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JUNE 12, 2006
Mr. Risk Goes To Washington Hank Paulson's profound understanding of risk and reward makes him the perfect pick for the Treasury
That's why many people were surprised when Henry M. Paulson Jr., CEO of Goldman Sachs Group (GS ) -- a power position if ever there was one -- accepted President George W. Bush's request to become the new Treasury chief. Treasury has been so minimized in recent years that most news outlets have been conditioned to downplay it. Most of their accounts of the Paulson nomination were heavy on fluff and devoid of specifics. Paulson was repeatedly lauded for the "credibility" he would bestow on the Administration's economic policy in the eyes of the financial markets. Some commentators opined, hopefully, that he would be a voice for "fiscal responsibility" who would have a "seat at the table" when economic policy was made. Others saw Paulson as a "heavyweight" who could more effectively deliver the Bush Administration's message of economic growth before the November elections. But all of that chatter misses the true significance of Paulson's appointment. What he'll bring to Treasury, and to Washington, is a more sophisticated understanding of risk and return than his two immediate predecessors had. As Treasury Secretary, he'll be perfectly positioned to explain to Senators and citizens alike the true consequences of various policy choices in such vital areas as free trade, where avoiding risk means falling further behind. PROFIT MACHINE Think of Paulson as Mr. Risk. He's one of the key architects of a more daring Wall Street, where securities firms are taking greater and greater chances in their pursuit of profits. By some key measures, the securities industry is more leveraged now than it was at the height of the 1990s boom. It has also extended its global supremacy since then. Goldman, under Paulson's leadership, became one of the greatest and most profitable risk-taking machines ever built. Since 1999, when he took over as sole CEO, Goldman has competed with bigger rivals such as Citigroup (C ) and JPMorgan Chase & Co. by being aggressive, making smart gambles, and putting the company's own money into deals. Paulson stresses Goldman's willingness to take risks along with clients in the latest annual report: "Investment banks are expected to commit more of their own capital when executing transactions." The subject has become an obsession at Goldman: how to find profitable risks, how to control and monitor them, and how to avoid the catastrophic missteps that can bring down whole companies. That means taking on more debt: $100 billion in long-term debt in 2005, compared with about $20 billion in 1999. It means placing big bets on all sorts of exotic derivatives and other securities. And it means holding almost $50 billion in the piggy bank, enough cash and liquid securities to keep the firm going in the event of a financial crisis. By contrast, Robert E. Rubin, head of the National Economic Council and later Treasury Secretary under President Bill Clinton, was Mr. Prudent. Rubin also came out of Goldman Sachs, but it was a much smaller firm back then, and because Goldman was a private partnership, it had limited access to the public capital markets. That made Rubin far more attuned to the need to preserve and protect capital. Perhaps that's one reason why he pushed for frugality from the very moment he entered government. The appointment of Paulson, Mr. Risk, as Treasury Secretary is at once ironic and completely appropriate. According to conventional economic wisdom, the single biggest problem the U.S. faces is a massive accumulation of debt. Both liberal and conservative economists warn that the bulging trade deficit, now roughly 6% of gross domestic product, poses a danger of sending the dollar plunging and causing a financial meltdown. The federal budget deficit for 2006 will hit at least $300 billion. And current projections call for Social Security and Medicare to run up enormous deficits in the long run. Yet Goldman actually has leveraged up faster than the U.S. government in recent years. In 1999, Goldman had about $1.60 in long-term debt for every dollar in net revenue. In the same year, the federal government had $3.10 in debt, mostly long-term, for every dollar in revenue. Today the government has about $3.70; Goldman, around $4. Clearly, Paulson isn't scared by debt and risk-taking. That might make him the ideal person to grapple with the U.S. economic and fiscal situation, which is more similar to Goldman's than most economists will admit. Facing intense competition from around the world, the only way the American economy can thrive is through risk-taking. Indeed, some economists have characterized the U.S. as a giant venture capital fund that sucks in money from overseas and invests it in high-risk, high-return projects. OLD ECONOMY THINKING The two previous heads of Treasury, Paul O'Neill and John W. Snow, came out of the old industrial economy. Before moving to Treasury, O'Neill was head of Alcoa Inc. (AA ), the aluminum giant, and Snow led the railroad giant CSX Corp. (CSX ) -- two industries where growth is slow and borrowing is to be avoided. Paulson comes out of the part of the economy where the U.S. still has a preeminent global position, growth is strong, and borrowing to take advantage of opportunities makes sense. It's hard to know whether Bush and his staff understood the difference between Paulson and his predecessors when he was first approached several weeks ago. At the time, Paulson said he wasn't interested. He didn't change his mind until he met with Bush on May 20. According to an individual close to Paulson, the President told the Goldman chief he wanted a "very senior person" from Wall Street. He also said he wanted Paulson to play a broader role in his Administration than had previous Treasury secretaries, taking on the role of Bush's "principal adviser" on economic matters and driving economic policy. Heady stuff. Yet it seems hard to imagine that Paulson will have more than a marginal influence on tax policy, especially if the Democrats make political inroads in November, as seems likely. And the dollar will be affected far more by economic events, such as the course of inflation and growth, than by anything the Treasury Secretary can do. Instead, what Paulson brings to the Treasury Dept., the Bush Administration, and, in fact, all of Washington, in addition to his understanding of risk, is an ability to communicate its upside and downside. The importance of risk shows up in virtually every economic issue of the day. Take free trade, a subject that falls under the purview of the Treasury Secretary. Keeping the U.S. open to foreign goods and services is essential for growth, both in this country and abroad. Yet free trade creates risks for Americans. If Paulson can communicate the pros and cons of trade to voters and politicians, he'll do the country a service. Or consider tax cuts, a subject dear to the President's heart. Whether or not you believe lowering taxes is a good idea, the logic seems clear: Cutting taxes accepts the certainty of a bigger budget deficit today in exchange for a less certain boost to economic growth in the future. A Treasury Secretary who can get that idea across could be highly influential in Washington. Paulson is already on the record as favoring the risk-reward proposition. "I still prefer the situation we're in to a situation without a deficit but with no growth," he told German news magazine Der Spiegel last November. Within Goldman, Paulson is known as an exceedingly effective communicator. If he can translate Wall Street's language of speculation into something the public and politicians understand, the President's gamble in appointing him will pay off for everyone.  By Michael Mandel
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