Morningstar Advisor - February/March 2012 - (Page 39)

Exhibit 1 Crisis-Damaged Budgets: The fiscal balances of Europe’s peripheral countries were healthy until the 2008 global crisis. General Government Primary Net Lending Greece % of GDP Italy Portugal Ireland Spain Exhibit 2 Exporters Benefit: The creation of euro was a boon to Europe’s core exporting countries at the expense of the periphery. Average Current Account Balance 2001–10 Netherlands Finland Germany Austria Belgium France Italy Ireland Spain Greece Portugal –10 % of GDP Exhibit 3 Periphery’s Debt: Giving up control of their currencies and low interest rates also caused debt levels to rise in the periphery. Net External Debt, Private and Public 2003 % of GDP 2009 4 0 –4 –8 –12 Avg. 2001–07 2008 2009 100 80 60 40 20 4 6 Greece Italy Portugal Spain Eurozone –8 –6 –4 –2 0 2 Source: IMF World Economic Outlook (September 2011) Source: IMF World Economic Outlook (September 2011) Source: Bank for International Settlements, 2010. The economic downturn fuels the vicious loop between growth, sovereign debt, and the solvency of banks. As unemployment rises and tax revenues shrink, the deficit grows. The increasing probability of a sovereign default undermines the soundness of banks directly, because banks hold a large share of sovereign debt, and indirectly, because weakness of the sovereigns makes it impossible to rescue the banking sector. As markets question the strength of banks, the wholesale lending market dries up. Deleveraging via balance-sheet shrinkage does not help either. The private sector is thus starved of credit, which in turn reduces consumption, investment, and growth. Unemployment rises, and so on. It is true that excess debt is an insurmountable problem for Greece and possibly others. Insolvent countries must default. And some measure of fiscal restraint is necessary for everyone. But the long-run issue with the euro is much harder to solve than mere profligacy. The euro project will eventually fail unless two problems are solved. First, external deficits must be reduced. This requires the Mediterranean members to become more competitive. That process is not easy or quick. If it were, they would have done it already. But it also requires that Germany adopt policies that discourage domestic saving, boost consumption, let its relative unit costs rise, and reduce the external surplus. In a nutshell, Germany must become less Germanlike. Instead, Germany maintains that current account surpluses are a virtue and imposes the burden of reform on others. Cutting the external deficits of the periphery requires wage deflation. Add to that higher taxes and a dwindling welfare state, and it is easy to envision general strikes, civil unrest, and the rise of populist leaders. Faced with a choice between restored self-determination and membership to a European Miserable Union, tired citizens might go for the former. Leaving the eurozone is not a good idea, but Germany’s mulish insistence on mercantilism and austerity raises the odds that the project fails. The eurozone’s second must-do is fiscal integration. The EMU needs to add some form of joint liability for national debts. Eurobonds allow countries that run into fiscal trouble to benefit from the strength of the others. In exchange, Germany would demand some control of the national budgets, deficits, and debt issuance to ensure some measure of fiscal discipline. It is a reasonable request, but the member countries are not ready for this loss of national sovereignty. Remember the rejection of a European Constitution in 2005, by none other than France. Even if the EMU went ahead with fiscal integration, a fiscal union without economic reform would not work. Under that arrangement, the south would become forever uncompetitive, underemployed, and dependent on fiscal transfers from the north. And to that, the Germans respond with a loud “Nein!”— with good reason. Alternatively, Europeans can have a monetary union without fiscal union. But if they follow this path, they must accept that sovereigns can default. In that world, bond markets would discipline spendthrift governments, and the ECB would discriminate against dodgy sovereign debt when it lends to banks. Countries with dicey fiscal records would face a higher probability of default, and it would be made explicit that Europe would not come to their rescue. Dealing with competitiveness, growth, and fiscal union will take years. Right now, the MorningstarAdvisor.com 39 http://www.MorningstarAdvisor.com

Table of Contents for the Digital Edition of Morningstar Advisor - February/March 2012

Morningstar Advisor - February/March 2012
Contents
Contributors
Letter From the Editor
Make a Difference Stories, Not Debates
How Concerned Are You About Europe?
Analytical and Independent
What to Ask When a Fund Manager Leaves
Past, Present, Future
Have Financials Gotten Cheap Enough?
Four Picks for the Present
Investment Briefs
Tactical Funds Miss Their Chance
Specialty Retail: Ad Hoc Opportunity
How Europe Is Making Its Crisis Worse
Impact on U.S. Economy Will Be Minimal
European Banks: Bargains or Value Traps?
Don’t Count the Euro Out Yet
Europe on the Brink
GoodHaven Realizes Its Vision
How Index Trading Increases Market Vulnerability
Nonlisted REITS: Handle With Care
Safety Picks for the Many Moods of Mr. Market
On the Prowl for Large- Blend Index-Beaters
Our Favorite Mutual Funds
50 Most Popular ETFs
Undervalued Stocks With Wide Moats
The Math That Matters

Morningstar Advisor - February/March 2012