The 2008 global financial crisis has been a testament to the failure of Adam Smith’s basic neoclassical principle: that making capitalism purer would bring the economy closer to an ideal state. While globalization improved the efficiency of the capitalist economy and brought about a high level of average growth for the world, it produced massive instability, demonstrating the inevitable trade-off that exists between efficiency and stability.

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The capitalism we inhabit has long been subject to two competing views. One is the view of the neoclassical school, which places its faith in the “invisible hand” of the price mechanism, as described by Adam Smith:

The natural price [that leaves capitalists a natural rate of profit after having paid workers and landholders their natural rates of wage and rent], therefore, is, as it were, the central price, to which the prices of all commodities are continually gravitating. Different accidents may sometimes keep them suspended a good deal above it, and sometimes force them down even somewhat below it. But whatever may be the obstacles which hinder them from settling in this centre of repose and continuance, they are constantly tending towards it. (Adam Smith, Wealth of Nations ; Book 1, Chap.7.)

If we trust in the “invisible hand” of the price mechanism, spread free markets across the globe, and bring the economic system ever closer to pure capitalism, we will approach the “ideal state” (or what Adam Smith called the “natural state”) that provides both efficiency and stability. The root of all evils thus consists of the “impurities” that keep all markets from operating smoothly. These include the various community conventions and social institutions that impede the free movement of people in the labor market and the many financial regulations and security laws that impede the free movement of money in the capital market. Once these impurities were removed, capitalism would be both efficient and stable. Milton Friedman of the University of Chicago, who died in 2006, was the twentieth-century champion of this neoclassical view of capitalism.

The second view is that of what I would call the “Wicksell-Keynes school.” This is the school of economic thought that came into being when Knut Wicksell worked out the monetary theory of cumulative process in Sweden at the turn of the nineteenth century. ¹ I place the names of Keynes and Wicksell together, because Keynes was Wicksellian in A Treatise on Money ² and remained Wicksellian in The General Theory , at least in his analysis of the stability of the economy under flexible money wages, even if his theoretical apparatus changed radically between the two publications. ³ According to this second view, there is no such thing as an “ideal state” in capitalism. This is not to suggest by any means that either Wicksell or Keynes was a romantic utopian who dreamed of the abolition of money, finance and capitalism. Both men agreed with the neoclassical school that the capitalist economy is by far the most efficient economic system at the microeconomic level. What they demonstrated theoretically was that such increases in microeconomic efficiency came hand in hand with macroeconomic instabilities in the form of bubbles and panics, booms and slumps, hyperinflations and depressions. Efficiency may increase as capitalism is made purer, but stability decreases at the same time. The capitalist system, while moving through regular ups and downs of business fluctuations, has managed to remain relatively stable throughout most of history only because of the “impurities” that have impeded the free adjustment of market prices, such as the rigidity of monetary wages and the regulation of speculative investments. To be sure, these impediments also have their costs, such as the underemployment of labor and the underutilization of capital in normal times. In a capitalist economy, in other words, there is an inevitable trade-off between efficiency and stability.

The publication of The General Theory in the throes of the Great Depression marked the beginning of the “Keynesian revolution” that was to have such an enormous influence on both the academic and policymaking worlds for the next several decades. For roughly two decades after World War II, advanced capitalist economies enjoyed both macroeconomic stability and relatively high growth rates, thanks to a substantially increased role for government resulting from New Deal policies in the US and a variety of welfare programs in other Western countries, together with a system of banking regulations and monetary intervention that provided a lender of last resort to financial institutions. But the success of Keynesian economics eventually brought about its own downfall. The very macroeconomic stability it was able to engineer until the 1970s revived the old faith in the “invisible hand” mechanism in markets, and governmental commitment—or rather, over-commitment—to full employment gave rise to an strong inflationary bias in most advanced capitalist countries after the 1960s. Both set the stage for the neoclassical counter-revolution led by Milton Friedman, who had gained the upper hand among both academics and policymakers by the mid-1970s. During the 1980s the administrations of US President Ronald Reagan and British Prime Minister Margaret Thatcher, both strongly influenced by the ideas of Friedman and his followers, shifted course sharply in the direction of laissez-faire economic policies. Many industries were deregulated, under the banner that “the government is not the solution to our problem; the government is the problem.” A financial revolution took place that securitized risks of every sort and then securitized the risks of these newly created securities. Rapid globalization of commodities, money, and information began, spreading the market economy across the entire world. Globalization can thus be interpreted as a “grand experiment” designed to test the fundamental principle of neoclassical economics: namely, that making capitalism increasingly pure would raise both efficiency and stability, bringing the economy closer to an ideal state.

