When it comes to the current state of the U.S. economy, Henry Paulson, chairman and chief executive of Goldman Sachs Group, is an optimist. Unlike some commentators, who see the economy as mired in a hangover that it can’t quite shake, Paulson might describe it more like a groggy giant, rising slowly from a nap.

Paulson, who spoke January 12 at Wharton, acknowledges that the economy faces challenges — less-than-robust growth, hefty trade and federal budget deficits, and a slumping dollar, among them — but suggests that economic conditions are far better than two years ago, when he last spoke at the school.

“Then I wasn’t worried about the deficits,” says Paulson. “I was worried about growth. There is a lot of argument now about what the Bush administration should have done differently, but the fact is we [are experiencing] a growing economy. And that’s the best way to deal with deficits. In the Clinton administration, the economy was a rocket ship. When Bush got it, it was a basket case.” If anything, Paulson says, people — especially CEOs — are too pessimistic these days. Partly, that’s just human nature. “Things are often not as good as they seem when they look good, and they are often not as bad as they seem at the bottom of the cycle.”

Paulson’s remarks echo loudly not only because his job gives him a lofty perch from which to survey the economy, but also because he’s a high-profile Wall Street executive. Goldman Sachs, which chalked up record earnings in 2004, has long been recognized as one of the country’s leading investment banks.

According to Paulson, the current pessimism among some CEOs has shows up in a lower-than-average volume of mergers and acquisitions, one of investment banks’ key business areas. “Over a long period of time, mergers and acquisitions represent about 8% to 10% of global market capitalizations,” he points out. “We have been below trend for some time. And I think it’s going to be a year or two before you see that business” recover.

Paulson speculates that the lower volume isn’t the result of a weak economy or CEO concerns about deals not paying off. Rather, corporate bosses are worried about taking risks amid the uncertain regulatory environment that has arisen in the wake of corporate scandals. “There has been intense regulatory scrutiny, which is nowhere near over, with the SEC raising all sorts of questions about everyone’s accounting.”

Even with mergers and acquisitions down, Goldman continues to thrive. The company reported net income of $4.6 billion, or $8.92 per diluted share, on revenues of $29.8 billion for fiscal 2004. That compares with net income of $3 billion, or $5.87 a diluted share, on revenues of $23.6 billion for the prior year. Shares in the firm, which went public in 1999, rose 21% over the five years that ended Jan. 18, compared with 4% for the Dow Jones Investment Services Index.

Post-bubble Fallout

Although Goldman is doing well, Paulson hasn’t forgotten the corporate scandals and excesses of the Internet bubble. Like several of the top investment/securities firms, Goldman was accused of misleading investors, and in 2003, the firm, along with nine others, signed a settlement with New York Attorney General Eliot Spitzer. As part of the deal, the companies agreed to pay $1.4 billion in fines and contributions. Goldman kicked in $110 million.

Paulson acknowledges that the post-bubble years have been especially difficult, including “the pressure that our industry has been under and recognizing that … we didn’t differentiate ourselves as positively as I would have liked us to,” he says. He rates the post-bubble scrutiny as tougher, personally, than even the Sept. 11 terrorist attacks. Goldman’s headquarters is just a few blocks from the site of the former World Trade Center. But 9/11 was the sort of crisis that brings people together, making a company and a nation stronger. The post-bubble criticisms, in contrast, have hurt. “We could have done things better,” he repeats, adding, however that the scandals involved firms like WorldCom, Enron and Parmalat, not investment banks. “Investment bankers happen to have been fooled just like the directors, just like the accountants.”

Paulson says he has tried to channel embarrassment from the scandals into strengthening Goldman, which employs about 20,000 people worldwide. Top managers, for example, have redoubled their efforts to encourage a culture where employees do what’s right, not simply what’s profitable or convenient, and where they make protecting the firm’s reputation a priority. “My biggest [initiative] this year is something called the chairman’s forum on reputational judgment and accountability,” he notes. “I’m going to take 30 days and meet with groups of 40 to 60 staffers all around the world. We are going to do very intensive [ethics] cases. We are also going to scare people. And we’re going to have 18 to 20 speakers come in, including Eliot Spitzer, to talk about accountability.”

To this end, Goldman also continues to stress teamwork even as the rest of Wall Street hands out hefty individual pay packages to hotshot traders and bankers. The toughest decisions, especially those about ethics, must be made collaboratively, Paulson argues.

Goldman has long been known for a culture that highly values teamwork and stresses the firm’s success over that of any particular employee. “Years ago, we would just move people up in lockstep in investment banking even when some people did much better than others,” Paulson recalls. “I remember complaining to [then-CEO] Bob Rubin about it when I was running investment banking. I said, ‘This isn’t fair.’ And he said, ‘What does fairness have to do with it? What we’re trying to do is encourage certain kinds of behavior.’” These days, Goldman has bowed to market pressures and bases its compensation more on individual performance, Paulson says. “But we still have 360 degree reviews, and if people are going to move ahead, they are going to be people who appreciate the team.”

China Bound

One of Paulson’s pet projects, in both his professional and personal lives, is building ties between the West and China. As Goldman’s CEO, he has made China a top priority, visiting the country 68 times since 1990. In 2004, Goldman received permission to open an investment banking and securities subsidiary in the country. In the process, Paulson has come to personally know many of China’s leaders.

His familiarity has made him optimistic about the country’s prospects for continued economic and political change. “The leaders are very bright, pragmatic and aware of their problems,” he says. “And they look for solutions wherever they can find them anywhere in the world … They have done a great job at economic reform. In my opinion, that’s a better first step because, until you have economic stability, political freedom isn’t going to make any difference. But I think the Chinese will loosen up on human rights and allow more political freedom.”

Paulson is also chairman of the Nature Conservancy, an environmental group, and has led efforts to set aside land in China. Among them is a big push to stitch together a string of parks in the Yunnan province in southwest China, where Paulson and his wife have spent time hiking. Paulson helped to persuade the Chinese government to contribute money and manpower. The Nature Conservancy has supplied energy-efficient stoves to poor villagers there, hoping to discourage them from chopping down too many trees.

At Wharton, Paulson told students that his environmental work makes him a better CEO. It not only raises his profile in China, but it also recharges him. “After I’m hiking in China for a few days, it’s a lot easier for me to think about mergers and public offerings.”