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Circuit theory extended: The role of speculation in crises

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  • Lancastle, Neil
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    Abstract

    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

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    Bibliographic Info

    Paper provided by Kiel Institute for the World Economy in its series Economics Discussion Papers with number 2012-30.

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    Date of creation: 2012
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    Handle: RePEc:zbw:ifwedp:201230

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    Keywords: circuit theory; macroeconomic simulation; carry trade; banking regulation; interest rate policy;

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    1. Christian Hellwig & Guido Lorenzoni, 2006. "Bubbles and Self-enforcing Debt," Levine's Bibliography 321307000000000383, UCLA Department of Economics.
    2. Christoph Fischer, 2004. "Real currency appreciation in accession countries: Balassa-Samuelson and investment demand," Review of World Economics (Weltwirtschaftliches Archiv), Springer, vol. 140(2), pages 179-210, June.
    3. Alvaro Angeriz & Philip Arestis, 2007. "Monetary policy in the UK," Cambridge Journal of Economics, Oxford University Press, vol. 31(6), pages 863-884, November.
    4. Philip Arestis, 2009. "New Consensus Macroeconomics: A Critical Appraisal," Economics Working Paper Archive wp_564, Levy Economics Institute, The.
    5. Bela Balassa, 1964. "The Purchasing-Power Parity Doctrine: A Reappraisal," Journal of Political Economy, University of Chicago Press, vol. 72, pages 584.
    6. Miklos Koren & Peter Karadi, 2009. "A Spatial Explanation for the Balassa-Samuelson Effect," 2009 Meeting Papers 891, Society for Economic Dynamics.
    7. Fama, Eugene F, 1991. " Efficient Capital Markets: II," Journal of Finance, American Finance Association, vol. 46(5), pages 1575-617, December.
    8. Keen, Steve, 2010. "Solving the paradox of monetary profits," Economics Discussion Papers 2010-2, Kiel Institute for the World Economy.
    9. Stephan Schulmeister, 2005. "The Interaction between Technical Currency Trading and Exchange Rate Fluctuations," WIFO Working Papers 264, WIFO.
    10. Hyman P. Minsky, 1992. "The Financial Instability Hypothesis," Economics Working Paper Archive wp_74, Levy Economics Institute, The.
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