The Lehman Brothers of the Persian Gulf

Dubai was supposed to be a new model for economic development in the Persian Gulf, and in the world. And like so many recent "new models," Dubai is proving to be a lemon.
The theory was that Dubai would be a competitive, free oasis in a region generally hostile to the open market. Lacking oil resources of its own, it set itself up as a sponge to sop up resources-generated cash. Dubai would be the playground, shopping mall, financial center, cultural zone, beach resort, and second-home mecca of the global oil patch—New York, Las Vegas, and Miami wrapped up in one. In a part of the world where politics were generally poisonous, Dubai was a comparatively free space, open to all investors. The world's financial elite embraced Dubai's new image as a blue-chip. In this year's World Economic Forum's ranking of the most competitive economies, Dubai came in 23rd, up from 31st the year before. It was the highest-ranking country not in Europe, developed Asia, or North America. Conservatives embraced Dubai as a small-government, capitalist heaven. "Think Dubai. Free and rich," as Donna Wiesner Keene wrote in a letter to the New York Times. (Click here to follow Daniel Gross).

Of course, Dubai was never particularly free. Now it's not quite so rich. And, shorn of access to easy money and weighed down by enormous amounts of debt, it's becoming less competitive. Like so many other blue-chips that garnered headlines during the boom years, it was held aloft by loans and a global bubble heavily concentrated in commercial real estate. Now that it has stopped paying debts owned by government-controlled companies, Dubai looks less like Singapore and more like an institution whose epic fail in 2008 helped paralyze the global financial system: Lehman Bros.

Like Lehman, Dubai made the mistake of borrowing short-term to buy long-term illiquid assets. The holding companies Dubai World and Nakheel borrowed tens of billions of dollars from global capital markets and used the funds to buy stakes in Cirque du Soleil and Barney's, yacht businesses, financial-services companies, and, above all, real estate. In much the same way, Lehman plowed its hundreds of billions of borrowings into illiquid investments such as commercial office buildings and apartment complexes. (When it went bust, Lehman had more than $40 billion in commercial real estate on its books.)

Lehman exploited all the new tools of financial engineering—the commercial paper market, CDOs, etc. Dubai did the same with all the new tools of civil engineering: a palm-tree-shaped complex of islands, an indoor ski resort, the tallest building in the world.

In theory, Lehman was a model of modern corporate governance. Public shareholders were represented by an august board, which was supposed to supervise an experienced leader. In practice, it was an autocratic regime run largely for the benefit of insiders and disdainful of outside stakeholders. The same holds for Dubai, where the key companies are essentially arms of the state and are controlled by the royal family and its associates. When challenged about emerging financial problems, Lehman Bros. leader Dick Fuld adopted a tough-guy approach. "I will hurt the shorts, and that is my goal," he said in the summer of 2008. When questions arose about Dubai's financial management, its leader, Sheik Mohammed bin Rashid Al Maktoum lashed out: "So to the people of you who nag over Dubai and Abu Dhabi, shut up!" Ultimately, neither leader was worthy of the praise and presumption of competence that the markets had given them.

Lehman Bros. never believed the government and other members of the investment-banking fraternity would let it go under. Just so, there's been a presumption in the market—and perhaps in Dubai's palaces—that the United Arab Emirates, the oil-rich political federation of which it is a part, would stand behind Dubai's many debts. So far, however, there's no sign of a full-on bailout for Dubai.

And that may be the final comparison between Lehman and Dubai. Both may have shared the illusion that they were too big to fail.

Daniel Gross is also the author of Dumb Money: How Our Greatest Financial Minds Bankrupted the Nation and Pop!: Why Bubbles Are Great For The Economy.