreciates, they lose. Unlike the speculator, however,


the Treasury and the Federal Reserve do not bear any losses because they are speculating with the taxpayers' money.
Treasury losses are an expense. Federal Reserve losses reduce
profits of the Federal Reserve and their contribution to the budget.
The record of losses and gains is available from published reports
of the realized and unrealized profits on foreign exchange operations.
As holders of between 6 and 10 billion dollars of foreign exchange from 1980 to 1985, the Federal Reserve and the Treasury
lost money during the period of a rising dollar, as they would be
expected to do.
The cumulative value of the loss reached $1.5 billion, approximately 20 percent of the average holding. The depreciation of the
dollar, beginning in 1985, first erased these losses, then produced a
profit that reached $2 billion in 1987 on holdings of approximately
$13 billion at the end of that year.
Since 1987, reports have shown some quarters with realized and
unrealized profits and others with losses. At the end of April 1990,
the cumulative profit was $2.9 billion, the highest recorded. Early
this year, depreciation of the yen cost the taxpayers more than $1
billion. This loss was offset by appreciation of the German mark, so
it will not appear in the published record.
A 7.65 percent appreciation of the dollar, given current holdings,
would wipe out all of the recorded profit of $2.9 billion. Such fluctuations are well within the market fluctuations of the dollar and
other currencies over the period we have been talking about.
I do not know any reason to expose taxpayers to the speculative
losses or gains implied by the current $46 billion of foreign currency holdings. Congress should put a limit on foreign exchange holdings.
A large part of the recent buildup of foreign exchange balances
at the Exchange Stabilization Fund has been financed by loans
from the Federal Reserve. These loans are off budget. They do not
go through the appropriation process.
They have been made by an agreement between the Treasury
and Federal Reserve known as warehousing. Congress has not been
asked whether it wishes to finance these operations of the Exchange Stabilization Fund, or whether it approves of the large increase in foreign exchange holdings and the inherent risks in the
speculative position, or whether it wishes to permit warehousing.
In my opinion, the operations are unwise and unnecessary. I do
not believe that any public purpose has been served by recent foreign exchange operations. Further, I believe it is unwise to permit
the Federal Reserve to lend money to the Treasury.
If the Treasury is to engage in foreign exchange market operations, expenditures for these operations should, like all other
Treasury expenditures, be subject to standard congressional appropriation procedures. Warehousing and any other direct financing of
the Treasury should be barred.
Part of the committee's letter raises the relevant question of
whether operations in the foreign exchange market should be conducted by both the Federal Reserve and the Treasury.
In my opinion, it is wasteful for the Treasury to operate in the
foreign exchange market while having the Federal Reserve offset

the monetary effects by sterilizing the Treasury's action, and it's
wasteful for the Federal Reserve to buy or sell foreign exchange
and offset the effects by selling or buying domestic securities.
This merely churns the markets. Authority for monetary policy
has been delegated by Congress to the Federal Reserve. Decisions
to intervene in the exchange market should be made a part of
monetary policy and made a responsibility only of the Federal Reserve,
The Exchange Stabilization Fund is a relic of the inter war gold
exchange standard. I recommend that the Exchange Stabilization
Fund be closed and that the decisions to intervene be made a part
of the regular monetary policy process.
My preference would be to have foreign intervention limited to
those rare and infrequent occasions when there is turmoil in the
foreign exchange market, such as occurred following the illness,
sudden death or attempted assassination of our presidents.
Even if that recommendation is not adopted, I believe that accountability and efficiency are enhanced by concentrating responsibility and authority in a single agency. Since the operations are
part of monetary policy, the Federal Reserve is the appropriate
The committee's last question asks who should determine the
value of the dollar. The value of the dollar is determined in the
marketplace in response to information, including information
about policies at home and abroad.
The foreign exchange value of the dollar should not be a policy
objective. The Federal Reserve should concentrate on the one task
for which monetary policy is best suited, maintaining the domestic
purchasing power of the currency. If they succeed in that task,
there is no reason to be concerned about the exchange rate.
If, by inflating or deflating, the Federal Reserve does not maintain the domestic value of the currency, it will not maintain its foreign value. Operations in the foreign exchange market cannot prevent the consequences of mistaken policies from affecting the domestic and international value of the currency and the public's
standard of living.
Congress should restrict these operations and prohibit warehousing.
Thank you, Mr. Chairman.
[The prepared statement of Mr. Meltzer can be found in the appendix.]
Chairman GONZALEZ. Thank you very much, Mr. Meltzer; excellent statement.
Dr. Schwartz.
Ms. SCHWARTZ. Thank you, Mr. Chairman.
The committee has asked me to provide some historical perspective on U.S. foreign exchange market intervention, and I will begin
by discussion of the origin of U.S. intervention activities.
The Gold Reserve Act of 1934 established the Treasury's Exchange Stabilization Fund with $2 billion in capital. That was part


