Government intervention in economy has big risks

The Bush administration's $13.4 billion rescue of GM and Chrysler is a fitting finish to a year in which governments around the world expanded their role in the economy and markets after three decades of retreat.

The intervention comes at what may prove to be a steep price. Future investment may be allocated less efficiently as risk-averse politicians make business decisions. Whenever banks decide to lend again, they are likely to find new capital requirements that will curb how freely they can do it. Interest rates may be pushed up by government borrowing to finance trillions of dollars of bailouts.

"We're seeing a more statist world economy," said Ken Rogoff, former chief economist at the International Monetary Fund and now a professor at Harvard University. "That's not good for growth in the longer run."

It's not good for stocks either, said Paola Sapienza, associate professor of finance at Northwestern University's Kellogg School of Management. Slower economic growth means lower profits. Shares might also be hurt by investor uncertainty about the scope and timing of government intervention in the corporate sector.

"If the rules of the game are changing, people are reluctant to invest in the stock market," Sapienza said.

The increase in the government's role in the economy has been breathtaking. The U.S. looks set to rack up a budget deficit of at least $1 trillion this fiscal year, while the Federal Reserve has already increased its balance sheet by $1.4 trillion since last December. By way of comparison, U.S. gross domestic product last year was $13.8 trillion.

Winding back the intervention may not be easy, said Sapienza, who has studied the effect of government ownership on bank lending.

When Italy nationalized banks in 1933, "the architects who designed the system envisaged it as temporary," she said. "It was in place until the end of the 1990s." More recently, the Japanese government injected capital into banks to get them to lend to big corporations, keeping alive "the zombie companies that economists talk about," she said.

Extraordinary year

Already, investors trying to decide where to put their money are "gambling very much on what they think the government will do, not what they think about the company," Sapienza said. "That's why there's so much volatility."

GM shares plunged as much as 37 percent Dec. 12 after the U.S. Senate failed to pass an emergency-loan plan. The shares recovered after President Bush said his administration would consider funding a rescue with money already set aside for bank bailouts, then shot up 23 percent on Dec. 19 when he announced the emergency loans.

The auto-industry lifeline is just the latest in an extraordinary year of market interventions that have redefined capitalism. The U.S. government previously seized control of mortgage lenders Fannie Mae and Freddie Mac and insurer American International Group Inc. and took stakes in the nation's largest banks.

Government activism has become a "necessary evil" to help pull the global economy out of recession, said Marco Annunziata, chief economist at UniCredit MIB in London. Even Bush, who ran for the U.S. presidency espousing smaller government, agrees. He told a CNN interviewer last week he has "abandoned free-market principles to save the free-market system."

Policymakers elsewhere extended their reach, too. Britain nationalized mortgage lenders Northern Rock PLC and Bradford & Bingley PLC. French President Nicolas Sarkozy created an $8.7 billion fund to invest in "strategic" firms. And the European Commission last week relaxed rules on state aid to businesses.

It isn't inevitable that bigger government will hamstring free enterprise, said William Niskanen, chairman emeritus of the Cato Institute, a Washington research group that generally favors free markets over government solutions. Niskanen predicts that government intervention will prove to be "selective and temporary," not "a long-term trend."

History highlights threat

Still, greater government involvement will make businesses less likely to deploy capital in ways that spur growth and profits, said Eric Chaney, chief economist at AXA SA in Paris and a former official at the French finance ministry. Carmakers may be slower to innovate or cut costs, and financiers may shy away from lending to entrepreneurs.

"It's the job of companies, not governments, to take risk and accept the consequences," Chaney said. "There is no incentive for governments to take risk, so they won't."

The history of public aid to automakers highlights the threat, said Stuart Pearson, an analyst at Credit Suisse Group in London.

While the U.S. rescue of Chrysler in 1979 gave then-Chief Executive Officer Lee Iacocca time to streamline the company and restore profitability, it also sustained an outsized U.S. auto industry, leading to its current woes, Pearson said. The 1975 bailout of British Leyland Motor Corp. ended up costing British taxpayers $16.8 billion and failed to keep successor MG Rover Group Ltd. from sinking into bankruptcy two decades later.

"Government help has only been an obstruction to getting the car industry into a more economic shape," Pearson said.

Until recently, "investors could, broadly speaking, ignore the role of the government when thinking about markets" said Alex Patelis, chief international economist at Merrill Lynch & Co. in London. "This period is over."

Regulation is back in style as policymakers seek to avoid a repeat of the financial crisis. Leaders from the Group of 20 nations are crafting a plan to require banks to maintain higher capital levels and disclose more about their holdings.

That likely means a lower "speed limit for growth," as banks have less cash available to lend and invest, said Mohamed el-Erian, co-chief executive at Pacific Investment Management Co., the Newport Beach, Calif.-based manager of the world's biggest bond fund.

"There will be less lubrication in the form of credit creation," he said.

Saving capitalism no sure bet