How government rules and financial markets interact is a complicated and diverse matter that can significantly shape the overall economy. From the money supply to industry regulations, the influence of government actions on markets can’t be overstated.
This article thoroughly explores how governments influence markets and the implications of these interactions on business operations and economic performance.
A Broad Overview of Government’s Influence
While the idealized concept of a free market suggests minimal government interference, the reality is far from this. Governments play a crucial role in market stabilization, transaction regulation, institutional framework provision, and enforcement of contract law and property rights. They also intervene during market failures, providing bailouts and implementing emergency measures.
Here are some critical considerations:
- Governments can implement sweeping monetary and fiscal policy changes, including interest rate adjustments, significantly affecting businesses.
- They can bolster the currency, temporarily boosting corporate profits and share prices but eventually leading to diminished values and higher interest rates.
- Governments can intervene when companies or entire sectors fail, threatening the economic system by offering bailouts.
- Governments can establish subsidies (taxing the public to support an industry) or tariffs (taxing foreign products to make domestic ones more attractive).
- Increased taxes, fees, and regulations can hinder businesses or entire industries.
The Influence of Currency and Inflation
Governments are the exclusive entities authorized to create their respective currencies. Generally, governments prefer inflation as it provides a temporary economic boost with companies charging more for their services and products; it also devalues the government bonds issued in the inflated currency.
Inflation might bring temporary joy for investors as corporate profits and share prices rise. However, it has a long-term detrimental effect, eroding value. Savings become less valuable, adversely affecting savers and bond purchasers.
Conversely, debtors benefit as they owe less value to pay off their debts. This scenario encourages borrowing, but interest rates soon rise to offset that incentive.
Governments Influence through Interest Rates
Interest rates, another tool in the government’s arsenal, are often utilized to mitigate inflation. Governments encourage companies and individuals to borrow and spend more by lowering interest rates through the central bank, thereby stimulating the economy. However, this can also lead to asset bubbles and the destruction of large amounts of capital.
The Role of Bailouts
The 2008-2010 financial crisis highlighted the government’s willingness to rescue struggling industries. However, this practice predates the crisis. The government has a history of saving both financial and non-financial companies.
Bailouts can distort the market by enabling poorly managed companies to continue operating. These bailouts can harm the rescued company’s shareholders or lenders. Under normal market conditions, such firms would go out of business and have their assets sold to more efficient companies to repay creditors and, if feasible, shareholders.
Impacts of Subsidies and Tariffs
Subsidies and tariffs, from the taxpayer’s perspective, are essentially identical. For subsidies, the government taxes the public and redirects the funds to a selected industry to enhance profitability. With tariffs, taxes are imposed on foreign products to make them more expensive, enabling domestic suppliers to charge higher prices. Both actions directly impact the market.
Government support for an industry encourages financial institutions to offer those industries favorable terms. This preferential treatment leads to more capital and resources invested in that industry, even if its only competitive advantage is government support.
This distribution of resources can harm other industries that are trying to compete on a worldwide scale. These industries must put in extra effort to get the funding they need.
The Impact of Regulations and Corporate Tax
Regulations and taxes can negatively affect profits, drawing criticism from the business world. As regulations increase, smaller providers may struggle to compete with larger companies that can leverage economies of scale.
This often results in a highly regulated industry dominated by a few large companies intricately linked to the government.
High taxes on corporate profits can discourage companies from establishing operations in the country. Countries with lower taxes tend to attract more corporations, putting companies unable to move at a competitive disadvantage.
Ranking the Freest Markets
Based on the Heritage Foundation’s Index of Economic Freedom, Singapore is the leader in markets free from government intervention, followed by Switzerland, Ireland, New Zealand, and Luxembourg, with the United States ranking 25th.
Libertarianism’s Perspective on Government’s Role in Markets
Libertarianism, a political and economic ideology, advocates for free markets, low taxes, and limited government. Strict libertarians believe the government’s role should be confined to a few primary functions:
- Enforcing and protecting private property rights
- Maintaining a domestic police force for citizen safety
- Maintaining a standing army to protect national borders and interests
- Constructing public works that would benefit society but wouldn’t be incentivized under a free market
The Necessity of Government Regulations
The efficiency of free markets hinges on “perfect information” among all participants. However, this is rarely the case. Regulations aim to rectify information asymmetry and protect consumers from fraudulent sellers and shoddy products.
Conclusion
Government actions have a significant and lasting impact on companies and industries. Investors consider legislative risk a critical factor when evaluating stocks, as great investment opportunities can become less attractive if they risk losing their competitive advantage and profits due to government actions.
Understanding and anticipating governments’ influence on markets is vital to strategic business planning and investment decision-making.