of the profit the U.S. Government obtained at the time by raising
the price of all the gold in the country from $20.67 to $35 an ounce.
The Act authorized the fund to deal in gold and foreign exchange. Its capital was reduced in 1947-48 when $1.8 billion was
withdrawn to pay for the U.S. subscription to the IMF.
The Treasury activated the Exchange Stabilization Fund for the
first time in the post war period March 13, 1961, acting through
the Federal Reserve Bank of New York as its agent, when it sold
Deutsche marks to reduce the premium on that currency.
On February 13, 1962, the Federal Open Market Committee authorized the Federal Reserve Bank of New York to buy or sell foreign currency on its account in both spot and forward markets. For
this purpose, access to a stock of foreign currencies in addition to
the limited amounts held by the Exchange Stabilization Fund was
For this reason, the Federal Reserve negotiated a network of
swap facilities with the central banks of other countries. The legal
authority for Federal Reserve is moot. Nothing in the Federal Reserve Act of 1913 and as amended authorized foreign currency operations by the Federal Reserve system.
There is no general and positive legislative authorization for the
system to operate in foreign currencies.
Section 14E, which empowers the Federal Reserve to maintain
accounts with foreign correspondents, nevertheless served as the
legal justification in January 1962 for approval by the Federal
Open Market Committee of a program of system foreign currency
operations to be conducted by the Federal Reserve Bank of New
The approval as based on an opinion of the FOMC's general
counsel, concurred in by the general counsel of the Treasury and
the attorney general of the United States, that the Federal Reserve
banks under existing law were authorized to conduct such operations.
Two governors dissented. One believed that legislation was
needed to clarify the system's authority to acquire, hold and sell
foreign currencies.
The other also questioned the legality of the proposed operations,
and in addition saw no need for two separate agencies to be engaged in buying and selling foreign exchange, since Congress had
conferred upon the Treasury's Exchange Stabilization Fund such
These dissenting views have not lost their validity since they
were expressed 28 years ago. Congress has never examined the
legal grounds for Federal Reserve intervention in foreign exchange
markets. Such an examination is long overdue, and these hearings
should serve to prod Congress to undertake this study.
Congress should also examine the legal grounds for Federal Reserve warehousing of foreign currencies for the Treasury, an action
it took for the first time in November 1963. Warehousing amounts
to a direct loan from the Federal Reserve to the Treasury to enable
it to finance purchases of foreign currencies without the resources
to do so.
Warehousing, in effect, bypasses congressional appropriations.
Initially, the Federal Open Market Committee found justification

