Journal Article
No. 2012-34 | August 28, 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 Godley and Lavoie (Monetary Economics: An Integrated Approach to Credit, Money, Income, Production and Wealth, 2007) and the Theory of the Monetary Circuit to give a mathematical representation of Minsky’s Financial Instability Hypothesis. In the extended circuit, 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 stable carry trades emerges. In high interest rate, hedge economies, powerful banks invest surplus loan interest. With speculation, banks lobby to enter investment markets and the system is precariously liquid/illiquid. In a Ponzi economy, where loans never get repaid, solvency is a balance between increasing reserves, reducing interest rates and rebuilding banks’ balance sheets during systemic crises. Simulating bank bailouts, household bailouts and a Keynesian boost suggests that bank bailouts are the least effective intervention, exerting downward pressure on wages and household spending: austerity.

Underlying data and models available on a production website:

JEL Classification:

E10, E27, E43, E58, E60


  • Downloads: 2057 (Discussion Paper: 1522)


Cite As

Neil Lancastle (2012). Circuit Theory Extended: The Role of Speculation in Crises. Economics: The Open-Access, Open-Assessment E-Journal, 6 (2012-34): 1—27.

Comments and Questions

G Y - Comment
August 29, 2012 - 07:20

An interesting and useful article.

Anonymous - Crisis formation
August 29, 2012 - 13:23

You have placed the cart before the horse! It is speculation, particularly in land values that causes the crisis.

The mechanism briefly is that as tax payers help governments to develop local infra-structure, so the value (and productivity) of the land rises. Speculators buy land before development has ...[more]

... taken place and sell it at a greater amount after the town has grown and it facilities have improved. But meanwhile the land is not used and this means that the opportunity for it to provide work and a decent wage is lost.

The land that is available becomes highly priced to rent or purchase because of the increased competition for what of it is not being withheld from use by the speculators. Produce becomes more costly and goods are less in demand. This results in less money circulation and less earnings to purchase the goods too. Workers find that it is
work to seek work further afield because their travelling expences and time lost to go further away from their homes. The lack of work results in poverty etc. This is our current crisis. Thus speculation causes the crisis and not the other way round!

Neil Lancastle - Neil L - reply
August 29, 2012 - 17:49

Has the respondent read the paper? In Figure 1, I stress the role of the Commodity Futures Modernization Act (Dec 2000) as a critical point for the US economy. My title also suggests I see speculation (in particular, leveraged speculation) as a cause, not an effect.

David Chester - Title is confusing
August 30, 2012 - 11:41

Excuse me for not getting it right but an unbiased look at the title makes the subject appears that it is the speculation what caused the crisis. I am glad to note that you don't really think this is true, but this title fooled me!