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Paulson Remains Bullish

Treasury Secretary Sees a Rebound for Economy

Treasury Secretary Henry Paulson, the former chairman and chief executive officer of Goldman Sachs, is prone to take the long view. And, perhaps not unexpectedly, he believes the economy will continue to grow.

Paulson was appointed the nation’s 74th Treasury secretary in June 2006, replacing John Snow.

He started his career at the Department of Defense, then worked in the Nixon administration as an assistant to John Ehrlichman. He joined Goldman Sachs in 1974.

On Feb. 1, he sat down with Roll Call Executive Editor Morton M. Kondracke to discuss the state of the U.S. economy and the chances of a recession.

ROLL CALL EXECUTIVE EDITOR MORTON M. KONDRACKE: So what do you think the chances of a recession are now in view of the fact that the last quarter growth rate was less than 1 percent and we lost jobs in the first month in January?

TREASURY SECRETARY HENRY PAULSON: I’ve been saying for a number of weeks now we can have our economy get closed out significantly, beginning at year-end, in January. I still believe that we are going to continue to grow, albeit at a slower rate. But the risks as I see them are to the downside.

ROLL CALL: Do you think the rate that we’re going, the first quarter of this year is going to be negative growth?

PAULSON: As I said, I think we’re going to continue to grow, and again, I don’t place too much emphasis on any month’s economic data. As you see, they’re all subject to revision. At the same time the jobs number was negative. That last month’s was revised upwards. So I don’t look too much at one month’s economic data. My views on the economy have been shaped by looking at a whole set of data and by talking to a wide range of companies in various industries, where I also got a good deal of anecdotal information indicating that this discretionary consumer spending has been slowed. But remember, we’ve had a diversified economy for over a year now. Exports have been growing faster than imports. That’s adding to growth. We have very substantial areas of strength. Again, in summary, I think we’re just going to continue to grow.

ROLL CALL: OK. Assuming that Congress does pass the stimulus package, what else does Congress have to do to help the economy grow — in the short run, to avoid the recession, and then after that?

PAULSON: Well, first of all, I believe the most important things, the things that will make a fundamental difference in the intermediate and longer term, are all the things you heard me talk about before, dealing with the longer-term structural deficits, Social Security, Medicare, keeping tax rates low, trade, investment — and then of course this year, a focus on the trade to Colombia, Panama and Peru, and of course, the housing initiatives. I think [Federal Housing Administration] modernization should get done very quickly, because we have a Senate bill and a House bill. And so I would look forward to having something hopefully on the president’s desk soon there. We have a proposal which I think would be helpful to housing, which would rate the caps on taxes and revenue bonds that could be used at the state and local level to help formulate mortgage financing programs, again to help the housing market.

ROLL CALL: Are the prospects good for that?

PAULSON: I think the prospects are excellent for that.

ROLL CALL: Is the stimulus package big enough? [Former Massachusetts Gov. Mitt] Romney has proposed a stimulus package that’s almost double the size of the one you agreed to.

PAULSON: I believe it is. In coming up with this proposal, we recognized that it needed to be big enough to make a difference to the economy this year. And with a $14-plus trillion economy, we felt the $150 billion program clearly does that. But we’re also trying to balance this with looking at some important longer-term objectives like balancing the budget, and we wanted it to be helpful and meaningful this year, but not fly in the face of some of the intermediate and longer-term objectives.

ROLL CALL: Some conservative critics say that what you’re doing is just dropping money from airplanes, and that it will have really no stimulus effect and that this is more political than it is economic.

PAULSON: Well, I think that’s absolutely wrong. When I have discussions with them, I really do believe what they mean is that it doesn’t have the same long-term supply-side effect that you get from, for instance, making tax cuts, tax relief permanent. And I agree with that. But on the other hand, this package was crafted to make a difference this year and it makes a very real difference this year.

ROLL CALL: Do you consider yourself a supply-sider?

PAULSON: I don’t put a label on myself. I do believe that as you look at long-term economic competitiveness in our economy, we have to be very mindful of the level of taxation, and I also believe that the kinds of benefits that we saw from the tax relief in ’01 and ’03 made a very significant difference to the growth and competitiveness of our economy. And I saw that real-time when I was on Wall Street and looked at economic activity you know, as a part of the clients I worked with, and looked at the way the market responded to those tax packages.