for warehousing by relying on the Thomas Amendment to the 1933
Agricultural Adjustment Act.
The amendment authorized the Secretary of the Treasury to sell
the Federal Reserve $3 billion in Treasury bills in addition to those
in the Federal Reserve's portfolio. The amendment was extended
every 2 years after 1933 until 1981, when it was allowed to expire.
Since 1977, when the FOMC agreed to a suggestion by the Treasury t h a t the Federal Reserve again undertake warehousing when
resources of the Exchange Stabilization Fund were inadequate, the
amount set rose from an initial $1.5 billion to $10 billion set in September 1989, and to $15 billion in March 1990.
In December 1978, the FOMC extended warehousing to the
Treasury's general fund, in addition to the Exchange Stabilization
Fund. Why the Treasury's general fund should have been included
as a recipient of warehousing in addition to the Exchange Stabilization Fund merits congressional scrutiny.
Since it appears t h a t at its last meeting the Federal Open
Market Committee voted to discontinue warehousing, the practice
of warehousing may now be regarded as of historical interest only.
In my judgment, the issue of the legal authority for warehousing
even so should be reviewed by the Congress, including the relevance of the Thomas Amendment until 1981 as legal underpinning for the practice.
Although Secretary Mulford indicated t h a t he thought Congress
obtained all the information it needed on the record of foreign exchange market intervention, I think t h a t both the Board of Governors and the Treasury Department should supply much additional
information over and above what is included in the quarterly reports t h a t are presented with a lag of 3 months and in their annual
The published record gives information on the dollar amount of
an individual currency or of several currencies combined bought or
sold on particular dates or some inclusive time period, but never
prices at which transactions were executed.
It's important to know the price at which individual currencies
were bought or sold. In any event, the compilation of a systematic
set of returns of what has been bought and sold at which dates
seems to be the very minimum needed to examine what the monetary authorities have been engaged in.
The authorities should make the full record available for at least
past periods. Congress should request such data for the period since
the abandonment of the Bretton Woods system. With the abandonment of Bretton Woods, although swaps continued to be used, the
authorities engaged in outright purchases and sales of foreign currencies to an extent t h a t was not previously the case.
With the exception of the first Reagan administration, official
intervention has been directed to maintain what authorities decided was the right open market price of an individual currency.
At the Plaza Hotel in New York City on September 22, 1985, the
finance ministers and central banking governors of five industrialized countries announced their agreement t h a t in view of the
present and prospective change in fundamentals, some orderly appreciation of the main nondollar currencies against the dollar was


They were ready to cooperate more closely to encourage this. Repeated meetings of the participants reaffirmed the principles of the
Plaza Agreement until the group of 6 major industrial countries
met at the Louvre Palace in February 1987 when they announced
that existing exchange rate ranges were broadly consistent with
economic fundamentals and that they would cooperate closely to
foster stability of exchange rates around current levels.
The authorities, however, have never explained the basis on
which they determine that a price is right. That is the question the
Congress should ask the Treasury and the Federal Reserve to
At the latest date in 1990, for which information is available,
total foreign currencies held by the Federal Reserve and the Treasury amount to $46 billion plus, mainly in D marks and yen. If the
dollar appreciates against these currencies, taxpayers will experience losses in proportion to the appreciation of the dollar.
Large foreign currency positions are vulnerable to loss. Does the
Congress support such gambles by the monetary authorities?
Dr. Meltzer has already discussed the economics of foreign exchange market intervention. I would only like to add one thing
about sterilized intervention which presumably is what the Federal
Reserve is engaged in.
How do we know that it's really sterilized intervention unless we
know in advance what was the money growth rate that the Fed
was seeking before it started the intervention, and that that's exactly the monetary growth rate that has been achieved following
Even if sterilized intervention by the Federal Reserve does not
change the desired U.S. money supply, it is the rate of growth of
the U.S. monetary supply relative to that of the money supply of
other countries that determines bilateral exchange rates.
One consequence of foreign exchange market intervention is that
it tends to introduce distortionary effects on monetary growth
rates. In pursuit of a weaker dollar until the end of 1986, U.S. monetary growth expanded.
From the end of 1986 to the end of 1988, when the exchange
value of the dollar was a adjudged weak by finance ministers of the
G countries, central banks loaded their portfolios with huge dollar
holdings, thus creating domestic money while the U.S. monetary
growth rate was restrained.
Absent its preoccupation with managing exchange rates since
the Plaza Agreement, the Federal Reserve could have concentrated
on achieving low money, price, and real income variability. Less
variability in these variables would have made exchange rates less
A consequence of sterilized intervention, whereby central banks
sell corresponding amounts of domestic assets in the open market
to offset foreign currency purchases as the Federal Reserve invariably does and the other central banks do intermittently is that
they raise domestic interest rates.
In addition, foreign exchange market intervention distorts foreign currency prices. Intervention has interfered with market adjustment of the exchange value of the dollar. Intervention simply
adds noise to the decisions traders make about pricing currencies.