Of course, the reality is that bailouts are likely to do more harm than good in the long run, regardless of what sector they are in. But given the choice, I would rather bail out General Motors Corp. (GM) than Citigroup Inc. (C), because the automaker has a better long-term future.

The financial services industry got far too big during the 1995-2007 bubble. Its growth accelerated in the 1990s on the back of innovative new financing techniques such as derivatives and securitization, as well as a huge expansion in areas such as leveraged buyouts. As a result, its share of United States gross domestic product (GDP) has approximately doubled since the late 1970s.

It is now clear that many of the new financing techniques were misapplied or even spurious. The problem of separating loan origination from credit-risk assumption has become obvious, and so securitization will have a much more limited future.

Of the derivatives, credit default swaps are clearly destabilizing and will be tightly regulated. Many of the new market participants, such as hedge funds and private equity funds, should disappear, since they merely represented conduits through which higher fees could be charged rather than truly innovative investment choices. It is thus likely that the financial services business will revert to close to its previous share of GDP. That would involve a downsizing of its 2007 capacity by 50%.

The automobile industry, on the other hand, has no obvious need to become smaller. With global warming now high on the political agenda, its products need to change radically, employing new technologies that greatly reduce carbon emissions. However, the basic demand for personal transportation has not gone away.

Indeed, it is still expanding rapidly in the growth economies of emerging markets such as China and India. And U.S. urban geography, with its widely spread suburban developments, is wholly incompatible with a sharp drop in automobile usage and would be impossibly expensive to modify except over a very long term.

Why Citi Should Fail

Allowing a large bank such as Citigroup to disappear is probably beneficial. It reduces competition for other major banks, allows medium-sized banks to expand into the space opened up, and provides an appropriate penalty for decades of bad management. Citi was a leader in the Latin American loan crisis of the 1980s; its then-Chairman Walter B. Wriston famously opined that “countries don’t go bust,” a sentiment that has been repeatedly disproved.

Wriston got his succession wrong in 1984, choosing the overaggressive retail banker John Reed (who had pioneered the unsolicited credit card offer in 1978 and lost $100 million – real money back then – in 1980 by doing so) over the capable corporate banker Tom Theobald.

Citi almost went bust in 1991, but was bailed out by Saudi Prince Alwaleed bin Talal. It assembled a financial services conglomerate in 1998 that proved unmanageable, and from 2003-2005 was prevented from making any more acquisitions because of its shaky position.

In short, Citi has been a classically mismanaged behemoth that, in any other industry would, have already collapsed.

Yet, its bailout risks more than $300 billion of taxpayer money, and to no obvious economic benefit.

Meanwhile, General Motors has been damaged by two factors: Misguided government regulation of the automobile industry, and a drastic societal shift away from unionized labor.

CAFÉ Backfires

GM had a 60% share of the U.S. market in the 1950s, and was recognized for large cars that performed distinctly better than their imported competitors and were well suited to U.S. driving conditions. Some expansion of foreign competition was inevitable, as Europe recovered and Japan became a major automobile producer, but GM was particularly hard hit by the Corporate Average Fuel Economy (CAFÉ) legislation. CAFÉ, which mandated fuel economy standards instead of simply raising the gasoline tax, put GM’s large models at a disadvantage to their smaller imported competitors.

However, U.S. automobile companies found a loophole, which is that its standards were limited to automobiles. Vehicles built on a truck chassis were exempt. That gave rise to the sports utility vehicle.  Now, higher fuel costs, environmental concerns, and tighter CAFÉ standards have made the SUV an endangered species, but it was a Frankenstein’s monster that only existed because of government meddling.

If GM and the other U.S. automobile manufacturers go out of business, only their foreign competitors will benefit. Furthermore, they have an interdependent network of suppliers, with a total of 3 million employees, which could easily be forced into bankruptcy by the disappearance of their major customers.  U.S. automobile manufacturers have important, and in some areas unique technological capabilities, whose loss would severely damage the U.S. economy as a whole.

The automobile business is unprofitable now, but will eventually return its previous size in the United States, as well as expand worldwide. So, while there is no capacity downsizing needed, capacity restructuring, away from SUVs and towards smaller cars, hybrids and innovative power technologies, is essential.

Ultimately, the right decision would have been to bail out General Motors and allow Citi to go to the wall.

The Case for Citi

Of course, there are important modifiers to this recommendation. In Citi’s case, its interconnection with the financial system as a whole is such that an immediate bankruptcy followed by years-long court proceedings could render many of its counterparties unviable and damage the global economy badly. Hence, an orderly liquidation is needed, with a receiver appointed to wind down Citi’s positions and sell the viable portion of its operations, making good on those obligations incurred by Citi that appear to have systemic importance. Even if the taxpayer made Citi’s counterparts completely whole, however, it would not have been as expensive as the bailout.

As for GM, it has labor costs and pension obligations making it uncompetitive with foreign-owned producers. Those “legacy” costs can most efficiently be removed through a Chapter 11 bankruptcy filing. The pension obligations will then fall on the taxpayer through the Pension Benefits Guaranty Corporation, while the labor contracts can be rewritten in a way that is competitive with the market in which GM operates. If a government subsidy is then needed to cover GM’s operating cash deficit during the recession, and the investment costs of transforming GM into a producer of environmentally friendly automobiles, it should be provided through a post bankruptcy “debtor-in-possession” financing.

