What Is Market Distortion?

To free-market purists, market distortion is any situation in which prices are determined by anything except the unfettered forces of supply and demand. By that definition, truly free markets are scarce. In a more practical sense, market distortion means any interference that significantly affects prices and, in some cases, risk-taking and asset allocation.

Governments are the source of most market distortions, including regulation, subsidies, taxes, and tariffs. At the same time, central banks have been accused of distorting markets in recent decades with monetary policy and asset purchases. Some of the world's biggest corporations also have enough power to distort their markets.

Key Takeaways

  • Market distortion is commonly viewed as any interference that significantly affects prices or market behavior.
  • Many government regulations are widely accepted forms of market distortion intended for the common good.
  • Global central banks have also distorted markets, especially following the 2007-08 global financial crisis.

Understanding Market Distortion

Most mainstream economists decided long ago that the government's market distortion was necessary and desirable to protect people from the sometimes unforgiving nature of markets. Government regulations intended to protect all market participants' general well-being are considered by market purists to be distortions but are broadly popular.

Regulators must make a tradeoff when deciding to intervene in any given marketplace. For this reason, analysts and lawmakers try to seek a balance between the general well-being of all market participants and market efficiency in the formulation of economic policy. Although an intervention may create market failures, it is intended to enhance a society's welfare.

Government subsidies

For example, many governments subsidize the agricultural sector, which sometimes makes farming economically feasible, at least for certain products. The subsidies can mean farmers gain artificially high prices for their products, giving them the incentive to produce more than they might otherwise. Although this type of intervention is not economically efficient, it helps ensure that a nation will have enough food.

Governments often object to each other's market interventions, though. For example, the U.S. and EU have long complained about the Chinese government's support for its steel and aluminum markets. And many countries have expressed opposition to former U.S. President Donald Trump's protectionist trade measures.

The Federal Reserve and Market Distortion

The U.S. Federal Reserve, European Central Bank, and the Bank of Japan are among major global central banks that have distorted asset markets since the 2007-08 global financial crisis. Central banks have bought many trillions of dollars worth of financial assets since the crisis, mostly government bonds, seriously distorting bond and equity markets in a bid to prevent deflationary forces from taking hold.

After the novel coronavirus began spreading in early 2020, the Federal Reserve promised to buy hundreds of billions of dollars more in Treasury bonds as well as government-guaranteed mortgage-backed securities. In the three months through the middle of June 2020, the nominal value of the Fed's securities holdings grew from $3.9 trillion to $6.1 trillion.

There is little doubt this is distorting financial markets. Despite predictions of the worst economic collapse in nearly a century, the S&P 500 remained near its all-time high months after the onset of the crisis.

Monopoly Power and Market Distortion

A market may become distorted when a single business holds a monopoly or when other factors prevent free and open competition. This often causes problems for consumers—at least in the long run—and their competitors. A lack of competition typically means fewer choices and higher prices. 

Tech giants Amazon, Facebook, and Google have all been accused in recent years of using their size and market power to engage in anti-competitive market behavior to harm competitors and achieve greater market dominance.