The Kroog Versus Dubai

With the U.S. markets losing a percent and a half or so on today's half-day session due to the growing likelihood of a 'major sovereign default' in Dubai, Paul Krugman takes a look at what Dubai means for the bigger financial picture here in the states and across the globe.

As far as I can tell, there are three ways to look at it — three stories, if you like, about what Dubai means.

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.

At the moment, I’m leaning to a combination of two and three. For what it’s worth (not much), US bond prices are up right now, suggesting that the Dubai thing hasn’t raised expectations of default.

(More after the jump...)

CalcRisk is backing the Kroog on this one:

Dubai seems like an extreme example of the CRE bust. "Vegas on steroids" as Nanoo-Nanoo wrote in the comments to an earlier post.

It is the state-controlled Dubai World that might delay payments - and both Moody's and Standard & Poor’s have said they may consider delaying payments a default - and it is unclear if oil rich Abu Dhabi will help out Dubai. So the situation is confusing ... but it does seem that Dubai is the most overbuilt city in the world.

Felix Salmon thinks this is a good precedent.

Personally, I’m quite happy about this default, since it sets another very useful precedent of a state-owned company defaulting on its debt. Historically investors in state-owned companies have perceived an implicit sovereign guarantee — there’s even a German word for it, Anstaltslast. The result is a huge and unhelpful moral-hazard trade.

I happen to back Felix on this one:  The moral hazard on Too Big To Fail was the problem all along here, and the only way to reverse it is to let TBTF fail.

Would that we would apply that to our own banking system, which is still in heaps of trouble.  The FDIC insurance fund is now in the red, and 124 banks have gone under this year.  There's still five weeks to go on that, too.

More will come in 2010.