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It Could Have Been a Lot Worse: A Conversation with Henry Paulson

Francis Fukuyama talks with former Secretary of the Treasury Henry M. Paulson, Jr., about his new book on the financial crisis.

Published on May 1, 2010


On the Brink: Inside the Race to Stop the
Collapse of the Global Financial System
Henry M. Paulson, Jr.
Hachette Book Group, 2010, 496 pp., $28.99

AI: Let’s start by focusing on China. You write in your new book that when you were at Goldman Sachs you went to China about seventy times to set up the business there. You got to know the Chinese leadership well before you came to be Treasury Secretary. Yet even during the period in which you made those trips, many observers expressed concern about the implications of large structural imbalances in the global economy: so much savings being accumulated in China, so much debt being racked up in the United States, and so much foreign money flowing back into the U.S. banking and financial system in ways that may have encouraged excessive risk-taking and contributed to the real estate bubble. Looking back, what weight of responsibility do you assign to those imbalances for the way the financial crisis unfolded in the second half of 2008?


Hank Paulson: A big part of the imbalances, in my view, stems from our proclivity here in the United States not to save—as a nation and as individuals, and to borrow too much. There are a number of policies that contribute to this proclivity: our tax code, for example, which taxes savings and capital and encourages consumption; and the weight of a number of our housing policies, which stimulated the housing market via Fannie Mae, Freddie Mac, FHA programs, the tax code and in other ways that contributed to asset inflation. By contrast, there are a number of nations—including China, of course—where savings rates are high, and where domestic consumption plays a smaller role in their economy.

When I became Treasury Secretary, we established the Strategic Economic Dialogue (SED) to address our economic relationship with China. And through the SED we looked for practical ways to address the economic imbalances. This included the currency issue because moving toward a market-driven currency would accelerate the progress of reform and help China transition toward higher levels of domestic consumption, and producing higher-value-added goods and services, and away from over-reliance on lower-cost, lower-value-added exports. But I also argued for capital markets reform and opening up their capital markets to more competition, not because I was trying to do bankers any favor, but because I believed a vibrant domestic capital market would help China deal with the structural transformations it wanted to achieve. One example I used frequently was that, in China, individuals with their savings in bank deposits received very low interest rates, well below inflation. Because of inefficient capital markets, they were, in essence, paying to save, or unable to earn any significant return on their savings. And of course inadequate government retirement programs and other safety nets led to high levels of precautionary savings. We also focused on very high levels of corporate savings in China, particularly in the state-owned enterprises. So yes, I was mindful of the imbalances.

AI: We’ve been talking until we’re blue in the face about the kind of liberalization you’ve just mentioned, and of course about revising the value of the renminbi. The results have been uneven, have they not?

Hank Paulson: Yes, they have. While I was Treasury Secretary, we saw substantial movement in the renminbi. That shows, I think, that the right way to deal with the Chinese is directly and in private, recognizing that they place a huge priority on economic development and reform. We need to continue to make a broad case for reform that includes several dimensions. There’s a lot of emphasis placed on currency, because that’s easy for people to understand. But the currency issue is just one of a number of significant factors. I continue to believe that it’s in China’s interest, as well as our own, that it continues toward a full transition to a market economy. We need to privately, continuously and forcefully make the arguments as to why it is in China’s best interest, however, and avoid finger-wagging and lecturing them in public.

AI: Let me play devil’s advocate on this. It seems to me that no American policymaker has taken a hardball option with them very seriously. One way of thinking about Chinese currency policy is to liken it to a form of industrial policy. But unlike the Koreans and the Japanese, the Chinese aren’t subsidizing one particular sector, like petro-chemicals. They’re basically giving their whole coastal manufacturing region a big advantage over the rest of the world by keeping their currency pegged to the dollar at its current, unreasonably low rate. If it’s harming us, it’s absolutely killing the Europeans and everyone else in Asia. In a certain sense, China has been in effect de-industrializing much of the rest of the world. I’ve been to maquilas in Latin America since the end of the microfiber agreement and seen firsthand how manufacturing capacity is now being sucked out of these developing countries and into China.

If one were to regard China’s de facto export subsidy via its currency policy as theoretically no different from a direct subsidy to its manufacturing/export industries, the normal way to deal with this would be with a tariff or some other kind of sanction. That might lead to a series of threats and counter-threats, but eventually they would discover an incentive to change their policy. An analogy might be the Plaza Agreements with Japan in the 1980s, when the Japanese similarly built up a huge imbalance. Because Japan was an ally of the United States, and because the Japanese worried precisely about a protectionist backlash, they agreed to a major revaluation of the yen. But we’ve treated China, which is not an ally and whose imbalances are even larger than Japan’s were, much more gingerly. Why?

