Free markets are often conceptualized as having little to no interference from the government. However, in reality governments do step in to stabilize markets, regulate transactions, provide institutional frameworks, and enforce rules around contract law and property rights. Governments can also intervene when markets fail in the form of bailouts and other emergency measures.
In this article, we will look at how the government affects the markets and influences business in ways that often have unexpected consequences.
- Governments have the capacity to make broad changes to monetary and fiscal policy, including raising or lowering interest rates, which has a huge impact on business.
- They can boost the currency, which temporarily lifts corporate profits and share prices, but ultimately lowers values and spikes interest rates.
- Governments can intervene when companies or entire segments of the economy are failing, or threatening to undermine the whole economic system, by providing bailouts.
- Governments can create subsidies, taxing the public and giving the money to an industry, or tariffs, adding taxes to foreign products to lift prices and make domestic products more appealing.
- Higher taxes, fees, and greater regulations can stymie businesses or entire industries.
Currency and Inflation
Governments are the only entities that can legally create their respective currencies. When they can get away with it, governments will typically want to see inflation in the currency. Why? Because it provides a short-term economic boost as companies charge more for their products; it also reduces the value of the government bonds issued in the inflated currency and owned by investors.
Inflated money feels good for a while, especially for investors who see corporate profits and share prices shooting up, but the long-term impact is an erosion of value across the board. Savings are worthless, punishing savers and bond buyers. For debtors, this is good news because they now have to pay less value to retire their debts—again, hurting the people who bought bank bonds based on those debts. This makes borrowing more attractive, but interest rates soon shoot up to take away that attraction.
Governments have a substantial and far-reaching influence on markets due to their ability to regulate everything from monetary policy and the currency to the rules and regulations that impact each industry.
Interest rates are another popular weapon, even though they are often used to counteract inflation. This is because they can spur the economy by making borrowing cheaper. Dropping interest rates via the Federal Reserve—as opposed to raising them—encourages companies and individuals to borrow and buy more.
Unfortunately, this can also lead to asset bubbles where, unlike the gradual erosion of inflation, huge amounts of capital are destroyed, which brings us neatly to the next way the government can influence the market.
After the financial crisis from 2008-2010, it is no secret that the U.S. government is willing to bail out industries that have gotten themselves into trouble. This fact was known even before the crisis. The savings and loan crisis of 1989 was eerily similar to the bank bailout of 2008, but the government even has a history of saving non-financial companies like Chrysler (1980), Penn Central Railroad (1970) , and Lockheed (1971). Unlike the direct investment under the Troubled Asset Relief Program (TARP), these bailouts came in the form of loan guarantees.
Bailouts can skew the market by changing the rules to allow poorly run companies to survive. Often, these bailouts can hurt shareholders of the rescued company or the company's lenders. In normal market conditions, these firms would go out of business and see their assets sold to more efficient firms to pay creditors and, if possible, shareholders. Fortunately, the government only uses its ability to protect the most systemically essential industries like banks, insurers, airlines, and car manufacturers.
Subsidies and Tariffs
Subsidies and tariffs are essentially the same things from the perspective of the taxpayer. In the case of a subsidy, the government taxes the general public and gives the money to a chosen industry to make it more profitable. In the case of a tariff, the government applies taxes to foreign products to make them more expensive, allowing the domestic suppliers to charge more for their products. Both of these actions have a direct impact on the market.
Government support of an industry is a powerful incentive for banks and other financial institutions to give those industries favorable terms. This preferential treatment from the government and financing means more capital and resources will be spent in that industry, even if the only comparative advantage it has is government support. This resource drain affects other, more globally competitive industries that now have to work harder to gain access to capital. This effect can be more pronounced when the government acts as the main client for certain industries, leading to well-known examples of over-charging contractors and chronically delayed projects.
Regulations and Corporate Tax
The business world rarely complains about bailouts to certain industries, perhaps because of the knowledge that their industry may one day need help as well. But Wall Street does object when it comes to regulations and taxes. That's because while subsidies and tariffs can give an industry a comparative advantage, regulations and taxes can negatively impact profits.
Lee Iacocca was the CEO of Chrysler during its original bailout. In his book, Iacocca: An Autobiography, he points to the higher costs of ever-increasing safety regulations as one of the main reasons Chrysler needed the bailout. This trend can be seen in other industries. As regulations increase, some smaller providers get squeezed out by the economies of scale the larger companies enjoy. The result can be a highly regulated industry with a few large companies that are necessarily intertwined with the government.
High taxes on corporate profits have a different effect in that they may discourage companies from coming into the country. Just as states with low taxes can lure away companies from their neighbors, countries that tax less will tend to attract any mobile corporations. Worse yet, the companies that can't move end up paying the higher tax and are at a competitive disadvantage in business as well as in attracting investor capital.
Which Country Has the Freest Market?
According to the Heritage Foundation's Index of Economic Freedom, Singapore ranks first in terms of having markets free from government intervention. This is followed by Switzerland, Ireland, New Zealand, and Luxemburg. The United States comes in at a middling 25th place.
What Is the Role of Government in Markets According to Libertarianism?
Libertarianism is a political and economic ideology that advocates for free markets, low taxes, and limited government. Following the writings of Adam Smith, strict libertarians see the government as responsible for just a few primary functions:
- to protect and enforce private property rights
- to maintain a domestic police force to keep citizens safe
- to maintain a standing army to protect the nation's borders and interests
- to build public works (e.g., schools and parks) that would benefit society but the free market wouldn't be incentivized to otherwise build
Why Do Governments Need to Impose Certain Regulations?
Free markets only work efficiently if there is full information (what economists call "perfect information") among all participants, including buyers and sellers, producers and consumers. However, in reality, some sellers may be fraudsters and companies may cut corners to produce shoddy products. This is known as an information asymmetry. While the market may eventually identify and sanction such bad actors, in the meantime consumers may be significantly harmed, both economically and otherwise. Therefore, regulations are put in place to rectify the information asymmetry and protect consumers.
The Bottom Line
Governments play a substantial role in the financial world. Regulations, subsidies, and taxes can have an immediate, and long-lasting impact on companies and whole industries. For this reason, Fisher, Price, and some other famous investors considered legislative risk to be a notable factor when evaluating stocks. A great investment can turn out to be not that great if it's at risk of seeing its competitive advantage and profits dwindle as a result of certain government actions.