Friday Flashback: The Folly that is “Local” Currency

alternative currencies, LETS, Local Currency, Mutually Beneficial Exchange, negative interest
Photo by Brad Holland, courtesy of Dana Lee Ling.

micronesian-yap-money-2(In light of a recent article in The Economist bearing out its main arguments, we thought it appropriate to devote this week's Friday FLASHBACK to this July 2011 post -Ed.)

How’s this for a great idea: we build a small fleet of cars, and market them to people in the local community. How do we compete with Ford, G.M., Toyota, and all those other huge car companies? Easy. You see, our cars will have special octane requirements that will prevent them from refilling at ordinary gas stations. Instead, we’ll set up a few local stations that will be the only ones equipped with the right fuel. To top it off (so to speak), our cars will also have small gas tanks to prevent them from reaching the next town on a single tank. (Should we decide to go electric, we can instead equip them with special plugs and voltage requirements to accomplish the same result.) What all this means is that unlike other cars ours—call them “LETS” for “Local Energy Transportation Systems”—can only be used around town. That way, people who go shopping with them have no choice but to shop locally, and so contribute to boosting the local economy. Who wouldn’t want to do that?

The answer, to get serious, is plenty of people wouldn’t. Even people who like to buy local don’t like having to do so; and the option of driving out of town, whether to shop or for some other reason, is valuable. So a car that can go anywhere is worth more—for many a lot more—than one that can’t, which means that so long as Ford or Toyota or any other manufacturer can make a decent “national” car for no less than what the local alternative would cost, we’d better leave making cars to them.

Such reasoning presumably explains why there’s no such thing as a Local Energy Transportation System aimed at challenging existing car makers. Yet there is such a thing as LETS: it stands for “Local Exchange Trading System,” and there are now several hundred such systems in operation around the world. LETS are part of a still larger “local currency” movement. Like the fictional LETS we were just toying with, actual LETS and other local currency arrangements are designed to encourage people to shop locally. The UK LETS website, for example, boasts that, unlike ordinary money which “is quickly sucked out of the area where it has been created,” LETS “stays local, benefiting the community, rather than outside-interests.” The schemes’ promoters see to it that their currency won’t “leak out” of the local economy by encouraging local merchants and banks to accept it, while scrupulously refraining from encouraging “outsiders” from doing so. In short, they make a virtue of their currencies’ limited usefulness—of the fact that, unlike most exchange media, they are not generally accepted.

This strategy ought to make local currencies about as desirable as cars that can only run on local gas. Yet (if Wikipedia’s experts can be trusted) there are some 2500 such local currency schemes afloat, with new ones popping up all the time. So are monetary economists wrong in supposing that to be any good money has to be generally acceptable? They aren’t, and the proof is that the 2500 local currency systems collectively represent an insignificant part of the world money stock, and that the vast majority of such schemes that manage to get off the ground collapse after a few years, if not sooner. As for the few that have lasted longer, almost all are, by no coincidence, located in (mostly “liberal”) communities where strong “buy local” sentiments prevail. This means that there are relatively large numbers of people who feel good about shopping locally, for whom the opportunity cost of employing a strictly local currency is relatively small. For such consumers using local currency is like clipping coupons for stuff one plans to buy anyway. As for the banks that agree to accept local currency, most do so solely for public relations reasons, and despite the fact that local currency dealings eat into their profits, as is evident from the general reluctance of banks with large out-of-town networks to participate.

More importantly, the object that the local currency movement would achieve if it could—that of of “keeping trade within the community”–is, like all forms of protectionism, a highly dubious one: As Tim Harford succinctly puts it, “the gains from more trade with locals are more than offset by the losses from less trade with strangers. Otherwise economic sanctions would be a blessing.” (Try telling a Palestinian or Cuban about the virtues of “buying local”!)

Besides constraining people to buy locally, many local currencies are designed to yield “negative” interest, by losing value relative to national money according to a fixed schedule, or by expiring entirely after a certain period, or both. The idea here—one first popularized in the 30s by Silvio Gesell—is to discourage people from holding on to local money, thereby increasing its velocity, so that a given quantity results in that much greater a boost to local spending. Here again the aim of boosting local spending is at loggerheads with that of making local currency an attractive substitute for national currency. To return to the “local car” analogy, it would be like saying to a prospective car buyer, “Look, our cars’ bodies rot fast, so you’ll have to go shopping more often to get your money’s worth!”