ROLL CALL: If as the Democrats are promising or threatening, they allow the tax cuts for people over $200,000 or $250,000 a year in income to lapse when they expire — do you think that will have a serious downward effect on the economy, especially in view of the fact that when Bill Clinton was president he raised the top marginal rate and we had a booming 1990s?

PAULSON: Well, first of all, clearly, given where we are in the markets today, and given where we are in the economy today, the last thing we need is any increases in taxes, so let’s start there. With regards to the marginal, the top two brackets, I think the thing that some people forget, that 70 percent of the small businesses in this country … pay taxes at one of those two brackets. And one of the real benefits that came from reducing those rates was that it was a real boost to small businesses, who are a big engine of growth in our economy. And anyone who has worked with small businesses like I have know, that often, when everyone saves some money, the first thing you do is reinvest in your business.

ROLL CALL: Is there any way for the tax code to separate out subchapter S, small businesses from individuals who are making these high salaries?

PAULSON: I’ve received that question a number of times, I think we have a tax code that already is enormously complex, overly complex, and I think that’s been a fundamental tenant of our tax system for a long time. We tax, you know, corporations, sole proprietorships, partnerships and so on. I think that would be a difficult proposition.

ROLL CALL: Back to the current situation — the Fed’s dramatic rate cutting, is there any sign that this is having a measurable effect on the credit crunch that’s contributing to slower growth?

PAULSON: Well, first of all, I believe that it’s clearly helpful. And the rate cuts coupled with the Fed’s innovative program of auctioning off internal credit has significantly reduced the credit spreads in money markets and the … funding markets, so that is clearly having a difference. When you look at credit extension more broadly, we are, it’s going to take us longer to work through this rough patch, and the issues, although they will be helped, will not be solved totally by rate cuts by the Fed. There’s a number of other important issues. One is it’s very important to get our financial institutions to remain well-capitalized. It’s quite important that they recognize their losses and move quickly to raise the necessary capital. That’s my clear — and the markets have just convinced me — if you’re a financial institution and you need capital, go out and get it when you can. If you don’t, the alternative is shrinking your balances and restraining your lending to businesses and individuals.

ROLL CALL: The primary source is overseas at the moment.

PAULSON: The primary source — there’s been a major source — have been sovereign wealth funds overseas, but there have been a number of U.S. institutions that also have participated in the capital raising. But to get back to the — also, there have been a number of other issues in the credit markets that we need to work through, that relate to the complexity of the product, so again it takes longer for the market to be able to assess that risk and to price that risk, to work through. And then of course, there are issues related to the housing downturn, in the United States, and the impact that that has on credit, particularly on a number of the structured mortgage products.

ROLL CALL: Is there a need for Congressional legislation to make these very complex financial instruments that have been invented in the last several years more transparent so people have a better idea of what they’re investing in?

PAULSON: The way I would answer this is that I have two focuses. The first as we work to get through this period to do so with as little impact as possible on the real economy. But secondly, it is, what is the right policy response? We had a long meeting [Jan. 31] with the president’s working group on national markets, and [Federal Reserve Chairman Ben] Bernanke and [Securities and Exchange Commission Chairman] Chris Cox … and we recognize that the issues surrounding mortgage origination, process, issues surrounding securitization … surrounding rating agencies, evaluation, accounting, take a strong policy response.

ROLL CALL: When will that come, and how will that come?

PAULSON: It will take — we’re still working our way through this period, still learning. It will take two or three more months and, but, I’m not sure, if the right response to everything here is legislation. We — there are multiple tools we have to work with, and it’s pretty difficult to legislate disclosure when it comes to complex instruments. Complexity has clearly been a significant issue. And let me just talk for a minute on disclosure. We have reams and reams of disclosure already, a lot of it written by lawyers trying to help everybody cover their backsides. But I think the key thing is how do we get the most relevant disclosure and how do we get it in an understandable form? … And of course, complexity is an enemy here, as it relates to some of these issues. It has been a friend to the extent that many of these instruments have also made the markets more efficient, and made capital more readily available to a broader cross section of this country. So we need to strike the right balance.

ROLL CALL: I mean, we do have an SEC that oversees public stock offerings and mutual funds and so on. Do we need regulation of hedge funds, for example, which are increasingly involved in the economy? It’s not the playground of rich people anymore.

