Fernando Ulrich takes an Austrian-economists’-eye look at the meltdown in Dubai and sees a classic credit-driven boom. Where did all the money come from to fund the extravagance? Look ye to Dubai’s central bank, which pumped up the money supply by around thirty percent a year from 2006 to 2008. And all that new money has to go somewhere, right—and where it went was to into fuelling the bubble. Into new office space with no tenants and new apartments with no renters, both of which were making paper gains (as long as the punch bowl kept being topped up) sucking in even more credit from overseas.
In other words, the lion’s share of new credit went into malinvestments—”investments” that looked good only as long as the money supply was being inflated:
Loans extended to the construction sector grew 41.7% annually from 2006 to 2008. In 2008 alone such loans increased a whopping 80.7% over the previous year. With all this funding, new projects were being launched constantly. Nevertheless, with all this supply, where was all the demand coming from?
“In this regard, banks also ensured there would be enough demand available through the usual means, credit.
“In 2006, mortgages to residents climbed 80.1%. During 2007, the increase was 82.1%. Finally, 2008 ended with $18.9 billion worth of additional loans, 122.8% growth over a year.
“It can hardly be argued that this demand was real. The United Arab Emirates' population stood at 4.76 million by the end of 2008, an approximate increase of 277 thousand in comparison to the year before.
“Taking into consideration that a disproportionately large part of the population are blue-collar workers (mainly from the Indian subcontinent), of whom the vast majority reside in labor camps, one may conclude that mortgages were concentrated in very few hands, suggesting the demand was indeed due to investment rather than ownership.
“If there had been no credit expansion, people would not have been able to buy on this massive scale. Without the potential buyers, developers would not have been able to launch so many projects. Likewise, if credit hadn't been readily available for developers, they also wouldn't have been able to fund so many projects. So did credit to consumers lead to more credit to contractors, or was it the other way around?
“Instead of trying to solve this conundrum, it suffices to conclude that credit expansion exerted a drastic force in promoting unviable projects.
Like someone hooked on hard drugs, credit expansion is the “easy fix” that leads to one shitload of a come down later. Because whether created by pharmaceuticals or monetary inflation, both artificial “highs” have to be paid for sometime. Mainstream economists have no conception of the full range of dangers created by rampant credit expansion—all they see is the danger of price inflation. It is Austrian business cycle theory that has had to point out the obvious: that the creation of counterfeit capital creates no new resources, it simply shifts them from truly profitable activities into activities that look profitable, but only as long as the artificial credit expansion continues.
“[The fact is] production takes time and labor. The creation of additional money out of thin air does not add to the available amount of goods and services in the economy. If more credit is extended to construction companies, it does not mean there will be enough steel, cement, etc. — certainly not at prices that make the developments profitable. As soon as each company starts bidding for the same resource, it will tend to increase in price, rendering some projects unviable.
“Resources are scarce. Printing more money can never alter this fact.
“With extremely low nominal interest rates and negative real interest rates (inflation is estimated at over 10% for 2007 and 2008), the rational behavior was to borrow and invest wherever it is possible. A booming real-estate market seemed to be the obvious choice most of the time.
“Under these conditions, everyone becomes a brilliant businessman. Entrepreneurial errors seem seldom while credit is abundant.
“Psychology clearly plays a role in stimulating a bubble, but only monetary inflation enables it. It is difficult not to succumb to the temptation of profiting astronomic amounts in a short period of time. Resistance is even more difficult if the means to engage in the bubble are easily available at the nearest bank.
“In the case of the housing sector, people failed to understand that demand for real estate is only sustainable if the ultimate reason for purchasing a property is to actually reside in it. . .
“Dubai's false boom, its unreal prosperity, was based on the illusion of cheap money. It was based on the illusion that credit expansion generates wealth — that money is wealth. Following the Austrian Theory of the Business Cycle, one could clearly see that the emirate's boom had to come to an end.”
The punch bowl is now empty, the empties are strewn over Dubai’s sands, and many of the party-goers have gone, leaving their cars abandoned at the airport as they fleed their debts. And the last signal downwards was given by Mark Thornton’s Skyscraper Index.
It was all a hell of a lot of fun while it lasted, but it was all an illusion. Real resources were being consumed, instead of increased. And unfortunately, all the real resources consumed in unprofitable lines in the boom now have to be replaced, and then reallocated into more profitable lines—and the pool of real savings (which was consumed unnoticed) must be built up again.
That’s not the sort of thing that gets the headlines Dubai was attracting, but it’s the sort of sensible sustainable growth that’s needed. But that takes time.
- Read Rise and Fall in Dubai: An Austrian Perspective for the full story.