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We have a new F word: failure.

One unhappy hallmark of the Great Recession is a dramatic spike in financial distress. Moody's predicts that the default rate on corporate debt--which helps foretell bankruptcies--will be three times higher this year than in 2008. Home foreclosures are already at record highs, and going higher. Defaults on credit cards and other consumer debt will crest right behind mortgages.

The Obama administration is on the case, bailing out banks and homeowners and aiding dozens of industries either directly, through a financial-rescue scheme that could top $2 trillion, or indirectly, through the $787 billion stimulus bill. Automakers, furniture companies, real estate developers, and even porn magnates have their hands out.

Those efforts ought to help soften a sharp recession. But the unprecedented aid to the private sector may also unleash new problems, the way antibiotics have generated stronger strains of bacteria. "There's something fundamental about the need for failure," says Syd Finkelstein, a professor at Dartmouth's Tuck School of Business and author of Think Again: Why Good Leaders Make Bad Decisions and How to Keep It From Happening to You. "We're tinkering with the genetic DNA of a capitalist society."

Before “failure” became an unspeakable word, entrepreneurs understood that most business ventures in America fail--producing acute lessons that have helped make America fabulously prosperous. In the 1870s, for instance, there was a five-year depression, followed by a historic era of mechanization that destroyed old industries and generated new ones at a pace nobody had ever seen. "It was a time of terrific insecurity," says James Grant, founder of Grant's Interest Rate Observer. "It was also a golden era of dynamism." Landmark companies like IBM (started in the 1880s), Johnson & Johnson (NYSE:JNJ) (1885), and General Electric (NYSE:GE) (1892) date from that time.

Other familiar companies have their roots in failure--either their own or somebody else's. Upstarts Nike (NYSE:NKE) and Reebok gained a foothold in the 1970s because their established competitors--Converse and Keds--failed to foresee the boom in running and aerobics. Toyota (NYSE:TM) has relentlessly exploited the failure of Ford (NYSE:F) and General Motors (NYSE:GM) to satisfy their customers. IBM went through a near-death experience in the 1990s after betting wrongly that the old mainframe would dominate the PC--a painful experience that the company's leaders now tout as a crash course in adaptation.

Failure is personally enlightening, as well. "Ask 100 people, 'What have you learned from success?' and most of them will just look at you," says Don Keough, former CEO of Coca-Cola (NYSE:KO) and author of The Ten Commandments for Business Failure."But ask what you learned from failure, and you'll get lots of answers." One of Keough's most painful failures was the 1985 introduction of New Coke, which market researchers predicted would be a hit. It was an instant flop. "The whole process made me a professional skeptic," he recalls. "I learned to look beyond data and apply common sense."

Saving companies from their mistakes short-circuits that kind of learning. Chrysler, for instance, got its first government bailout in 1980. It recovered, but it is now burning through another $4 billion in government loans–and asking for $11 billion more. The unseen harm of floating weak businesses is the "opportunity cost": What might have happened if more nimble, innovative companies got a chance. "The American [auto] industry would be much stronger today if Chrysler had been allowed to go out of business in 1980," insists Jack Nerad of kbb.com, a car research site.

Banks are a special case, since the capital they provide is the lifeblood of capitalism. But billions in aid to huge, struggling lenders like Citigroup (NYSE:C) and Bank of America (NYSE:BAC) might be counterproductive. A recent study by New York University's Stern School of Business, Restoring Financial Stability, argues that the government has been too generous to bailed-out banks, giving them up to $70 billion more than necessary. A better approach, the study argues, would be to plump up healthier banks, while letting market forces determine the fate of sick banks.

The bank-rescue plan unveiled by Treasury Secretary Tim Geithner–the Public-Private Investment Partnership--seems to go in the opposite direction. Under the plan, the government would heavily subisidize private purchases of so-called “toxic assets” from banks. It could restart the market for these assets and help banks clear them out. But because the government will bear most of the losses if it doesn’t work, “it amounts to yet another subsidy to banks,” says Dirk van Dijk, director of research for Zacks Investment Research. And even then, he says, the government may still have to nationalize some of the most troubled banks.

There’s another mechanism for dealing with insolvent companies--bankruptcy protection. Once failing companies like GM declare Chapter 11, the NYU study contends, the government could offer loans to help them restructure. Bankruptcy judges have broad power to boot existing management, cut executive pay, and order sweeping changes. And if liquidation looks like the best option, the company probably went too far astray to be saved.

That’s clearly what happened at AIG, where disastrous bets made by a small financial trading division essentially wrecked a conglomerate built mostly of healthy insurance businesses. But AIG is considered too important to consign to an indelicate bankruptcy process. Since it insures hundreds of the world’s biggest institutions–and held nearly $3 trillion worth of derivatives contracts with trading partners worldwide, as of last fall–its collapse could have triggered a chain reaction of institutional-level bank runs. So instead of letting AIG fail, the government executed the biggest corporate bailout in American history, totaling $180 billion so far. The outrage over $165 million in bonuses for executives of that very same division may mark a turning point in Americans’ tolerance of bailouts.

AIG’s lengthy tentacles make it “too big to fail,” which is why Obama and Geithner are pushing for new laws that would allow the government to take over the biggest institutions if they become insolvent and threaten the rest of the economy. Another solution might be to downsize the biggest firms until they are small enough to let fail. Once they’re out of the way, better-run firms will be able to take their place, and free enterprise will no longer come with a government warranty.

Disclosure: no positions

Source: How Bailouts Are Messing with Capitalism