Michael Pettis — China, Europe, and optimal currency zones

I typically think of four main factors that determine whether or not an economy can function efficiently as a single currency or economic zone. They primarily determine the level of adjustments costs and how these costs are to be shared, so that regions more able to bear the costs absorb a larger share of those costs:

1. Labor mobility. If workers can move from one part of the economy to another with low frictional costs (which range from legal restrictions to transportation to language and other social barriers), this reduces the distortions caused by differing growth rates in different parts of the economy. Workers move easily from where they are less valuable to where they are more valuable, reducing downward pressure on wages in the weaker parts of the economy and increasing the value of labor overall.
2. Capital mobility. The same is true if capital can move easily from one part of the economy to another. Declining prices and costs in the weaker parts of the economy should attract investment from the stronger parts.
3. Fiscal policy. Mechanisms that allow an entity (usually the government) to transfer wealth from rapidly growing sectors to more slowly growing sectors – most obviously income taxes used to fund unemployment benefits – help reduce the disparity between sectors that are growing at very different speeds. This helps stabilize the economy overall.
4. Monetary policy. The transmission of monetary policy should be consistent both in timing and effect so that interest rates reflect the needs of the different parts of the economy. This is always hard to do unless each economic entity imposes strict capital controls and has its own discrete monetary policy, and while capital controls are hard enough for a country to impose successfully, they are much harder to impose at a sub-country – e.g. provincial – level.

Although I think China is clearly much more integrated as an optimal currency zone than Europe is today, it is probably less integrated than the US (I will use the US and Europe as the two extreme cases between which China falls).

Kind of a non-issue since China is a sovereign country that is the sole provider of its currency. Although China does not borrow in a foreign currency, it is not a currency sovereign since it pegs its currency to the USD. This is the key difference between China and the US. As a currency issuer, China is also very different from the EZ countries in that they are currency users rather than issuers. However, the post is interesting in that it outlines some of the challenges that China faces.

China Financial Markets

China, Europe, and optimal currency zones
Michael Pettis