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Commentary By Edward L. Glaeser

The Problem With Bailouts

RECESSIONS can pierce through financial fog and reveal weakness in seemingly invulnerable businesses, like Citibank and Toyota. But diagnosing the nature of corporate ill health may be difficult. Some firms suffer from a fatal disease; others have a temporary virus. Typically, professional investors must decide which troubled firms deserve a new round of financing. With the government increasingly playing angel investor to fallen firms, this task now falls to politicians and their bosses, the voters.

The distinction between permanent and transitory troubles appears across industries, companies, and cities. The metropolitan areas of San Jose and Detroit are both suffering from double-digit unemployment rates of 10.9 and 13.6 percent respectively. Despite California’s political mismanagement, San Jose has a superb base of tech-savvy entrepreneurs and a terrific climate. Silicon Valley will rise again, but the prognosis for Detroit is less rosy. Overdependence on one not very competitive industry, a shortage of college graduates, and a cold climate have led the city of Detroit to lose more than 50 percent of its population since 1950.

Many currently troubled industries have solid prospects. According to the Wall Street Journal, ”since the beginning of 2008, there has been just one biotech IPO,“ but biotechnology still has a bright future. The demand for healthcare miracles will continue, and America has many superb scientists. Many of our region’s wealthier universities have lost billions, but there is still a strong market for their teaching or research. In these cases, the business model is basically sound, despite temporary financial problems.

When investment is private, professional investors determine which companies are doomed and which are salvageable. In the current situation, however, the government has decided that a large number of firms are too big to fail and so our elected leaders are deciding which firms to save and which to let go.

The right answer is not ”save everybody.“ Human and physical capital should move out of declining industries and into more productive areas, unless America wants to be a permanent, industrial underperformer. But public-sector intervention usually errs on the side of the status quo. Politicians respond to the workers in an existing firm who are well organized and rallying to keep their jobs. The customers and employees of the new firms that will rise from a collapse have no seat at the table.

Since the collapse of Lehman Brothers, the public sector has spent billions saving the banks. While these decisions are certainly debatable, they are understandable. The US financial industry misbehaved badly, and many firms became insolvent, but it is still a sector with a future. America has plenty of smart bankers, and the world desperately needs banks. After all, every other sector in the economy depends on banks for their financing.

But what about cars? Oceans of ink have already been spilled arguing that General Motors’ problems long predate the current crisis. Does anyone, other than GM’s management, believe that this company can come back? The current treatment, cash infusion and a reduction in corporate liabilities, provides a solution for a company that is broke, not for one that is broken.

The great cost of saving GM as a single company is that there may be several good car companies living inside one poorly performing one. America’s car industry - and Detroit for that matter - might be better served with a number of smaller, nimbler firms. Across metropolitan areas and across sectors within areas, there is a strong link between small firms and economic success. Detroit was, a century ago, among the most entrepreneurial places on the planet, and it achieved automotive miracles, the scale of which ultimately turned the city into a model of big-firm stagnation.

If General Motors becomes a permanent employee-owned, state-sanctioned enterprise, the firm will lose its chance to split up and become entrepreneurial once more. This could be the great price, even greater than the tax costs, of treating a permanently plagued company like one with a temporary cash shortfall. As flawed as the free market may be, it is hard to be enthusiastic when politicians start playing financier with our tax dollars.