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Thursday, Feb. 14, 2008

“I was able to tell the president as recently as a couple of hours ago that although the risks are clearly to the downside, I believe that we're going to continue to grow -- at a slower rate for a while.” — Henry Paulson

Henry Paulson Jr., 61, has been Treasury secretary for nearly 20 months. The former chairman and CEO of New York City investment firm Goldman Sachs, Paulson is the Bush administration's point man on economic policy, unlike his predecessors who often played second fiddle to the White House. With the United States teetering on the edge of recession, Paulson's tenure is likely to be judged by the economy's fate; the reforms he engineers for the ailing financial system; and his handling of America's biggest creditor, China. Paulson met on February 5 with National Journal reporters John Maggs and Bruce Stokes. Edited excerpts follow. For previous Insider Interviews, click here.

Paulson: There is a whole range of things that are always a possibility, and I don't think it is my job to start talking about possibilities. I have been focused intently on the economy, not just looking at the economic data, but getting a range of anecdotal data from a wide range of industries. So I was able to tell the president as recently as a couple of hours ago that although the risks are clearly to the downside, I believe that we're going to continue to grow -- at a slower rate for a while. I also said that our economy is structurally sound and that our long-term fundamentals are healthy.

I spend a fair amount of time outside of this country. And it is enlightening, because here we are all focused on our problems, but as far as I'm concerned, every other country has a wide range of more difficult issues to deal with than we do, over the next five, 10, 20 years. So I'm not minimizing our issues, but I think that we are well positioned and that the challenge we have is to continue to adapt and make the changes we're going to have to make to keep our competitive edge.

Q: Clearly you think that the economy will ride this out, with slower growth. But if the downside risks prevail, is the administration ready to entertain a further stimulus?

Paulson: We're focused on now. I don't think it makes sense for me to be speculating on what we may or may not do under different scenarios. The focus is on this stimulus plan, not on a second stimulus plan.

Then we have a number of other initiatives, which will continue to be important. I believe housing has been the biggest drag on the economy, and it is by far the biggest risk on the downside. So there is not a day that goes by that I don't talk to someone here at Treasury or elsewhere in the government about what is going on in the housing market, how our initiatives are working, getting the status on the legislation that still needs to be done, and just asking ourselves, are we missing something? Is there something else we should be doing?

Q: Some reports have said that the program that Treasury organized with lenders to help subprime borrowers avoid foreclosure is not reaching many homeowners.

Paulson: Not so. I don't believe that to be the case. Remember what this program does. The Hope Now alliance was designed to prevent avoidable foreclosures, and to prevent a market failure. So, my definition of success here is, if you hold a subprime mortgage and you are able to make your initial payments, and you are unable to make the higher payment, and you want to stay in your house, are you able to stay in your house?

There will be some people who can't make the initial payment. And there may be some people who bought a home thinking that the price would keep rising -- and when it didn't keep going up, they said, "I don't want to own a home anymore." But this program, which is in the best interest of owners, of lenders, of investors and homeowners, is a way to fast-track loan modifications. And in a number of cases, it will result in interest-rate freezes. So again, I don't know how anyone is able to say this hasn't been successful. We'll have the data for the fourth quarter soon. We're going to watch it every month. But even if it works, and meets or exceeds our expectations, this is not going to prevent many foreclosures that might take place for other reasons.

Q: When you leave this office in a year, are there any regulatory reforms that you would like to see in place to avoid this kind of problem?

Paulson: Yes, yes, yes -- triple yes. We have two focuses. The first is getting through this period so that it has as little effect on the real economy as possible. The second focus is to have a policy response that is designed to minimize the likelihood that we will have these same problems again. And that will take a number of forms. We at Treasury are working on a blueprint to lay out what we think is the right regulatory structure in the U.S., given how our economy has evolved over time, given that the current regulatory structure is a patchwork. There are holes in it, and there are some parts that will require multiple regulators.

We also are working at the president's Working Group on Financial Markets on specific responses to deal with issues such as the ratings agencies, the securitization process, off-balance-sheet contingent liabilities from the financial institutions. So you will see, sometime over the next several months, our recommendations for a policy response. What we don't want to do is see our policy recommendation work against what is our primary objective right now, which is to protect the U.S. economy.

