The CEO of Goldman Sachs talks about world economy

"We Should Expect Upheavals:" Der Spiegel interview with Henry Paulson

Henry Paulson, CEO of the investment bank Goldman Sachs discusses global imbalances, the rise of China and German pessimism.
(Henry Paulson spent several years with the Nixon administration before he moved to Goldman Sachs -- one of the world’s leading investment banks -- in 1974. An offensive lineman in his college football days and a Harvard MBA graduate, Paulson (59) has been heading the group and its 21,000-strong global workforce since 1999. There is no sign on the firm’s Manhattan headquarters. Discretion is the name of the game in this business of buying and selling entire corporations -- with billions of dollars at stake.)

SPIEGEL: Mr. Paulson, the global economy is shaky: China is flooding the world with cheap products. The Americans have to finance their spending sprees with loans, and worried Germans are saving every euro they can. How long can this last?   

Paulson: I don't share your pessimism. Most of the countries in which we do business are either performing better than they did last year or are doing better than expected. The U.S. economy has grown at a healthy rate and, notwithstanding the severe hurricanes, it is likely to continue producing solid growth. That gives us a position of strength from which to deal with these imbalances.   

SPIEGEL: You aren't worried about the dramatically rising budget and trade deficits in the U.S.?   

Paulson: The United States has a long way to go to achieve a balanced budget. The trade balance is a problem; the fact is we're just not exporting enough. That said, I still prefer the situation we're in to a situation without a deficit but with no growth.   

SPIEGEL: So, U.S. President George W. Bush and his administration can lean back and relax?   

Paulson: Absolutely not. The US still has a lot to do to resolve its budget problems. However, the trend in foreign trade is unlikely to be reversed any time soon.   

SPIEGEL: The U.S. economy is increasingly dependent on the willingness of the Chinese and other Asian countries to buy huge quantities of U.S. dollars to keep the currency from crashing. Is America's monetary independence under threat?   

Paulson: I think it's ironic when the very people who rely on growth in the United States for their exports complain about our deficit at the same time. The majority of the world's countries depend on America as the most important engine for growth.   

SPIEGEL: But this situation - where the world's poorest nations feed capital to its richest country - flies in the face of all experience. It would be like water running up a mountain.   

Paulson: It is as much in China's interests as those of the U.S. that China invests in the dollar. I would say the same about some of our European trading partners. Moreover, a lot of money around the world is seeking investment opportunities. Growth and returns on capital are important drivers of these inflows.   

SPIEGEL: Nonetheless, how do we get out of this situation?   

Paulson: The United States can only reduce its budget deficit through further growth and greater spending discipline. Trade imbalances normally take care of themselves over time, as currencies adjust or - as in Europe - there is increased growth. Provided, of course, that we are not going to have trade wars or an increase in trade barriers. Those would be very bad for the world economy.   

SPIEGEL: One other scenario is conceivable: The dollar crashes, interest rates take off, oil prices climb, the U.S. real-estate bubble bursts, the American consumer stops spending - and the global economy collapses.   

Paulson: The risk I worry about the least right now is a dramatic drop in the dollar. And I don't believe there is a general housing bubble. There might be anomalies in certain regions but I don't see a real estate bubble across the U.S. What I am really concerned about is energy prices. A cold winter in the U.S. could affect growth and the behavior of consumers. But, having said that, who would have thought two years ago that the US, Japan, China and parts of Europe would be doing as well as they are right now? From my perspective the glass is half full rather than half empty.   

SPIEGEL: China has abandoned the yuan's peg to the dollar  and is now using a basket of its currencies. Other countries, including Russia, are maintaining their currency reserves in euros. Is the dollar's global supremacy over? 

Paulson: The decision by Beijing is an important step on the way to letting market forces drive the value of the currency. And having a currency basket makes a great deal of sense. After all, China trades with the entire world . However, although central banks regularly adjust their foreign exchange holdings, there is no credible evidence of a flight from the dollar as the most important reserve currency.   

SPIEGEL: International currency markets have become highly speculative. In the past, investors with huge hedge funds - like George Soros - have successfully attacked the British pound and Asian currencies. Could that also happen to the dollar?   

Paulson: Given the dollar's size and its role as a reserve currency, I don't believe that is likely to happen.

SPIEGEL: Don't hedge funds have far too much power? 

