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Treasury, Urged to Act, Finds Few Tools

By Neil Irwin
Washington Post Staff Writer
Wednesday, August 22, 2007

As financial markets went haywire this month, Wall Street looked to one of its own, Treasury Secretary Henry M. Paulson Jr., for help.

He hasn't given them much in return, partly because there is not much he can do.

Paulson, who was chairman of the investment bank Goldman Sachs before joining the Bush administration, has acknowledged that the downturn in the markets could damage the U.S. economy. But the Treasury Department under Paulson has taken no dramatic public moves to shore up frozen markets for home mortgages and other debt.

Yesterday, Paulson and Federal Reserve Chairman Ben S. Bernanke met with Senate Banking Committee Chairman Christopher J. Dodd (D-Conn.) as the debate over the government's response to the breakdown of markets for mortgage and other debt moved to Capitol Hill.

Dodd, in a news conference after the private meeting, called on Paulson and Bernanke to "use all the tools at their disposal" to ease the problems. Most of the policy changes Dodd suggested would do little to affect frozen credit markets in the near term, economists said, but rather might help prevent another such an event.

The reality is that, for Paulson and the Treasury Department, there are relatively few tools that would allow this or any administration to manage the ups and downs of financial markets, according to economists and economic policymakers of both parties.

"There are no real instruments that the Treasury Department has that directly deal with a situation like this," said Laura D'Andrea Tyson, economic adviser to President Bill Clinton and now a professor at the University of California at Berkeley. "This is all about communication and coordination with the central bank."

The Federal Reserve has the power -- and mandate -- to ensure that the financial system has plenty of cash flowing through it. But even a Wall Street-savvy Treasury secretary can do little but keep information flowing between bankers and policymakers -- and choose his words very, very carefully. That has been Paulson's strategy.

This is quite a difference from crises involving Mexico in 1994-95, East Asian nations in 1997-98 and Argentina in 2001, in which Treasury secretaries were able to take the lead in restoring stability to big chunks of the world economy. They could use their voting power on the International Monetary Fund to arrange bailouts and a tool called the Exchange Stabilization Fund, as well as pressure on foreign leaders, to try to prevent wild swings in exchange rates.

"If there's a liquidity crisis in the United States, the tools available to combat it are primarily with the Federal Reserve," said Brad Setser, a senior economist with Roubini Global Economics who was on the Treasury Department staff in the late 1990s and early 2000s. "If a liquidity crisis involves another country, there are many more instruments and tools at the Treasury Department's disposal."

When he became Treasury secretary just over a year ago, Paulson took steps to make the department more ready for financial crisis, rebuilding the agency's market monitoring room and calling regular meetings of the Working Group on Financial Markets, a confab of the Treasury Secretary, Fed chief, and heads of the Securities and Exchange Commission and Commodities Futures Trading Commission.

Since serious market turmoil began three weeks ago, aides said, Paulson has kept tabs on the markets by speaking frequently with the chief executives of large investment banks. He is known to be close with John Mack of Morgan Stanley, Charles O. Prince of Citigroup, E. Stanley O'Neal of Merrill Lynch and James Dimon of J.P. Morgan.

Treasury staff, particularly Robert Steel, undersecretary for domestic finance, and Anthony Ryan, assistant secretary for financial markets, have been brainstorming for ways to ease the crisis and acting as a clearinghouse of information between Wall Street and various government agencies involved in the response.

There has been no serious discussion, sources inside the administration and outside of it said, of any bailout of the subprime mortgage market, which could reward the irresponsible lending that created the current problems.

People outside the administration note a couple of things the Treasury Department might do to ease the short-term problems in the markets.

Dodd and other Democrats have advocated that the administration lift restrictions that Fannie Mae and Freddie Mac agreed to with their regulator limiting the volume of mortgages they can purchase. If the two companies could buy more mortgages, it might make more money available to home buyers.

Paulson has resisted such a step, most recently in an interview with CNBC yesterday, saying that changes to the restrictions should come about only from Congress. A bill changing regulation of the two companies has percolated on the Hill in recent months.

Another strategy the Treasury Department might take, said Wachovia global economist Jay Bryson, would be to auction a higher-than-usual volume of short-term Treasury bills, which are the asset that investors have most been bidding up, distorting debt markets.

There is nothing legally to prevent the department from doing that, but it would be a departure from the agency's long-standing practice of issuing debt according to a strategic plan that the department believes lowers the government's cost of borrowing money in the long run, rather than reacting to temporary blips in the bond market.

"The reality is the options of what Treasury can do to deal with the crisis are very, very limited," Bryson said.

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