Morningstar Advisor - February/March 2012 - (Page 54)

Morningstar Conversation Edward Chancellor Member GMO Asset Allocation Team The Germans are quite stubborn. They’re not very good at economics. I hate to say it, but they’re not very good at finance, either. German DNA as much as the Great Depression is in ours. The reunification of Germany itself gave Germans additional cause to reflect on the implications of what was for them an explosion in their fiscal deficit and in their bond yields and in inflation. Chancellor: It’s true that the Germans want the single currency to survive, because if it doesn’t survive, the German financial system is in a very perilous state. Secondly, they want to limit the amount of money they are paying to the periphery in terms of bailouts or future support. And thirdly, they want the European Central Bank to keep to its mandate to keep inflation low. I don’t think you can have all three of those together. I don’t think the single currency will survive if you put the periphery through a deflationary bust with Germany refusing to put its hands in its pockets to provide large, continual transfers to the periphery. But that seems to be the course we’re on at the moment. The Germans haven’t budged from that position. Now, one potential solution is that they relax on the inflation side of things. I’m not in general an inflationist, but if Germany accepted a higher level of inflation, then the uncompetitiveness of the periphery would diminish. They wouldn’t have to go through a deflationary bust because German unit labor costs would rise relative to the periphery. I’m not saying that it’s in the cards, but if you had a weak euro and very strong relative credit growth and money supply growth in Germany, and that fed through into a boom in Germany— and this would answer George’s desire that Germany begin to run a current account deficit—then the eurozone might hold together. But the Germans are quite stubborn. They’re not very good at economics. I hate to say it, but they’re not very good at finance, either. And they’re quite puritanical. So, they are setting Europe on this disastrous course. Magnus: The great inflation of the 1920s is in comfortable to stay. Bit by bit, I think the Europeans will probably change their governance structures and mechanisms with a view that makes it easier to leave the eurozone—well, as I say, “easier,” note that there is no provision for anybody to leave the eurozone. But I think that may change. It’s also possible, of course, that countries could make a decision to leave and try to win the moral support of the rest of the eurozone countries to ensure that the departure is as orderly as possible, if it is possible. Obviously, the extreme version is that there’s a complete implosion of the eurozone, which could occur as a consequence of some kind of dire economic backdrop—involving a really steep recession, together with the inability of countries to effectively stay the fiscal austerity course, and this might give rise to a banking crisis that we were so close to seeing back in November and early December. Johnson: Edward, your vision of the endgame? remember the inflation of the early 1920s, but they appear to forget the deflation of the late 1920s and early 1930s. It was the deflation—with Germany going back onto the Gold Standard, wringing inflation out of the system—that set the political preconditions for the rise of the Nazis. Inflation preceded it, but it was the deflation that was so politically destabilizing. And exactly the same, I’m afraid, can be said for Japan in the 1930s. So, the Germans may fear inflation, but we know that inflation is, when you have too much debt, the path of least resistance. Default is a much more painful route. If the Germans really want to go down that route, they may one day rue it. The Tough Road Ahead Chancellor: It depends on which side of the Johnson: What’s the endgame here? Magnus: I think it is really difficult to look much beyond the next few months at this point. But forced to choose, I think that there may still be enough political bonds between European countries, particularly between Germany and France. Politics was the driver of the project in the first place after World War II. Those political binds may be sufficiently strong to maintain some sort of eurozone in the future. bed I get out of in the morning. There is a nightmare scenario, which can come about in various different ways—a European banking crisis, as capital flows from the periphery to the core are not sufficiently replaced by the European Central Bank funding. The other is a more long, drawn-out deflationary bust—that is just too painful for countries like Ireland, Greece, Spain, and possibly at some stage, even Italy. There’s a more optimistic outcome in which a credible solution is found and the yields in the But I can’t possibly imagine a eurozone in which all 17 incumbent members will find it 54 Morningstar Advisor February/March 2012

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