Morningstar Advisor - April/May 2012 - (Page 52)

Morningstar Conversation could be a replacement for the gold standard. You could actually get more stable prices. So the short story is that the experiment was done. We went off the gold standard. And if you look at what happened to prices in the 20th century, the fiat money standard was not well managed. You got explosions in prices, not just in Latin American countries, but in so-called hard-currency countries. It took 70 years to “learn how to run” a managed fiat system. What we got to is a period of inflation targeting. But it took the world a long time, and it was a struggle. In the 1970s and ’80s, one country after the other beat inflation basically by applying those principles that I wrote about in “Four Big Inflations.” There was a great struggle to avoid inflation. And now, just when inflation targeting has come into being, we’ve created a culture in central banks in which no one will talk about generating inflation. We’ve created what Barry Eichengreen calls “golden fetters” for the gold standard. We’ve basically created a simulated gold standard that’s restricting our ability to use inflation to get out of these debts. It’s a big conflict. Torralba: It definitely would be an uphill battle to convince monetary policymakers in Europe to allow higher inflation. Sargent: They won’t do it. You hear it over and over again—the Germans will not tolerate inflation, because they’ve been through two big ones. And it is true. I can say technically I’m going to have a 30% jump and then flat. That’s perfect management. What these policymakers know and fear is that once it starts it’ll be very hard to end. They’re probably right about that. But nevertheless, the experiment does identify a force for inflation. unemployment and long unemployment duration. You have done some work with Lars Ljungqvist about this in the European context, but I’m sure some of it can be extrapolated to the United States. What is most concerning about the long duration of unemployment? Sargent: I hope what Lars and I did for Europe Sargent: Your skills, knowledge of the firm, knowledge of the business, work habits. You said it beautifully—all those intangible things grow when you’re employed. When you’re unemployed, they deteriorate. It’s like a stock of capital that’s falling apart if you don’t use it. So, a worker has attached to him this human capital. It’s going north when he’s employed, and it’s going south when he’s unemployed. What we think happened, starting in the 1980s, is that an older worker is more likely to be fired from a job where his human capital just disappeared—that job’s ended, it’s been shipped to India. So he suffers a big loss in human capital. But his unemployment compensation is linked to his past earnings. So this person has an incentive to be picky when he’s going for new jobs, because there’s a mismatch between his aspirations and his human capital. That creates a trap—workers get trapped into saying that the option of staying on unemployment, given current job prospects, is better than taking a job. In Europe, it was subsidized. In the United States, you got six months, so even though your human capital took this hit, you’re going to go back to work. That’s what the mathematics of our model says. The political trap is when we get a big negative shock like we got in the United States. Our natural compassion is to make unemployment compensation more generous. But now, we’re up to 99 weeks. Torralba: You seem to be hinting at a matching problem. In the United States, all these people who were working in construction or in mortgage financing in the 2000s—their jobs are gone. So these people who worked in those sectors now don’t have the human capital to do something else, so they have to accept a much lower wage level. Sargent: Yes. It’s the essence of the story. It isn’t a new phenomenon. There are so-called displaced worker studies. Dan Sullivan at Chicago did a paper in 1980s on steelworkers in Pennsylvania. If a steelworker is in a plant is not relevant for the United States. But I fear it may be. It’s a trap that you have to be aware of. Lars and I asked: Why is it true that in Europe—until 2008—many European countries had systematically higher unemployment than the United States over the past 30 years? Germany, France, Sweden—most countries were having unemployment rates of 10% or 12%, not just in recessions but in boom times, year in and year out. Some people say it’s just kids unemployed. That’s not true. Lots of the unemployment is people over 50. So why? Well, one superficial reason you can give is that they have more generous unemployment benefits. The replacement rate—the unemployment you get as a fraction of your previous wage—is higher in Europe than in the United States. And the duration is longer. In Europe, the replacement rate is higher and the duration is basically indefinite. The United States is stingy; and in normal times, the duration is six months. So you could ask, is that what did it? But there has to be something more. Here’s why. In the 1950s and ’60s, Europe also had generous unemployment, but its unemployment rates got lower than ours. So, how can you account for both things? That’s the puzzle. So here’s the story: Something in the environment changed. Between the 1950s and ’60s and the 1980s, the economic environment changed to confront individuals with some bigger risks at the microeconomic level. We call it turbulence. Here’s our mechanism: A worker’s human capital—his general skill level when he’s employed—is building up. Torralba: Just to clarify, when you say human The Unemployment Trap Torralba: Another consequence of the big contraction in 2008 was a high rate of capital, you mean a set of intangible qualities, like experience, education, IQ, etc. 52 Morningstar Advisor April/May 2012

Table of Contents for the Digital Edition of Morningstar Advisor - April/May 2012

Morningstar Advisor - April/May 2012
Contents
Contributors
Letter From the Editor
We’re Too Smart
How Do You Use Alternatives?
Taking the Lead
How to Find Economic Moats
The Beauty of Currencies
No Clarity on Bonds
Four Picks for the Present
Investment Briefs
Performance Chasing, Evaluated
Technology’s Slim Pickings
How Much Is Enough?
The Fear Bubble
Three Traits of a Successful Long-Short Equity Manager
Why Absolute-Return Funds Fail to Deliver
An Economist’s Response to Crises
Undiscovered in Plain Sight
Untangling ETF Tax- Efficiency Myths
Central Banks Driving the Gold Rush
U.S. Industrials Could Add Some Magic to Europe-Weary Portfolios
No-Hesitation Allocation Funds
Our Favorite Mutual Funds
50 Most Popular ETFs
Undervalued Stocks With Wide Moats
The Greatest Story Ever Told

Morningstar Advisor - April/May 2012