Since writing the post advocating local currencies in the euro periphery, Torrens has discovered that quite a few of these are popping up in the periphery – apparently there are 325 of them in Spain alone! They were popular in pre-crisis Germany too. So, it seemed like an opportunity to think about the circumstances in which these currencies would appear and whether they are really as useful as originally hoped. Can local communities (residents and businesses) partially take over the role of the ECB?
In a nut shell, local currencies:
- are a temporary monetary solution that coulld reduce slack in the local economy
- can provide monetary stimulus when the usual (national) monetary transmission mechanism isn’t functioning properly (or possibly when national interest rates are higher than required to maintain local price stability) and hence boost output and reduce unemployment
- can also introduce a distortion into the economy that, under some circumstances, could act as a “tax” on purchases of non-local goods (most likely when the local dollars are paid to unemployed workers or cash constrained individuals). This tax might also cause too many local services to be produced and consumed.
- Because the tax discourages imports, it also means that the monetary stimulus generated by the local currency is less likely to leak out of the region or cause increase indebtedness in the region.
The rest of this post is a bit long and academic in nature, for which TH makes no apology.
What is a local currency?
Local currency is what economists call scrip. It is typically a money issued by a local retailers association or a local council, but there are electronic (purely private) forms of it on the web too (often to avoid taxes). Typically, it is 100% backed by a national currency on deposit at a bank (local dollar for national dollar) and can be spent at local businesses that choose to accept it. Because money relies on a network effect (I am more likely to accept it if I know you are prepared to accept it) it is unlikely that the money will be usable outside of the local region and is more likely to be successful the more local retailers are prepared to use it. There is nearly always a fee for conversion back into the national currency and sometimes local currencies lose value over time (called demurrage — the Albertan prosperity certificate had this trait), which makes them circulate faster.
If the local chamber of commerce wanted to start a local currency, it would need to get as many members to participate as possible. Depending on the set up, these will tend to be retailers of locally produced goods and services that will find it easier to get rid of their local money by paying wages, giving it away in change or paying suppliers, than say wholesalers of goods imported into the region or easily exported out of the region (traded goods). To get started, the retailers would have to raise $20,000 of national dollars and deposit it at a bank. This deposit would then be used as backing for $20,000 local dollars that the retailers would have to get printed. The 100% backing ensures that there can never be a run on the local currency – every dollar can always get converted back into the national currency. That being said, the chamber of commerce typically charges a fee to anyone who wishes to convert local dollars back into national dollars, say about 10%. Sometimes the chamber of commerce will require that the local currency get “stamped” periodically for a small fee (say 2% of its face value) in order to remain valid. This means that the currency is depreciating over time so people will want to spend it faster. It is reasonable to assume that the local chamber of commerce will incur some administrative costs (the cost of printing and storing the money as well as organising their members etc., which can be high).
Assuming some degree of success (a decent network effect), local residents will be willing to use the local dollars to buy locally made goods and services (e.g. to buy a nice loaf of bakery bread) and sometimes for their novelty value. They probably won’t keep them as a store of value and will not use them as a unit of account – that is what the national currency is for (amongst other things).
So here are the key questions:
1) When is it beneficial to the local chamber of commerce to issue a local currency?
2) When is it beneficial to the local community?
3) When is it beneficial to the country as a whole?
When is it beneficial to the local chamber of commerce to issue a local currency?
The local currency will prove to be beneficial when the extra revenues (if any) to the local retailers exceeds the administrative costs. Let’s ignore the costs and assume that prices don’t change because of the local currency (at least initially). The cases when nothing happens are easy to figure out. First, nothing happens if you have enough national currency to make all your planned purchases of both local and traded goods. Nothing will happen either if the amount of national currency in your pocket just happens to be sufficient to buy the amount of traded goods you need, and the amount of local currency sufficient to buy the local goods.
In the cases when nothing happens, the chamber of commerce can still benefit, some of the local currency might get lost, or held on to as a souvenir, and so the chamber of commerce will never have to redeem those. But this revenue is likely to be small, so let’s ignore it.
