This is a partial transcript from "Your World with Neil Cavuto," October 12, 2006, that was edited for clarity.

NEIL CAVUTO, HOST: Well, who says China is not getting tough on North Korea? It is a big deal in the nation's capital that these sanctions are coming at all, or even the threat of them, maybe because the fallout would be even tougher on the Chinese economy if we weren't looking at this issue.

In an exclusive chat with FOX, Treasury Secretary Henry Paulson told me that a variety of influences came into play.

(BEGIN VIDEOTAPE)

HENRY PAULSON, U.S. TREASURY SECRETARY: I have no idea how much the economic interests weighed into their thinking. But I would — would — would make this point, that the — China's economic relationship is very important with the U.S. and with the rest of the world.

And the more constructive engagement we all have together, the higher the cost of — of any kind of conflict or anything that would undermine the — the global economic stability.

CAVUTO: Do you think China underestimated North Korea and how far along it was?

PAULSON: I — I would just simply say, I don't — that is an area where I have not spent a lot of time. And, so, the — and I would just simply be speculating if I answered that question.

CAVUTO: If you will indulge one more question in this area, sir...

PAULSON: Yes.

CAVUTO: ... the feeling seemed to be in the financial community that China took a look around, saw itself as the global economic force, and that that was threatened by North Korea's behavior, and that it underestimated what North Korea might or might not do, as far as testing, and weighed that seriously.

PAULSON: Well, I — I, again, come back and make the point I made earlier, which is that China's economic development is very, very important to China. And it is very important to the rest of the world.

And China needs to keep growing its economy, needs to keep reforming its economy, needs stable economic relations around the world. And I think that is very important to China.

CAVUTO: So, there was never any quasi-threat on the part of the United States to say, China, you do something about North Korea, or...

PAULSON: I have got to say, again, to — to come back, I am responsible for the economic dialogue with — with China, managing the economic relationship. And the diplomatic relationship with China has been handled by — by Secretary Rice and the president.

CAVUTO: There are many conservatives, as you know sir, who, economically, are worried about the Chinese, and say that they are just waiting to take this town with that economic power. Do you buy that?

PAULSON: Well, I, again, make the — the same point I made earlier, which is, the most important — and we have some very important economic relationships, but I really believe the most important long-term economic relationship we are going to have is going to be our relationship with China, and — and vice versa.

And, when I hear people who say that — that they are concerned that China is, somehow or other, going to out-compete the U.S., overtake the U.S. economy, you know, I — I answer that this way, that — that the thing that I am most concerned about is that — that China won't move ahead quickly enough with their reforms, and, that, if they don't move ahead quickly enough with their reforms, then, they — they may have their own economic issues.

And I really believe that — that a China that is a growing part of the global economy is going to benefit the U.S. and benefit the rest of the world.

CAVUTO: Reading just the numbers, Secretary, they are growing three or four times the rate of the United States. In 20 years...

PAULSON: Yes.

CAVUTO: ... they could conceivably be the world's economic power. Do you buy that?

PAULSON: Yes, well, let me say this, that those who make the argument you just make look at the past, and then they what to extrapolate the future growth from the past, and just assume that the economy will keep going up at the rate it has been growing, and defy economic gravity.

And they are just assuming that, somehow or other, China will be immune from all of the — the economic issues and problems that confront the rest of the world.

CAVUTO: And you don't?

PAULSON: And what I assume is that — that nothing is that good, that China has — as — I, you know, take my hat off to the Chinese leadership and what the Chinese government has accomplished, what the Chinese people have accomplished.

But they have got some formidable economic challenges. And, as the economy gets bigger and bigger, and as they are partway from an economy which is planned, centrally planned, to one that is market-driven, it is increasingly important that they move ahead quickly with their reforms.

So, I think there is — that there is more risk on the downside for China, although I am an optimist. And I'm — you know, I would like to believe they are going to continue with their reform program, and that they are going to accelerate the pace of those reforms.

(END VIDEOTAPE)

CAVUTO: Up next: With the Dow at yet another new all-time high and approaching a milestone, gas prices plunging, and the deficit dropping, why is all this good news being virtually ignored? The treasury secretary thinks he knows — more of my exclusive chat with him on what he thinks is going on.

(COMMERCIAL BREAK)

CAVUTO: The president showcasing low gas prices today, the plunging deficit only yesterday, hammering home the good economic news that many Democrats are not.

It is a point I took up with Treasury Secretary Henry Paulson.

(BEGIN VIDEOTAPE)

CAVUTO: Switching gears to the budget numbers out, a prominent Democrat was quoted as saying, only this administration could brag about having a deficit still over $200 billion.

What did you make of that?

PAULSON: The progress on the deficit is a huge positive.

And when I look at the hand that I have been dealt, coming down here as treasury secretary, one of the strongest hands I have been dealt is a very healthy economy, and an economy that is growing, and where revenues are coming in way ahead of forecasts.

CAVUTO: But maybe you came in at a top.

PAULSON: Our deficit is now 1.9 percent of our GDP. That is well below the — the average we have had for the last 40 years, and that despite the — the cost of the war and two hurricanes.

So, the concern about the deficit is not the — the present budget deficit. It is looking ahead a few years at — at the big structural deficit we are going to have, if we are unable to — to move quickly to reform our entitlement programs.

(CROSSTALK)

CAVUTO: That — that is where you created some waves, because the president, when he visited entitlement programs, namely Social Security, when he was reelected, touched the third rail, and was electrocuted.

Now, here you are, coming in as treasury secretary, touching that third rail all over again.

PAULSON: See, I — I don't look at it that way. I don't think the president was electrocuted.

I think the president really advanced the dialogue here. And one — one of the attractions for me, in coming down and joining his team and becoming the treasury secretary, is, I knew he was focused on the long-term entitlement issues. And...

CAVUTO: Well, he might be, but a lot of others were not. They — they look at it akin to raping Social Security, getting rid of Medicare.

You lost in the P.R. debate — not you, but the administration.

PAULSON: Well...

CAVUTO: How do you reclaim that?

PAULSON: Well, let me just say this.

I — I want to be an optimist, because, as I have had conversations on both sides of the aisle up at Capitol Hill, I have had Democrats, as well as Republicans, tell me that they understand that the long-term issue that our economy is — is — is facing is the increase in — in benefits, you know, in the health care, Medicare...

(CROSSTALK)

CAVUTO: What Democrats have told you that?

PAULSON: Medicaid.

I have had conversations in — in — in private with — with a good number of Democrats and Republicans.

CAVUTO: Who — who — who say the administration was right to address it?

PAULSON: I say, what they said to me was that they understand that as we look ahead, we have a big structural deficit. They understand that the structural deficit impairs our economic flexibility, if we don't reform the programs, impairs our competitiveness, and impairs the retirement security of a younger generation of workers today.

So, there is, I think, broad agreement that there is an issue.

(CROSSTALK)

CAVUTO: There's broad agreement, Secretary, that, as it stands now, it can't continue standing much longer. I guess what I would like to ask you is whether you think programs like Social Security should either be means-tested, that rich people, such as yourself, shouldn't get it. What?

PAULSON: Well, I would say — to come back, I would say that there is agreement on both sides of the aisle. At least, I have talked with a fair number of people on both sides of the aisle that agree that there is a — a problem, and it's a problem that needs to be addressed.

(END VIDEOTAPE)

CAVUTO: All right. Treasury Secretary Paulson.

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