Hank Paulson: I’ve heard those arguments, and I understand them, but I don’t believe that tariffs or protectionism is the answer. And there are, of course, a number of countries in the world that don’t have market-determined currencies, but what is so extraordinary here is to have an economy that is so important, so large and so integrated into the global economy in terms of goods and services but does not yet have a market-driven currency or an open financial system.

So it is important for China to move more quickly toward a market-determined currency, which is its stated goal. But it should not be the job of the United States alone to make the case. The IMF, for example, also has an important role to play, as do China’s other trading partners. And again, factors other than the currency are important here, such as the extent to which corporate savings are not paid out in dividends. The picture that emerges is a complex one. I believe that China is committed to reform, and it is very much in their interest to continue to move the currency. We need to encourage speeding this process up while working to address our own imbalances.

AI: Let me ask you about the Chinese response to the crisis. Right now everyone is giving the Chinese plaudits for their really big stimulus, and for the fact that they only suffered for a quarter or so. (The last quarter showed almost 10 percent growth again.) They’re obviously feeling quite good about themselves as a result. But it seems to me that their response to the crisis was just to do more of what they’ve traditionally done, which is to fill in for missing external demand through huge infrastructure spending that greatly privileges the coastal manufacturers against the rural consumer population. Do you think this is sustainable?

Hank Paulson: First of all, in terms of their response, I think one of the benefits of the SED was that we had active engagement and built up a relationship of trust. So the Chinese were quite constructive and supportive as we worked through the crisis. We talked to them regularly and this benefited both countries.

Secondly, we all needed China’s economy to keep growing. If it hadn’t, we’d be much worse off today. I give the Chinese a lot of credit for their stimulus. I believe their most important action was increasing bank lending by more than $1 trillion. There will certainly be some repercussions from that, not all of them attractive, but I think that was a net positive.

I do believe, too, that the Chinese understand there’s more to do. There are a number of countries in the world in which the gap between the top and bottom rungs of the economic ladder is widening, and this is something the Chinese are concerned about in their own country. I believe their commitment to reform includes finding ways to spread wealth more broadly. One way to do that is to encourage an increase in domestic consumption and less reliance on exports for growth.

That will certainly take time. But again, the imbalances are bilateral and we can’t overlook our own penchant to overspend, overconsume and overborrow. We will, and we should, continue to forcefully engage with the Chinese, but we’ve got important responsibilities of our own to deal with. It will do us no good to shirk those responsibilities by focusing too much on China.

AI: I’ve heard you say over the past year that you’ve been at the Johns Hopkins University’s School of Advanced International Studies that oftentimes you didn’t find economists, particularly academic economists, to be particularly helpful. I haven’t been able to get you to say anything negative about the Chinese, and I don’t want you necessarily to say anything negative about economists, but I’m curious about what you think is missing from the way that economists think about the world.

Hank Paulson: I have a high regard for the profession in general and admire many economists. I was privileged to have a partner like Ben Bernanke, who is a brilliant, world-class economist and a great economic historian. This made a big difference. His skill set complemented mine.

My point then was simply that in the middle of a firestorm economic models and theoretical approaches aren’t particularly helpful. In the panic, many investors and creditors were driven by fear. Few, if any, economic models account for emotional responses like that. Economists, in my experience, largely seem to assume rational behavior, and that isn’t what happens in a crisis. Looking back after the fact a number of economists who understand the real world and markets have provided insightful postmortem analysis while others make observations that are so impractical they reveal an academic naiveté. But of course in any profession some professionals are better than others.

It is also worth noting that even in the buildup to the crisis, economic models weren’t as helpful as we would have liked. Of course, many economists warned of the dangers inherent in the global imbalances and some cited excesses, speculative behavior and signs of a bubble. But many of us, including most economists, made an incredibly significant assumption: that mortgages were relatively safe investments because residential housing prices have generally gone up for decades and we’d never experienced a nationwide housing price decline. This was reflected in most models, the work of the ratings agencies, and in the assumptions economists and bankers made. So economists and other experts only began to anticipate the impact on our capital markets and economy and the behavioral changes by homeowners that would accompany such a dramatic decline after it had begun to manifest itself.

AI: Apart from economists not being useful in the middle of a severe crisis, there seems to have been a certain amount of ideology in the way they thought about the world. Let’s take the idea of capital accounts liberalization, which we were pushing on everyone a few decades back. We kept pushing it even when the Asians who suffered the crisis of 1997–98 decided that it didn’t work so well. They started accumulating dollar reserves, doing to some extent what the Chinese had been doing all along; we kept encouraging liberalization.

