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from Expert Zone:

There is no place like home

(Paul Donovan is a Managing Director and Global Economist at UBS. The views expressed in this column are the author's own and do not represent those of Reuters)

Most economists believe that nearly everything in this life can be reduced to an economic explanation.

This even applies to popular culture. The Wizard of Oz has been explained as a parable of late 19th century economics, as a veiled commentary on the gold standard versus the use of silver that dominated the 1896 presidential election in America. The yellow brick road is gold, the cowardly lion was William Jennings Bryan (a pro-silver politician). The wicked witches represented Wall Street (east) and railroad interests (west). Dorothy had to put on silver shoes to make her way to the Wizard of Oz (the U.S. President). She then learned that she could escape the bizarre, fantasy world of Oz and get back to reality by clicking her heels and repeating “I want to go home”.

Confronted by the bizarre, fantastic world of the Euro today, investors could learn from the Wizard of Oz. Global investors may well want to click their heels and mutter “I want to go home”. After two decades of globalising capital flows, investors may once again feel the urge to have their money at home, or at least closer to home than has been the case hitherto.

Why should investors favour home or regional markets? In a rational world, investors should search for the best risk adjusted returns they can find, and put their money there. However, as the Euro only too clearly demonstrates, we do not live in a rational world.

There are two forces at work here. The first is the fact that political risk is playing a larger and larger role in the world’s financial markets. Governments have an increasing impact through regulation, government debt (and default fears), intervention in currency and bond markets and policy statements.

What this means is that the performance of markets can no longer be interpreted through economic activity alone. Increasingly, one must understand the political environment and the likely changes that that environment may bring to bear on investments. For many investors this is a development that they have not experienced before: political risk was a declining force in financial markets in the two decades that preceded the global financial crisis. The problem is that political risk is very often specific to a country or to a culture.