Free markets are often conceptualized as having little to no interference from the government. However, in reality governments 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 markets and influences business in ways that often have unexpected consequences.
Key Takeaways
- Governments have the capacity to enact monetary and fiscal policy, including raising or lowering interest rates, which has a huge impact on business.
- They can boost 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 by taxing the public and giving revenue to an industry, or it can impose tariffs by adding taxes to foreign products to lift prices and make domestic products more appealing.
- Higher taxes, fees, and regulations can stymie businesses or entire industries.
Currency and Inflation
Governments are the only entities that can legally issue currency. When they do so, they typically want to see inflation, which 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.
In the long-run, inflation can lead to an erosion of value across the board. Savings lose their worth, punishing savers and bond buyers. For debtors, this is good news because they now have to pay less value to retire their debts.
Important
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
Interest rates are another tool that government can use to influence the market. When raised, interest rates can counteract inflation. When lowered, they can spur the economy by making borrowing cheaper. Dropping interest rates via the Federal Reserve encourages companies and individuals to borrow and buy more.
Bailouts
As seen in the Great Recession, the U.S. government is able to bail out industries that have come into crisis. The savings and loan crisis of 1989 was similar to the bank bailout of 2008.
Prior to that, the government had 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.
Subsidies and Tariffs
The government is also able to influence markets through subsidies and tariffs. In the case of a subsidy, the government taxes the general public and gives revenue 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 sector, even if the only comparative advantage it has is government support. This may cause an indirect resource drain for other industries, which might have to work harder to gain access to capital.
Regulations and Corporate Tax
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.
High taxes on corporate profits have a different effect in that they may discourage companies from entering certain markets in the first place. For instance, states with low taxes can lure companies from their neighbors, and countries that tax less tend to attract mobile corporations.
Which Country Has the Most Free 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; and
- 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, or 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. They can issue currency, change interest rates, and issue bailouts, In addition, governments impose regulations, subsidies, and taxes. All of these measures can have immediate and long-lasting impacts on companies, industries, and markets at large.
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