Hank Paulson On China And The Year Ahead

By Maria Bartiromo

Treasury Secretary Hank Paulson traveled to China on Dec. 12 for his first strategic meeting with his Chinese counterparts. He arrived in Beijing with a briefcase full of issues, including a weakened dollar and a mind-boggling trade deficit. I caught up with him before he left to talk currencies and competition.

I have in front of me, Mr. Secretary, 20 bills that are basically anti-Chinese measures from the incoming Congress. Are they sensing a new hostility in China from the Democratic majority?

I don't know what they're sensing in China and what they're not sensing. But I do know... that there is a growing protectionist sentiment not only in this country but in China and all around the world. It's a paradox, because the lesson of the past 25 years has been that those economies that have opened themselves up to competition, reform, and integration into the global economy have benefited, while the rest have been left behind.

How long is the Administration going to give the Chinese to put the changes in place that you are looking for, whether on currency, trade, or opening up markets to foreign companies?

A big part of the strategic economic dialogue will be to persuade the Chinese to accelerate the pace of their reform. When we talk about reform with the Chinese, there's total agreement in terms of what they need to do... so the debate is about timing. The case we're making is that there's more risk in going too slow than in going too fast, and that they need to speed up the pace of the reforms because...they're somewhere between a market-driven economy and [a managed economy]...and that'll get them nowhere. If China were a small country, it might be easier for them to say, "You know, we're in transition. Give us more time." But it's a global economic leader, and the rest of the world isn't going to give China a lot more time.

What would be the right way for China to adjust its currency?

They need a currency whose value is set by the competitive marketplace. That's what every other major participant in the economic system has. And China is unable to do that now and will be unable to do it until it opens up its capital markets...to competition and foreign investment.

Let me ask you about hedge funds. We've got 9,000 hedge funds managing some $1.3 trillion. Are you more worried about the leverage at hedge funds or the exposure that the banks and brokers [bankrolling them] have?

The whole hedge fund area is something that is being looked at very carefully...by the President's working group, which is me, Ben Bernanke from the Fed, Chris Cox from the SEC, and Reuben Jeffery from the CFTC. There have been major changes in capital markets over the past 5 to 10 years. And one of those changes has been big increases in private pools of capital. As we think about this, we need to come at it from a number of different perspectives. One is investor protection, and that's something Chris Cox is very focused on. [We've got to make sure] we've got enough liquidity in the system, enough transparency between the hedge funds and those regulated entities that are lending them money. But by and large, hedge fund derivatives have been positive for the capital markets. They've made them more efficient, more liquid, and been very helpful in dispersing risk. That may be one of the reasons we haven't had a financial shock in the past eight years.

I was just in London, and people were talking about London becoming the new financial capital of the world. Do you see that happening?

I see pretty clearly that New York is the financial capital of the world and...the center of innovation. But London is a very vibrant financial center. What they've accomplished there has been very good for London and very good for the world.

Do you think London has weakened its standards?

I didn't say London had weakened its standards. I believe that the U.S. played the major role in moving quickly to clean up after the financial scandals...and the rest of the world has benefited. The question now in the U.S. is how do we get the balance right? How do we recalibrate? I spend a lot of time thinking about it, the President's working group is thinking about it, and... Chris Cox is making a major move in terms of how...Sarbanes-Oxley is going to be implemented.

Income inequality in this country is getting dramatically worse. What can be done to fix this?

That's a trend that has been going on for over 20 years. I think it's largely attributable to a greater integration of the global economy, an increase in unskilled labor globally, and technology. We're going to have to think more creatively about how to deal with some of the dislocations that we're seeing and work very hard on this problem.

Does that mean a minimum wage hike?

I don't think the minimum wage, in and of itself, is going to be the long-term answer. But clearly this Administration is supportive of a minimum wage hike that's structured properly.

President Bush has suggested that he wants to revisit Social Security reform again in the next two years. Has he asked you to lead that effort or be part of that?

Yes. Social Security reform, entitlement reform overall, is a major issue for the President. The sooner we fix it, the less costly it will be, the more economic flexibility we will have, and the fairer it will be to the younger generation.

Is privatization a must-have in any reform?

I do not want to condition the discussion. The President believes strongly that personal accounts are an important part of this puzzle. And I see it that way, too. But the Democrats can come to the table and talk about their alternatives. What I want to do is get reasonable people together and come up with something that works.

What are the most pressing economic priorities for 2007?

I have to say energy security is a very important issue for this economy. We are too dependent upon oil—much of it foreign oil, and much of that from troubled places around the globe. And so we need to do more to invest in alternative fuels, renewable fuels, cleaner fuels. That will ultimately lead to cleaner air, cleaner water, and more diversity of our energy sources. We've talked about entitlement reform. Again, very, very important. Then, of course, we need to be vigilant and keep our capital markets competitive because capital markets are the foundation of our economic strength... and prosperity over the long term.

Do you think, as Wall Street's recent behavior seems to sug-gest, that the housing slump has bottomed out?

I don't know whether it has bottomed out. The one thing I do believe is that we've had a correction that in many ways was inevitable and necessary. And I'm feeling good about where we are in the economy right now. The housing correction has taken about 1 percentage point off of GDP, so we're growing below our sustainable rate right now. But the economy is diverse and strong. We've got a service sector that's very strong, the consumer is still very solid, the corporate sector is strong. So whether [housing] has bottomed out, not quite bottomed out, or is going to take a quarter or two longer, the thing that we've seen is that other parts of the economy are doing so well that we're just powering through this.

As part of that strength, we've got incredible amounts of money moving into private equity. Do you worry that a bubble is developing?

No, I'm not worried about a bubble. We have a very strong stock market [that's] at record levels. But it's getting there the good way. When you look at multiples of earnings today relative to what they were in the late '90s, this is a solid market. And I think one of the real positives we've seen is that this has added to the consumer's net worth. Consumers have felt the benefit of [the strong market] through their 401(k) accounts, and this has more than offset the slowdown in the retail housing market.

Maria Bartiromo is the anchor of CNBC's Closing Bell.

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