Adam Smith’s Invisible Hand and Your Money Flow

Adam Smith’s invisible hand of competition has long be heralded as a mechanism for turning greed into good. Each business owner seeking their own profit works hard to make better quality products and, in competition with similar businesses, offers these products at ever lower prices. Some take this free enterprise message to an extreme and declare that “Greed is good.” Not quite. A purely greedy person, defined as someone who plays I-win-you-lose or winner-take-all, does not appreciate the need to meet the needs of others. But ultimately free trade must be a win-win situation. When you go to the store, you get what you want. But the business owner also gets what he or she wants – your money. You both win.

In some sense we all want to feel good about ourselves. But feeling good may come about through a win-win strategy of helping others or through an I-win-you-lose strategy of taking from others. A burglar may feel good about pulling off a clever burglary. The I-win-you-lose strategy tends to be a short-term strategy that more often than not fails in the long run with a failed business or an extended stay in jail.

With a very low return, your suppliers may be able to continue to supply your business with the inputs you need in the short run, but in the long run your suppliers must cover both their variable costs and ultimately their fixed costs. As long as your suppliers are covering variable costs, you may be able to pressure your suppliers to provide those inputs at a very low price. But when your suppliers’ equipment wears out or rental contracts end, your stinginess in cutting your suppliers’ profits to the bare bones may backfire as your suppliers refuse to continue supplying you at prices that fail to cover their full costs. Suppliers may choose to shift their production to supply businesses that are more reliable and willing to pay more. Business relationships matter so playing hard ball with your suppliers may not a good long-term business strategy.

Moreover, in focusing on their own money flow, individual businesses may lose sight of the bigger picture of the money flow in the overall economy. On an isolated island, a business owner that owned the only general store, bar and restaurant would quickly realize that being too stingy with their store, bar and restaurant workers and with the farmers and fishermen that supplied the food would cause their customer base to dry up. Keeping the businesses going would mean paying people enough to be able to maintain a good money flow. Increasing the money flow or velocity of money would mean raising the annual production and distribution of goods and services until the yearly limits of consumption and work effort reached their natural limits. Here again the win-win strategy wins out. Being too greedy in maximizing short-term profits may undermine the long-term profitability of the business.

Just as the sole owner of a lake understands that fish are a resource that can be destroyed by overfishing, a sole business on an isolated island may come to see money flow as a common property resource problem. But what if other businesses come to the island. As more and more businesses establish themselves on the island, each business wants the other businesses to provide the money flow to customers and suppliers but naturally wants to act as a free rider in not having to pay more itself. In other words, money flow as a common property resource exhibits the moral hazard problem of businesses losing their motivation to contribute fully to the island’s money flow to ensure full resource utilization including the full employment of the farmers, fishermen, and workers. Ironically, this common property resource problem that motivates business owners to pay as little as possible creates slack in the labor and resource markets that further enables businesses to pay less. This has been referred to as the reserve army of the unemployed. Consequently, we see that the economic conditions that work best for individual businesses do not always correspond to full employment utilization and maximum production.

Other common property resource problems include the failure of individual businesses to create and pay for interstate highways or standing armies. Even locally, maximizing productivity and overall production may require the building of roads and bridges. Electricity and water supply may require the establishment of a natural monopoly that must be regulated by government for the common good. Positive externalities in the form of vaccination for highly contagious diseases and negative externalities such as water and air pollution all provide examples of where government intervention is needed to ensure the efficient allocation of resources, which is the very essence of the economic problem.

What this all boils down to is that government plays an essential role at the heart of the free enterprise system. Without government, the system would fail to allocate resources efficiently and would fail to maximize productivity and overall production. Getting the money flowing to allow businesses to prosper means imposing taxes to benefit everyone in achieving the optimal money flow for the economy as a whole. When applied fairly and efficiently, taxes and the corresponding government expenditures can contribute to the common good as a key part of the win-win strategy that makes us all better off in the long run.