Things get interesting when you haven’t got enough national currency to buy the traded goods but more than enough local dollars to buy the local goods. Because then you have a problem, you have to decide whether to exchange local dollars for additional national currency at an exchange rate of 90cents per dollar of local currency, or buy more non-traded goods. In this case each additional traded good you plan to buy now costs you 10% more. The fee for converting the currency is just a tax on consumption of traded goods, so you will tend to buy less of them and more of the local good. In this way it is like the local currency exchange rate has been devalued (at least on the consumption side). And it is this mechanism that will drive an increase in revenues for the non-traded sector.
A good example of someone who might open their wallet and find a mix of local and national currencies such as this is an unemployed worker who gets hired by the local bakery to deliver bread. If they don’t have a lot of national currency savings to draw on then they will find that their weekly cash budget has more local currency than they would prefer. A not so obvious example is the person who is accumulating more local cash than they plan to spend in the future. These people will try to get rid of excess local currency by spending it (just like if you were travelling overseas and ended up with too much foreign currency in your pocket at the end of the trip and didn’t want to hold on to it or pay the penalty to exchange it). This effect is enhanced if the local currency depreciates over time. Another possibility is that a person may simply misjudge their (national) currency needs because of unexpected events.
Thus, it is possible that the distorting convertibility tax can boost the revenues of the chamber of commerce, but it does so at the expense of whoever has to hold it. So it may be beneficial for the chamber of commerce but not necessarily the residents of the local community.
When is it beneficial to the local community?
Despite the negative consequences for the holders of the cash, the introduction of the local currency could still be beneficial to the local community by acting as monetary stimulus. Monetary policy is set at the national level, and is not perfectly tailored to local conditions. If the local economy was in a sufficiently bad slump, then having the local community issue currency – especially if it can get it into the hands of people who are short of cash and will spend it – can be quite beneficial. It might even be the local council using the cash to fund local projects.
You might argue that there are, in a way, already local monies that circulate alongside the national one in the form of bank deposits. Bank deposits are private money (or inside money as monetary economists call it) and the creation/destruction of inside money is a key channel through which monetary policy is transmitted to regions such as those that we have in mind. Private banks create bank deposits by making loans and depositing the money into people’s bank accounts. Under a system where there are no reserve requirements and when all is going well, banks can freely expand the supply of deposits at an interest rate similar to the central bank’s policy rate. So in principle, if the local economy was in a bit of a slump, people could just go to the bank and borrow money and spend it to make up for the shortfall in demand. No need for anyone to set up a Spanish Spud.
But suppose local borrowers used the bank loan to buy traded goods (i.e to buy imports). Then instead of being deposited back at a local branch, the local bank’s cheque gets spent on TV that was made in some faraway place, and the cheque gets deposited in another bank there The region thus has a trade deficit, and the local bank potentially has a problem. Because it made a loan and didn’t get the deposit back, it now owes the far away bank money and will have to ask it for a loan to balance its books. This would be OK in normal times, but if the local bank is stressed (because of slack in the local economy), the faraway bank won’t be forthcoming with the loan.
In such a situation, the local bank would be OK if it could be sure that the loan would get re-deposited back at one of its branches. Suppose the bank lent the money to the local chamber of commerce, who promised to leave the loan on deposit in the bank and used the money to back its issuance of a local currency (dollar for local dollar). If the local dollars are going to the cash strapped, who spend it all on local goods, then this scheme could boost local demand and reduce unemployment without causing increased indebtedness. These benefits would have to be weighed against the costs of excessive consumption of local goods. When the increase in local currency just encourages people to use national currency to buy more imports, then there would be no difference between creating local currency and relying on the usual bank channel.
So creation of local currencies could be beneficial, but it would require that the local community be experiencing an economic slump, and that there wasn’t sufficient money to fully meet people’s demand for money already.
Is it beneficial to the country?
The answer might be yes, to the extent that it simply boosts local demand without detracting from demand in the rest of the country. But the problem is when local currencies start to be used to steal market from other communities. You can imagine two local regions using local currencies to try and dissuade local residents from shopping in neighbouring towns. This can happen because of the network effect – money is only useful if there is someone else that is willing to accept it as payment. So if you have a local currency in your pocket you tend to shop locally rather than in the other town. Surely everyone would be better off if the two communities decided to simply use one common currency and not two. By induction you get to a point where it seems sensible to abandon local currencies altogether in favour of one national currency. Which makes TH wonder, perhaps a “Spanish spud” would be better than a “Barcelona Bit”. But that said, he rather likes the idea of people not politicians solving the crisis in their economies.