CHICAGO – Though it’s clear that the origin of our current financial recession has its roots in the U.S. and in some ways right here in Chicago, I think it has been fueled and exacerbated by investors throughout the world.

Niall Ferguson (a professor of history and business at Harvard) says on his Web site: “A leading British journalist has asked me: ‘Why should the rest of the world ever again take seriously the American free-market model after this debacle?’ This crisis, he argued, was to economics what the Iraq war was to U.S. foreign policy: a fatal blow to the credibility of American claims to global primacy.”

There has been trillions of dollars of new wealth created in the last 10 to 15 years in countries that have never known such riches. In many cases, these entrepreneurs invested their earnings in their businesses to help them grow and they have prospered. But they haven’t invested all their profits in their businesses.

Much has been invested in stocks both in their home countries and the U.S. My impression is that many of these new investors were relative neophytes in the knowledge of the risks that go along with the potential returns. As long as you had enough to invest, many have assumed their investments could only go up.

With the recent downturns, they learned that their stocks could go down. After a short while, they saw buying opportunities and brought the market back up. This is the mentality that has changed.

Though I understand the United Kingdom suffered from the same plight with their mortgages following the collapse of subprime mortgages in the U.S. and the subsequent fall of the credit markets, the rest of the world lost trust in the American financial system and is hesitant to come back.

Some of the financial instruments in which they invested were created here in Chicago at the Chicago Mercantile Exchange and the Chicago Board of Trade. These instruments were too complicated for novice investors to understand. Now that they’ve been burned, they don’t see the same security in our securities as they did before.

When I lived in Poland, many Poles simply didn’t trust the banks. They kept their money stuffed in their proverbial mattresses. I think that’s what a lot of the rest of the world is doing with its money right now. I spoke with Adolpho Laurenti – a senior economist at Mesirow Financial and the author of the “Themes on the Global Markets” newsletter – who helped shed some light on the subject.

His first thrust was toward China. In other words, China is our biggest creditor. A big part of the reason the U.S. government didn’t let Fannie Mae and Freddie Mac fail is because that would have led to less confidence in U.S. government securities by the Chinese. We can’t risk that mistrust because the Chinese in some ways hold our future in their hands.

If or when they want to cash in their U.S.-denominated assets, we will be at their mercy. As their biggest customer, it’s risky for them to exert that power over us. There has been criticism of the Chinese for not revaluing their currency more quickly. I haven’t heard much of that lately.

Interestingly, the rest of the world remained confident enough in America to prop up the U.S. dollar. However, those investments seem to have been in securities from the U.S. Department of the Treasury rather than shares in equities. While foreigners are confident in our government, they’re not confident in our business leaders.

Even after the falls of Enron, Arthur Andersen, etc., Laurenti agrees that the Sarbanes-Oxley Act hasn’t solved investor confidence problems. Europe and the developed world still hold most of the wealth. Here in the U.S., it’s much more common for commoners to be invested in the stock markets.

When I lived in Germany, much less of the general population invested in stocks than in the U.S. I think this is common throughout the rest of the developed world. I think that has changed somewhat since then. Laurenti agrees that the composition of investor pools varies greatly across countries.

In Europe, my experience was that shares of firms were cross-invested by other firms by principals at the top. That said, few pedestrians bought and sold in public stock markets. Laurenti says the risk and danger in Europe is European bank duplicity in mortgage-backed securities.

They were caught up like everyone else, and because their reporting structures aren’t as strict as in the U.S., those exposures are just coming to bear. Sovereign funds were much more influential in the good-old days when the price of oil and many other commodities were sky high.

According to Laurenti, the impact on Chicago financial institutions will have a downside and an upside.

Like many others, Chicago banks and brokerages will feel the pain of the financial fallout. My impression is that one of the roots of the crisis is the complexity of financial instruments. These were so complex that customers couldn’t understand all of the risks associated with derivatives and swaps. Service providers need to simplify their products and better educate their prospects on what they’re getting into.