Hank Paulson: There’s plenty of blame to go around. Perhaps some economists and some policymakers were too wedded to certain ideas. But, again, in the afterword to my book I argue that to use any one lens to see these problems is to miss a lot of what’s causing them. Quite aside from ideology, the structural imbalances we’ve already mentioned played a part. The financial architecture we had, globally and domestically, did too; it was woefully outdated, particularly in terms of the structure of the U.S. regulatory system. We had a situation in which there were gaping holes in some places and duplication in others. Big parts of the mortgage regulation function were not done at the Federal level.

We must create a systemic risk regulator to monitor the stability of the markets and with the power to step in and restrain or end activity at any financial firm that threatens the broader market. And the government must have resolution authority to impose orderly liquidation on any failing financial institution outside of the bankruptcy process to minimize its impact on the rest of the system so that no financial institution will be too big to fail.

Together these two reforms will enable the regulatory system to better prevent the kinds of excesses that fueled our recent crisis, restore market discipline and prevent the failure of a large institution from bringing down the rest of the system, because as long as we have capital markets, financial institutions will fail and we will have periods of market turmoil.

AI: Certainly a broad perspective is necessary to understand these issues, and for that reason it seems to me that the country was fortunate that you, someone who came out of Wall Street, had been appointed Treasury Secretary prior to the crisis. I think your two predecessors, Paul O’Neill and John Snow, would have been limited in their ability to handle a financial crisis of the sort we experienced. By contrast, you knew all the players and the rules of their particular games. I remember you talking about the tri-party repo market at one of our SAIS seminars, and everybody around the table went blank because no one had ever heard about this. Unless you’re in lower Manhattan dealing with these kinds of things, you don’t have a way to learn about it. On the other hand, having a Treasury Secretary come from Wall Street also has its problems, because you’re so close to the people you’re regulating. Do you have any reflections about that particular dilemma?

Hank Paulson: I’ve thought about this question in very practical terms. For the period of time I was there as Treasury Secretary during this severe crisis, we had the right team. As I describe in my book, we complemented each other well. I believe Ben Bernanke, not only a world-class economist but also a student of the Great Depression, wasn’t bound by bureaucratic or organizational structures, so he was able and willing to think out of the box and to be courageous. Tim Geithner, as head of the New York Federal Reserve, had excellent knowledge of both Treasury and the Federal Reserve and was a good crisis manager. We all knew it would be catastrophic if the financial markets collapsed. We understood how concentrated finance had become and what would happen to the country’s entire economy if the system went down.

I also believe that, in dealing with the crisis, at least as valuable as my knowledge of the markets was decisiveness. You could have Treasury Secretaries from a number of different backgrounds who, if they had the right kind of management experience, would be accustomed to making difficult decisions. They would know that in a crisis things come at you quickly, and that if you wait until you have every bit of information you would like before making a decision, you’ll end up looking in the rearview mirror at a smoldering ruin. So my finance background was very useful, but it was perhaps not as important to what was a team effort as was my management experience.

AI: You discuss some lessons, or themes, from this experience in the book.

Hank Paulson: Yes, three themes in the book are most important. One, which we haven’t talked about yet, is that there has been an ongoing collision of politics and markets. The crisis couldn’t have come at a worse time. The November 2008 election was just weeks away, and everyone had an eye on the voters—that’s about keeping their job—so anything that smacked of a bailout was going to be unpopular. But despite these obstacles Congress did act in time to let us prevent economic calamity. There, my skill-set in terms of working with clients and being able to communicate one-on-one in small settings allowed me to work with Congress to get things done, even if my public speaking skills were somewhat lacking.

The second theme of the book is how fast things were happening and how rapidly we needed to respond. We were always concerned about the unintended consequences of the actions we needed to take, but we knew that the consequences would likely be much worse if we didn’t take them. I hated so many of the things we did, but I didn’t spend a lot of time agonizing over them because I knew how bad it would be if we didn’t do them.

The third theme is the way people worked together during the crisis. Washington is usually pretty divisive and turf-riven. Just look at what’s going on now among different regulators as they talk about financial reform. But those differences were set aside during the height of the crisis. My background, or for that matter Ben’s or Tim’s, was less important than whether collectively we had the skills needed and the trust to work together effectively. There were areas in which team members needed to be independent, but others in which it was quite proper to work together and pool their respective authorities. That’s probably more important than any other single factor.

I’m grateful I had a year before the crisis to build a relationship of trust with the President, White House staff, my cabinet colleagues and members of Congress. I didn’t participate in political activities and this allowed me to build relationships with Democrats as well as Republicans, treating them like the clients they were.

