When the Dubai debt crisis broke over the long Thanksgiving weekend, it was like a gruesome flashback to the fall of 2008: panic buying of dollars, government bonds, and gold; falling stocks in emerging markets; bankers pleading for a government bailout.
Dubai had announced that it was seeking a six-month standstill with creditors of Dubai World, a government-controlled company that was having difficulty staying current on $26 billion in debt. Its implosion wasn't exactly surprising.
The nontransparent sheikdom sought financial excess just for the sake of financial excess—Dubai was home to a seven-star hotel, an indoor ski resort, and the world's tallest building. But the fallout was curious. Why would Dubai's debt problems cause the price of insurance on Greek government bonds to soar? After all, while Dubai's two main troubled state-affiliated companies, Dubai World and Nakheel, have about $80 billion in debt between them, the emirate was a mere drop in the international debt bucket.
And while Dubai, like Lehman Bros., was overleveraged and surprisingly ill-run—a point I made earlier this week—the emirate is actually a much smaller problem for the world than Lehman, AIG, or Fannie Mae and Freddie Mac, which had trillions of dollars in liabilities. Dubai World and Nakheel own real stuff, including ports, hotels, the high-end retailer Barney's, and Scotland's Turnberry golf resort. As Willem Buiter, the newly appointed chief economist of Citigroup, which extended an $8 billion loan to Dubai in late 2008, wrote, "Dubai is not systemically significant."
So why did the markets stage a mini-meltdown? Chalk it up to muscle memory, an important concept in markets as well as in physiology. Financial behavior is conditioned by prior trauma. Once a lightning bolt strikes, people tend to overestimate the likelihood of a repeat strike. "Before they occur, these virgin risks are somewhat disqualified from your thought process," says Erwann Michel-Kerjan, an expert on catastrophic risk at the Wharton School and co-author of the new book The Irrational Economist. "But once they occur, they become very salient and you will always overestimate the likelihood of them reoccurring."
In the aftermath of the great crash of 1929, the Dow plummeted more than 80 percent. Probably no more than 10 percent of the population owned stocks at the time. But the damage was so traumatic that the crash sapped the national tolerance for risk for decades. By the early 1950s, the Dow had regained its 1929 peak and the nation was enjoying an extended period of rising prosperity and low inflation—but the only financial asset most Americans wanted was one that would protect them from losses. In 1952, 82 percent of families had life insurance, but only about 4.2 percent of the population held stocks. It wasn't until the 1980s, when the generation born after the Depression matured financially, that stock ownership rose sharply.
In the late 1970s, when inflation reared its ugly head, the Federal Reserve, led by Paul Volcker, choked it off by pushing the federal-funds rate to 20 percent. The harsh medicine worked, although it also precipitated a deep recession. By late 1984, the fed-funds rate was down to 8.25 percent, and inflation had fallen back to the low single digits. But the 30-year government bond still yielded more than 13 percent. Despite evidence that inflation had long since been brought under control, investors acted as if it were still raging.
Today it appears that investors are suffering from post-traumatic stress disorder. Every fresh failure leads people to relive the events of 2008 and take evasive action. To a large degree, the concerns about Dubai really aren't about Dubai, unless you're one of the unfortunate hedge funds or banks that was expecting full debt repayment. Rather, the Dubai anxiety is really about Lehman Bros., AIG, Fannie Mae, and Iceland.
Understanding this sort of touchiness is critical to understanding the psychology of a post-crisis world. A loud noise in lower Manhattan in August 2001 wouldn't have caused people to think twice—it was a car backfiring or construction materials falling. Three months later, the same sound would have caused panic. Just as 9/11 became the lens through which we have come to view national security, September 2008 has influenced the way we regard financial security. The global economy may have pulled itself out of the ditch and gotten back on the road to growth, but it's still trying to avoid the hazards that pop up in the rearview mirror.