Bifurcated Monetary expansion and low inflation…

Low inflation continues to be a concern in Europe and the US, especially in Europe. Central bankers project that inflation will rise as the economy gets closer and closer to full employment. Yet, what is behind low inflation?

I refer to the work of Michael Pettis who is a professor of finance at Guanghua School of Management at Peking University in Beijing. He puts low inflation in China within the context of financial repression.

“…why is it that what seemed by most measures to be an extraordinary surge in money creation did not also result in significant wage and consumer price inflation?

The answer, I will argue, has to do with the nature of money growth in financially repressed economies. Because the Chinese financial system is so severely repressed, money growth in China cannot be compared to money growth in a market-based financial system. Monetary growth is effectively bifurcated and affects producers and consumers in very different ways.

What does it mean to say that monetary growth was bifurcated? By this all I mean is that nominal money growth showed up as different rates of money growth for different parts of the economy. More specifically the rate of monetary growth for producers exceeded the rate of monetary growth for consumers, and this becomes clear by measuring the monetary impact on different sectors within the economy of monetary expansion under financial repression.

Countries with significant financial repression can experience periods of rapid monetary expansion with results that do not conform to normal expectations precisely because of this bifurcation in the monetary impact of credit creation.  On the production side of the economy it is easy to see in China over the past decade what looked like the consequence of rapid monetary expansion – rapid growth in credit, rising productive capacity, surging production of manufacturing goods, asset bubbles, etc.

“On the demand side of the economy, however, and especially considering household consumption, one gets a very different view – monetary expansion seemed to have been very subdued. Household consumption typically grew much more slowly than GDP and its share of GDP declined steadily.  Consumer price inflation also tended to be low or moderate even in the face of what seemed like rapid monetary expansion.”

Financial repression is not recognized in the US. However, there is a monetary bifurcation related to labor share. And in China over the last 16 years, along with financial repression labor share fell in China by quite a lot. Andrew O’Connell pointed that out today. He cites that in Guangdong, labor share fell 20% over 10 years. Capital share would have risen 25% as a result. That is a large bifurcation in monetary potential.

As labor share falls in the US and Europe, is household consumption also being subdued by a bifurcation in monetary expansion? Yes… We see consumption by capital income rising fast, while consumption by labor income is extremely weak. (source) This is evidence of bifurcation.

US Nonfarm business sector Labor share fell from 109.6 in 2000 to currently 96.6. (source) That is a 12% point drop, which is comparable to how much labor share fell in some parts of China over the same time period. And if you assume an actual economic labor share drop from 75% to 66% (a 12% drop), capital share then rose from 25% to 34% (a 36% rise!!!).

What is behind low inflation? … Monetary expansion is bifurcated.