Manias, euphoria, insanity, blind passion, orgies, frenzies, fevers, wishful thinking, intoxication, overconfidence, hysteria, rage, craze, mad, rash, etc—these are the words often used to describe people’s behavior during financial bubbles, business booms, and hyperinflations. Panic, depression, despair, distress, terror, sudden fright, confusions, paralysis, suicidal, etc.—these are the words often used to describe people’s behaviors during financial busts, business slumps, and economic depressions. [1]

I have absolutely no intention of denying that people’s behaviors during such abnormal economic times are often quite irrational, and can be described by these psychopathological terms. We human-beings are far from being the cool-headed rational decision-makers postulated in neoclassical economic models, as numerous experimental studies on human behaviors have amply shown. [2] No doubt recent developments in behavioral economics have enriched our understanding of the ways in which a capitalist economy behaves, both microscopically and macroscopically. [3] I am afraid, however, that too much emphasis on human irrationality may lead us astray from the essential insight of what I have called the “Wicksell-Keynes school” of economic thought.

Individual speculators who play the Keynesian beauty contest among themselves in financial markets do not have to be irrational to generate bubbles and busts that look totally irrational at the macroscopic level. On the contrary, it is rational for them to buy a barrel of oil futures when they believe that everybody else believes that its price will rise further, and it is rational for them to sell stock in a corporation when they believe that everybody else believes that its price will decline further. When there emerges a disequilibrium between aggregate demand and aggregate supply, most producers start to raise or lower their price relative to their expectations of other prices, because most of them face an excess demand or excess supply for their product. But their simultaneous actions will inevitably cancel each other out and result only in raising or lowering the general price level above or below their expectations. The general price level then rises or falls continuously and without limit. During such cumulative inflation or deflation, each producer’s decision looks irrational ex post , but is in fact rational at least in intentions ex ante . Moreover, as inflation or deflation continues and people begin to believe that other people believe that the inflation or deflation will continue, it is rational for them to reduce or augment their holdings of money when they expect a further depreciation or appreciation of its value. But their adjustment of their money holdings tends to widen the original macroscopic disequilibrium, and this may turn a normal inflation or deflation into the most irrational of macroscopic irrationalities—a hyperinflation or depression.

On top of all that, Keynes’ most profound insight in his General Theory is the observation that it is the downward stickiness of money wages that prevents the capitalist economy from plunging into a process of cumulative deflation and eventually into a great depression when aggregate demand falls below aggregate supply. What neoclassical economists would characterize as sheer irrationality—money illusion!—on the part of individual workers thus works to infuse a certain rationality or stability into the capitalist economy at macroscopic level. This, however, does not imply that such a suppression of a cumulative deflation process removes all the instabilities from the capitalist economy. Far from it. The downward stickiness of money wages merely replaces the cumulative process of price deflation by the income multiplier and investment accelerator processes, during which every consumer’s rational decision to lower consumption in response to a reduction of income and every producer’s rational decision to curtail investment in response to a reduction of profit will induce a further fall in aggregate demand that will eventually become many times larger than the original decline.

One of the core teachings of the Wicksell-Keynes school is that apparently irrational behaviors of the capitalist economy at the macroscopic level do not necessarily result from microscopic irrationality on the part of individual participants. On the contrary, they are often the unintended aggregate outcomes of many individuals’ rational actions or reactions in response to the macroeconomic conditions in which they find themselves.

More fundamentally, the Wicksell-Keynes school has located the ultimate cause of macroeconomic instability in the very monetary nature of the capitalist economy. It is the circulation of money as the general medium of exchange that has provided the freedom to exchange any commodity at any time at any place with anybody, thereby allowing the sphere of economic exchanges to expand temporally, spatially, and socially in a major way. Money is thus the original source of efficiency in our capitalist economy. At the same time, this freedom is the original source of the instability in our capitalist economy. This is because it also gives people the freedom to hold or not to hold money at any time, thereby allowing aggregate demand and aggregate supply to deviate from each other. And it is this disequilibrium between aggregate demand and aggregate supply that sets off a cumulative process of inflation or deflation and may drive the entire capitalist economy into a hyperinflation or a depression if all the prices, including money wages, are perfectly flexible. If some prices, especially money wages, are sticky downward for some reason, a decline of aggregate demand relative to aggregate supply will trigger not a cumulative deflation process but an income multiplier process and an investment deceleration process, which are perhaps not as violent as the cumulative deflation process but are severe nevertheless. Indeed, if the induced decline of aggregate demand becomes so large that workers can no longer resist the downward pressure on their money wages, the Keynesian economy will then revert to being Wicksellian and start a cumulative process of deflation that may end up in a depression. On the other hand, since money wages are unlikely to be sticky upward, whenever aggregate demand exceeds aggregate supply, the capitalist economy is always in danger of setting off a process of cumulative inflation that may turn, when worst comes to worst, into a hyperinflation—the true crisis of the system.

