Insolvency Vs. Illiquidity

Is Dubai going through a temporary liquidity crisis, or is it facing a serious insolvency problem? Does it need a couple of billion to tide it over a rough spot, or is the income produced by the assets it built by the dozen insufficient to cover their debt load?

The answer is, obviously, the latter: Dubai has a serious solvency problem, as can be seen from the see-through buildings dotting its shore and spiking its skies.

Does it matter? Of course it does; the ONLY remedy for insolvency is debt liquidation and a commensurate drop in the price of the associated assets. That's how asset prices may once again come into line with the income said assets can produce. Corollary to this basic truth is that monetary bailouts of the type envisaged by the central bank in Abu Dhabi do nothing in such cases - except possibly avert panicky bank runs. That's a laudable and necessary step, of course, but what must come next is, perforce, the painful liquidation phase.

And why does it matter to the rest of the world what is going on in Dubai? Because it is the world's most glaring, most spectacularly obvious case of what is wrong in the real economy, all over the world. The quantities and prices of all kinds of assets rode high on a sea of easy credit with no regard to their end use. Assets were built and financed with an eye only to their immediate sale, to flipping them for an instant capital gain instead of operating them for real economic gain, like rents or dividends. That's the economic principle known as "the greater fool" or "the trading sardine". It works for a while and then always fails, quite often most spectacularly.

In my opinion, Dubai is the warning bell that the global economy has entered Phase B. The greater part of the liquidity crisis is over; but now starts the real pain of dealing with insolvency. Central banks and financial ministers did a creditable job of subduing illiquidity. They even fostered the view that the global Great Recession was over. That's a mistake.

Dealing with insolvency will require far greater political resolve and much different skills than merely lowering rates and opening credit facilities to all comers.