Thanks Vector. Yeah I wouldn't dare try a placebo, I'm sure it may convince him for a while that he's cured, but I'm pretty sure he has a real problem and it would come back regardless of whether he thought it was gone. The official name of it is schizophrenia paranoia, he takes medication to help him function (his condition was bad enough that if medication were not possible, we probably would have institutionalized him :/). He hears voices, feels things touching him that aren't there, has trouble with math beyond simple addition/subtraction/division/multiplication, is probably very forgetful (we often discuss the same things a few times a week, he acknowledges that we do that but insists the repetition helps), has trouble doing things on time and keeping a regular schedule, although he's teaching a class and working in a cafe now, so he's learning how to get around that.
He used to believe demons are reprogrammed his family to ignore him (he'd get weird enough that we had no idea how to talk to him), would break things, flip out for no apparent reason, or was easily provoked to anger. Now he's given up the demon thing (although he always asks me about it "just to make sure"), is relatively calm now but instead, he often starts crying out of nowhere, especially after he yawns. I never ask why he cries, but the few times my mom did, he said "it's getting dark outside" and at a different time, "I miss grandpa" (that grandpa has been gone for... 15 years now?)
Ah, this is a tricky case. Paranoid Schizophrenia is a bitch to deal with, but it's not impossible to subdue. Schizophrenia, by my perspective, is not a mental illness, but a way to better oneself mentally; but it requires some serious development in order to prevent it from causing harm. Short answer is, it is, in fact, uncurable; however, it's not necessarily a bad thing. It just needs to be controlled by the person that has it in the first place. Sorta like taking responsibility for one's own self. As bad the advice may sound, medication will only numb the pain, or turn him into a zombie (some sad cases there are), and he wouldn't be able to confront the problem head-on as easily, along with everyone else.
But according to the description, it's a layered case. One part of it is really in tune to awareness (why the paranoid part), and another part is really well tuned to creativity/imagination (which explains the demons' reprogramming thing previously, as well as voices and feeling touched). The harmonization of these two is a bad reaction if not in check by the person that has the problem.
It sounds like his mind is very much in tune with his imagination; but he isn't aware of it, and if his mind wanders too much without his direct attention, he can easily lose it, sliding his problem more towards paranoia, than as an unique ability involving imagination. Simple solution, provided he's capable: art. Let him extract his experiences and such in any way shape or form that he can. Let him be able to manifest his mind-sight to the point that he's capable to being aware he's in complete control of it. Let him make sculptures, draw crazy-ass pictures, write stories of his experiences, anything.
The only real demons I can see in this mess are his own; as if it's a form of personal guilt or martyrdom. Maybe he's been left out alot in family events and other things; as well as got picked on lots in school. It seems to be a case that would make the most sense in developing this problem. Who knows? Maybe he's able to sense the dead and even interact with them? From what I see, schizophrenia is a gateway to mental evolution (up to, theoretically, psychic levels; like an initiation). But the first step to developing it is being aware of it (best if done at an early age, of course), the next step is gaining control over it, if the problem is showing horrors, think of something far worse, and counter it with that. If you can out-do your problems (fighting fire with fire; or overtaking it with your own spirit/willpower), you would become an Alpha towards it, and gain control over it quickly.
If it's a chemical/mental imbalance, just put a counter-weight on it. Simple. It just depends on what kind of counter-weight you need; be it emotional, spiritual, physical, or social; but I am against chemical treatments of any kind (meds of all kinds especially). Primarily because they have likely chances of knocking people into comas (even with proper dosage). To be trapped in a mental hell while in a coma is a fate worse than death.
If it helps any, let him talk to himself as a self-therapist; make him go through TVTropes and have him line up his life with different tropes (at least start with ones he's interested and reserve nightmare fuel for late-end). Sometimes mental problems are like venom, and should be bled out before treatment in order to speed up fixing it one way or another.
And that's it from me. If my advice doesn't fix him up entirely, he should at least be more functional and still be comfortable with himself. And do me a favor, and don't make it all self-help motivational style for him, or intervention style. Otherwise he won't buy it, and wouldn't try any of this.
EDIT:
Cthulhu does make a good point however.