This isn’t to say that local currency can never serve any purpose apart from that of allowing some people to better display their kind disposition toward local merchants and producers (or, perhaps, their poor understanding of basic economics). Historically, local currencies have played a crucial role in sustaining exchange when national alternatives were in short supply, as happened during the Great Depression (when in many communities “scrip” made up for vanished or inaccessible bank deposits), and as happened in late 18th-century England (when private mints and coin issuers made up for a dearth of official small change). Despite its inconvenience local money is of course better than no money at all; besides, the further back one goes the less onerous local currency becomes, since people traveled less anyway.

Though the shortcomings of local currency are serious ones, they are far from being inherent shortcomings of all substitutes for official (national) currencies. On the contrary: far from being inherent to such substitutes the shortcomings of local currencies are ones which, as I’ve indicated, have been purposely built into those currencies by persons seeking to make them serve an end quite at odds with that of making it as easy as possible for people to exploit potential gains from exchange. There is, in fact, nothing to prevent other kinds of unofficial currency from commanding a national market. The key to having them do so is that, like modern bank deposits, they must be fully compatible with the existing monetary standard, and readily useful throughout the national economy, if not beyond it. Historically, private banknotes have possessed these qualities wherever legal restrictions haven’t prevented banks from establishing branch networks or taking other measures to make their notes current beyond the banks’ headquarters; and it is conceivable that other forms of private currency, including privately-issued token coins, could also take the place of government-supplied alternatives, if only the government would let them.

So, while I applaud the effort of local currency proponents to break the Federal Reserve’s currency monopoly, I regret that they’ve chosen to sabotage this merit-worthy mission by linking it to the much less worthy one of keeping people from trading with “outsiders.” As the ever-sensible Bastiat once observed, “The worst fate that can befall a good cause is not to be skillfully attacked, but to be ineptly defended.”

  • speedmaster

    GREAT column, I'll link to this tomorrow, thanks.

  • jamesoswald

    Still, local currencies are better than barter. If monetary disequilibrium is correct, they should be counter-cyclical.

  • Tom Dougherty

    “Buying local” and “local currencies” have the same goal of keeping money in local hands, whether the money is US currency or some newly created local currency. Both of these are mercantilist schemes that believe keeping money in the local economy will make everyone wealthier, when in fact, it is the goods and services that money can buy that make us wealthier. Having more money in circulation will just drive up prices. The “buy local” mentality at heart is a mercantilist fallacy that confuses money with wealth.

  • Doc Merlin

    And what's great is the EXACT same arguments apply to national currencies. Yay for denationalizing money.

  • RalphMusgrave

    George Selgin claims that using a local currency is a form of protectionism. I can see his point, but I suggest that protectionism consists of FORCEFULLY preventing someone buying something. Local currencies rely on persuasion, idealism, etc, not force.

    He then criticises the fact that local currencies are sometimes designed to lose value so as to encourage their use. Exactly the same strategy if often suggested in respect of the US dollar: i.e. "let's boost inflation so as to increase demand and escape the recession." So the two currencies are equally defective in that respect.

    I fully agree with his point that “Historically, local currencies have played a crucial role in sustaining exchange when national alternatives were in short supply..”. Therein lies the main merit of local currencies: during a recession, i.e. when Keynes’s paradox of thrift rears its ugly head, there is a shortage of the standard national currency. I suggest local currencies facilitate local trade in this scenario. The latter is inefficient trade, but it’s better than nothing.

    • George Selgin

      Ralph, I meant to suggest that local currencies are "protectionist" in the sense that their issuers are motivated by protectionist beliefs. I quite agree that their voluntary nature makes them relatively inoffensive and harmless.

      As regards the dollar, you must bear in mind that most local currencies have values fixed to it, allowing often for a "discount" factor. So, to the extent that they are designed to include special Gesell-like features to make them lose value over time, they must loose it relative to the dollar as well.

