Now that the sovereign default cat is out of the bag (Ecuador defaulted last year but nobody paid attention, they do it all the time), the question is how long will it take for the entirety of the problem to emerge?

Remember, the finance crisis was initialed by the bankruptcy of New Century Financial Corporation a day after April Fools’ day in 2007. The Fed started cutting short- term rates August 17, then the Bank of England offered support for flailing Northern Rock about a month afterward. April, May June, July … August; that is five months.

Let’s allow three months for the current round of troubles to blossom. After two hard years, the money- community is better equipped and trained to ferret out insolvency truths from finance’s Decepticons.

Collapse of AIG and Lehman Brothers did not occur until almost a year after Rock’s demise. Behind the scenes was the steady erosion of values as insiders measured the relative worth of investments against the ability of those investments to repay and decided to cut their losses. This was the cashing out of the smart money. As the dumber money started to follow, the public took notice and the bad things started happening.

It appears the same sort of measuring is now taking place in other areas of lending. The shifting of bottom lines from private to public supports has been taking place over a long enough period to allow consequences to unfold. Having foreseen outcomes, the smart money long ago left the building leaving the dumb money holding the bag.

All that is missing is Mr. Bernanke suggesting to Congress that the crisis is confined to Subprime Dubai.

An unknown is the exposure of investors downstream and off the books of the Dubai government and Dubai World. Money flooded into that country as speculators raced to partake and inflate the frantic, frenzied bubble. The amounts at risk by this class of investor is probably several times the $50 billion amount at risk by Dubai World’s and developer Nakheel’s default.

Dubai’s brick and mortar extravaganza was not financed by oil reserves; it has almost none. Instead, Dubai is the money- laundry and conduit for the entire Middle East; where the Iranians go for dollars … and where 9/11 hijackers received funding. Hot, dirty money has been funneling in and out of Dubai for years. Amounts at risk and not to be discussed could amount to hundreds of billions of dollars.

All somewhat like “deja vu all over again” as Yogi Berra put it so sublimely. At bottom of the various popping bubbles is investment in ‘luxury’ real estate; Las Vegas, Southern California, China … Dubai, all supported before and after the fact by various subsidies. The subsidies themselves are recycled returns on energy. Any ‘investments’ really aren’t. What our crisis is really about is this particular asymmetry; returns from energy production fuel exponential demand growth rather than production growth. Even as production catches up to current (reduced) consumption, demand leaps farther ahead.

Energy invested in developing more energy supplies and sources – either directly or by conservation – would have meant much less prestige real estate development. Less development would have meant less consumption of energy wasting transport and transport infrastructure. The energy demands of components of this mis- investment amplify each other. Having more cars and trucks demands more roads to drive them on, more destinations to go to and more services at the destinations. There is no net return on this expenditure of energy, only on- running energy demand and consumption.

What is left is Dubai’s hedging against its minuscule and shrinking oil production with ‘something else’, in this case luxury, real estate and hot money trading/laundering. ‘Not- quite- oil- rich’ Abu Dhabi – Dubai’s neighbor – also has real estate excesses, not so outlandish and bizarre as underwater hotels or islands in the Persian Gulf built of pumped mud bulldozed into the shape of continents. Serious consideration is being given to the (inevitable) bailout of the one by the other. The process of bottom- line shifting is a given. It will continue until it cannot, anymore. As long as there is oil to be sucked out of the ground, money to be spent and both to be wasted, there will be bailouts.

The most interesting comparison is not so much between Dubai and AD – or Dubai and Las Vegas – but Dubai and China. In both instances, the public input has been large with investments in real estate predominating. Both Dubai and China have been suffering from increasing vacancy overhangs and falloffs in utilization both on the construction side as well as on the occupancy side. That this manifestation of brain lock is found around the world in all cultures suggests there is little imagined use for oil other than pointless retail consumption and silly diversions. The amalgam of collective dull- wittednss concentrates itself toward ‘financial services’, where tall buildings in windswept plazas contain large numbers of attractive young people selling ‘securities’ back and forth to each other, the fact of the sales themselves causing prices to increase.

Until they don’t anymore …

This is the subprime crisis writ increasingly large. The securities, the services, the jobs, the towers, the plazas the cities that contain them … are worth very little. Oh, deflation! Perhaps China will escape hyperinflation after all … and fall into the pit:

Albert Edwards: Here Comes A Trade War, A Yuan Revaluation, And A Stunning Chinese Trade Deficit
Joe Weisenthal

In his latest report, ultra-gloomy SocGen analyst Albert Edwards warns of a trade war in 2010, especially if his views of a synchronized global downturn comes to pass.

I think the next 18 months will see major ructions in the financial markets. The consequences of a double-dip back into recession next year require some lateral thinking. If the carry trade unwind results in a turbo-charged dollar, any collapse in the China economic bubble will be doubly destructive to commodity prices. A surging dollar, coupled with China moving into sustained trade deficit through 2010, could prompt the Chinese authorities to acquiesce to US pressure for a more flexible exchange rate. But why does no-one expect a yuan devaluation?

Investors seem to have spotted that the global economic cycle may be on the wane. The ECRI leading indictor for US activity has now slid for five weeks in a row. Recent data such as the slumping October US housing starts are causing very valid jitters of what will occur as the turbo-charged fiscal stimulus now starts to abate.

Our Asian Economist Glenn Maguire has been very right on China this year. I was chatting to him on my recent visit to the region and he re-emphasized his call that China will be heading into trade DEFICIT (!) throughout 2010. This is a mega-call and will have major implications for the global financial markets. First and most obviously is that China will not be accumulating FX reserves at anywhere near its recent pace. This has implications not just for US treasuries etc., but also for the pace of Chinese growth itself, as the rise in reserves has previously been a major stimulus to domestic monetary growth and activity.

I don’t know if this will be true or not as hyper- merchantilist China has so far proven adept at vacuuming reserves by any and all means necessary. At the same time, empty factories and vacant cities put the brakes on goods production. There are fewer future goods to spend the reserves on. On the other hand, if Soc Gen is right, the world is facing a thumping, big deflationary crash and soon. Either as cause or effect, such a crash would dry up world- wide liquidity for all including China as was the case during last year’s credit freeze.

A wild- card is oil prices. High oil import prices propel money outflows. China’s increasing fuel consumption would have an effect on trade if oil prices remain near current very high levels.

As oil prices fall alongside business failures and debt defaults, the oil cost to China will decline. Oil costs will also decline to Japan and the US. Reducing this flow of funds to OPEC will be hard on Dubai and its neighbors, but good for China’s trade balance. With less of these funds in the trade/Forex cycle the outcome would be more money in local circulation in China. By itself this would not effect the trade balance. China’s establishment will do everything possible to increase Chinese citizens’ buying so as to keep what factories are still open … humming.

The Chinese big shots also have little choice but to add to their own rounds of bailouts of well- connected real estate developers who have already received special consideration and loan hand- outs. It’s a part of maintaining the value of sunk capital. Here is a characteristic of the great unwinding: the individual defective and corrupt bits are of a piece with the defective and corrupt whole. The race is not to the bottom of wage rates or respective currencies, but rather the race to the bottom of real asset values versus the effect the values have on system output. It’s a vicious cycle as a return on inputs – particularly energy – is necessary to support asset values … along with the rest of the entire economy! Our dilemma is that low oil prices are necessary for the economy, but the only road remaining to low prices is a serious economic decline and shrunken consumption.

Money proves to be no substitute for oil, even when money categorizes oil as simply another risk asset. This ‘failure of the hedge’ is the overall lesson of our Greater Depression. In this case study, money is wrong, even the smart variety. All efforts to hedge against the obvious outcome of oil depletion … fail.

In the end, both Dubai and China Inc seem certain to follow New Century Financial Corporation to that big palm- shaped island development in the sky … it’s just a matter of time.