Diversification, Schmversification: All Correlations to 1.0(-ish)

Below is a really interesting graph taken from a recent paper about global diversification. In each graph the top line is the correlation with developed markets, the middle line is with developed & emerging combined, and the bottom line is correlation with emerging markets alone (all are equity correlations).



The basic point here is that the economic fates of countries around the world are becoming increasingly connected. We learned this lesson the hard way last year. As some may recall, many pundits touted 'decoupling' theory, which essentially said that emerging markets could grow even as developed ones were experiencing a crisis. As the global recession and these graphs show, this is untrue.

What do you think of this trend? Is this a bad thing? Why are markets becoming more correlated?

Link:

http://paul.kedrosky.com/archives/2010/03/diversification.html

Preventing Another Crisis - 10 Questions for Financial Reformers

As some of you may know, two bills are floating around congress that attempt to reform our financial system so we won't experience another crisis. In theory, in order to prevent another crisis, we need to know what caused the last one. This article addresses 10 possible causes and provides possible solutions through the form of questions our congressional representatives should be thinking about.

The article begins as follows:

"The current series of proposals for reforming Wall Street and bankers are toothless facades of what real regulation should look like.

It seems that each new proposal for reforming Banking and Wall Street is more banker friendly – and ineffective – than the previous one. They are milquetoast, meaningless, appeasing nonsense. The reformers are in a race to see who can offer up legislation that is least offensive to bankers.

In order to legislate reform that will prevent the next meltdown from occurring, I suggest that anyone who introduces new reform legislation must answer the following questions about their proposals:"

Do you agree with the author that the current legislative proposals are not strong enough? Of the 10 causes / questions, which do you think is most important?

Personally, number 4 really stands out to me as something that we need to address. From the article:

"4. Insulating Main Street from Wall Street: Glass Steagall separated FDIC insured depository banks from the more risk embracing investment houses. Prior to the repeal of Glass Steagall in 1998, the market had regular crashes that did not spill over into the real economy: 1966, 1970, 1974, and most telling of all, 1987. These market crashes did not freeze credit for the real economy.

How does your proposal prevent the inevitable future market crashes from spilling over to the real economy – especially as applied to real credit availability?"

Link:
http://www.ritholtz.com/blog/2010/03/10-questions-for-finance-reformers/

Brad DeLong on the historical change in investment mentality

A big debate is going on between Mankiw, Paul Krugman, and others about the existence and characteristics of market failures involved in banking. DeLong weighed in and made the following comment:

Back before the industrial revolution [bankers could give back the investment when asked], for the capital stock of the economy was overwhelmingly composed of consumption goods of one sort or another. If Antonio, Renaisssance-era merchant of Venice, faces a sudden shift in his investors' portfolio preferences as they want more safety and liquidity, with a sigh he unloads the silks of China, the spices of Indonesia, and the perfumes of Arabia from his ships and distributes them to his investors. But once you get canals, railroads, and cotton mills on a large scale you cannot do that anymore--you cannot deleverage the economy as a whole rapidly by consuming your existing capital. That is why it is no accident that the modern market-driven financial crisis and the industrial business cycle start in 1825, as the British Industrial Revolution enters its heyday.

The full article can be found at his blog (http://delong.typepad.com/sdj/2010/03/the-maturity-transformation-and-liquidity-transformation-and-safety-transformation-industtry.html?utm_source=feedburner&utm_medium=feed&utm_campaign=Feed%3A+BradDelongsSemi-dailyJournal+%28Brad+DeLong%27s+Semi-Daily+Journal%29&utm_content=Google+Reader).

DeLong's point is that there is no truly safe asset anymore. In theory, the safe asset (government bonds) is used as a measuring rod for risk for all other assets. He says that this is a market failure that requires the government to act as the lender of last resort. I like the history but I am uncomfortable with the argument. What do you think?