The Dubai Gambit

Although we just wrote about Dubai and its impressive level of debt - not to mention its impressive malinvestment of its resources - the Emirate has made a manoeuvre which we didn't even think of: declaring the debt of Dubai World not backed by government guarantee. From the BBC:

"[Creditors] think Dubai World is part of the government, which is not correct," said finance minister Abdulrahman al-Saleh. "Creditors need to take part of the responsibility for their decision to lend to the companies."

Clever, very clever; it seems to us that Dubai is looking to have its cake and eat it too, after a manner of speaking. They got their theme parks and little islands, and now the investors can go stick it wherever they'd prefer the pain. And if those investors attempt to foreclose on the assets of Dubai World, they just might run into the little problem that said parks and islands are property of the Dubai government, or perhaps the Abu Dhabi government; in other words, foreclosure is not happening, because we really don't think an UAE court would care to strip a sovereign government of its assets. Certainly not for foreigners, and the latest incident with the Swiss banning minarets will likely not help the situation.

A thought arises from the move, which we give the same title as this post: the Dubai Gambit. We'll put it in the general terms for starters. A nation's Government spawns this enterprise (we'll use the U.S. term of Government-Sponsored Enterprise, or GSE, with apologies for such Amero-centrism), and lets it just toddle along, doing its thing. As a GSE, it would seem to investors that the GSE enjoys an implicit Government guarantee; the Government made it, so why wouldn't it keep it going if times were tough? So, investors cheerfully pile into the debt of this GSE, because from their perspective it's just as good of debt as sovereign debt.

But surprise! It doesn't say anything anywhere in the GSE's charter (or what have you) about a Government guarantee. That means the Government, at its fickle discretion, can either help out the GSE in times of trouble, or not. The average investor, being apparently rather dim-witted when it came to reading fine print, was speculating much harder than he or she thought; the money he or she plopped down for the GSE's debt might never come home from the front lines of the Free Market. It's a messy place, we hear, and casualties can be heavy.

Bad times come along, and the GSE gets into some serious trouble. Investors start thinking "Boy, I be sure glad that thar GSE's got some sort of gum'ment guarantee or some such. I's real smaaart," and patiently sit on the deck of their double-wide trailer waiting for the cheque from the Government to make them whole. Grandma Kettle's rocking chair creaks as she loads up the shotgun to take aim at a stray dog; the hole in the roof gets a little bigger; no Government cheque comes in.

That's because the Dubai Gambit was brought into play; the Government decided the GSE was not, in fact, going to enjoy a bailout. In the real world, this would probably happen when such a GSE was in such horrible shape, that the Government would have risked its own credit rating to support the malinvestment of the investors, and the GSE's own malinvestments. GSE debt goes from being 'as good as Government' to 'someone has to do something about this!' overnight, as the bonds go belly-up. Investors are left footing the bill for someone else's good time, and the Government comes out, theoretically, smelling like a rose, at least to the credit markets.

As this meltdown of the GSE is underway, the Government finally steps in, but not in the way the investors were expected. Instead of providing a backstop for the full value of the GSE debt, the Government starts Agency X, with the explicit goal of winding down the GSE's debt. With a pre-packaged bankruptcy agreement - and a sufficiently... agreeable... court system - Agency X gets to cherry-pick the good assets of the GSE, and leave the GSE with all of its liabilities. Investors in the failed GSE would get Agency bonds worth pennies on the dollar of their original GSE debt, and the Government gets to have at least something for its efforts.

We fully expect Dubai to do this manoeuvre, or at least something like it. If it seems far-fetched to you, dear Reader, please consider the shenanigans surrounding the General Motors bankruptcy fiasco in the United States. The 'old' GM went into bankruptcy, gave its few good assets to the 'new' GM (owned by the U.S. Government, the Crown in Right of Canada, and a few other favoured parties), and then left its legacy of toxic waste dumps (or, 'factories,' as they are charmingly misnomered) and other such massive liabilities upone the shoulders of now wiped-out investors; the 'new' GM is in the clear. This, in civilised countries, is typically considered unlawful conveyance, but since the Federal Government was involved, such trivialities were easily brushed aside.

The Dubai Gambit is, at its core, entirely designed to have the Government - any Government - protect its credit rating at all costs. Dubai seems to be very much conscious of that factor, as why else would the Emirate have explicitly withdrew any implicit Government guarantee? Dubai World et al. is a mess financially, and it would probably bring down the Government if it tried to back the enterprise's debt for its full value. At pennies on the dollar, as it were, Dubai might be able to convince the UAE central bank, or Abu Dhabi, to bankroll a resolution of the fiasco; Dubai keeps its sovereign credit rating, the UAE and Abu Dhabi look like heroes, and investors in Dubai World don't feel quite as raped as they otherwise would have.

