This website contains the data, simulations and results for the Economics eJournal papers 'Circuit Theory extended: the role of speculation in crises'.

Introduction

Why have modern finance and the efficient market hypothesis failed to explain long-term carry trades; persistent asset bubbles or zero lower bounds; and financial crises.

Before the 2007 Financial Crisis, some alternative economists did 'see it coming'. Their models used accounting techniques and something called the Theory of the Monetary Circuit (TMC).

This website has models that show how an Extended Monetary Circuit (EMC) works. There are two circuits: banks lend to businesses, and they lend to households. These models suggest that the interest rate set by the central bank is not neutral, and that economies are unpredictable.

Unlike neoclassical economics, EMC includes concepts such as a living wage, and asset price inflation (speculative bubbles). The possibility of stable high and low interest rate economies emerges. Where interest rates are high, powerful banks divert surplus loan interest to productive and financial investments. With speculation, banks prefer to invest in markets with high investment gains, and to lend in markets with low investment gains. This makes the system precariously liquid/illiquid.

The paradox of a speculative bubble, where loans never get repaid, is that banks rely on systemic crises, debt expansion, and further speculation, to maintain solvency.

Carry Trade

Following the methodology of Godley and Lavoie, spending is treated as the redundant equation. The central bank rate (a component of rL) is not neutral.

Banks prefer to lend money where returns (r) are low, and to invest where returns are high: the carry trade.

Banks prefer high rates, and households prefer low rates. Banks also prefer higher household lending. Households prefer lower household lending, but higher business lending. Two ratios stand out as particularly important. The wage rate (wr) is the ratio of wages to business loans, and shows how much household spending is met from wages. The ratio of household to business loans (ah/ab) shows how reliant bank spending has become on household lending.

A series of graphs shows how these ratios have varied for the US, UK and Greece. In the US and UK, the wage ratio dropped below the household lending ratio in 1984 and 2001, respectively. In the European countires examined so far, Greece shows a similar cross-over pre-2005 (OECD data), but wage data are hard to find.

Austerity

There are three bailout simulations.

i) Bank bailouts.

ii) Household bailouts.

iii) A Keynesian boost .

Each simulation begins with the same parameters and settings. Bailout money is spent at the rate of 25% p.a.

i) With the household bailouts, there is an immediate increase in household spending as a consequence of the reduction in household loan payments.

ii) With the Keynesian boost, wages rise, consumption increases and there is even an increase in bank spending, due to the higher business loan payments.

iii) With the bank bailouts (assuming the money is spend, and not retained), the outcome depends whether or not wages are 'sticky'.

If wages are not 'sticky', businesses pay down their loans, and wages (which are a function of business loans) reduce. This shrinks the economy.

If wages are 'sticky', businesses still pay down their loans, but maintain wages with the additional bank spending. The model shows emergent behaviour. Households reduce their spending, and increase their loan payments. As bank spending reduces, businesses increase their loans to maintain wages, and a new equilibrium is reached. The long-term effect is the same as the household bailouts, but it is reached more slowly, with an intervening period of austerity.

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Introduction

Carry Trade

Austerity

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