In Part Two of this series, post-World War II Keynesian policy was described in terms of the means by which real productivity gains were achieved in the American economy by coupling industrial policy with expansionary monetary policy to increase aggregate price levels faster than wages and salaries could keep up; the latter mechanism, expansionary monetary policy, was used to induce the labor force to work harder (more productively) to keep up with rising prices. The graphics presented in that installment speak for themselves: real wages—the compensation to labor net of inflation—have been at a virtual stand-still for decades; worse, in every inflation cycle, wage increases have lagged overall price increases by time frames measurable in years. This was precisely the desired effect described by the great 20th Century economist John Maynard Keynes: as long as wages are "sticky"—that is, unreactive to price run-ups in the short run—then the aggregate supply curve is not perfectly vertical, which means that stimulating aggregate demand through fiscal and monetary policy will result in real output increases. If that aggregate supply curve actually were vertical in the short run—a condition economists call "perfect inelasticity"—then suppliers would have no incentive to increase real output in the face of rising aggregate demand because there would be no greater profit since all factors of production would be absorbing their share of the price increases caused by government spending paid for by printing money at a rate in excess of the real growth rate of the economy.

The graphic at left illustrates the aggregate demand curve for a national economy. Like its microeconomics cousin, which is called a "market" demand curve (for a single good or service), the aggregate demand curve slopes downward, but that is where the similarity ends. A market demand curve is downward sloping because of the Law of Demand, which asserts that, as the price of a good or service rises, consumers will tend to buy a lesser amount of it because its price relative to substitutes is rising, thereby inducing consumers, to the extent that they can, to substitute away from it. In the national economic frame, however, when the aggregate price level rises, households cannot substitute away because the model is encompassing all goods and services of the economy, meaning that no substitution effect can occur. The national, aggregate demand curve slopes downward simply because, as the aggregate price level—all prices in the economy taken as a whole—rises, national income of households must be spread over a higher overall price base of goods and services, meaning that less total output can be purchased.

The graphic at left illustrates the Keynesian short-run aggregate supply curve. Once again, like its microeconomics cousin, which is called a "market" supply curve (for a single good or service), the aggregate supply curve slopes upward, but the similarity ends there. A market supply curve slopes upward because of the Law of Supply, which asserts that, as the price of a good or service rises, producers will re-allocate productive resources toward making and selling that good or service because not doing so means incurring the rising opportunity cost of continuing to use those productive resources for goods and services whose relative prices are now falling with the rising price of the good or service under consideration. The overall, aggregate supply curve cannot be upward sloping for this same reason, though, because, again, the entire output and price level of the whole economy is being represented, which means the aggregate amount of output being supplied is not responding to shifts in productive resources away from other goods, since all goods are under consideration to begin with. The aggregate supply curve slopes upward for another reason, and this is where the Keynesian short-run scenario diverges from the long-run view held by the previously dominant, so-called "Classical" school of economics. Keynesian economic theory holds that, as the aggregate price level rises, in the short-run, producers can make greater profits because not all of the input factors they use will be getting an immediate and commensurate share of that inflationary price run-up. The founder of Keynesian economics, John Maynard Keynes, called this phenomenon "sticky wages," because labor contracts do not have instant adjustments for inflation, so workers who are facing rising prices for the goods and services they buy have to work harder, at least in the short run, to keep up with inflation. This effect affords businesses the ability to make more money because they can charge higher prices for their output, but they do not immediately have to pay their workers—and possibly some of their other productive factors—higher wages, even thought they, the producers, are making extra money because of the price run-ups in the products they produce and sell. Hence, in the Keynesian short-run economy, an increase in the aggregate price level actually causes an increase in real output. This means the graphical depiction of a short-run aggregate supply curve represents it as upward sloping; and, quite importantly, that slope is very shallow in the short run because only a small amount of inflation at the retail level will drive producers to create considerably more output since workers will ramp up their productivity smartly in the face of the need to make more money to maintain their lifestyles in the face of rising retail prices and stagnant wages and salaries.

