Morningstar Advisor - June/July 2013 - (Page 56)

Morningstar Conversation that Europe can’t, and I don’t see any short-term or easy solution to this question. Why do they keep doing QE even when there’s no evidence it works? Again, we can go back to Japan. It’s curious that people say that the Bank of Japan hasn’t ramped up its balance sheet as much as anybody else. In fact, it did ramp up its balance sheet quite a lot before the crisis started, so the baseline is a bit different there. But we are locked into these kinds of situations because nobody’s come up with a better idea. The alternative to this is not to raise interest rates. So, what do we do? Torralba: Speaking about inflation, a prediction that you hear about sometime is that the monetization of government debt in the long run will imply much higher rates of inflation. In fact, this is one way how governments are going to deal with their fiscal problems: just wipe away the real value But it was quite obvious that in fact QE didn’t work the first time it was tried in Japan. There was this critical moment in 2005 when the G20 had decided that everybody was going to go back home and try to start raising interest rates, because the environment was perceived as being excessivley risky with people extending too much credit, etc. People were anticipating, a little bit, the crisis. Japan got as far as putting the rate up a quarter percentage point and then stopped the whole tightening cycle, because it couldn’t go any further without imploding the economy. So, on the one hand, it wasn’t working, but on the other hand, Japan wasn’t able to apply a more hawkish monetary policy without really putting the economy itself at risk. This is the whole point. It’s working in that it’s boosting the equity markets and boosting carry trades across the planet, but this way may be indirectly creating a little bit of inflation. But it’s not meeting its primary objectives of restarting credit flows and generating a slightly higher inflation rate to aid deleveraging. Fine, but what would? So, if you haven’t got an answer to “what would?” then you stay where you are. I think that’s why we are where we are. There are people in the United States who would argue that QE is doing certain things, achieving some of its objectives. That’s a huge debate that I don’t really want to go into because it isn’t really within the bounds of my expertise. 56 Morningstar Advisor June/July 2013 But the interesting thing is that these countries with large net-negative external investment positions and high levels of sovereign debt normally would experience a big run on their currency. What the euro does is stop the big run on the currency, because they’re in a common currency—although it isn’t a national level currency. of their debt by letting inflation run higher. Do you think this eventually is an outcome that we should be worried about? Hugh: Well, it’s not a concern that I have at the moment, because there seems to be a structural deficiency in domestic demand in many of the economies where they’re applying this technique. So, it’s hard to see how you can get domestically driven inflation. How you could get troubling inflation is if you provoke a collapse in the currency. This is a risk Japan is running, as George Soros is pointing out. So, in the long run, you could have hyperinflation, let’s say, in Japan, if the yen really collapsed—not if it went from JPY80 to JPY100 to JPY120, but went from JPY120 to JPY300. If there was a dramatic collapse in the yen, because there was a dramatic flight of funds out of Japan at some moment, because people anticipating continuing falls in the yen started really panicking, then, this could precipitate a very strong inflationary dynamic. This creates a peculiar position, then, for the countries in Southern Europe, because the only way you can avoid breakup risk coming back again is to let some economies spend more money. The advantage of doing it through the national central banks is that it doesn’t all fall back onto Target2 balances and generate additional liabilities for the Germans. If this is shown to be the case, then maybe the Germans will become more relaxed about the situation. But what Willem Buiter, the chief Citigroup economist, has spoken about over the past months, and it’s becoming increasingly relevant, is the possible ruble-ization of the euro, making a comparison with the old USSR, when the ruble was retained as a common currency for a number of increasingly independent states. In fact, 5 euros in Germany may already effectively have a different value, even though we’re talking about the same banknote, to 5 euros in Greece. Torralba: Just to make sure I understand what you’re saying. Right now, the value of the euro is in a sense anchored by Germany. Germany is seen as a responsible country with a current account surplus. Hugh: Yes, and as a result of that perception Germans get all kinds of financial perks, like cheaper interest rates when they want credit. But it’s interesting, the Germans and the French are increasingly arguing now about this point that you’ve drawn attention to. It was interesting to hear Jens Weidmann, the president of the German central bank, recently raising doubts about the French will to implement major structural reforms and to bring the fiscal deficits under control. If the tensions grow on the German/French axis, we’re going to be in even more trouble. But, yes, Germany is seen at the moment as the heart. K Francisco Torralba, Ph.D., is an economist with the Morningstar Investment Management division.

Table of Contents for the Digital Edition of Morningstar Advisor - June/July 2013

Morningstar Advisor - June/July 2013
Contents
Contributors
Letter From the Editor
Not Your Values
How Do You Use Alternatives for Clients?
Working to Build a Niche
How to Put Buffett’s Investing Philosophy into Practice
Sophisticated Strategies for the Masses
Investments á la Carte
Investment Briefs
The Percentile Trap
Defense Firms Will Stay Aloft
Beware the Lure of Diversification
Using Alternatives in Practice
Managed Futures and Cash Rates
The World Is Getting Grayer
Waiting to Pull Up Anchor
The Price of Managing Volatility
Let’s Get Back to Basics
Our Favorite Mutual Funds
50 Most-Popular Equity ETFs
Undervalued Stocks With Wide Moats
Mutual Fund Urban Myths

Morningstar Advisor - June/July 2013