Q: Give us a sense of how the credit markets have fared since September.

Paulson: There has been improvement. But given the complexity of the products and the global integration of capital markets, it is going to take a while. I think there will continue to be unforeseen surprises. These things don't go on a straight line.

One of my big focuses today is on banks being well capitalized. It is very, very important that banks and financial institutions recognize their losses and go raise capital. It is so clear to me, based on my years of experience in the market, that if you are a financial institution and you think you need capital, you'd better go get it when you can. If you don't have it and you are forced to shrink your balance sheet, you miss opportunities for your shareholders and you hurt the economy, because it is very important to keep the lending going and make credit available.

Q: How do you encourage that?

Paulson: We talk about it when I get together with the various regulators, we talk about it in the president's working group, we talk about it with financial institutions one-on-one. We talk about it publicly. And we do everything we can to encourage it. The U.S. institutions have made plenty of mistakes. But I think they have been in front of the parade in terms of recognizing losses and raising capital. I think they came into this turmoil well capitalized, and it is essential that they remain that way.

Q: Internationally, our banking problems have had a contagion effect, especially in Europe. Does it suggest to you a need for an international regulatory response?

Paulson: Of course, this is being coordinated very carefully. I'll be at a G-7 meeting this weekend, and we'll be talking about it there. And we have the Financial Stability Forum for the G-7 looking at the same issues. One of the issues they are dealing with, which is making the turmoil in the capital markets more difficult, is not only the complexity of the products but the degree of integration we all have in the global financial system.

Q: Concern is growing about sovereign wealth funds. What is your perspective?

Paulson: So, with sovereign wealth funds the focus is really twofold. First, to work with the sovereign wealth funds and to encourage them and the [International Monetary Fund] and others to work on best practices because, although there are many concerns about sovereign wealth funds, as far as I am concerned the one legitimate issue that is raised is, are they being driven by their commercial economic interests or some other strategic political interests? And, as far as I can see in talking to many sovereign wealth funds, they are being driven by economic interests and getting a higher risk-adjusted rate of return. So I believe that the more transparency we have, best practices, and communications, the more these fears will be dissipated. But I think we need to take them seriously and need to have that dialogue.

And then the other dialogue that needs to take place is at the [Organization for Economic Cooperation and Development] among the countries that are going to be the recipients of these investments, so that we can have our own best practices and make it clear that we welcome investment and not use the fact that it's a sovereign wealth fund as a way to get into protectionist sentiment.

Q: Do we need more regulation of sovereign wealth funds?

Paulson: I think we have enough regulation. We have a [Committee on Foreign Investment in the United States] law. We have a CIFIUS executive order. We have regulations. We are being vigilant in terms of talking with sovereign wealth funds. So I don't think regulation is the answer. And I am hoping that these concerns and fears don't spawn unnecessary regulation in other parts of the world.

Q: How do you respond to the dissatisfaction in Washington that your strategic economic dialogue, or SED, with China has not produced more results?

Paulson: I think it has been a significant success in terms of what we are doing with China. And sometimes I think people get confused when I say we are making progress -- but I am impatient, and that we should make more progress.

Just about everyone agrees that China is not ready yet to have a market-determined currency. I would like them to move quicker and to have a currency that more closely approximates underlying economic fundamentals. I think the ultimate test of the dialogue is, are we making progress we wouldn't make if we didn't have it? Are we able to talk at the most-senior levels and keep our relationship on an even keel at a time of tension?

We always want to make progress on the most sensitive issue of the time. At the last meeting in Beijing, it was import safety. Has that issue been solved? No. But we have made real progress and come up with something that can be prototyped around the world. There is real progress there.

There has been real progress on a number of other really important issues. We agreed when I was in Beijing at the last SED that prior to the meeting we are going to have in June, we are going to work with the Chinese to develop a 10-year program about energy security, the environment, and climate. What could be more important? This is strategic.

Q: What about growing congressional interest in legislation with regard to suspected Chinese currency manipulation?

Paulson: I think to try to legislate currency or macroeconomic policies, given what is going on in the world, is almost disconnected from reality. I would be very careful about anything that legislatively looks like a trade war, given what is going on in the global economy and global capital markets, and given how important exports are to us today.

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