Why Markets Overreacted to Dubai's Debt Trouble

Over the long Thanksgiving week-end, some bad newsemerged from the Persian Gulf. Dubai announced that it was seeking a six-month standstill with creditors of Dubai World. The government--controlled company was having difficulty staying current on $26 billion in debt. Cue the video from the fall of 2008: panic buying of dollars, government bonds, and gold; falling stocks in emerging markets; bankers pleading for a government bailout. (Click here to follow Daniel Gross).

The implosion of Dubai wasn't ex-actly 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 isn't Lehman Brothers, or AIG, or Fannie Mae and Freddie Mac, which had trillions of dollars in liabilities. Lehman's $600 billion in debt was backed—or not backed, as it turned out—by a hedge fund masquerading as an investment bank. By contrast, 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 over-estimate the likelihood of a repeat strike. "Be-fore 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 coauthor 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 height of that decade's investment craze. But the damage was so traumatic, the scars so deep, 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 posttraumatic stress disorder. Every fresh failure leads people to relive the events of last fall and to 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 were expecting full payments of debt from the emirate. Rather, they're about Lehman Brothers, AIG, Fannie Mae, and Iceland.

This sort of touchiness is a key component of 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 is back on the road to growth, but it's still trying to avoid the hazards that pop up in the rearview mirror.

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