The picture of the capitalist economy painted by Knut Wicksell, or rather, the picture Wicksell would have painted if he had pursued the implications of his theory to their logical conclusion, was a self-destructive laissez-faire capitalist economy. Any disequilibrium between aggregate demand and aggregate supply (or the natural rate and the market rate of interest) would set off a dynamic process that would move the general price level cumulatively away from equilibrium. Unless some outside authority intervened to restore equilibrium, its ultimate destination would be either hyper-inflation (if aggregate demand continued to exceed supply) or a major depression (if aggregate demand continued to fall short of supply).

But—and this is a critical “but”—the actual capitalist economy in which we live does not appear to be so violently self-destructive. Of course, booms and slumps have always been with us as different phases of the regular business cycle; but hyperinflations and depressions have been rare exceptions in history (although we may be on the brink of another great depression now). This observation must have been the starting point for John Maynard Keynes when he began work on his General Theory . He wrote:

It is an outstanding characteristic of the economic system in which we live that, whilst it is subject to severe fluctuations in respect of output and employment, it is not violently unstable. Indeed, it seems capable of remaining in a chronic condition of sub-normal activity for a considerable period without any marked tendency either towards recovery or towards complete collapse…. Fluctuations may start briskly but seem to wear themselves out before they have proceeded to great extremes, and an intermediate situation which is neither desperate nor satisfactory is our normal lot. ( General Theory , pp. 249-259.)

We are thus led to pose a question that would have sounded paradoxical to those who used to live in the world of Adam Smith: “What saves the capitalist economy from its self-destructive tendency?”

Once the question has been posed in this manner, the answer presents itself immediately, although it appears as paradoxical as the question itself. For it is not hard to notice that the Wicksellian theory of disequilibrium as a cumulative process makes one critical assumption: namely, that the price of every commodity, including labor, will respond flexibly to any disequilibrium between demand and supply. After all, Wicksell was too pure a neoclassical economist to introduce any imperfections into his theory.

As I have already pointed out, Keynes was a Wicksellian when he wrote his Treatise on Money ¹ and remained so, at least in part, even in The General Theory , as exemplified in the following passages:

If ... money wages were to fall without limit whenever there was a tendency for less than full employment ... there would be no resting place below full employment until either the rate of interest was incapable of falling further or wages were zero. (pp. 303-304.) ²

Keynes then argued that:

In fact, we must have some factor, the value of which in terms of money is, if not fixed, at least sticky, to give us any stability of values in a monetary system. (p. 304.)

What Keynes pointed to as a factor whose monetary value is, if not fixed, at least sticky, was of course “labour”. In normal wage bargaining, he wrote, “labour stipulates (within limits) for a money-wage rather than a real wage,” for “[w]hilst workers will usually resist a reduction of money-wages, it is not their practice to withdraw their labour whenever there is a rise in the price of wage-goods.” Such behavior is of course “illogical” from the standpoint of neoclassical economics, for it appears to imply that workers suffer from a money illusion and do not care about the purchasing power of their money wages. (p. 9.) ³ Keynes, however, argued that “this might not be so illogical at it appears at first,” and then added an enigmatic sentence: “and, … fortunately so.” (p. 9.)

In the first place, once we accept that workers are not isolated individuals whose aim is merely to seek their own well-being, but social beings ( zoon politicon , à la Aristotle) whose main concern is how they stand vis-à-vis others in the same social network, it is no longer illogical for workers to resist a reduction of money-wages but not to resist an increase in the price level. One object of workers in wage bargaining is not to determine their real wage but “to protect their relative real wage.” Indeed, insofar as there is imperfect mobility of workers across jobs, regions, employers, etc., “any individual or group of individuals, who consent to a reduction of money-wages relatively to others, will suffer a relative reduction in real wages,” whereas “every reduction of real wages, due to a change in the purchasing-power of money … affects all workers alike,” keeping their relative position more or less intact. (p. 14.)

More fundamentally, we are now able to make sense of Keynes’ enigmatic statement: “and, … fortunately so.” It is indeed “fortunate” for the capitalist economy that workers resist a reduction of money wages but not an increase in the general price level, in line with their self-identity as social beings who care about the fairness of their treatment within a social network. The real paradox is that this seemingly illogical behavior of workers—their money illusion—and the consequent stickiness of the value of wages in terms of money that has given us a degree of stability in our capitalist economy. In other words, it is the presence of “impurities” in the labor market that saves the capitalist economy from its self-destructive tendency! As Keynes himself put it:

To suppose that a flexible wage policy is a right and proper adjunct of a system which on the whole is one of laissez-faire, is the opposite of the truth. (p. 269.)

However, it should be emphasized that this suppression of the cumulative process in no way implies the disappearance of disequilibria from the capitalist economy. On the contrary, the downward stickiness of money wages will merely replace one form of macroeconomic disequilibrium with another. Indeed, under the downward stickiness of money wages, the laissez-faire capitalist economy is subject to severe but not violently unstable fluctuations in output and employment, through the multiplier process of incomes and the acceleration principle of investments. When aggregate demand falls below aggregate supply, the majority of producers who are unable to force a reduction of money wages must reduce the number of workers they employ in order to scale down their output supply. Consumers are forced to curtail consumption in reaction to lower incomes, and producers in turn are forced to cut back on their investment in plant and equipment in reaction to lower profits. Aggregate demand will decline further and set off a second-round reduction of output, employment, and investment, which will then induce a third-round reduction, followed by a fourth, and so on. In the end, the induced fall in aggregate demand will be many times larger than the original fall. Under the downward stickiness of money wages, therefore, laissez-faire capitalism tends to suffer a large amount of inefficiency in the form of chronic underemployment and recurring underutilization of productive capacities.

It was for this reason that Keynes devoted the entirety of The General Theory to the study of “the forces which determine changes in the scale of output and employment as a whole.” (p. vii.) The macroeconomic inefficiencies of underemployment of labor and underutilization of capital is the price we have to pay to tame the inherent instability of general price movements under capitalism. ⁴ This is the second form taken by the fundamental trade-off between efficiency and stability under capitalism, where everybody has to deal with the object of the purest speculation—money—in their daily economic activities.

¹ For instance, Keynes wrote in A Treatise on Money that: “[I]f the volume of saving becomes unequal to the cost of new investment [i.e., if aggregate demand becomes unequal to aggregate supply], or if the public disposition towards securities take a turn, even for good reasons, in the bullish or in the bearish direction [ie., if the natural rate rises above or falls below the market rate of interest], then the fundamental price levels can depart from their equilibrium values without any change having occurred in the quantity of money or in the velocities of circulation.” A Treatise on Money, Vol. 1: The Pure Theory of Money , p. 132.)

² Similarly, on p. 269, he wrote: “[I]f labour were to respond to conditions of gradually diminishing employment by offering its services at a gradually diminishing money-wage, this would not, as a rule, have the effect of reducing real wages and might even have the effect of increasing them, through its adverse influence on the volume of output. The chief result of this policy would be to cause a great instability of prices, so violent perhaps as to make business calculations futile in an economic society functioning after the manner of that in which we live.”

³ See George Akerlof and Robert Shiller, Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism , Princeton University Press: Princeton, 2009; pp. 42-50, for a history of thought on the money illusion.

⁴ Note that because of governments’ commitment to full employment after the (short-lived) success of Keynesian economics after WWII there emerged an inflationary bias in most advanced capitalist countries and that inflation, rather than unemployment, was the price we had to pay until 1980s.