There is nothing magic about banking that should allow the industry to be uniquely permitted access to taxpayer money when disaster hits. Only bank customers and the market should be protected. Conversely, the automobile industry plays an important role in the U.S. economy that is unlikely to be significantly downsized. So, there is considerable justification for assistance to GM and Ford Motor Co. (F), which have valuable capabilities and long-term competitiveness, though less for a bailout of the smaller and less industrially valuable Chrysler Corp.

Source: Why GM is More Bailout-Worthy Than Citigroup

“What’s different?” asked colleague Manraaj Singh at this morning’s conference.

Early every morning, while most Americans are still in their beds, your editor joins a group of analysts and financial journalists to discuss the day’s news.

“What happened to the price of copper? Why are Asian stocks going down? Are they really going to cut rates today?” The answers are not always satisfying, but the questions keep coming.

And the question this morning was: what has really changed?

U.S. stocks held steady yesterday, but they’re down 5% so far this year. The dollar held steady yesterday too, but it is down for the year too – about 6% against the euro and the yen. The Europe- or Japan-based stock market investor has lost more than 10% of his money.

Meanwhile, the fall of the dollar has increased prices for imports. While the United States used to “import deflation” from Asia and elsewhere, now it imports inflation. Prices are rising all over the world.

Yesterday, European producer prices were reported rising at 6.1% per year. High prices have caused the biggest drop in retail sales on record. And yesterday, they had to call out the riot squad in Brussels, to battle fishermen who were kvetching about high fuel costs.

In China, retail prices are rising at an 8.5% rate – the fastest in 12 years.

In Russia, prices are going up at a 14.39% rate.

In Vietnam, the consumer price inflation rate is running at 25%.

In Venezuela, the inflation rate is 29%.

And in Zimbabwe…well, Zimbabwe is another story altogether, with inflation going up so fast they can’t even measure it. Prices are said to be increasing at 160,000% to 200,000% per year. But who can tell? There’s nothing to buy.

Back in Asia…the region’s central banks had hoped that Milton Friedman was wrong. They had hoped that a worldwide economic slowdown would reduce domestic inflation rates. So, they left their lending rates low – considerably lower than the CPI – in order to keep their economies turning over. In Thailand, for example, the central bank lends at 3.25%, while consumer prices rise at more than 6%.

Sound familiar? The United States also keeps its key-lending rate well below the inflation rate – and for the same reason. The Fed lends at 2%. Inflation was last clocked running twice as fast.

We pause here in honest admiration for our fellow investors – the kind of admiration we feel for members of a bomb disposal unit, or a knife-thrower’s assistant. What are we to think? They are lending money to world’s biggest debtor – the U.S. government – for 10 years at 3.94%. That’s yesterday’s yield on the 10-year T-note. If nothing changes, they will get nothing for their trouble. If inflation rates rise (or just happen to be understated), or the dollar falls, the speculation will blow up in their faces.

But along comes Ben Bernanke, with an apparent change of brain. Now, says the captain of the Fed’s rapid response recession-fighting team, further inflation is unwelcome in the United States of America. Supposedly, these words alone took $5 off the global oil price.

But what really has changed? Can the U.S. central bank really begin fighting inflation in a serious way?

The feds have discovered the same two things that their Asian central banker colleagues have found out: that the globalization street goes both ways…and that Milton Friedman was right. Inflation is a monetary phenomenon, observed Friedman. When you increase the amount of money in circulation, ceteris paribus, prices are going to go up. That they didn’t go up much in the last 15 years is merely because there were important other trends going on – notably, globalization, which was driving down prices. But now, traffic on the Avenida de Globalization is going in the other direction. And just as it was very difficult to cause inflation while globalized markets were cutting prices, so is it very difficult to stop inflation when globalized markets are increasing them.

*** Can the Fed really begin fighting inflation? Ah, dear reader…do you see the cruel twist to the story?

While the Fed couldn’t seem to create inflation in those wonderful years of the Great Moderation…now, it probably can’t do much to stop it. The U.S. imports an Everest of stuff from overseas. And stuff made overseas is becoming more expensive. The Fed can raise rates to try to cool the U.S. economy and reduce the amount of stuff Americans buy. But those darned Asians and Europeans can still buy more, and prices can still go up.

Besides, any further ‘cooling’ of the U.S. economy is risky. It could freeze up.

The crisis is said to be over on Wall Street. But the Financial Times says new IPOs are being taken off the schedule…short action on Lehman Bros. is at a record level (speculators are betting that the company is going down) and Moody’s says it might downgrade credit ratings for MBIA and Ambac.

The money just isn’t flowing as fluidly in Manhattan as it used to. An AP story tells us that apartment sales were off 21% in the first quarter. And over on Long Island, where the Wall Streeters have their weekend homes, lenders are said to cutting off home equity lines.

In the center of the country, bankruptcy filings are up 27% in Illinois. And out in Las Vegas, the mortgage fraud capital of the world, a $5 billion casino project has just been cancelled.

And this just in – California is officially suffering a drought.

Under these conditions, we’d expect Ben Bernanke to make some gestures toward protecting the dollar and reducing inflation. But we’d also expect that most of the air coming from the Fed will be hot, not cold.

“The Fed seems to be trying to create a situation whereby they are seen to be fighting inflation, simply by not lowering rates any further,” says MoneyMorning. “This is because, while the Fed may have no interest in fighting inflation, they have a big interest in fighting what they call ‘inflationary expectations’. In other words, they are more interested in fighting people’s perception of the problem, rather than the problem itself.