I am enjoying the goings-on in Dubai tremendously. It’s like the field mouse of an economics drug trial: take every extreme symptom, jam it into one place of absolutely no global consequence, and then try to figure out the cure.
Suppose you had a tiny country that decided it wanted to be important. Playing on confusion with its oil-rich neighbors, it goes out and borrows a lot of money to build buildings. Taking the Paris Hilton strategy that if you insist on your caricature long enough others will eventually believe it, the country makes a big show of people piling into the buildings. Real estate developers, the ultimate momentum players, pile in. The country goes the offshore tax haven route – no income taxes – and throws in absolutely no labor standards to ensure that construction can proceed on whatever blistering pace can be achieved by malnourished Thais and Pakistanis welding in 115F heat. Eventually it hits the wall – for reasons completely beyond its control, at some point people look around and realize they have the world’s largest Potemkin village. There is no market. The locals are preposterously corrupt. Islam is not compatible with the hedge fund lifestyle. What then?
I don’t know what Dubai will do. I suspect Dubai doesn’t know what Dubai will do. Abu Dhabi has the resources to make good Dubai’s promises, and perhaps among the emirates that will be seen as the smart thing to do, or at least the path of least resistance. In a part of the world where we are speaking less about nations and more about families with flags, perhaps some quiet accommodation is best for everyone. Dubai could give Abu Dhabi Emirates, for example – eliminating the completely duplicative Etihad – and some amount of offshore assets, and Abu Dhabi could advance the money to pay off the debts.
I do know that I would like Dubai to tell its creditors to pound sand. As Willem Buiter points out:
The debt of the Dubai World Group and of Nakheel was not Dubai sovereign debt or sovereign-guaranteed debt. The sole shareholder may be the state of Dubai (indistinguishable from its ruling family), but limited liability applies to governments as well as to private entities. The government of Dubai is under no legal or moral obligation to provide an ex-post guarantee of the debts of the Dubai World Group and Nakheel. The creditors will have to manage this contingency the way God meant them to: hoping for the best, but living with the restructuring and taking their losses. Requiring the debt holders to live with their losses will not damage the reputation of the Dubai sovereign. The only way a bail out by the Dubai sovereign of the debt holders of Dubai World and Nakheel would enhance the sovereign’s reputation would be by enhancing its reputation as a sucker.
A curious thing has happened over the past seven months of stock market frothiness: governments have come to believe that they should be suckers. Here is Brad DeLong stating essentially the orthodox party line:
The fact that investment bankers did not go bankrupt last December and are profiting immensely this year is a side issue. Each extra percentage point of unemployment lasting for two years costs us $400 billion. A recession twice as deep as the one we have had would have cost us as a country some $2 trillion–and cost the world as a whole four times as much. In that scale and context the bonuses of Goldman Sachs are rounding error. And any attempt to make investment bankers suffer more last fall and winter would have put the entire support operation at risk: as Federal Reserve Vice Chair Don Kohn said, ensuring that a few thousands investment bankers receive their just financial punishment is a non-starter when attempts to do so put the jobs of millions of Americans–and tens of millions outside the United States–at risk.
This view accepts as its starting point the premise that banks have some sort of preferred claim upon the economy of the state, that there is no way to get around the banks in delivering some measure of stimulus.
The Fed could very easily have stated that it would intervene to guarantee the custodial accounts of Goldman Sachs but not its bonds or its equity. Goldman would have been unable to roll its debts and would have defaulted on its short-term paper at some point in October 2008. If the goal was to preserve the economic unit of Goldman Sachs, the Treasury could have bought the bankrupt company – office space, letterhead, org chart – for pennies on the dollar from its creditors in bankruptcy court. If you have any doubt that this was possible, note that this is exactly what happened with GM and Chrysler. The only difference is that the government was willing to allow any number of stakeholders of the auto companies to get crammed if it would maintain employment, while the government was unwilling to allow any stakeholder of Goldman (with the possible exception of shareholders) to suffer. That’s a decision, not an inherent fact of life.
Buiter points to the several nations that have run out of room to bail out their private sector creditors:
Given the severely-impaired fiscal-financial positions and prospects of so many countries, the notion of a sovereign of one of these countries assuming responsibility for any debt that is not sovereign or sovereign-guaranteed is ludicrous. Even banks and other financial institutions that would in the past (when fiscal pockets were deeper) have been considered too big and too systemically important to fail are now too big to save. Ireland’s government could not today afford to guarantee virtually all of the liabilities of its banking system, as it felt compelled to do at the beginning of this year.
If I may, a small disagreement on language: not doing something you cannot do is not ludicrous. It is simply impossible. Ludicrous is deciding to do something stupid and then going through with it because there is no one to stop you. Dubai not paying foreign debts that it cannot perform is recognizing reality; the US debasing two centuries of bankruptcy law in an attempt to shield a few private banks from the consequences of their decisions is ludicrous.
The Krug offers three explanations of the drama in the desert, before settling for a combination of #2 and #3:
First, there’s the view that this is the beginning of many sovereign defaults, and that we’re now seeing the end of the ability of governments to use deficit spending to fight the slump. That’s the view being suggested, if I understand correctly, by the Roubini people and in a softer version by Gillian Tett.
Alternatively, you can see this as basically just another commercial real estate bust. Either you view Dubai World as nothing special, despite sovereign ownership, as Willem Buiter does; or you think of the emirate as a whole as, in effect, a highly leveraged CRE investor facing the same problems as many others in the same situation.
Finally, you can see Dubai as sui generis. And really, there has been nothing else quite like it.
That is correct but insufficient. Dubai itself can do nothing. Even if #1 were the case, it would only be important in the way that the assassination of Franz Ferdinand was important to the beginning of World War I: the pretext seized by a bunch of players to do what they always wanted to do anyway. The key question is how the lessons of Dubai are applicable to economies of relevant size. What would we do if, say, Fannie Mae failed? And if we would find the temptation to do something overwhelming, what should we be doing before the storm hits to ensure that there is no such organization that would be able to compel us to act?
It is this second part that curiously seems left out of serious discussion about our own financial house. I disagree on large bank failures; fair enough. But even if I could agree that there is something particularly earth-shattering about the restructuring of obligations of a massive bank (mind you, the US survived a four-year intramural war of unspeakable carnage and two subsequent world wars; I think we’d handle a Citigroup filing with some degree of resilience), wouldn’t that make it all the more imperative to gain control over the operations of the bank? So long as Citi, for example, is too big to fail, Vikram Pandit is essentially running his own branch of government. In fact, he has the power to print money; whatever losses he runs come straight from the Treasury/Fed if there isn’t money in the till. And once the government publicly allows this state of affairs to continue, it loses any meaningful supervisory authority. Sure, the government could fire Pandit…but what would that accomplish? The next guy would face all the same incentives. The only way to control any aspect of the bank is to remove the bank’s ability to write checks on the taxpayers’ checkbook – and that is the step the government appears most loathe to take.
It’s a case of learning the wrong lessons from last fall, and the wrong lessons from the sands.
By the way, if any of you are tempted to feel bad for the emirs, note that this couldn’t have happened to nicer guys: