The Dubai government refused to guarantee the huge debts built up by its conglomerate Dubai World, dashing investor hopes that the latest episode in the global financial crisis might be swiftly resolved.
In an interview on local television, the director general of Dubai's department of finance, Abdulrahman al-Saleh, appeared to suggest that investors only had themselves to blame for the unfolding crisis. "Creditors need to take part of the responsibility for their decision to lend to the companies," he said.
"They think Dubai World is part of the government, which is not correct. Dubai World was established as an independent company; it is true that the government is the owner, but given that the company has various activities and is exposed to various types of risks, the decision, since its establishment, has been that the company is not guaranteed by the [Dubai] government."
Moral hazard describes the phenomena where a party that is insulated from risk behaves differently from the way it would behave if it were fully exposed to that risk.
It is very easy to see in this case that the limited liability status of Dubai World â€“ an entity created and owned by the Dubai government, presumably (although I have not checked this) registered under Dubai law that the Dubai government created â€“ means that the Dubai government can deny responsibility for the risks that it created Dubai World to assume in pursuit of its own economic strategy for which it now denies responsibility. A better example of moral hazard is hard to imagine.
Unless, of course, we consider the case of banks in the UK and elsewhere that also trade with limited liability but in their case with the implicit unlimited guarantee of the taxpayer to back them, creating another form of moral hazard.
In both cases the moral hazard has, of course, been created by a form of asymmetric information: Dubai World knew the risks it was taking and the fact it could not enjoy a state guarantee. those who lent appear (as is the way of the market â€“ so ill informed is it) to have been unaware of the risks they were taking and assumed there was an implicit guarantee.
I am not suggesting as a consequence that we should get rid of limited liability entities: as a matter of fact I suspect that near enough impossible to do, although I know some argue for it.
I am arguing that if we are to have limited liability then there is a special duty of care imposed on those who take advantage of it, which no one is obliged to do. That duty of care is to provide considerable information concerning the beneficial ownership, true nature of management and financial performance of each and every limited liability entity that exists â€“ anywhere in the world and for whatever purpose it is used. The argument is simply that without this information, including country-by-country reporting. those who engage with a limited liability entity are, without exception, the potential victim of moral hazard of the form now being suffered by the creditors of Dubai World.
That is not acceptable: if markets are to be effective, if unjust enrichment and straightforward fraud is to be avoided, if risk is to be allocated appropriately then the price of limited liability is transparency.
Secrecy jurisdictions promote secrecy: they promote moral hazard, risk, distorted markets, unjust enrichment, fraud and more besides as a consequence.
That is why secrecy jurisdiction undermine the effective operation of all markets.
And opacity undermines markets in exactly the same way.
You cannot support markets and support either opacity or secrecy jurisdictions: they are incompatible.
Dubai should teach us an expensive lesson. It is time it was learned and action taken.