Morningstar Advisor - April/May 2012 - (Page 53)

that doesn’t get closed, his earnings keep going up. However, for the steelworker whose job is terminated, the time series takes a huge hit. Now, he’s on unemployment compensation. He gets six months. He’s not a steelworker anymore—all the stuff he knew how to do. He takes some new crappy job. He eventually builds up his human capital, but he takes a 25% permanent earnings hit. Torralba: His new earnings path is 25% lower. Sargent: Yes, he takes a big hit. And it’s permanent. At first, it’s even bigger, a 60% hit, and then he builds it up. And if he’s 50 years old and has European unemployment compensation levels, he would not come back. This is all about how society gets people to participate in the labor market. are just hot air, just so much talk. A real rule, you have to test it. But this was not done. So you go back to 1995 or so, and Germany says, “Look, you are free to join a monetary union, and it’s a monetary union with Germany. And, by the way, we’ll change the name of the Deutschemark to the euro. And this is going to be a currency issued by Germany. You’re free to denominate in terms of the euro if you want. You can trade in terms of it. And actually if you want to use it, we’ll print some up so you can issue it. But if you issue debts denominated in euros, that’s your problem.” Germany could have treated the rest of Europe like the United States treats Panama. Panama uses the dollar. But if they want to issue dollar-denominated debt, that’s not the United States’ problem. So then what would happen is that various countries would join the euro. They might issue some debt, and some of it might go bust. At that point, Germany could say, “Um, sorry. That’s not our problem. That’s not the deal.” So then, Spain could still use the euro, and the debt could go under, be renegotiated. That would be a clear understanding. A few defaults like that, and people would get the message. Torralba: The funny thing, however, is that is going to change its fiscal behavior. Or, it was, “Oh, boy, now the Germans aren’t going to let them fail.” I think the market thought it was the second, or maybe the market thought it would be some combination—that the Germans would make the Italian fiscal policy different. Torralba: What about creating some joint liability, like eurobonds? Just create a joint Treasury or some form of guarantee of debt. Then, how would you deal with incentives and the moral hazard problem? Italy could say, “Why am I going to be disciplined if the Germans are going to bail me out?” Sargent: It’s a good question. There’s a great Germany’s been very aware of this problem, and they’ve done a bunch of reforms. Now, as a U.S. citizen, I don’t want Germany to have flexible labor market institutions that allow them to avoid these problems while we, for benevolent reasons, back into very perpetual generous unemployment compensation that traps people. It sounds hard-hearted, but I think it’s really a more far-sighted benevolence, because you want people to be participating. paper, which everyone should read, by [John] Kareken and [Neil] Wallace [“Deposit Insurance and Bank Regulation,” 1978]. It’s about moral hazard and deposit insurance. Their analysis says that if you have deposit insurance and it’s not priced properly—and it never is—it provides incentives for banks to become as big as possible and as risky as possible. You will have a crisis with probability one. The reason is it’s in banks’ shareholders’ interests for the banks to become big. Kereken and Wallace’s conclusion was, if you’re going to have deposit insurance to fight this moral hazard, you’re going to have to regulate banks’ portfolios to prevent them from becoming too risky. You can translate that to what you were saying and just change the names of the variables. If Germany is going to foster a facility of lender of last resort, to fight the moral hazard, it is going to have to put in controls. Torralba: So Italy needs to give up some of the fiscal sovereignty. Sargent: Absolutely. Torralba: Which is a political issue. Sargent: That’s the heart of the issue, right? K Moral Hazard in the Eurozone Torralba: I want to talk about the eurozone. What is really at the core of the problem? Is it that countries flaunted the fiscal rules or is it the current account imbalances? Or is it both? Sargent: One reason is accounting, when those when the eurozone was created there was no explicit provision for bailouts. Yet the markets, if you judge the yields in that period, were assuming no defaults or bailouts. Sargent: In the early 1990s, interest rates on Italian debt were 20%. I told friends from Italy—I was just kidding—that I was thinking of buying some. My friend said, “Are you stupid? Why do you think it’s 20%?” Well, I should have bought it, because they joined the union and those bonds had huge capital gains. Someone made a lot of money on those things. rules were imposed. In some countries, there are implicit obligations, where the government is standing ready to bail out various kinds of debts that are incurred by other people, like regions or maybe some banks. So when you’re in good times, the books are not going to show the value of these obligations. Here’s a rule: Fiscal rules that are announced Why do you think those default premiums or inflation premiums went down? Well, you have two possibilities. The Italian government Francisco Torralba, Ph.D., is an economist with Morningstar Investment Management. MorningstarAdvisor.com 53 http://www.MorningstarAdvisor.com

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