Paulson: Most hedge funds are run by highly sophisticated investors and many of them are long-term investors. They provide liquidity and also play an important role in addressing corporate governance issues. From my perspective, it is a mistake to demonize them. They are, however, currently at a cyclical peak because there is so much money around the globe seeking profitable investments. That does pose a risk.

SPIEGEL: The crash of the LTCM fund brought the world economy to the brink of disaster in 1998. Is a similar crisis around the corner now?   

Paulson: Since then we have not seen a comparable financial shock globally. We have gone through the Internet bubble and September 11. There have been wars and spectacular corporate failures. Nevertheless, there has been no genuine crisis in the financial markets so far. It's been a long time since 1998. Markets and the various groups of market participants are increasingly interconnected. That said, we must never lose sight of the possibility of a shock that might have broad implications. 

SPIEGEL: The world is more tightly networked today than ever before. The next crash would be much more dramatic. 

Paulson: We need to think about this differently because the markets have changed dramatically. We also need to remember that many of those people who now work at regulators, central banks and investment banks didn't experience the last crisis. That lack of experience could be a potential problem. 

SPIEGEL: And what are the advantages? 

Paulson: Just think of the collapses of Enron and WorldCom. They had an enormous impact on the business community and on the rules and regulations for jointstock corporations. But the financial markets absorbed the shocks reasonably well. One reason for this is the development of relatively new financial instruments, such as credit derivatives, that have made it possible to manage risks better. That has been a major breakthrough. 

SPIEGEL: Today, there are regulatory agencies for banks, insurance companies, mutual funds and stock markets. But risky instruments such as hedge funds and credit derivatives are barely regulated. Why? 

Paulson: The fact is these instruments have grown extremely quickly and regulatory bodies have relatively little experience of how to deal with them. But it is inaccurate to say that there is no regulation and there are also a lot of discussions going on between the relevant authorities and market participants. I am sure that much thought and action will take place in this area, particularly within the industry, and all parties involved need to do their part. 

SPIEGEL: But voluntary commitments don't help. We would feel more secure if there were some form of government regulation. 

Paulson: SEC registration of hedge funds is a positive step and certainly helps create greater transparency. But I believe it would be a mistake to deprive hedge funds of their flexibility. They make a major contribution to market efficiency. 

SPIEGEL: For many people, the effects of globalization are felt at their workplaces, rather than on the stock exchange. How has the rise of such countries as China and India changed the global economy? 

Paulson: First of all, we should be happy that so many Chinese and Indians have escaped poverty during the last two decades because their countries have opened up. And it is welcome that this has provided the world with additional growth engines. If China and India failed to grow we would all have a much bigger problem. 

SPIEGEL: That's no consolation to the people who have lost out in the process. 

Paulson: Countries that have opened themselves up to globalization have benefited overall. For instance, in the US, cheap imports from China have helped to keep inflation low despite the fact that energy prices have been rising for some time. 

SPIEGEL: But: Where are the new jobs to replace the millions that have been lost to the Far East? 

Paulson: I doubt whether we're really talking about millions of jobs. However, when societies as a whole benefit it is inevitable that there will be winners and losers in every country, including China. While the standards of living have been rising generally the gap between the very poorest and the very richest has also widened. In the best interest of the poor, we need to learn to better cope with such strains. 

SPIEGEL: But how? Aren't you concerned that public opinion might turn against globalization and open markets more dramatically? 

Paulson: I agree that there is a lot of concern about what this change means for individuals. As a matter of fact, during the last century people were always coming up with alternatives to capitalism, and they were broadly either communism or socialism. 

SPIEGEL: You think the downside of capitalism is becoming the focus of attention because there aren't any alternatives? 

Paulson: Exactly. Overall, societies benefit from free trade. But there will be winners and losers. What we need to do as a society is to figure out how best to deal with some of the most difficult effects and how to protect those least able to protect themselves. By the way, these are not new problems. 

SPIEGEL: What do you have in mind? Investment banks like yours are not exactly known as being charitable organizations. 

Paulson: With good reason. However, in their own best interests, businesses have to think about this issue. In this context, business leaders normally talk about ongoing education, development programs etc. I am not sure whether this will be enough. But one thing is certain: Wherever we hold back or delay globalization, we will create difficulties for even more people. If there is one lesson for us to learn from the disastrous economic policies of the 1920s it is this. 

SPIEGEL: What needs to be done? 

Paulson: Governments have a duty to fight poverty. At a minimum there should be health and pension insurance. The key question for the 21st century is how we can promote free trade without losing political support for it. 

