The Great Depression set off by the US stock market crash in 1929 dragged on through the 1930s. I doubt anyone will deny that the current financial crisis is the biggest in scale that the world has experienced since then. Unlike at the time of the Great Depression, when governments were slow to take countermeasures, the financial authorities of Japan, the United States, and Europe have been coordinating their response to provide financial institutions with infusions of public funds. This seems to have worked for now, causing the situation to become somewhat calmer. The chances of another 1930s-style Great Depression are small. But stock prices continue to move up and down violently, and the world is at the brink of falling into a “lost decade” if matters are mishandled in the period lying ahead.

I am surprised that such a major financial panic has occurred during my own lifetime. Timing aside, however, the occurrence itself does not surprise me. I have always maintained that capitalism is inherently unstable, and so this development was theoretically predictable.

John Maynard Keynes believed that the market economy was unstable and that it was necessary to use monetary and fiscal policy to tame its instability. This thinking became the pillar of government policy after the Great Depression, particularly in the United States, and it proved successful. But this successful approach ended up being carried too far, with the result that the institutions of the state for countercyclical economic policy measures became overgrown and highly wasteful.

From the 1960s on, the neoclassical economics propounded by Milton Friedman and others came to the fore in Britain, the United States, and elsewhere. According to this theory, the market economy should be kept as free as possible of government intervention and regulation; the purer it is allowed to be, the more efficient and stable it will become. Neoclassical economics provided the theoretical underpinnings of the policies adopted by the Thatcher administration in Britain and the Reagan administration in the United States during the 1980s, and it has established itself as the orthodox form of economic thinking. [1]

This thinking has been carried to the extreme by the current Bush administration, which has sought to do away with regulations, allow the securitization of debts and everything else imaginable, and spread the workings of the market to every corner of the world.

It is fair to consider what we have been witnessing in recent years to have been a grand experiment of global scale aimed at the creation of the laissez-faire utopia conceived by the neoclassical school. The experiment’s success came under test from around the time of the East Asian currency crisis in the late 1990s, and it had begun to show signs of unraveling, but the current crisis has brought its collapse. An inconvenient truth about capitalism is that efficiency and stability cannot be achieved simultaneously.

Even Money Is Purely Speculative

Why is capitalism unstable? Because it is fundamentally based on speculation. Consider carmakers, for example. They build automobiles not for themselves but in the expectation that others will buy them to ride in. There is an element of speculation in this process.

Milton Friedman and his followers in mainstream economics, however, claim that speculation leads to stability. Those investors who buy high and sell low, they argue, are irrational and will promptly fall by the wayside. Only the rational investors who buy low and sell high will survive; this will cause markets to be stable.

What they assert may apply to an idyllic market where investors mediate between producers and consumers. But, the activity in financial markets, including markets for stocks, bonds, foreign currency and their derivatives, is of entirely different nature. It is professional investors and investment funds that dominate the markets and compete with each other. They buy and sell based not on their forecasts of long-term demand/supply conditions but on their observations of each other’s movements and readings of each other’s intentions. When a price is expected to rise or fall, it is not irrational to buy or sell more and move the price further up or down, leading to speculative bubbles and panics.

The more fundamental reason I believe that capitalism as a whole is speculative and inherently unstable is that the money on which it is based is itself speculative. Money has made the economy much more efficient by making it possible to conduct transactions without the trouble of exchanging on a barter basis. But money has no intrinsic value. People are willing to hold it only because they expect other people to accept it in exchange for something else, with the people who accept it expecting that yet other people will accept it in turn.

To hold money is, in other words, the purest form of speculation, and trust in it is based on circular, bootstrap logic: Everybody uses money as money merely because everybody believes everybody else uses it as money.

In this light, we can see that money has two faces: It brings greater efficiency, but at the same time it has the potential of causing great instability. In a capitalist economy supported by money, it is impossible for efficiency and stability to coexist as claimed by the neoclassical economists.

This bootstrap logic of money also underlies the present financial crisis. The subprime loans that set off the crisis are extremely risky loans to people with low creditworthiness. Because the risk of default on such loans is so high, a single subprime loan by itself is unattractive as a financial product. But bundling many such loans together and securitizing them made the risks seem diluted, and as a result of further bundling with numerous other financial instruments into big packages that were then dispersed around the globe, the risks became invisible from the surface.

As the financial products created in this way were traded more and more steadily among numerous parties, they began to be considered readily convertible to cash and other safe assets. They came to be seen as being like the money in which people place supreme trust. Here again we see the workings of bootstrap logic: Everybody trusted the products as safe merely because everybody believed everybody else trusted them as safe. But when the subprime loans whose risks were concealed therein went bad, trust in all financial products toppled like a row of dominoes. This is the essence of the current financial crisis.

A major difference between this and the Asian currency crisis and other financial crises that preceded it is that the value of the US dollar, the key currency of the international monetary system, may be severely shaken. The instability of money as a purely speculative construct—a problem that has been concealed up to now—may come to the surface henceforth in the form of the crisis in the key currency. I do not have space to discuss this problem here, however.

Aim for Second Best

What should we do next? The capitalist world is inherently unstable. So, contrary to the assertions of the neoclassical school, there is no ideal state that we can seek to achieve; all we can do is aim for second best. Capitalism has to be freed from the capitalistic ideology of laissez-faire, and we have to reassert the old-fashioned idea of the necessity of governmental controls on financial institutions to curb their high leverage and excessive speculation. And whenever a crisis strikes, we just have to deal with it using a patchwork of rescue measures, such as buying up of bad loans and infusions of public funds.

This outlook may seem bleak, but if we look back over history, we see that economies have repeatedly experienced the formation of bubbles followed by their collapse, but meanwhile, they have steadily grown more efficient over the course of time. Our only option is eternal pragmatism in search of a better second best.

Like Adam and Eve, we have tasted the forbidden fruit. In our case it is the freedom that capitalism has given us. The sweet fruit of freedom carries its own “original sin,” namely the knowledge that capitalism is inherently unstable. But this freedom is not something we should—or can—give up.

The original Japanese article appeared in the Asahi Shimbun, October 17, 2008. No reproduction in any form of this article is allowed without the prior written approval of the Asahi Shimbun.

[1] In Japan’s case, neoclassical economic thinking informed the structural reform program of Prime Minister Jun’ichiro Koizumi’s administration (2001–6), which sought to achieve an economic recovery led by the private sector, eschewing the previous reliance on fiscal pump priming. Concerning the Koizumi reforms, see the prime minister’s January 2006 general policy speech to the Diet at http://www.kantei.go.jp/foreign/koizumispeech/2006/01/20speech_e.html .