Traders at the Chicago Mercantile Exchange don’t care what currencies tank so long as they’re still buying and selling. However, there is an upside. The Chicago Board of Trade and the Chicago Mercantile Exchange have vast potential opportunities ahead of them to provide liquidity for some markets where they haven’t existed in the past.

They have the platforms to provide these like few others do. Ferguson also speaks to the opportunity on his Web site: “The failure of financial firms has triggered a further crisis in the vast but opaque market for derivatives and especially credit-default swaps.” They just need to put them together and present them simply so investors clearly understand the risk and return tradeoff.

Despite the dollar’s recent surge, I hypothesized that the crisis could spell a move to the euro as a reserve currency. Ferguson chimes in: “The days when the dollar was the sole international reserve currency may also be coming to an end. Reserve currencies do not last forever (as the British pound makes clear).”

Adolpho debated that it’s unlikely simply because money holders don’t have as much confidence in the governments of smaller economies like Ireland and Greece (which are part of the euro) as they have in the U.S. Federal Reserve System and U.S. Department of the Treasury departments working together to solve these problems. Believe it or not, they trust U.S. politicians more than Europeans.

There’s another way to look at this. The U.S. stock markets lost about 40 percent in 2008. As stock markets in some countries lost much more, perhaps those investors have lost even more confidence in their own local businesses than in the U.S. Perhaps we’re not so bad off after all.

Michael Muth is managing director of GATA, an international business development consultancy that helps technology companies build international partnerships. He can be reached at muth@midwestbusiness.com.
Click here for Muth’s full biography.

Previous Columns in 2007:
Q&A: Ex-Chicago Tribune, ‘Caught in the Middle’ Writer Richard Longworth (1/5/2009)
Q&A: Midwest Regional Director Michael E. Howard of Export-Import Bank (6/17/2008)
Q&A: Intetics Managing Partner Alex Golod on Belarusian Economy (4/15/2008)
Q&A: Intetics Managing Partner Alex Golod on Protecting Intellectual Property (4/9/2008)
Q&A: Intetics Partner Alex Golod on Being a Jack of All Trades (3/31/2008)
Q&A: Motorola WiMAX Director Tom Mitoraj on Unstoppable Freight Train (11/26/2007)
Q&A: Motorola WiMAX Director Tom Mitoraj on Global WiMAX Differences (11/20/2007)
Q&A: Motorola WiMAX Director Tom Mitoraj on Widespread WiMAX Growth (11/12/2007)
Q&A: InterPro Translation CEO Ralph Strozza on Translation Tools, Costs (9/18/2007)
Q&A: InterPro Translation CEO Ralph Strozza on Globalization, Translation (9/11/2007)
Q&A: InterPro Translation CEO Ralph Strozza on Intercultural Translation Issues (8/7/2007)
Q&A: Madison Capital Partners CEO Larry W. Gies on Specific Country Issues (7/10/2007)
Q&A: Madison Capital Partners CEO Larry W. Gies Jr. on Cultural Differences (6/26/2007)
Q&A: Madison Capital Partners CEO Larry Gies on International Private Equity (6/11/2007)
Q&A: Scott H. Lang of S.H. Lang & Co. in Chicago on Foreign Deal Making (5/15/2007)
Q&A: Scott H. Lang of S.H. Lang & Co. in Chicago on Middle-Market M&A (5/8/2007)
Q&A: Scott H. Lang of S.H. Lang & Co. in Chicago on Middle-Market Firms (4/24/2007)
Q&A: George Filley of NAVTEQ in Chicago on Data Localization, Reach (3/27/2007)
Q&A: George Filley of NAVTEQ in Chicago on Partners, Personal Privacy (3/20/2007)
Q&A: George Filley of NAVTEQ in Chicago on Digital Mapping (3/7/2007)
Click for 2006 column archive.
Click for 2005 column archive.
Click for 2004 column archive.

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