SPIEGEL: President Bush is no friend of strong government. He prefers to let the markets decide. Now, of all people, a Wall Street banker is suggesting this is wrong? 

Paulson: This isn't a specifically American problem, it's one facing all industrialized countries. The most important task is to determine what we are to do about those industries and employees that are no longer competitive. How, and more importantly, for how long, will we support the adjustment process? What safety net can be offered to the people who are affected by the changes in their industries? 

SPIEGEL: With all due respect, you haven't explained where the new jobs will be coming from. After all, you can't retrain millions of unemployed people to be bio-tech engineers. Paulson: Right. And former assembly line workers are unlikely to be able to work for Google. For certain issues we have no immediate answers. We still have to figure them out. And we will see major upheavals. Throughout history there have been upheavals. Just think of the Industrial Revolution in the 19th century. I only hope that we will manage them better this time around. 

SPIEGEL: Right now, the Chinese have set themselves the goal of becoming the world's leading economy. 

Paulson: They still have a long way to go. At the moment, for the most part, they assemble products at low cost. China is an important country but it faces many challenges. Just think about the currency or the issue of copyright protection. I have traveled to China more than 70 times since the late 1990s and have seen the changes taking place, but I'm surprised that many people who have not followed China closely in the past suddenly see the country moving to the top in the express lane, if you will. This change hasn't happened overnight. 

SPIEGEL: Your own economists predict it will overhaul the United States by 2040. 

Paulson: At the moment, China is stuck half-way between a market economy and a planned economy. Many state-owned companies have already been privatized, but those were the easier cases. Some 150,000 businesses are still state-owned. Agricultural reform remains an issue. Moreover, in the long run, the leaders of the country will have to deal with the question of whether it is possible to give people economic freedom without opening up politically. And, finally, the capital markets: You have to bear in mind that the market capitalization of the entire domestic Chinese stock market is the same as that of General Electric!

SPIEGEL: How much business do you do with the Chinese? 

Paulson: We are proud of what we have achieved but, compared to the business we do in Europe, we are still at an early stage. We are building relationships which Goldman Sachs will hopefully benefit from in the distant future. 

SPIEGEL: There are other risks to the U.S. economy and possibly the world economy: What sort of consequences will hurricane damage have for the States? 

Paulson: Katrina will slow down growth in this quarter. But we will benefit from reconstruction spending during the next half year. The effects of the hurricanes are serious because they destroyed oil refining capacity and other energy production. High gas prices represent the biggest risk. They could have negative consequences for overall economic activity and affect several industries. But there is something else I am really concerned about. 

SPIEGEL: And that would be? 

Paulson: We have to consider the impact on the American psyche. The pictures of widespread poverty from New Orleans and other parts of the Gulf Coast were really shocking. We need to hold a discussion about the gap between the poor and the rich in America. As Katrina has shown in a startling way, a lot needs to be done. In my view that is the most important consequence of the catastrophe. 

SPIEGEL: You visited Germany just before the elections in September. What was your impression? 

Paulson: I talked to several CEOs. Many of them were skeptical about the state of the nation and whether the reforms would continue. But their companies are doing quite well. They have made many of the necessary changes. I can think of no other country in the world where businesses have done more to put their houses in order during the last five years than Germany. 

SPIEGEL: Does that apply to the government as well? 

Paulson: Of course, I would like to see more dynamism. But Agenda 2010 has brought important reforms. Sometimes it simply takes more time for success to become evident. Germany still needs to move on wages and consumption, but we believe that the German economy will grow somewhat more strongly during the fourth quarter. 

SPIEGEL: Were you surprised by the result of the election? 

Paulson: Like many others, I was concerned about the challenges of forming a government given the lack of a clear majority for either one of the political camps. What is important is that Germany does not stand still but builds on Agenda 2010. However, by and large, I am much more optimistic about the country's prospects than many of the people I have spoken with in Germany, and I also believe that the economy would grow much more strongly if there was more optimism. 

SPIEGEL: Mr. Paulson, thank you very much for this interview.   

(Interview conducted by Frank Hornig and Alexander Jung.)

I LOVE THAT Paulson brings up the rich-poor income gap in America as a matter for serious discussion. But who's going to discuss it: the a-holes in Congress? What the hell are they good for? They're about as useless as our administration, who don't have the brains or the balls to get us out of Iraq.