Some major news has been hitting global financial markets hard over the last day or so: there is a prospective default by Dubai World, which is an investment vehicle operated by the second-largest of the seven United Arab Emirates.

It appears that a total of about $80 billion in debt is now at risk. About $10 billion of that is subject to rollover in the very short term, and may not be fully repaid. Major holders of the assets include HSBC, the London-based banking giant; the Royal Bank of Scotland; Japan’s Sumitomo; and others. None of these organizations is in a position to sustain another big hit to capital. RBS, in particular, has been all-but-nationalized by the UK government.

Until the financial crisis got really bad a year ago, Dubai had been on an ambitious campaign to become a global center for finance and high-end real estate. The original funding came from oil-rich Abu Dhabi, the largest emirate in the UAE. (Dubai has no oil of its own.) There are stories that Abu Dhabi decided to pull the plug on what is now not looking like a good investment story.

I’m still trying to figure out what the real impact is here, a process which may take some time because many people won’t be in the office today. $80 billion is a relatively small default in the grand scheme of things, but it is a sovereign default, and if it results in any kind of sizable loss-recognition by Dubai’s bankers, then that’s a hit to capital, and no one needs that right now.

Stock markets are down 3+ percent overseas. That’s a pretty strong reaction. The 2-year Treasury note, which We The Taxpayers sold at 0.802% earlier this week, has leapt upward to yield only 0.65% this morning. The dollar and yen are stronger, gold is down 2%, and oil is down a whopping 5%. As I write, the impact on markets is easing up a bit, but we should still see at least a 200-point decline in New York stocks when they open later this morning.

The overall viewpoint that I’m taking at this point in the situation is that it’s going to trigger a big spike in volatility across many markets. That reinforces the point that the emerging-market rally (which we know has been fueled by cheaply-borrowed dollars) isn’t based on fundamentals. The Chinese have gone on an investment boom, and that is perhaps the only fundamental positive in the world economic picture, but of course they’re taking a big risk that customers for their new production capacity will actually materialize.

Meanwhile, Congress, the Treasury and the Fed are continuing their overall policy strategy, which is reflation. Some people call it “pretend and pray.” In other words, we’re making it possible for everyone (from Wall Street to large banks to homeowners) to avoid recognizing losses on their assets. A big burst of volatility from Dubai ought to show everyone just how dangerous that strategy really is.

Governments can lie about the true level of global capital and economic activity, and markets will believe the lies as long as it’s advantageous to do so. But not forever.

For more information, listen to my podcast on Dubai at The New Ledger this morning.