Borrowing Limits, Not Bailouts, Prevent Market Failure

Last week, Dubai World, the Dubai government’s investment arm, shocked markets when it said that it wanted to freeze some debt repayments and cut the nearly $60 billion that it owed. Why was everyone surprised?

Because we’ve become Bailout World -- endangering the world’s ability to create wealth.

Dubai World, which has invested in hotels, luxury department stores, office towers, and amusement parks all over the world, never had the official backing of the Dubai government, despite its government ownership.

But global investors always assumed that if Dubai World’s projects ran into trouble, the Dubai government would stand behind it -- just as the U.S. government stood behind mortgage giants Fannie and Freddie last year. Beyond that, investors assumed that if Dubai itself couldn’t or wouldn’t bail out Dubai World, Abu Dhabi -- another of the seven members of the United Arab Emirates, and the richest -- would step in with its own cash.

But the Emirates governments are showing reluctance to follow what the United States did with Fannie and Freddie as well as with AIG: To use finite state resources to bail out sophisticated investors without asking for anything in return.

Dubai World’s request is only weird in a world where government bailouts are the norm. The company is saying to its lenders: These projects aren’t worth what we thought they were -- or what you thought they were.

Working through the consequences of inevitable bad investment decisions is part of doing business.

But the financial world has grown accustomed to a one in which, if banks and investment firms get themselves into enough trouble through their own bad decisions, they can depend on a government bailout.

This creeping permanent nationalization of finance’s risks -- in effect, freeing financial investors from the consequences of their decisions -- is terrible for free-market capitalism. Investors need to assess projects on their own merits, putting capital in companies and ideas that they think will succeed, and withholding capital from white elephants.

They won’t do so if they know that the world’s governments stand behind their bad decisions.

Unfortunately, the United States has led the way here -- letting the world think that financial firms should be immune to market discipline.

But the American government can lead the way back to market discipline. To do so, it must make the economy better able to withstand inevitable financial-industry failures, so that the financial world can no longer hold the economy hostage.

That means predictable, consistent limits on borrowing across similar financial instruments and financial firms, no matter what their perceived risks. Clear borrowing limits are necessary because sometimes nobody sees any risk at all.

Over the past two decades, financial firms and instruments have escaped such limits. In 1995, a British investment house, Barings, went bankrupt because of bad derivatives bets. But the bankruptcy didn’t ruin the economy, because Barings had made its bets in markets that regulated borrowing.

Just three years later, the Long-Term Capital Management hedge fund needed a government-engineered bailout, because it had made similar bets through unregulated financial instruments that had no such limits.

Borrowing limits in the housing market would protect the economy, too. A requirement for, say, a 10 to 20 percent down payment would prevent people who couldn’t afford houses from buying them, thus dampening demand and keeping a housing bubble from growing too fast.

And when the bubble burst, it wouldn’t leave behind so much unpaid debt.

Dubai has sent us a wake-up call: Losses on bad investments should be considered a healthy part of capitalism -- not an inconceivable shock. We can’t stop failure (nor should we), but we can better protect the economy from its effects.

This piece originally appeared in Washington Examiner

This piece originally appeared in Washington Examiner