  • MichaelM

    Coincidentally, George, I was just reading your section in 'The Experience of Free Banking' on free banking in Fuzhou. In it you note that some of the smaller local banks would circulate currency that was really only used locally and, sometimes, even only on the same street as the bank in question.

    What makes these currencies different, besides the obvious public/private distinction?

    • George Selgin

      For starters, Michael, the Fuzhou bankers didn't treat the limited circulation of their notes as a virtue; it's just that their credit didn't go further than that. Nationally (or at least regionally) current (copper-based) paper money would have been better, other things equal. But this was also a situation in which trade itself was heavily localized, and banknotes–any banknotes–were an improvement upon copper cash.

      In sum, my beef isn't with local currency per se. It is with those who insist on treating limited circulation of a currency as a virtue, and who do so on faulty economic grounds.

  • Redmond

    Great piece George, what is your republishing policy?

    • George Selgin

      I'm told that we free market types shouldn't believe in policies, so be my guest, Redmond! Please consider throwing in a plug for

      • Redmond

        Will do! Thanks!

      • Redmond

        Oh yeah I really enjoyed your talk "A Century of Failure: Why It's Time to Consider Replacing the Fed" – great stuff!

        We are looking to get some research done on the BoC along similar lines! ;-)

  • Spencer Hall

    "as happened during the Great Depression"

    The loss of faith in the private commercial banks had become so pervasive by the end of 1932, banks were being forced to liquidate by the thousands. People everywhere were attempting to convert their demand and time deposits into currency. Thousands of towns and cities throughout the country were attempting to finance their daily commerce without a single operating bank. And by March, 1933, just before Roosevelt’s “banking holiday” there were even entire states without a single operating bank.

    The thing is, the E-$ is not the same as the U.S. $. – just as CNY/CNH

    • Ray Lopez

      Yawn. I've talked to people who lived through the US bank crisis of the Great Depression of 1933/34. Only a few people lost everything, mostly in the US South. And from what I understand, the ones that did lose everything and had a lot of money in the bank that failed were told: 'pick any of these foreclosed properties as compensation for losing everything; the property will be yours', and, according to rumor, the lady that picked such a property got rich when that property went up in value tremendously after WWII.

      • Spencer Hall

        I figured you were young. The GD produced failures and severe hardships and people hung themselves in their barn lofts.

        • Ray Lopez

          Evidence Mr. Hall, evidence. FYI, suicide rates hardly change during good times or bad, but indeed GD suicide rates went up, but then again the rates were nearly as high during WWI (Google this). As for being young, I may be younger than you but it's doubtful that you lived through the GD. As I say, hardly anybody lost all their money, and arguably, as George Selgin would know, without FDIC deposit insurance there's less moral hazard and hence a more robust bank system. The GD was a natural phenomena that burned itself out, Andrew Mellon was right.

          • Spencer Hall

            Nothing normal at all about the GD. It was almost inevitable. It wasn't until 1933 that the FRB-NY operations were set up correctly. But then there was no eligible collateral for the banks. FDIC insurance wouldn't have mattered.

            It was not until 1933 that we began to unshackle our paper money from the numerous and unnecessary restrictions pertaining to its issuance. With the numerous types of paper money in circulation at the time, this would seem to have been a non-problem. Here is the list: gold certificates, silver certificates, national bank notes, United States notes, Treasury notes of 1890, Federal Reserve Bank notes, and Federal Reserve notes. With that array of paper money there should have been plenty to meet the liquidity demands placed on the banks by the public. But the volume of each type that could be issued was so circumscribed by restrictions that even the aggregate group could not begin to meet the panic demands of the public.

          • Ray Lopez

            Yawn. Try and study the graph at Wikipedia on the Gold Standard (GS) during the GD, the chart on per capita GDP by year, and tell me why the countries like Argentina and Germany had a GDP that went *down* after going off the gold standard, and numerous countries had no change in GDP/capita after going off the gold standard, and some that stayed on the GS had no change either, and only the US, UK and maybe Japan benefited from leaving the GS?

            Here, I'll make it easy for you: ("Ending the gold standard and economic recovery during the Great Depression"). Simple explanation: leaving the gold standard is irrelevant. When the US/UK recovered from the bank panic of 1933/34, as had happened many times during the 19th century under a true gold standard, their economies recovered, as did some of their trading partners. Or, Mr. Hall, you can believe in whatever you wish; relativism is common in economics.