The graphic at left depicts how an economist of the Classical school of economics would depict the aggregate supply curve. Focusing on the long-run, a Classical economist would point out that it would be entirely illogical for any model to assert that a mere aggregate price level increase could possibly affect real (inflation-adjusted) aggregate output. Any short-run "stickiness" of wages or compensation to any factor of production would surely be temporary; in the long-run, every factor of production must command its share of an aggregate price level increase (otherwise, it would not be an "aggregate" price level increase, anyway), which consequently and necessarily means that the aggregate supply curve—at the very least, the long-run version, which is all that matters to a Classical economist—simply has to be completely insensitive to inflated prices once the inflation has settled into the overall, aggregate price structure and level of the economy. To this point, a true Keynesian would most likely agree; although John Maynard Keynes is famous for his statement, "In the long run, we're all dead," Keynesian economics as policy guidance certainly was not intended to play a short-term trick to death lest it lose its effect. Unfortunately, this is exactly what happened; neo-Keynesians and their Presidents in the 1960s and 1970s kept trying to stimulate the economy over and over again with short-term punches of money, providing liquidity for everything from social programs and war on through to amelioration of the OPEC oil embargo price shock.

With the aggregate supply/aggregate demand model in place, the first panel below depicts the Keynesian short-term economy as a robustly downward-sloping aggregate demand curve and a very shallowly rising ("highly elastic," in the terminology of economics) aggregate supply curve. At their point of intersection, the aggregate price level is just sufficient for the aggregate amount of output being produced by the national economy to meet the amount of national income able to afford to consume that output. At an aggregate price level higher than equilibrium, more output would be supplied than could be afforded, and the aggregate price level would have to back down as inventories built up; at an aggregate price level lower than equilibrium, national income could buy more, which would cause inventories to be wiped out too quickly, and the aggregate price level would be bid upward to the equilibrium aggregate price level.



The next panel, below, gets down to the Keynesian policy action. Fiscal stimulus supported by printing money in excess of the real growth rate of the economy is enacted. Because this is demand-side policy initiative, it kicks the aggregate demand curve outward from AD₀ to AD₁ as the demand side of the national economy as a whole feels the effect of what appears to be greater national income. The aggregate price level rises a little bit, which is the same thing as saying that a small amount of inflation ripples through the economy, and this is the real bite in Keynesian economic policy: the aggregate supply curve is so flat because labor cannot immediately get its share of the inflation being created by the injection of excess money into the economy, so businesses can increase real output and make higher profits because one of their big costs—wages and salaries—is not being paid more even though what they produce is commanding inflation-pushed, higher prices in the marketplace. That's why the aggregate price level in the short run does not shoot straight up to exactly reflect the excess money that was printed: labor is actually being forced to higher productivity instead of higher pay, which means inflation does not get out of hand, and real output—gross domestic product, by one measure and standard—goes up.



The third panel, below, is when the piper starts to get paid. Some of those previously "sticky" wages start coming unstuck as businesses, producing more output, have to start bidding for workers and have to deal with existing workers' contract renewals. Other factors of production previously not getting their share of the inflation settling into the economy start demanding their fair share, too. All of this means that the aggregate price level rises more aggressively. With more inputs costing more money, businesses find that the greater profits they were previously realizing with higher output prices and fixed input costs are eroding, and aggregate output begins to ease back. A further problem emerging is that, whereas that jump in real GDP might have been attended by lower unemployment, now that real GDP is pulling back, unemployment is retracing its steps back upward. This was the difficulty faced by neo-Keynesian policy in the 1960s and 1970s: fiscal stimulus designed to push the unemployment rate down to some target would do so only for a while; then unemployment would start rising again, which gave Congresses, Presidents, and ever-willing-to-help Governors of the Federal Reserve the impetus to hammer the economy with more stimulus, continually chasing an elusive, desirable "natural unemployment rate" that kept slipping away into stronger and stronger spirals of inflation.



The next panel, below, takes the long view the Classical economists had described. At the end of any series of short-run plays to push real GDP higher by stimulating aggregate demand, the end result will be that all factor prices will finally impound their share of the inflation created by fiscal stimulus paid for by increasing the money supply at a rate faster than the growth rate of the real economy. The so-called "monetarist" school of economics, in its modern form, asserts that a central bank should have one and only one duty with respect to monetary policy, and that duty is to rigorously maintain the stability of the aggregate price level. To this end, propping up the pandering fiscal programs of Presidents and Congresses, helping out the economy when recessions are looming, and all manner of other excuses for manipulating the money supply to one intended purpose or another will lead to one and only one thing: inflation. In another vein of modern conservative economic thought, the so-called "supply-side" school of economics points out that, if the long-run aggregate supply curve really is vertical ("perfectly inelastic," in the terminology of economics), then aggregate demand-management policies are exactly useless except to create inflation; on the other hand, stimulating the aggregate supply curve to shift to the right would not only cause real output to increase, but would also cause the aggregate price level to decrease, meaning that supply-side fiscal policy would increase GDP and deflate prices. (The part the supply-siders avoid discussing at length is the very real possibility that, just like aggregate demand-management policies have a consequential, show-stopper effect on the supply side, aggregate supply-management policies might very well have a similarly consequential, show-stopper effect on the demand side.)



