Discussion Paper

No. 2012-30 | June 27, 2012
Circuit Theory Extended: The Role of Speculation in Crises


This paper asks why modern finance theory and the efficient market hypothesis have failed to explain long-term carry trades; persistent asset bubbles or zero lower bounds; and financial crises. It extends Keen (Solving the Paradox of Monetary Profits, 2010) and the Theory of the Monetary Circuit to give a mathematical representation of Minsky’s Financial Instability Hypothesis. In the extended model, the central bank rate is not neutral and the path is non-ergodic. The extended circuit has survival constraints that include a living wage, a zero interest rate and an upper interest rate. Inflation is everywhere. The possibility of a high interest rate, hedge economy emerges, where powerful banks invest surplus loan interest. With speculation, banks lobby to enter investment markets and the system is precariously liquid/illiquid. The paradox of a Ponzi economy, where loans never get repaid, is that private banks must speculate to increase reserves and rely on systemic crises to rebuild their balance sheets. Estimating model parameters for the US gives a scissor-graph like the The Financial Crisis Inquiry Commission (The Financial Crisis Inquiry Report, 2011) with other nuances, namely i) a ‘heart attack’ in 1973–1974 that corresponds to the collapse of Bretton Woods ii) an accelerated decoupling of household wages and loans after the repeal of Glass-Steagall. Simulating bank bailouts, household bailouts and a Keynesian boost suggests that bank bailouts are the least effective intervention, with downward pressure on wages and household spending. Bailing out hedge households is a form of monetary contraction, and boosting hedge business loans is a form of monetary expansion. The appropriate policy choice would seem to depend on the external balance and inflation concerns. The paper concludes that, with international Ponzi sectors, viable resolution mechanisms include reparations (dL < 0), turning Ponzi debt into equity or ‘junk’ debt (dL → ∞), household bailouts and a Keynesian boost.

Underlying data and models available on a development website:


JEL Classification:

E10, E27, E43, E58, E60


  • Downloads: 1522


Cite As

Neil Lancastle (2012). Circuit Theory Extended: The Role of Speculation in Crises. Economics Discussion Papers, No 2012-30, Kiel Institute for the World Economy. http://www.economics-ejournal.org/economics/discussionpapers/2012-30

Comments and Questions

Philip George - Circuit Theory Extended
June 28, 2012 - 05:24

The inability of economics to take financial crises into account can be explained very briefly: the existing model of money assumes that money is spent on real goods and assets but not on financial assets.

When I manufacture and sell a loaf of bread I earn $1. This figures ...[more]

... in GDP, the sum of spending on real goods and services. When I sell a share of Wonderful Widgets I still earn $1, but this does not figure in GDP. What happens to this $1? If it is spent, it can only fuel imports (since there is no corresponding increase in the production of domestic real goods and services) or raise the price of financial assets i.e. fuel speculation.

Any model of money must take into account this fact: that income is not just real income but also includes financial incomes, and that spending is not only on real goods and services but also on financial assets.

This is what I have done in my book "The General Theory of Money" which is available as a Kindle ebook. http://www.amazon.com/dp/B0080WPK2I

It predicts the last recession and shows that we are heading for a crash of epic proportions.

Neil Lancastle - No comment
June 28, 2012 - 19:27

There is not specific to the Discussion paper, so I do not have a reply to this comment.

Philip George - Circuit Theory Extended
June 29, 2012 - 06:06

Your graph of household to non-financial liabilities (Fig 11 of your paper) is quite impressive. Its overall shape seems to mirror the overall history of the US economy very well for the past half-century. The events it depicts well are the 1973-74 stockmarket crash, the short-lived 1987 stockmarket crash. Some ...[more]

... parts of it are difficult to understand, e.g the upward movement from 1962, whereas this was a period when the stockmarket crashed.

You might want to take a look at http://www.philipji.com/Mc/ which shows my measure of money for the same period. Where your graphs are mine differ substantially are for the present period. Your graph falls whereas mine rises steeply. The next couple of years should show which is right. I predict a collapse of one or more financial asset markets, resulting in a collapse in lending, leading to a recession or Depression.

What do you predict?

Incidentally http://www.philipji.com/busloans/M1SL+sweeps-BUSLOANS.html shows much the same shape. I wonder whether anyone can guess why.

Neil Lancastle - Prediction
June 29, 2012 - 16:41

The model is non-ergodic. It does not aim to predict crises ex-ante, unlike the commentators.

Ex-post, from 1962-5, US household loans simply increase more than wages (Figure 11). From 1965, increases in wages and business loans are higher. All three trend positively until 1967, when household ...[more]

... loans contract.

It is surprisingly difficult to get monthly or even quarterly data. For Greece, the OECD data stops in 2009 and is only annual:


Anonymous - Referee Report 1
June 29, 2012 - 10:48

see attached file

Neil Lancastle - Changes
June 29, 2012 - 14:56

Thank you for the recommendation and comments.

I will read Graeber (2011) and re-write pg 3, para 3 to place non-commodity money in a wider historical context. Ditto for pg 2, para 3.

I agree that my work uses the Godley and Lavoie method (rows and columns ...[more]

... sum to zero). I will consider re-writing (from end of pg 4 to the beginning of pg 6 'Circuit Theory Extended', and line 3 in the abstract) to make this clear. My acknowledgment (and debt) to the referee is because he models a 'deus ex machina' injection of money into worker deposits and bank vaults.

I will read the referee's Appendix carefully, and give serious consideration to a subsequent paper on the same topic, based on the Mathcad simulation program provided. Thank you.