PAULSON: Let me give you a general answer on something we’re doing at Treasury in terms of regulatory reform. And then I’ll specifically answer your hedge fund question. We have been working diligently for some time now at the Treasury … with a regulatory blueprint, which we plan to unveil sometime in the next several months, which would outline a regulator structure which we think would make sense in this country given the way in which our economy has evolved, the way in which capital markets have evolved, the way in which the global markets have evolved. The current structure is a patchwork quilt that has grown to a conglomeration over a 75-year period. And I don’t think it is optimum for the world we live in. With regards to private pools of capital — the hedge funds — we spent a lot of time on this at the president’s working group. We came up with, and when we decided that the status quo wasn’t sufficient, we had all of the regulators in the U.S. come together, behind a center of principles, that we outlined. We then had worked to put together two groups: one with investors, and another with managers, and working with them to come down with a set of principles, that they can agree to, and would meet our objectives.

But again let me come back to disclosure, and give you a little bit of background. When I first took on this job, and had the first meeting with the president’s working group on financial markets, I made the point that every five to eight years we’ve gone through periods of financial stress or turmoil in the markets that we are overdue for a period like this. That when we have the next problem, that we were going to be dealing with levels of complexity and financial products we have not seen before with a much greater degree of global integration. … Now at that time, we were all focused on hedge funds, and credit default … those were the two things we were focused on. And so the focus was on the relationship between these hedge funds and the prime brokers and regulators and financial institutions that lend them money. And so, we spent a lot of time looking at that relationship, looking at the disclosure that was made, looking to make sure there was enough margin, and as it turns out, the problem which came up in the housing downturn and subprime mortgages wasn’t created by the hedge funds. As a matter of fact, the hedge funds have operated in a very constructive way there.

ROLL CALL: When you revisit regulation, isn’t Congress going to insist on getting into the act, and shouldn’t they be part of the …

PAULSON: Of course they should be, and Congress has been actively and constructively engaged in all of this. And, there’s nothing we can do that’s significant in terms of the regulatory blueprint without Congress. As we work through the housing issues, and talked about them — you know, [Rep.] Barney Frank [D-Mass.] and [Sen.] Chris Dodd [D-Conn.] have both been very constructive there. They both got legislation and there’s clearly a legislative/regulatory piece to all of this.

ROLL CALL: Compare this crisis or panic or whatever you call it to previous real big problems, like to the [savings and loan] crisis, the bursting of the tech bubble, the Asian crisis of the ’80s and so on: What is the order of magnitude that you see?

PAULSON: First of all, it is very interesting, when we had a meeting yesterday with the president’s working group, and we were getting reports on the lessons learned in the financial institutions, and I would say a number of the mistakes were made, were very similar to things we’ve seen in the past. And that’s just the truth. … But I would say the biggest difference is that the markets have developed a lot since hedge funds. And so they’ve more integrated all of us into the global markets. And I think that’s something that’s going to need — that just takes longer. And secondly, the points you made early on, the level of complexity. And so I think the complexity of the products and the degree of global integration, makes this more complicated to work through. But I think we’re making good progress.

ROLL CALL: But the tech bust did produce a recession. We got through the S&L crisis without — it cost a lot of money but I don’t think we had a recession over it. The question now I guess is how bad could this get and could we have a global recession over it.

PAULSON: I would say again, I think this is much smaller — I’m not discounting what’s going on in the capital markets. It is significant, it’s not over, we are going to continue to have volatility — I’m sure there will continue to be, because there always is, not because I know anything particular so much — there will be, and again, this is not just U.S. European banks are very much involved, and we’ll need to watch this continue to unfold. But putting that all aside, I think it’s now much more about the U.S economy than the capital markets. And I think there, the major risk to the downside is housing. And that’s taken longer to go through that correction than some people have predicted, it’s been a drag on our economy for some time, that’s what we’re watching most closely. But again, I’ve told you, despite that, I think we’re going to continue to grow.

ROLL CALL: All right. When the Fed keeps lowering interest rates, isn’t that going to produce an even weaker dollar than we’ve had up until now? And is there any reason to feel that foreigners would actually start pulling out of the dollar? It’s something that’s always been written about in dire terms.

PAULSON: Well, as you know, and Treasury secretaries always repeat the mantra of the importance of the strong dollar. That’s particularly easy for me, given my background in financial markets because I believe in my heart and soul here that a strong dollar is in our nation’s interest. And as I explained to you, our economy like any other has got some ups and downs, but I believe that if we’re going to continue to grow, this strength will be reflected in our currency.

