Governments' Influence on Markets

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.

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.

Interest Rates

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.

Bailouts

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.

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.