At a conference to honor the ninetieth birthday of Milton Friedman in November 2002, Ben Barnanke, then a governor and since 2006 the Chairman of the Federal Reserve, endorsed Friedman’s monetarist explanation that the Great Depression was caused not by the stock market crash of 1929 but by the Federal Reserve’s failure to prevent the sharp decline in the money supply from 1928 to 1933. ⁴ He said to Friedman and his co-author, Anna Schwartz: “Regarding the Great Depression, you’re right; we did it. We’re very sorry. But, thanks to you, we won’t do it again.” ⁵

Three months later, in his presidential address to the 115th meeting of the American Economic Association, Robert E. Lucas Jr., the prime architect of the so-called rational-expectation theory of macroeconomics and probably the most influential neoclassical economist since Milton Friedman, declared: “Macroeconomics . . . has succeeded.” The “central problem” of preventing the recurrence of the Great Depression, he claimed, “has been solved, for all practical purposes, and has in fact been solved for many decades. . . . Taking US performance over the past 50 years as a benchmark, the potential for welfare gains from better long-run, supply-side policies exceeds by far the potential from further improvements in short-run demand management.” ⁶

Then, suddenly, in 2007, scarcely five years after Bernanke’s pledge and Lucas’s declaration, a “once a century” financial crisis erupted in the United States. The crisis not only spread instantaneously throughout the world via a tightly knit global network of capital markets, but also led to a sharp downturn in the real economy on a scale not seen since the Great Depression.

This was a spectacular testament to the failure of the basic neoclassical principle: that making capitalism purer would bring the economy closer to an ideal state. It is true that globalization did indeed improve the efficiency of the capitalist economy and bring about a high level of average growth for the world as a whole. At the same time, however, it produced massive instability, demonstrating conclusively the “inconvenient truth” about capitalism—the inevitable trade-off that exists between efficiency and stability.

Why does this trade-off between efficiency and stability exist? It exists because capitalism is a system that is built essentially on “speculation .”

¹ Knut Wicksell, Geldzins und Güterpreise (Jena: Gustav Fischer, 1898); English translation by R. F. Kahn, Interest and Prices , (London: Macmillan, 1936) and Reprinted edition (New York: Kelly, 1962); John Maynard Keynes, General Theory of Employment, Interest and Money (London: Macmillan, 1936).

² Keynes recorded in a footnote of A Treatise on Money the following remark: "There are many small indications, not lending themselves to quotation, by which one writer can feel whether another writer has at the back of his head the same root ideas or different ones. On this test I feel that what I am trying to say is the same at root as what Wicksell was trying to say." ( A Treatise on Money: The Pure Theory of Money , MacMillan: London, 1930); reprinted as Volume V of The Collected Writings of John Maynard Keynes ,MacMillan: London, 1971; p.177.)

³ See Katsuhito Iwai, Disequilibrium Dynamics – A Theoretical Analysis of Inflation and Unemployment , (New Haven: Yale University Press, 1981 [downloadable: http://cowles.econ.yale.edu/P/cm/m27/index.htm] for an attempt at synthesizing the Wicksellian theory of cumulative process and the Keynesian principle of effective demand.

⁴ Milton Friedman and Anna Schwartz, A Monetary History of the United States, 1867-1960 , (Princeton: Princeton University Press, 1963). Bernanke’s own academic work on the Great Depression is collected in Essays on the Great Depression (Princeton: Princeton University Press, 2000).

⁵ See http://www.federalreserve.gov/BOARDDOCS/SPEECHES/2002/20021108/

⁶ Robert E. Lucas, Jr., “Macroeconomic Priorities,” American Economic Review , 93 (1) (Mar., 2003), pp. 1-14.