          • Spencer Hall

            The intention of the framers of the 1913 Federal Reserve Act was to establish a unified banking system under 12 central banks. There were many flaws in the original Act, one being the establishment of 12 rather than one central bank. The fatal flaw was not making membership in the System compulsory for all money creating institutions. And had not Franklin Roosevelt declared a “banking holiday” in March 1933, the lack of confidence in the banking system would have resulted in the failure of virtually every bank in the United States.

            Some unprecedented things have been happening since the coming of the “New Deal” in 1933. On a year-to-year basis, Federal Reserve Bank credit has always expanded. The same applies to commercial bank credit, and the means-of-payment money supply. The consumer price index has fallen on a
            year-to-year basis in only two years, 1937 and 1949. The chief factor affecting the level of long term interest rates since the early 1950’s is inflation expectations, not the level of business activity.

            We now actually have a Central bank. It is called the Federal Reserve Bank of New York. An amendment to the Federal Reserve Act in 1933 established The Federal Open-Market Committee and gave it the power to
            control Total Reserve Bank Credit. The Fed can now buy an unlimited volume of earning assets. (with the federal debt at over 19 trillion, and expanding, and billions of dollars of “eligible paper” available, the term “unlimited” is not an exaggeration in terms of any potential needs of the Fed.) In the process of buying Treasury Bills etc., new Inter-Bank Demand Deposits (IBDDs) are created. These deposits can be cashed by the banks into Federal Reserve Notes, without limit, on a dollar-to-dollar basis.

            Today, the public, seeking to cash their deposits, would soon have a surfeit of paper money. A general run on the banks is impossibility. Where the Federal Deposit Insurance Corporation cannot handle the situation (Continental Illinois, for example), the Fed will guarantee the liquidity of the bank’s deposits. In other words, a liquidity crisis leading to the wholesale failure of commercial banks is impossible. Where banks are allowed to fail, or are absorbed into solvent banks, customers never suffer losses if their deposit does not exceed $250,000. The fed intervened in the Continental case because many corporations, foreign and domestic, had deposits
            far in excess of $100,000.

            These institutional changes plus the numerous “safety nets” now provided business and consumers preclude a recurrence of a “Great Depression”.

            In the period from 1929 – 1932 stocks were spiraling down, unemployment was becoming endemic, businesses were failing in increasing numbers, bank failures were accelerating, and millions of people were suffering severe malnutrition, there was not a single piece of legislation passed by Congress or action taken by the administration which had any significant effect in stemming the tide of economic disaster.

            In retrospect, the answers to the depression seem simple. We needed a central bank that could and would pump IBDDs into the commercial banks in a volume sufficient to satisfy the public’s demand for currency, specifically paper money (currency is an asset the Fed does not, should not, and cannot control).

            In the control of the monetary aggregates, the monetary authorities are completely dependent on their power to control the volume of bank credit. They have no power over the volume of the Treasury’s General Fund Account or the currency holdings of the public.

            It was not until 1933 that we began to unshackle our paper money from the numerous and unnecessary restrictions pertaining to its issuance.

            Today we have only the Federal Reserve Note, and there is only one restriction placed upon its issuance. No Federal Reserve Note can be put into circulation unless there is a prior transaction involving the relinquishing by the public of an equal volume of bank deposits, and an equal diminution of the holdings of IBDDs on deposit with the Federal Reserve Banks; In
            other words, the issuance of our paper money contains no inflationary bias. Its issuance does not increase the volume of money. It merely substitutes one form of money for another form

            The last vestige of legal reserve and reserve ratiorequirements against the Federal Reserve Note, demand deposit, and inter-banks demand deposit liabilities of the District Reserve banks was eliminated in 1968. Today the Federal Reserve Note has no legal reserve requirements, and the capacity of the Fed to create IBDDs has no legal limit. These IBDDs are owned by commercial banks; they are bank reserves and can be converted dollar-for-dollar into Federal Reserve Notes.

