It was inevitable to be writing this story. The tales from Dubai, a city that seemed almost from another planet, from some cartoon sci-fi depiction of excess, grew more lurid with each passing year. They built a series of man-made islands into a scale map of the world. They built the world’s tallest man-made structure, the Burj Dubai. They built an indoor ski slope in a city where the temperature gets up to 106 degrees every August. With only 6% of the city-state’s revenues come from oil and gas – though the rest of the United Arab Emirates have plenty of petroleum – there might as well have been a big flashing “UNSUSTAINABLE” sign greeting people at the airport.

Now that the financial crisis has led to them attempting to suspend their debt, valued at perhaps more than $80 billion, everyone should just chuckle to themselves about the obviousness of the outcome and go on with their day. However, in an interconnected global financial system, one out-of-control speculator could end up impacting every corner of the market. Is that the case with Dubai?

It appears that much of their debt is held by European banks, particularly in Britain, where the stock market encountered its largest drop since February on the news. Gordon Brown tried to downplay the news today.

The prime minister said this morning that Dubai’s problems were “a setback”, during a summit meeting of Commonwealth leaders in Trinidad and Tobago. “My own view is the world financial system is stronger now and able to deal with the problems that arise,” said Brown.

“I think we will find it is not on the scale of previous problems we have dealt with. I think global recovery has depended on monetary action and fiscal stimulus,” he added.

Brown also said that he had spoken to senior figures in Dubai, and was confident that their plans to redevelop the ports they own in the UK would still go ahead.

Brown claimed that there are “mechanisms” in place to deal with the possible default of Dubai World, and certainly the other emirates could step in if the crisis reached epidemic proportions. The London stock exchange has actually clawed back to positive territory thus far today. The Dow is down 144 points but also climbing back after earlier losses.

The fear is that even a small default might leave some banks scrambling, confounding all the debt swaps that they have with other banks all over the world, leading to another round of credit tightening, prolonging recession.

While Dubai itself may not be a long-term threat to the economy, it symbolizes a potential market crash in commercial real estate, which pushed the emirate to prominence earlier in the decade. This is one of the potential signals that Paul Krugman highlights in his post today:

First, there’s the view that this is the beginning of many sovereign defaults, and that we’re now seeing the end of the ability of governments to use deficit spending to fight the slump. That’s the view being suggested, if I understand correctly, by the Roubini people and in a softer version by Gillian Tett.

Alternatively, you can see this as basically just another commercial real estate bust. Either you view Dubai World as nothing special, despite sovereign ownership, as Willem Buiter does; or you think of the emirate as a whole as, in effect, a highly leveraged CRE investor facing the same problems as many others in the same situation.

Finally, you can see Dubai as sui generis. And really, there has been nothing else quite like it.

At the moment, I’m leaning to a combination of two and three. For what it’s worth (not much), US bond prices are up right now, suggesting that the Dubai thing hasn’t raised expectations of default.

I’ve heard too many initial predictions not come true throughout this Great Recession not to dismiss the Dubai situation. The “CRE canary in the coal mine” scenario sounds the most plausible to me, but we’ll have to see.

UPDATE: Numerian at The Agonist has a darkly perceptive take.