Socialism, So What?

September 16, 2008 marked a watershed moment. That day the US government injected $85 billion into crippled AIG, citing that the company was too big to fail. 

Nine short months after the move to rescue AIG, the record $3 trillion TARP plan has been widely tapped by troubled banks, insurance companies and automakers to mitigate the erosive effects of the troubled economy.

The government’s aggressive capital infusions have many US investors concerned that such intervention squarely positions the country's free market system on a collision course with socialism. Indeed, the US government holds a nearly 61% stake in GM, and a whopping 79% stake in AIG and rumors swirl daily about sweeping healthcare reform.

Such concerns are widely publicized. Newsweek magazine’s cover for February 16, 2009 announced, “We Are All Socialists Now.” The article stated, “Whether we want to admit it or not…the America of 2009 is moving toward a modern European state.” It concluded, “More government intrusion in the economy will almost surely limit growth.”

Such conclusions can certainly frighten investors, stirring overwhelming worry about their own financial outlooks. Such concerns are not new, however. History shows that after nearly every major economic downturn, questions arise as to whether the free market system remains an appropriate way to organize and direct the nation’s resources.

Many individuals may be surprised to learn that government intervention can play a key role in free market systems. Milton Friedman, widely known as the most vocal proponent of the free market system cited that the true cause of the Great Depression was the US government’s failure to act swiftly to inject capital into the failing banking system.

"The Federal Reserve system stood idly by when it had the power and the duty and the responsibility to provide the cash that would have enabled the banks to meet the insistent demands of their depositors without closing their doors," Friedman stated in “Free to Choose 3: Anatomy of a Crisis.”

But let’s momentarily entertain the much-articulated mantra that “it is different this time.” Let’s imagine that the US economy experiences a much greater degree of government intervention in the years ahead than it has in the past — how would such a development impact expected returns? Even under those circumstances, the reality is far from grim.

The chart below shows the relationship between equity returns and economic freedom rank. Economic freedom rankings data from Heritage Foundation awards their rankings in consideration of 10 specific elements. According to the data, Hong Kong secured the number one ranking, while the US ranks sixth and France ranks 64th out of 179.

It would be widely determined that the equity returns of a more Socialist-leaning France would be lower than those of the US. The reality, however, is quite the opposite. The chart’s vertical axis measures the equity returns of the countries.  It shows that higher returns over the 39-year period were not always delivered to the countries with the highest degrees of economic freedom. Notoriously socialist-leaning countries relative to the US include UK, Canada, Sweden, France, Norway, Belgium and Denmark. The 39-year annualized returns of each of these countries defy the presumption that increased returns come from increased economic freedom.

The bar chart directly below depicts the 39-year returns shown in the above graph.
 

The bar chart below shows the 10-year returns for countries based on their economic freedom rankings, as well. As you can see, in both long-term and short-term data, economic freedom indicators dispute the commonly held belief that government intervention hampers returns.
 

While the data presented here may seem surprising, the explanation is very straightforward. Just as value investments demand a higher return relative to growth investments to compensate for the higher risk associated with them, so too should investments in countries with increased government intervention demand higher expected returns to compensate investors for the increased perceived risk of investing in them.

This research, once again points to the simple and profound truth that investment returns come from investment risk, proving once again that there is no free lunch — even for perceived free market economic systems