Mr. Paulson goes to Washington

(Fortune Magazine) -- When President Bush confessed that he was stunned by the GOP's "thumpin' " in the midterm elections, he also announced his intention to stay in the domestic policy game - with Treasury Secretary Henry M. "Hank" Paulson Jr. as his running back. Now, with the Democrats set to take control of Congress, Paulson is positioned to emerge as the most important Republican economic figure in Washington. The former Goldman Sachs (Charts) CEO, initially reluctant to accept the job, has brought to the office in a mere four months an aura of gravitas that eluded his two predecessors. Just as important, he has cultivated ties to leading Democrats - something sorely lacking inside the Bush White House. Paulson also provides the deepest relationship with official China of any American in public life, giving him a unique vantage for shaping the global economic landscape and aiding on critical foreign policy concerns, such as stopping a nuclear-armed North Korea.

Still, Washington isn't Wall Street - and it remains an open question whether this dealmaker, known for his rigid discipline and follow-through, can break through the partisan stalemate and make Bush's last two years in office count for something. At the top of Paulson's to-do list: a renewed charge to reform Social Security and Medicare, which officials describe as a massive unfunded liability. But in a wide-ranging interview with FORTUNE two days after the election, Paulson also revealed his negotiating strategy with China, his plans to block Democratic tax hikes, and his intention to revisit corporate-governance standards. An avid conservationist, Paulson is active in administration policies to halt "America's addiction to oil," as President Bush has put it, by promoting alternative energy.

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Managing editor Andy Serwer and Washington bureau chief Nina Easton sat down with Paulson in his 19th-century Treasury Department suite overlooking the White House. On the wall behind Paulson hung a pair of Impressionist paintings from the department's collection; in front, a massive portrait of Alexander Hamilton. Paulson has infused this sedate setting with signs of his adventure-filled personal life: photos recording his travels to exotic locales (and his odd passion for snakes), and a wall filled with wildlife shots taken by his wife, Wendy, who once led bird walks in New York City's Central Park. As the 6-foot-1 Paulson leaned into his answers, it was clear that the intensity behind his climb from gridiron star at Dartmouth to an $800 million man hasn't cooled. Edited excerpts:

Mr. Secretary, yesterday the President designated you the point man on entitlement reform. Are you going to surprise Washington by partnering with incoming Ways and Means chairman Charles Rangel on this issue?

The big issues will take bipartisan support. Retirement security will take cooperation with leadership on both sides, Republicans and Democrats. I like Charlie a lot personally, and I look forward to working with him. He's going to come in for lunch next week.

How hopeful are you about finding some common ground within the next year on this politically thorny issue?

I don't want to give any impression that I believe this is an easy matter. If it were easy, it would have been solved by now. But I'm going to make a big effort. I'm not just talking about Social Security but also Medicare and Medicaid. If we can get people to come to the table and make some progress, great. And if we can't, I'm not going to tilt at windmills. I'm not a politician. I'm not going to accept conventional wisdom.

When you first came into office in July, you spent a lot of time on Capitol Hill meeting with lawmakers from both parties. Do you feel as if this administration up until now has fallen short on reaching across the aisle to address some of these issues?

I wouldn't say the administration has fallen short. I would say that there is, in general, more partisanship than people on either side say they would like. So my whole approach is going to be to work very hard myself to come up with solutions. If I don't succeed, I don't want it to be for lack of trying, and I want to ascribe the very best to everyone else unless proven otherwise.

I always told people in the private sector, "You can be the smartest person in the world, you can have the very best ideas, but if you can't sell them and you can't get other people to work with you, you're not going to succeed."

What is your greatest fear about the American economy going forward right now?

I don't have a greatest fear about the economy. I know that obviously there is no certainty. But I feel much better about the economy today than I did when I was in the private sector in January. Then, I was looking at a rate of growth that was unsustainable and a housing market that was clearly growing at an unsustainable level. I was looking at some early signs of inflation, and I knew it was very important to get that under control if we were going to extend this business expansion.

I heard the talk of a soft landing, and I remember joking with people and saying, "Well, that will be one in a row." Now we've got a healthy, diverse economy. There are some very good signs that we're making the transition from an unsustainable level of growth to a sustainable level of growth. There has been some recent good news on the inflation front, and even more important, there have been data that indicate that the average worker is sharing in the benefits to a much greater extent.

Aren't you concerned that GDP growth dropped to 1.6% in the latest quarter? That's kind of anemic, and we've seen a downturn in the housing market. Convince us we're not going to have a recession next year.

I can't convince you. But as I looked at the third quarter, I felt good because I saw a major correction in the housing market, and I knew that was going to take more than one percentage point off GDP. And then I'm looking at the rest of the economy - strong corporate profits and investment, good growth outside the U.S., strength in the construction sector away from housing, and then an equity market that has gone up and added $1 trillion in value.

I know how much people care about housing. But I would be quite hopeful that through 401(k) plans, pension plans, and elsewhere that the average American is feeling an uplift from the appreciation of the equity market that would be very offsetting to any potential decline in housing.

What's the outlook on the Bush tax cuts now that the Democrats will control Congress?

We had a cabinet meeting this morning, and I made a point, which I know the President strongly agrees with: With our economy still as strong as it is and the expansion where it is, the last thing this country needs is a tax increase right now.

Will the President use his veto power to block tax hikes?

I can't speculate. I've been actually very encouraged by what I read Charlie Rangel was saying - that he didn't think a tax increase made sense either.

As Treasury Secretary, how do you defend a policy that pairs tax cuts with the financing of a costly war in Iraq?

