So, we (my girlfriend with the MBA and I) just discussed this and she's on the other side of the discussion from me, with the mantra, "You have to Pay to Play" (there ya go Tibs!)

She made the strong argument that your mind is shattered if you're even making the attempt to read a spell requiring 2 Sanity when you have only one remaining.  It's easy to conjure in your mind what it's like for someone beat to a pulp or completely wracked with 1 Stamina…now compare that to one's Sanity.

Frankly, I see her point..and those of Tibs, jgt7771, and others.  In the end, "You have to Pay to Play"

@ Thomas…for the love of a Guardian, let the individual go to the Asylum, if the Investigator fails the Spell Check…however, my girlfriend says, "Let the monster beat the crap out of you" and then go the Asylum or St. Mary's.  Her theory, why should the monster care that you failed the spell check…now THAT'S HARSH!

Julia said:

That is exactly the argument I would make. It requires a loss. The sanity and stamina loss is a side effect of using the Flute. You don't need to have the entire requisite up front, but using the Flute will incur damage.

You can extend the argument to an encounter that says you "gain 3 clues and lose 3 sanity." If you have 2 or fewer sanity, you wouldn't argue that this effect simply would not happen. Same thing with the Flute.

Also, officially, a spell takes effect even if it drives you insane to cast. A combat spell does nothing, but something like Bless or Yellow Mist will still work. That means that you will still roll for them.

Tibs,

     What do you mean by "a combat spell does nothing?"  Are you implying, like jgt7771 that once you've spent the Sanity, you don't get to roll the Spell check.  That would seem particularly peculiar, as why would you spend the Sanity if the outcome…insanity, is inevitable.  Maybe I misunderstood.

 For example, Shriveling or Dread Curse. They add dice to a combat check. A combat check that you will be unable to make, as you have no sanity and have to go to the asylum.

Tibs said:

I'm glad my memory is not completely blurred yet. Could you please address where the official clarification of this lies, just to have a future reference?

In my games, if an Investigator has sacrificed Sanity to the point of going Insane, they will definitly have the option of either a.) taking advantage of the Combat Bonus OR b.) being whisked away to the Asylum, without suffering the Sanity loss from the combat. I will not have the Investigator go Insane and forfeit the benefit from the Combat Bonus AND suffer the Stamina loss from the monster. 

Just weighing on Bind Monster: keep in mind that the check for Bind Monster is not actually the Combat check, it's a Spell check that grants you an auto-pass on the Combat check (sort of like how Mists of Releh gives you an auto-pass on an Evade check).  Of course, that raises the question of whether things cast just to affect a check take place at the same time as the check.  My ruling, honestly, would be no.  I don't see that there's a fundamental difference between a bonus-granting Spell like Shrivelling and an auto-pass granting spell like Bind Monster.

jgt: I'm going to get a bit wacky here and do not just a thematic interpretation, but a thematic comparison, utilizing an entirely different kind of game.  Bear with me here: I haven't read any stories in which the Elder Sign (the Derleth version) features, so I'm going to go with the Call of Cthulhu RPG version.  In the RPG (on which, after all, Arkham is based), the Elder Sign, just drawn on something, does nothing.  You need to activate with a sacrifice of life energy (in Arkham represented by 1 Sanity and 1 Stamina), and this process of activation is a spell, no different from any other (I think that here we must assume that the Elder Sign Unique Item represents both the knowledge of the spell and a previously-drawn sign large enough to plug a Gate).  I'd also say it's a safe bet to assume that the wackier effects caused by reading Unique Tomes (Naacal Key, De Vermiis Mysteriis [sic], Eltdown Shards) are also caused by Spells, yet they are losses and so activate even if you go insane (by my interpretation, at least).

Julia said:

Check the stickied "Official Answers" thread: it's the first entry in the second post (by ColtsFan).

Tibs said:

Thx!

I was just looking at the list of spells over at Arkham Horror Wiki to see how many could conceivably be useful to cast if doing so drove you insane. Foresee (Cast and exhaust to re-roll any one skill check you just made) is giving me a serious headache.

Thomas Cartwright said:

I should take a moment to interject here that I strongly believe that the spirit of Call Ancient One is to get devoured if you go insane casting it. A legitimate argument can be made against this, but for this spell I will not concede.

Going to weigh in on this because it's an excellent question and issue that does stand to be clarified in the FAQ.

Using an Elder Sign sacrificially only makes sense for a couple of reasons.  First and foremost because you only loose 1 sanity and stamina, it makes sense that you could drive yourself insane / unconscious (devoured) by using it.  You can't go into a negative sanity state, you simply reach zero and are sent to the asylum.  The second reason is being as Elder Sign is an item with no die rolls attached after you activate it.  Comparatively speaking, there IS a die roll after you decide to pay the sanity cost on a spell.  To me, this is the most important difference between casting a spell regardless of the fact you are going to go insane and using an item which will cause you to go insane.

Flute seems to make the most mechanical sense if you treat it as a combat check against a single monster who only needs 1 success to be defeated.  Because of the way flute works, this happens to defeat all the monsters in the area but you can't make the check in you're insane and at the asylum.  This deters investigators from voluntarily playing it when they stand to go insane or unconscious from it's use since there is no benefit unless one can make the combat check.

So on to the OP's question.  In my games, I've found that the application of this rule is very very very situational.  It is very easy to abuse it.  Be careful with how you apply the rules and hopefully we get a FAQ that can clarify this one.

That analogy doesn't work because you're never making a combat check, even if you fully survive the use of the Flute.

You're blowing into the Flute, and it emits the sounds of the Outer Gods, which kills all the nearby monsters and brutalizes you. So whether or not you're actually sane and conscious, the monsters are still defeated.