The question is, if Dubai makes this Gambit work, and to paraphrase Tom Lehrer, who's next?

A Modest Proposal to Save California

With the State of California presently pumping out $3 billion in unconstitutional IOUs, we suspect that a more impressive meltdown of the State's government is not too far off. It seems unlikely that any mixture of creative accounting and tax schenanigans will be able to stave off the collapse of the State's tax revenue, nor its downgrading debt rating. Unless Governor Arnold Schwarzenegger manages to both get the California legislature to accept his drastic cuts to the State's outlays - as well as pushing for even deeper and sweeping cuts - California will likely perform a sovereign default, and experience a collapse of the Government's services.

But, as with most things, it really doesn't have to go down like that, and to that end we have an idea: de-State-ify California, and convert it into the District of California. We think the move could go, as Bob Newhart says, something like this:

The Federal Government forces bond holders to swap California's debt for fresh Treasury debt at face-value, or perhaps a token premium. With that move complete, the Federal Government would then dissolve the State Government, and place the political administration of California directly under the authority of Congress. As we understand it, this would convert California into a Territory (which is how the District of Colombia is classified). In order to get the residents of California to feel happy about this move, the Congress could pass a Constitutional amendment allowing territories - like the District of Colombia, and possibly the District of California - to vote in elections of Representatives and the President.

This move would not be without benefits to both parties (i.e. California and the Federal Government): Californians could conceivably see lower taxation, as there would be no parallel State/Federal services, such as welfare... but we would count on that one too much. The Federal Government would be the bigger winner, because California would lose its Senators. That may not seem like such a big deal, but if turning a State into a District is successful, or at least not a total catastrophe, the Federal Government would likely perform the act on several other failing States. With fewer and fewer Senators, an argument could be made for the dissolution of the Senate, and the transfer of the Senate's powers to the Executive or the House of Representatives. Such a move could be dressed up as a 'drastic change to increase efficiency in Government, and reduce public expenditures.'

Be that as it may, if the Federal Government were to take over California directly, it would at least stave off the embarrassment, and potential fallout, from having a State default on its debt. It would also be a shrewd move for the Federal Government, for a somewhat complicated reason. As, in theory, the Federal Government is the representative of its constituent nations (as in a Republic), the credit rating of the Federal Government probably would be affected negatively by a Californian default. Such an effect would have a concurrent negative affect on the Federal Government's spendthrift ways. Ergo, prevent a Californian default at all costs, to protect the Federal budget.

Or... the Federal Government could just fork over a tonne of money to California, since Michigan has already gotten its own, private bailout. We can only remark on how well it seems to have worked.

The Looming Tax Catastrophe

The 2008 Depression is lowering tax revenues due to investment losses, declining earned income, and falling property values. To raise taxes at this point, even to maintain revenue, will create even less investment if levied on business, thus hurting prospects for job creation; and if levied against individuals, will lower discretionary spending and further the crash in consumer spending.

Governments can cut spending, as is happening in most U.S. states, but the effects of that are also depressing - government spending is, after all, somebody's income. Governments at present are actually increasing their spending in a big way via the bailout mania both by 'investing,' and by covering the losses these 'investments' will inevitably bring. Additionally, there are plans in the works for a new, New Deal.

Governments tend to have pretty good credit ratings, so they can borrow quite a bit to cover the shortfall of tax revenues, but there are limits. There comes a point when lenders begin to doubt whether the funds will be repaid and that source is precluded. Currently the USA has a direct federal debt liability of about $40,000 for each and every person in the country. Evidently the USA's creditors (mostly trade partners) think that is a viable sum. How much higher will they let that go, especially as incomes start falling? We don't care to hazard a guess, but probably not too much higher. So while this option is open to the USA Federal Government for the time being, it is a temporary phenomenon.

There is a darker 'solution' to where a government could get money to spend - the printing press. This would, of course, cause a ruinous decline in purchasing power - furthering deepening the depression.

Raise taxes to cover spending - deepens the depression. Cut spending to match the fall in taxes - deepens the depression. Max out the Federal Debt 'credit card' - keeps the bills paid for the time being, but what to do when it's maxed out? 'Print' money - one way ticket to Zimbabwe. This is looking like a no-win situation.