Clearly, nothing could be more important than making sure that our troops in Iraq have everything they possibly need to allow them to be successful. And fortunately the answer to your question is made much simpler by the fact that we have a strong economy.

So while we financed the war on terror and dealt with the cost of a couple of hurricanes, we still have a fiscal deficit that's roughly 1.8% of GDP, and that's below the average size of the deficit over the past 40 years. Revenues are pouring in right now. The whole concern about the deficit doesn't come from the current fiscal deficit; it comes from looking ahead a number of years to the entitlement deficit we see looming on the horizon.

You recently suggested that you share concerns about the disparities in wealth in this country.

There have been a number of years where our economy was growing and employment growth was strong, but the average worker didn't feel the benefit, largely because of the cost of energy and health care. What you've seen happen this last year - separate and apart from the appreciation of the equity market - is good news on the inflation front, particularly with energy prices. And for the past 12 months you've seen real wage growth, up just a little bit less than 2.5%.

You've said privately you were surprised at the breadth of protectionist sentiment you have encountered on Capitol Hill. What does that mean for the President's fast-track authority on trade agreements, which expires next year?

There has been an interesting paradox in that the lesson over the past 20 years is that those countries that open themselves up to competition - through trade and integration into the global capital markets - have benefited, and the rest have been left behind.

But in virtually each of those countries you can see that there is greater protectionist sentiment. You could see this in the U.S. You could see it in China. You could see it throughout Europe. Shorter-term dislocations - job losses - can be very painful and are visible, and the new jobs aren't as visible. The prosperity and increases in living standards aren't quite as visible.

I've listened very carefully to what some of the Democratic leaders are saying after the election, and some are very encouraging. When I go up and talk to people on the Hill, the sentiments they're expressing are the sentiments of their constituencies. I always knew that I was going to swim against a strong current here, and I still expect that to be the case, but I remain optimistic because with our economy as strong as it is, we approach these discussions from a strong starting point.

Are you going to look at changes on environmental standards, labor standards - all the kinds of concerns that the Democrats are likely to raise in the next few years?

Those are part of the political calculus in any trade agreement, and they're not going to go away.

What's your view on Sarbanes-Oxley, and what sort of reforms do you think are needed in the capital markets?

There are a number of [outside] committees that are studying this, and we'll look carefully at what any committee says. But I've been spending a fair amount of time here at Treasury and with the President's Working Group on Financial Markets - with [Federal Reserve chairman] Ben Bernanke, [SEC chairman] Chris Cox, [Commodity Futures Trading Commission chairman] Reuben Jeffery - thinking through these issues. I will be making some remarks on this topic in New York on the Monday before Thanksgiving.

Care to preview those remarks for us?

What I would say to you is that the capital markets are a cornerstone of our economic success in this country. They play an important role in job creation and prosperity. In terms of [recent] business scandals, you would have to go back a long time - maybe to the Depression - to find a comparable period. We had a great deal of fundamental reform and regulation: Sarbanes-Oxley, the listing rules. Virtually all of it was well intentioned and based upon sound principles, and in totality I think it went a long way toward helping restore confidence in the markets.

I care about making sure we have markets that are strong but that regulation is not overly burdensome. I don't believe we're going to need new legislation. I think that the things we want to accomplish can be accomplished through implementing the existing regulation differently.

And then I think there are some other things, which are much more fundamental and difficult, that we're going to have to think about and deal with over a much longer period of time, but that are very important and don't lend themselves to easy answers.

Mr. Secretary, you've been to China 60, 70 times?

I've stopped counting now but it's well over 60, probably over 70 by now.

Given that rare breadth of experience, can you offer some lessons in negotiating with the Chinese?

The key is to understand that our economic futures are very much interrelated, that for us to have a successful economic relationship it needs to be mutually beneficial. We have to listen as well as talk, and we need to do things that will address the relationship over a much longer period of time. But if we're going to be able to do that, we have to get through the night, as it were, and so we have to deal with short-term issues in order to make sure we keep confidence on both sides.

If we talk about the biggest issues - greater flexibility, greater growth in their imports, their consumption, making the transition from savings of close to 50% to consuming more, protection of intellectual property - we agree on every one of those points in terms of a policy. But there are differences on timing. The case that I will be making is that it is in China's best interest to speed up the pace of their reforms and move ahead more quickly. There's greater risk to China and the rest of the world if they move slowly as opposed to moving faster.

So how do you apply that thinking to the currency issue?

As I talk with the Chinese on currency, I encourage them to move much more quickly with opening up their capital markets to competition, because I don't believe the world is going to give them as much time as they would like. The world is not going to say, "You're just some poor little developing country," because they are a huge part of the economic system. If they're going to take their economy where they need to go and move up the value-added chain - moving from being a manufacturer of low-value-added products to a developing and more complex economy - they're going to need to have a currency that is flexible and reflects economic reality.

When North Korea agreed to come back to the six-party talks, many credited Chinese pressure and some of the financial pressure we've put on the regime. Did you personally have discussions with Chinese officials regarding North Korea's nuclear tests?

This is an area that [Secretary of State] Condi Rice handles. And my role is to coordinate all of the economic discussions within the administration and to work toward having a stronger economic dialogue. I do believe that one of the benefits we get out of a strong economic dialogue with China or any other country in the world is that the more integrated any country is into the global economic system, the higher the cost of any disruption, political tension, military tension, or whatever. So China has a great stake in continued economic growth around the world, and instability is the enemy of that growth.

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