Paulson is pressured by G-7 demands to aid dollar, credit markets

By Rich Miller and Simon Kennedy
Bloomberg News Service
Monday, October 15, 2007

http://www.bloomberg.com/apps/news?pid=20601087&sid=aiXgH4EYAOe0&refer=home

A former Master of the Universe like Henry Paulson doesn't often find himself on the defensive. At international meetings this week in Washington, he will be.

Under pressure from European governments to abandon his hands-off approach to financial regulation and the depreciating dollar, the U.S. Treasury secretary and former Goldman Sachs Group Inc. chief executive officer may be forced to accede to the first while resisting the second.

"The U.S. is no longer able to give a flat 'no' to some of the suggestions" coming from overseas, says Brad Setser, a former Treasury official and now a fellow at the Council on Foreign Relations in New York.

As Paulson, 61, prepares to host Group of Seven finance ministers and central bankers in Washington Oct. 19, his ability to fight back has been undermined. He lacks the bully pulpit the U.S. had in recent years, when its economy was the strongest in the industrial world, and the August credit-market turmoil has tarnished his reputation as a financial authority.

"You have a Treasury secretary who comes from Wall Street, who is supposed to know about markets," says John Kirton, director of the G-8 Research Group at the University of Toronto and a former Canadian government official. "We haven't heard from him that he's got a handle" on the situation.

...Leading the Charge

European nations are leading the charge against him. With the euro hitting a record high versus the U.S. currency, European exporters are being priced out of foreign markets.

"Sales of German exports are falling off drastically in the U.S.," says Anton Boerner, president of the Berlin-based BGA association of wholesalers and exporters. "We've stepped beyond the pain threshold."

France has been particularly vociferous in advocating action to stem the euro's rise, with Finance Minister Christine Lagarde, 51, even pushing the European Central Bank to sell the currency. She has also called on Paulson to say "loud and clear" that he still backs a strong dollar.

While Paulson has said repeatedly that a strong dollar is in America's interest, he says the value of currencies should be set by the market. Under President George W. Bush, the Treasury has never intervened in the currency market, either to buy or sell dollars.

...'Most Important'

"The most important thing for the U.S. is to maintain the stance on currencies that they've had," says John Taylor, Bush's former Treasury undersecretary for international affairs and now a professor at Stanford University in California. He says it's "unlikely" Paulson's rhetoric will change.

Paulson should be able to fend off pressure in part because the Europeans themselves aren't united on the issue. In spite of complaints from exporters, Germany has made clear it doesn't want to weaken the euro, with Finance Minister Peer Steinbrueck saying Oct. 9 that the currency's recent rise is "nothing sensational."

"Europe is not speaking with one voice yet," says Neil Mackinnon, chief economist at London-based hedge fund ECU Group Plc and a former U.K. Treasury official. "The Americans may take the view that there is no reason for them to change tack."

...Biggest Contribution

What's more, the dollar's fall -- it has dropped more than 8 percent this year against a broad basket of currencies -- has helped boost U.S. exports and the economy at a time when the housing slump has slowed the expansion. Trade added 1.3 percentage points to growth in the second quarter, its biggest contribution since 1996.

Paulson may also be loath to take a more activist line on the dollar because of his efforts to persuade China to let its currency trade more freely.

"It would undermine Paulson's credibility in China's eyes," says Michael Woolfolk, senior currency strategist at Bank of New York Mellon Corp. "He would rather avoid opening himself up to such criticism."

That argument may be enough to persuade European officials to back off. They too are growing more concerned that China hasn't allowed the yuan to appreciate more. It has risen about 10 percent against the dollar since China loosened its peg to the U.S. currency in July 2005, while falling about 5 percent versus the euro.

...Greater Oversight

Europe may have more success influencing Paulson to accept greater oversight of financial markets, especially with U.S. lawmakers pressing for action as well. While Paulson cautions against rushing regulation, he has said there "should be and will be changes."

That contrasts with his stance at the G-7 meeting in September 2006, when he told fellow policy makers from Britain, Canada, France, Germany, Italy and Japan not to fret over the U.S. housing slump. In February, he brushed off a German campaign to crack down on hedge funds.

"Paulson seems to be moving a bit away from the view that there's nothing absolutely wrong with the markets, that the less regulation there is the better," says Edwin Truman, a former Federal Reserve and Treasury official who's now at the Peterson Institute for International Economics in Washington.

European policy makers have pinned much of the blame for the market turbulence on what they see as lax U.S. supervision of subprime-mortgage lenders.

...'Looked Closely'

If U.S. regulators "had actually looked closely" at whom financial institutions were lending to, "some of these problems might have been avoided," U.K. Chancellor of the Exchequer Alistair Darling told BBC Radio Sept. 14.

In response to similar criticism from Congress, Fed Chairman Ben S. Bernanke agreed with state regulators to collaborate on supervision and enforcement of nonbank subprime lenders.

Europe is also pushing for increased supervision of U.S. ratings agencies, arguing that they have been too lenient in judging the creditworthiness of subprime loans and the securities they are packaged into. Among possible changes: separating the agencies' consulting businesses from their ratings services, so they wouldn't be advising the same companies whose securities they're grading.

Paulson has agreed to allow the Financial Stability Forum to look into regulatory and other remedies for the recent market tumult. The forum, a body of central bankers and regulators, was created in the wake of the Asian financial crisis of the late 1990s.

...Investigation

A task force headed by Bank of Italy Governor Mario Draghi will present a work plan to the G-7 this week, with a final report due in April. The task force will also investigate bank supervision, including off-balance-sheet investments and liquidity.

"The U.S. is going to be under some pressure," says Raghuram Rajan, a former chief economist for the International Monetary Fund who's now a University of Chicago professor. "It may have to accept a little bit of responsibility for making changes in the way things are done."

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