Published in the Financial Times on May 31, 2006
Rosenberg Professor of Global Finance at the International Business School, Brandeis University
|Paulson has the tools
but needs Bush's support
The announcement of Hank Paulson's nomination as US Treasury secretary is good news for everyone. In many ways he is the perfect complement to Ben Bernanke, the new Federal Reserve chairman. A giant among monetary policy thinkers is being joined by one of the most important financiers in the world. We now have the essential combination of a theorist working with a practitioner.
The big question is what will President George W. Bush do with his new top-quality team? Will the White House finally promote high-quality economic policy above pure politics? Or will Mr Paulson be frustrated in the way that past Bush economic advisers have been?
We will at least see the benefit of having a highly placed government official who knows how to communicate with Wall Street. Having spent nearly his entire professional life in the financial markets, Mr Paulson is fluent in the language of traders and investment bankers. He knows the concerns of the markets and how to respond to them using an efficiency of language that comes only from experience.
As we have seen recently, it can be very difficult to communicate economic policy. Small missteps can create large movements in stock and bond prices - movements that are potentially damaging. Since the retirement of Alan Greenspan as Fed chairman, no one on the Bush economic team has had the ability to soothe the markets in the face of minor problems of language. It is amazing how important it is to get the adverbs and adjectives exactly right when speaking to financial markets. Now we have someone who knows how to do it, leaving the Fed to concentrate on making interest rate policy. The benefits are likely to be enormous.
But we can expect much more than just words from a person of Mr Paulson's experience and accomplishments. We now have someone who has the tools to face the country's big economic problems head on. Those challenges are huge. A successful Paulson Treasury must put the relationship of capital markets and economic growth on a more solid footing. This means facing three separate, but related issues: the relationship of the federal government to the economy, the interactions between the US economy and the rest of the world's economies, and the problems associated with financing retirees.
The job of fiscal policy is to provide the underlying foundation for a growing economy. That is a very complex job involving not only security, but ensuring that capital flows to its most productive uses. The ideal Treasury secretary is a successful advocate for fiscal policies that maximise economic efficiency. This is a matter of implementing the right combination of tax and expenditure policies. In recent years, tax law has become riddled with special provisions that both distort incentives and leave most people feeling it is unfair. The solution is fairly simple: we need to simplify the tax system and, of course, find a way to reduce the fiscal deficit at the same time. This requires a good relationship with the US Congress - something few recent Treasury heads have had.
In an increasingly globalised economy, the Treasury secretary has taken on an ever bigger role as the facilitator of international capital flows. This is more than just running US exchange rate policy, which the secretary does in conjunction with the Federal Reserve. It includes working to ensure that global imbalances are kept under control, reducing the threat of large, sudden movements in exchange rates, or abrupt reversals of the flow of capital. Again, a steady hand (and voice) at the Treasury can help to reassure foreign governments and investors, thereby reducing harmful volatility.
We can be optimistic that there will be an improvement in the relationship between the US and China. Economic policy towards China is about much more than just exchange rates. It is about how to integrate emerging Asia into the modern economic system. Here, Mr Paulson seems likely to excel, assuming that he is given the appropriate independence to make policy.
Finally, Americans are consuming all that they earn, saving nothing. Foreigners are providing all of the 7 per cent of gross domestic product that makes up investment net of depreciation. As a result, it is hard to see how Americans will be able to finance their retirement years. Something has to be done about this. We need someone with the stature to lead a national debate on this subject, culminating in a course of action that is agreed by all parties.
Solving these problems means negotiating the co-operation of groups with disparate interests. Mr Paulson will have to negotiate tax reform and deficit reduction; find a way to convince people that trade creates low-priced goods that benefit everyone and that international capital flows allow us to grow faster. He must persuade younger workers to save while convincing the relatively well-off elderly to give up some of their government-supplied pension benefits.
Among the hardest to convince of any of this will be Congress. Paul O'Neill and John Snow, the previous two Bush Treasury secretaries, surely understood the economics of everything that I am saying. But they lacked the full support of the White House to push for good economic policy in the face of political unpopularity, and the ability to articulate the message using the language that markets understand. Mr Paulson will definitely provide the second of these. Let us hope that President Bush gives us the first.
Stephen G. Cecchetti is Rosenberg Professor of Global Finance at the International Business School, Brandeis University.
Archive of his articles
published in the Financial Times