Why Credit Crisis Bail-outs are Bad News for Investors

By: MoneyWeek

The banks were too big to fail. Everyone agreed on that, it seemed.

But once you give one lot of badly run, bust companies a bail-out, it becomes a lot harder to justify knocking back the rest. And soon everyone has their hand out.

Now the car makers are looking to dip the taxpayers' pockets. Even organic farmers apparently want a "holiday" from having to rear their animals to the necessary standards. And that's all before you consider the fact that the banks are almost certainly getting in line, Oliver Twist-style, to come back and ask for more.

And knowing the Government, there'll be some gruel left for every last one of them...

The government is always going to go for the popular option

Jaguar Land Rover seems to have survived for the time being. According to The Times , the Government was set to announce some sort of bail-out package "today or tomorrow." But the fact that the Government was planning to act has enabled the group to raise short-term cash, enough to "postpone the bailout until after Christmas."

So if The Times is correct, then the banks are now acting on the assumption that Jaguar is a state-backed corporation. "Tata found the cash because its banks were convinced that the Government would prevent a collapse, a source said."

This is not remotely surprising. The Government is always going to go for the popular option – and people who lose their jobs are not happy voters.

But it's also a disaster.

The market is consumers exercising choices

Let's go back to basics here for a moment. We have markets to encourage the efficient allocation of capital. What's that mean in English? It means money flows to where it should generate the best return, given the risks involved.

The best returns – compared to risk – should come from supplying things that people need or want. If there's an opportunity somewhere – in other words, if there's a demand that's not being met - then various entrepreneurs will compete with each other to take advantage of it. Competition ensures that the demand is met in the most efficient way, and we all end up with a better standard of living (you can read hedge fund manager Hugh Hendry on how capitalism and 'creative destruction' is supposed to work here: Why are billionaires voting for Obama and backing Brown? ).

Now, when pundits talk about the market or capitalism failing, as has been the case for much of this year, there's a general impression that the 'market' is a bunch of investment bankers sitting in the City somewhere, smoking cigars and wearing suits and manipulating prices for their own selfish ends.

But the market isn't Gordon Gecko and his minions. The market is ultimately consumers exercising their personal choices. It's democracy. And it's not a perfect system by any manner of means. But as Winston Churchill said of democracy, it's "the worst form of government except for all those others that have been tried."

Bailing out single companies is unfair on those who aren't in trouble

One of the reasons that Jaguar is losing money is because consumers are exercising their choices, either to buy other cars, or as is the case at the moment, not to buy cars at all. The fact that Jaguar is losing money, tells us that it needs to change (become more efficient, or sell more cars, or both), or it needs to go bust.

Some argue that the Government should bail out carmakers (and to be fair, it's not just our government, the US has just spent $17bn on their own industry) because the jobs are more highly skilled and harder to replace. But as Ian King points out in The Times , regardless of any merit in this, bailing out single companies is unfair on those car makers who aren't in trouble.

Rescuing such businesses "would send out a bad message to their competitors, in particular the Japanese-owned Honda, Nissan and Toyota . They have found their own ways of dealing with the financial crisis."

The recession screams that changes are needed

If the overall car market is shrinking, as it will in the recession, then the only way for the industry to survive is for it to become smaller. That means it can support fewer manufacturers. If the ones who should have gone to the wall are propped up by their governments, then that just puts more pressure on the efficient ones. If they are squeezed out of the market by public-sector backed rivals, then you have an industry that is regressing, rather than improving.

And this is what this all comes down to. A recession – or depression – is Nature's way of telling you that your economy is on the wrong path and you need to make some changes. For now, governments around the world would rather stick with the old model, based on the endless appetite – and inexhaustible credit lines – of the US consumer. But this model is broken, and can't be fixed.

The real lesson from Japan , as far as I can see, is that the longer we try to resist change, the longer this slump will go on. In the meantime, it will become ever harder for investors to work out where to put their money. When a company's success depends on political whim, rather than demand for its products, it's anyone's guess as to who will stand or fall.

By John Stepek for Money Morning , the free daily investment email from MoneyWeek magazine

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