If the ultimate cause of the instability in a capitalist economy lies not in individual irrationality but in the disequilibrium between aggregate demand and aggregate supply, it is not a mere agendum but a true imperative of the government and the central bank to try to maintain equilibrium by a suitable mix of fiscal, monetary and other macroeconomic policies, together with an efficient system of financial regulations that can mitigate excessive credit creation.

Globalization was a “grand experiment” to test the laissez-faire doctrine of the neoclassical economics, which claimed that spreading free markets across the entire globe and introducing a purer form of capitalism would increase both efficiency and stability. The global economic crisis that began in 2007 was a spectacular testament to the grand failure of this experiment. Instead, it has demonstrated the “inconvenient truth” about capitalism—the inevitable trade-off that exists between efficiency and stability. As an almost reflexive reaction to the swiftness, broadness, and deepness of this crisis, we have seen a sudden revival of a large scale fiscal and monetary stimulus in most advanced capitalist countries, together with an effort to implement tighter financial regulations, which only a few years ago would have been summarily dismissed as harmful to the smooth working of the “invisible hand” of the price mechanism.

This certainly seems to mark the end of laissez-faire—in fact, its second end, since its end was already declared once after the Great Depression of the 1930s (though miraculously the system came around again in the 1970s).

Can this second end really be the true end of laissez-faire? The answer is perhaps “no“.

People’s memories are short, especially on economic matters. When all the dust raised by the current global economic crisis has settled down and, with the help of discretionary fiscal and monetary policies as well as stricter rules of financial regulations, global capitalism has regained a certain degree of stability, the advocates of the laissez-faire doctrine are bound to come back and start to rain praise upon the virtue of the “invisible hand” of the price mechanism. History may then repeat itself, the first time as tragedy, and the second time probably as tragedy too.

There is, however, a more objective ground for feeling pessimistic about the true end of laissez-faire. Globalization has covered the world with a tightly knit network of markets and has transformed the world economy from a league of trading national economies into what we now call a global capitalism that more or less transcends individual national economies. Scarcely had this global capitalism come into being than it got caught in a global economic crisis that reminded us of the inevitability of discretionary macroeconomic policies and well-designed financial regulations. Yet this global capitalism has neither a central government nor a central bank to implement such policies and regulations. All it has is the G8 or G20, loose groups that can hope at best to coordinate fiscal and monetary policy between a selected group of countries, the US Federal Reserve Board that is endowed with a de facto monopoly power to control the money supply of the entire global, and a motley of not particularly powerful international organizations such as the IMF, the World Bank, OECD, and so on. With all the teachings of the Wicksell-Keynes school of economics at our disposal, this global capitalism is still at the stage of laissez-faire capitalism during the age of Adam Smith. It will be in the far-off future when we can finally declare the true end of laissez-faire.

[1] Most of these terms are taken from Charles Kindleberger, Manias, Panics, and Crashes: A History of Financial Crises , Rev. ed., New York: Basic Books, 1989, and J. K. Galbraith, A Short History of Financial Euphoria , New York: Penguin, 1994.

[2] Since the pioneering work of Tversky and Kahneman, we have seen a huge increase in works, both experimental and theoretical, that try to integrate insights from psychological research into economics, especially concerning human judgment and decision-making under conditions of uncertainty. Kahneman, Daniel and Tversky, Amos. "Prospect Theory: An Analysis of Decision under Risk." Econometrica, March 1979, 47(2), pp. 263-92. See also "Psychology and Economics," Journal of Economic Literature, Vol. 36, 11-46, March 1998; Camerer, C. 2003, Behavioral Game Theory , Princeton: Princeton Univ. Press.

[3] See, for instance, George A. Akerlof, “Behavioral Macroeconomics and Macroeconomic Behavior,” The American Economic Review, Vol. 92, No. 3 (Jun., 2002), pp. 411-433, and Akerlof and Shiller, Animal Spirits , op.cit.