ROLL CALL: You’ve obviously got a lot started in dealing with the housing foreclosural problem. The question is, how many people are going to lose their houses as a result of this and what percentage of the total — who are in danger, and is there anything more that Congress ought to be doing?

PAULSON: Well, first of all, this is something we’re very focused on. There’s not a day that goes by, no matter how busy I am, where we don’t have some meeting where we talk about what’s going on, what we should be doing. The huge focus we have on the roughly 2 million — a little bit less than that — subprime mortgages … I think it is going to make a very big difference, in keeping those people who want to stay in their homes and can afford to do so in the homes, because I think you’re going to see, you’ve already seen in the fourth quarter, a big step-up of the number of the foreclosures that were avoided as a result of fast-track modifications or refinancing, and I think that’s going to accelerate. The challenge is also getting greater because the mortgages that are being reset are the ones that were made right — in 2006, and were the poorest quality in terms of the underwriting standards. So we’ve got a big challenge there.

ROLL CALL: [Sen.] Hillary [Rodham] Clinton [D-N.Y.] is proposing a freeze on foreclosures and a freeze on interest rates. Does that make any sense?

PAULSON: I think in terms of the foreclosures, I think the way we’re getting at it, gets at it more effectively. Because if rates are going to go up, then what this does is basically the program we have in place — basically says that if someone can afford the initial rate, then it’s either going to be fast-track into modification that is going to be in essence be a freeze, or they’re going to have the opportunity to do a refinancing. So, it’s that subset that can’t even afford the initial rate where it’s taking a lot more work. So that, I think, is maybe as much as anything, communication, because this … if the program works the way we expect it to work, if you have a mortgage and you being able to make the initial rate, to make that payment, that you won’t be forced into foreclosure.

ROLL CALL: What do you say to the Lou Dobbs argument that the U.S. middle class is being hollowed out, that wages are stagnant, and the cost of fuel and education and health care is going up, eating into their income, that jobs are going overseas, and the only way that Americans can manage to make ends meet is to have two earners per family, and work extra hours, and there’s a limit to how much you can keep on doing that. So the argument is, and I’m not sure what the solution is except to close the borders, but nonetheless, the argument is that, you keep saying that the fundamentals of the economy are good, but the middle class doesn’t …

PAULSON: I gotta say, first of all, three things. First of all, we as a country, have always been a self-confident, optimistic people, that aren’t afraid of competition, we benefit from competition. … Having to fence this country off from any kind of competition, trade, capital flow, etc., is backward looking and self-defeatist, and a road to failure. Now, put that aside. I don’t question those that would say we have a number of people in this country that despite the economic growth we’ve enjoyed, have had trouble making ends meet in today’s economy. But the way to deal with that is twofold. First of all we need to keep this economy growing, because that better than anything else is going to create opportunity. And secondly, I think we, in years ahead, are going to have to give much more thought to how to get the skills … [so] more people have the skills that it’s going to take to be successful in today’s and tomorrow’s economy. I think that is going to be very important. The last thing I would say, which to me is a positive differentiating characteristic of America, is the economic dynamism we have. I’m going to say this and I’m going to say one other thing I take great pride in, is that if you look at the people in the bottom 20 percent in terms of earnings, half of that group will move out of the bottom 20 percent over any 10-year period. When you look at the people in the top 20 percent, half of those people will be new over a 10-year period and half will move out in a 10-year period. That to me is an indication of a healthy society. The other thing I would say is that those who want to blame trade for economic ills are either ignorant or disingenuous, because the benefits to society overall in terms of increasing standard of living are less transparent. But, I would say, and I know this from looking at economic data, but I know this from a whole lot of personal experience over a business career, that by and large it’s automation, and it’s technology. Now, no one can stand up and say, let’s disconnect ourselves from the Internet, let’s turn back technology. But the example I use, is that people talk about manufacturing all the time and losing the good manufacturing jobs overseas. That’s what I hear. Now, if you look at the facts, we had 15 manufacturing jobs in this country in 1950 …

ROLL CALL: Fifteen?

PAULSON: 15 million, 15 million. When I say — [laughter] OK …

ROLL CALL: That’s what Lou Dobbs says.

PAULSON: OK, 15 million, and that was 30 percent of the jobs. Today we have 15 million and that’s 10 percent of the jobs. But, the output has gone up seven times, so that 15 million manufacturers have become much better manufacturing workers. They’re the best in the world and they’re much more productive.

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