The fifth panel, below, shows the short-term view of what will ultimately come about from the best efforts of policy-makers to use excess growth of the money supply to prop up the economy. The aggregate price level is now higher, GDP has returned to what it was before the fiscal stimulus was executed, and the aggregate supply curve is steeper, reflecting the inevitable expectations in factor markets that hints of price increases in output markets have to be matched as rapidly as possible by commensurate increases in compensation, meaning that producers have less room to increase real output to make higher profits before the factors of production start demanding higher rewards. Although businesses can postpone this era of reckoning—and with the help of certain Presidents and Congresses, they have—the eventual effect is that even the short-run aggregate supply curve becomes more and more inelastic, to the point where inflationary expectations become so embedded that factors of production act with forethought to anticipated excess growth of the money supply, and no one believes the Federal Reserve when it claims that it has stopped accommodating uncontrolled spending and irresponsible tax cuts.



As mentioned above, the Keynesians certainly understood the long-run effect of excessively expansionary monetary policy and would have prescribed using growth of the money supply only in a disciplined, counter-cyclical manner. Unfortunately, the temptation for most Presidents and their yes-men has been too great, and such expansionary policies have rarely abated and, as would have been prudent, reversed during economic booms. As the shining example of where this leads, the result was that the short-run aggregate supply curve became less and less elastic through the 1970s, and markets for labor, as well as for other factors of production, became so proactive that inflationary monetary policy actions in support stimulative fiscal policies came to be expected in advance of their actual occurrence, so, by the end of the '70s, large and increasing "expected inflation premiums" were finally being impounded into wage increases, into price increases of final goods and services, and into interest rates on loans. The effects became utterly debilitating: interest rates were impounding such high expected inflation premiums that they were causing a major slowdown in the U.S. economy, and the government had no more room to use fiscal or monetary policy as a countervailing force. The short-run aggregate supply curve had become every bit as perfectly inelastic (vertical) as the long-run version, so any stimulus to push the aggregate demand curve outward resulted in nothing but pure inflation from the get-go. In what arguably stands as the sublime example of a U.S. President falling on his sword, President Jimmy Carter in 1979 appointed hard-core monetarist Paul Volker to head the Federal Reserve. Volker immediately set about crushing the money supply, commencing a long, grueling process of absorbing all of the excess greenbacks that had been pumped into the economy from the era of Jack Kennedy on through to Gerald Ford. Because interest rates are the price of money, when the Fed rapidly contracted that money supply, interest rates—already high because of the expected inflation premium being impounded in them—went into orbit. Mortgage interest rates. for example were in the 25 percent-plus range. Worse, because labor, capital, wholesale, and retail markets did not believe for a minute that the Fed was finally serious about defeating inflation (Ford's "Whip Inflation Now" campaign comes to mind), the expected inflation premiums in interest rates and other price increases did not vanish, certainly not until everyone finally grasped that Volker meant business and did not care just how close to death the economy was getting in the regime of interest rates that, in another time in history, would have gotten bankers burned at the stake.

Eventually, after the American electorate kicked Carter out of office for being such a terrible President, the expected inflation premiums began to vanish from interest rates and other prices, and the economy got back on its feet and grew fairly comfortably throughout the first part of the 1980s. The aggregate supply curve, which had become so perfectly vertical, settled back to a more flattened, Keynesian short-run profile, and modest counter-cyclical policies by the government could once again work. A sustained stewardship over monetary policy by Governors of the Fed who considered their exclusive job as maintaining stability of the aggregate price level allowed markets the confidence to view the aggregate supply and demand conditions as reflecting far more of the real, normal, private activity of the economy than the dynamics caused by opportunistic government intervention.