AI: I was struck in reading the book that though the technical knowledge of financial markets was certainly important, so much of what you did was political. I’m thinking about your being on the phone constantly with candidates Obama and McCain to make sure they didn’t say or do something that would have exacerbated the crisis.

Hank Paulson: Yes. As I said, we couldn’t possibly have avoided the fact that political forces and market forces were colliding. The election was staring us in the face. I am grateful that both candidates supported the TARP legislation. If either of them had come out against it, I don’t think we would have gotten it passed, and we would have been left defenseless. It would have been particularly easy for John McCain to play the populist card at a time when he was falling behind in the polls, and when a number of Republicans found what we did to be particularly offensive because it went against our system’s core principle that those who take risks are supposed to bear the losses. I felt that way myself, and so did the President. But President Bush counseled that we needed to do what was necessary to save the economy, save American jobs and keep the system from collapsing.

AI: It’s hard in a democratic political system to set up institutions like the Federal Reserve and your office of Secretary of the Treasury, where the Executive Branch can act quickly and decisively without being second-guessed by Congress.

Hank Paulson: It’s very hard. Indeed, one of the major lessons I discuss in the book, which is of great concern to me as I look at the deficit right now, is that, unless there’s a crisis, it is extraordinarily difficult to get things done in Congress, particularly if they’re big and important and controversial things. Even if I had been omniscient, it would have been impossible to get the extraordinary powers we did to deal with Fannie and Freddie if they hadn’t been on the verge of collapse. Similarly, I don’t think we could have gotten the TARP legislation passed any earlier than we did. Remember that even in the middle of the crisis, the House voted “no” once. One of the things I’m proudest of, in part because it was so difficult, was our ability to work with Congress to get these things done, because virtually everyone who cast a vote for the TARP was making a politically unpopular vote.

AI: Can you make a case that, in a certain sense, the crisis wasn’t big enough? Thanks to the extraordinary efforts that you and Ben Bernanke and Tim Geithner and others put forth, the financial system did not completely collapse. Now, a year and a bit later, people are already saying, “Hey, what financial crisis?” We can both feel the political impetus for long-term change waning, just at a time when we need not just to learn but to apply the lessons of the crisis.

Hank Paulson: It is truly of great concern that more than a year later, a very popular President has not yet gotten the reforms we need for the regulatory structure: a systemic risk regulator with access to the necessary information and the power to step in to restrain any activities that are dangerous to the system, regardless of the type of financial institution; and the resolution authority to liquidate institutions when they fail, so that the taxpayer doesn’t have to come in and bail them out. Part of the reason we haven’t been able to get these reforms done is that, as you say, the sense of imminent danger has lessened. But this is complex legislation. It’s important to get it right and I am optimistic Congress will act.

There is something very ironic about this. When the markets froze up, Ben, Tim and I understood when we went to the Hill that the economy was not as bad as it was soon going to be. We knew things would turn down in a matter of weeks as a result of what was happening. There would be a lag effect. Congressmen didn’t yet see the effects in their districts, so we had to paint a picture of how bad things would be and how much worse they would be if we didn’t act now. We said, in essence, if you don’t give us these powers, great economic harm will befall the American people. They gave us those powers. And we used them.

The irony is that now the American people believe that economic harm has befallen them anyway, and they are right. We have unemployment of 10 percent. As painful as this is, however, I believe that without our extraordinary interventions we could easily have had up to 25 percent unemployment, like during the Great Depression. I knew we were on the brink in September of 2008 when blue-chip industrial companies were having great trouble raising financing. If the system had collapsed, many Main Street companies of all sizes would not have been able to get short-term financing to maintain basic business operations, to pay their suppliers and employees who then wouldn’t have been able to pay their own bills. This would have rippled through the economy, resulting in millions more jobs lost, millions more homes lost, trillions of dollars more in lost savings.

The American people don’t see that. It’s hard to get credit for preventing a catastrophe that never happened. People are very angry because in our system we don’t like to see taxpayers helping private business of any kind, and we think banks should be responsible for their own losses. Today, the anger that’s focused on Wall Street bonuses, which is quite understandable, but I’d like to see it channeled into getting the reforms we need so that no financial institution is ever again too big to fail and when it does, it will be liquidated and not preserved in its initial form. If we don’t get the necessary reforms the next financial crisis could be truly calamitous. Our political system is difficult to energize unless there’s an immediate crisis, and the situation now is that while a lot of ordinary Americans think there is still a crisis, it’s an economic crisis that requires job creation measures rather than a financial crisis that requires a new regulatory system. That helps explain both why there is so much anger out there, and why at the same time it’s been so hard to get regulatory reform passed.