Financial Crisis of 2007- the Government: Boon or Bane

Financial Crisis of 2007- The Government: Boon or Bane

Adam Smith was an economist born of Scottish origin, and he based his arguments not on abstract principles but on observations he found valid. His metaphor of an invisible hand stated that every individual, or businessman, at the end of the day does what is best for himself, and which will benefit himself the most. By pursuing interests which will benefit him the most, he in turn promotes the interests of the society more effectually as compared to when he actively tries to contribute towards the society. This is because an invisible hand guides him to do so and in turn helps him to contribute effectively to the market, which he had no intention to do so. Adam Smith commented that he did not know of any situation of where an individual had actively tried to trade for the public good. (Cassidy, 2010)Instead, if every individual worked towards his personal gains, that would collectively contribute to every individual doing what is best for society, and hence upbringing the society which is guided by the invisible hand which enables this mechanism. Smith states that there is a spontaneous order that comes out of the pricing system because the markets are competitive. This very nature of markets, the fact that they are competitive, regulates the pricing system in an efficient manner, and no individual or a body of authority had to carry out this task. He explains that if the demand for any given commodity exceeds the supply of that particular commodity, the price of that commodity will rise and the existing suppliers will make more profits as opposed to normal, and this will attract other other people to enter the market. Similarly, if the demand of any given commodity is lesser than that supply of that particular commodity, the price of that commodity will decrease, along with their profits, which may result in a few suppliers exiting the market. According to Smith, competition forces business to supply what the consumers want to purchase or consume, thereby increasing the production of those certain goods and cutting down the production of less popular goods, which prevents them from profiteering. Prices then gravitate to something he calls as a “natural price” which covers only the cost of production of that commodity along with the normal rate of return expected, and this is because prices are tied to costs. Hence, there is a spontaneous order as this is also self-correcting. If there is a shortage of goods, the prices of those goods rise, which in turn increases the supply, and vice versa, until the supply and demand come into a correlative balance.

Smith believed that banking needed to be regulated because he coherently believed that one of the most important duties of the government was to protect the public from financial swindles and speculative panics, which was a common occurrence in the eighteenth and nineteenth century. A large part of the provincial banks which existed then used to issue their own promissory notes, which acted as money, to various businesses and entrepreneurs. The main concern was that these banks would issue too much of these promissory notes to borrowers who wouldn’t be able to repay the assumed loan. This would cause a rise in economic panics if the concerned depositors tried to withdraw their money. Smith claims that yes, this did provide some relief to the businesses which claimed these loans on the basis of promissory notes, but it only served as a medium for these businesses to run for a maximum of 2 years ahead, which eventually ended with the demise of the business, thereby increasing the debt substantially, because when the ruin came, it came more so heavily on the borrowers as well as their creditors. Hence, to prevent such panics and a recurrence of credit busts, Smith believed that these banks should be prevented from issuing these notes to speculative lenders. He believed that these liberties of few individuals, which would have a heavy negative impact on the whole society, should be restrained by the laws of all the governments.

General equilibrium theory rests on the fact that competitive markets are efficient. It can be noticed with this theory that businesses try to supply the commodities the people want, in the right quantities, making them available at the right places, at the least possible cost. In order, consumers have a wide variety of goods to select from, and hence they purchase the products they most highly desire. This supports the ideology if laissez-faire, which states that transactions in the market are free from government interference, at its bare minimum. This is because after considering all the factors of production, once the prices are posted, the supply for each commodity will eventually be equal to the demand for that commodity, ensuring that no resources, however valuable or invaluable, will be idle. This in order generates the fact that all the resources of production will be at the epitome of efficiency and also it won’t be possible for any single individual or body to profit without making another person worse off from the state they were at. Hence, it can be summarized that General equilibrium theory illustrates the most proficient working of the idea of the invisible hand, as it points out that the economy will regulate itself and allocate the available resources in the most efficient manner, without the interference of the government. General equilibrium theory undoubtedly states that there is some sort of a coordinating mechanism which works above the whole array of individual organisms, when looked at from an economic point of view. It says that prices determine the marginal value of goods and convey this to the customers, and the cost of production to the producers. It says that there is no need for any governing body to overlook all the transactions that are taken place, as all those transactions are being regulated by the price mechanism. Researchers from the 1970’s found out that this theory was based on a lot of assumption, which if taken into consideration, would result in the breaking down of the general equilibrium theory in the face of reality and facts and limits based on the ability of various agents to compute optimal strategies which would maximize efficiency. These assumptions incorporated that the economies of scale were absent everywhere, stating that the firms would not be able to reduce their unit cost by increasing production, and it also did not guarantee that even if all the technical assumptions were met, the economy would be Pareto efficient.