Interestingly, as shown in Part One of this series, the years of the Bush Administration have been hallmarked by yet another factor of production experiencing "sticky" compensation: the stockholders, themselves, of publicly held corporations have had flat to negative real returns on their investments during the period from 2001 to present, indicating that common shareholders, be they investing in blue-chip stocks or run-of-the-mill NASDAQ equity, are losing to inflation. This means that businesses have had not one, but two resources from which they have been profiting through increases in productivity: both human capital and financial capital have been contributing to real economic growth in which they have realized little, if any, inflation-adjusted reward. The aggregate supply curve is not vertical in the short run only to the extent that suppliers are able to achieve real increased profit by raising prices and increasing output without having to pay labor more. As was demonstrated in Part Two of this series by the very fact that wages and salaries have persistently and consistently lagged general inflation throughout the last half-century, at least for several generations the short-run aggregate supply curve has been relatively flat for considerable periods; but now, in these first years of the 21st Century, that short-run flattening effect has been boosted by the depletion of real gains by not one, but two factors of production, labor and equity capital. This goes a long way toward explaining why rewards to other factors like land, physical capital, and the human capital of top managers have been rising so aggressively: they have had extraordinary leeway to absorb part of the share being lost both by rank-and-file workers and by similarly rank-and-file equity investors.

But surely, one might argue, a President as conservative as George W. Bush, buttressed by a solidly Republican Congress, would not have gone hog-wild with using monetary policy to prop up fiscally irresponsible spending and taxation policies just to keep the American economy growing. Unfortunately, the record—the part the Federal Reserve still reports—speaks otherwise. The last graphic, below, tracks the three broad monetary aggregates, M1, M2, and M3, with the reporting of last of these, M3, having been suspended by the Fed in early 2006 for reasons that are rather immediately obvious.



In the Summer of 2004, the Federal Reserve Board, under the leadership of its new Chairman, Ben Bernanke, intoned that the central bank would no longer pursue an "accommodative" monetary policy, which was taken to mean that the Fed's excessive printing of money—first, to blunt the recession of 2001, then, later, to prop up massive tax cuts and a global war on terror, among other things—was at an end. The graphic above tells a decidedly different story.

By way of brief explanation, the three money stock aggregates go in order from money that is the most liquid—that is, the most easily traded for goods and services—on through to money that is relatively illiquid. M1 reports the amount of cash and currency, plus demand deposits (bank checking accounts), Travelers Cheques, and negotiable order of withdrawal accounts (such as "checking" accounts at credit unions). M2 includes M1 and money market accounts, small time deposits, and smaller savings accounts. M3 includes M2 plus large time deposits and very large savings account-type instruments, institutional money market accounts, short-term repurchase agreements, and other large deposits like those in eurodollars. In the money aggregates graph, above, the Fed was, indeed, serious about clamping down on growth of the money supply, as long as "money supply" is taken to mean M1, the cash, currency, and checking accounts most normal people have; in fact, by 2006, the central bank had brought the year-over-year growth rate of this money stock down to an average of about zero, indicating a strict monetary discipline in line with an anti-inflationary policy regime.

However, the growth rates of the broader money aggregates render compelling evidence of a far different Federal Reserve when it comes to money in the larger metrics. After what appears to have been a spirited contractionary effort at the beginning of the post-accommodative period, the central bank let loose of M2 and M3. The growth rate of M2 has been slowly accelerating to the point where it stands at better than five percent, which is unquestionably much higher than that of the economy. But the big not-so-secret secret is M3, the aggregate the Fed stopped publishing in March of 2006. This broad, huge money stock, representing everything in M1 and M2, plus giant institutional deposits, eurodollars, and others masses of big money, has been growing at an accelerating rate that now tops fifteen percent a year, roughly five times the most optimistic estimate of the growth rate of the American economy; and this has been going on since long before the recent, widespread talk of a looming recession.

Worse yet, all three of the aggregates were growing well above the growth rate of the economy throughout the Bush Administration, with the growth rate only of M1 finally being cut to nearly zero in order for the Fed to show grave dedication to fighting inflation.

Recall the explanation above about what happens to the aggregate supply curve when economic stimulus through expansionary monetary policy continues for too long. Once that curve has become highly inelastic, all the demand-management policy initiatives in the world will do no good to pump up real GDP; and with a Federal Reserve allowing the total money supply to grow at an ever-accelerating rate, the inevitable spiral of inflation will most assuredly come, and it will be the next President, his or her Federal Reserve Board, and the Congress that must take the drastic, painful, awful steps necessary to rectify, repair, and clean up what will by this time next year be an economic catastrophe created by the stupefyingly irresponsible policies of George W. Bush, his Federal Reserve, and a Congress controlled for most of his Administration by Republicans who, in retrospect, appear to have had no grasp of the long-term consequences of their economics policies.

As John Maynard Keynes said, "In the long run, we're all dead." For the United States, the long run is about to arrive.


The Dark Wraith trusts the American electorate to vote for a President thoroughly capable of managing the economics of wreckage.