            The volume of IBDDs is almost exclusively related to the volume of Reserve Bank credit. When Federal Reserve Banks expand credit, for example by buying U.S. obligations, the balance sheets of the Banks reflect an increase in earning assets and an equal increase in IBDD liabilities, i.e., gratis reserves.

            Actually the issuance of Federal Reserve Notes is deflationary, other things being equal, since the issuance diminishes the clearing balances and legal reserves of the commercial banks. The Fed recognizes this fact and uses its open market power to replenish bank reserves and prevent any unwarranted contraction of bank credit.

            In 1933 the Federal Reserve Note had to be collateralized by at least 40 percent in gold bullion or coin, and the remaining collateral had to consist of eligible comer paper, principally Trade and Banker’s Acceptances. The problem was the banks had practically no eligible collateral.

            The first tentative step was to reduce the gold requirement to 25 percent and allow U.S. government obligations to provide the remaining collateral. The framers of the Federal Reserve Act did not believe that the credit of the U.S. government was inferior to that of the Federal Reserve Banks and the short term commercial paper of business; they merely believed that the volume of paper money should rise and fall with the level of business activity. They also had the naïve belief that this country was so big, so diverse in its commercial needs, that it needed twelve central banks.

            Had the present Federal Reserve System been in place at the beginning of the Great Depression, there would have been no Great Depression. We were not reduced to practically a barter economy because the banks were insolvent; we needed that condition because perfectly sound banks could not meet the liquidity tests imposed upon them by a panic-stricken public.

            One of the preconditions the U.S. needed in 1929 was a much larger national debt, and a willingness on the part of the Congress, the Administration, and the business community to tolerate an adequate expansion of the national debt. In 1929 the national debt was less than $17
            billion, and the banks held only a small proportion of that amount. We needed a larger debt and a much more rapidly expanding debt in the 1930’s, not only to “prime-the pump”, but to meet the monetary management needs of the Fed. Note: Both Roosevelt and Hoover in 1932 ran on platforms calling for balanced budgets.

            The open market operations of the Fed require a depth of market that will enable the Fed to buy or sell billions of dollars’ worth of treasury bills on any given day without deeply disturbing the bill rates. Another of the many lessons from the Great Depression was the realization that if a financial panic is allowed to reach crisis proportions, monetary policy becomes useless, totally ineffective.

            For all of the Great Depression legal reserve management was impossible even though the Banking Act of 1933 provided for the coordination of all open market operations through the New York Reserve bank (that is to say, before 1933 one FRB could be conducting operations of the buying type — expanding credit, creating gratis reserves and laying the foundation for a multiple expansion of money, while another FRB was doing the opposite, — conducting open market operations of the selling type) Before April 1933 any excess reserves in the system were quickly wiped out by the massive
            “runs” on the banks.

            But even after bank failures were brought under control business confidence remained so traumatized the expansion of gratis reserves remained to a large extent excess reserves. There were not enough credit worthy borrowers in the private sector (according to the bankers), and in the public sector there was an insufficient volume of government debt to absorb excess bank lending capacity. From 1933-1942 the centralization of the
            open market power was of little consequence. It was not until about 1942 that the member banks operated with no excessive amount of excess reserves.

            After 1933, after we had a central bank and a coordinated Fed credit policy, the Fed pumped billions of dollars of gratis reserves into the banks; and nothing happened. There were years during this period when the excess gratis reserves held by the member banks were larger than the volume of required reserves. The exercise of Fed policy was likened “to pushing on a string”.

            Note: before 1942, and before the federal debt became a controlling economic factor, demand deposits fluctuated up and down with the business cycle. Commercial banks were commercial banks and when business demand for loans increased, demand deposits increased, and vice versa.

            World War II changed this and since 1942 (up until Oct. 2008), the member commercial banks have operated with no significant amount of excess reserves. Excess reserves were, and should be, made equal to total reserves minus the product of all deposit liabilities times the reserve

            It was true, as the Keynesians insisted, that monetary policy didn’t matter; fiscal policy was everything. No more. Never will we allow a financial panic to get out of hand, and never will we have another Great Depression. That does not mean the future is rosy. The future holds the prospect of sharply declining levels of consumption for the vast majority of the American people, who will be facing years of stagflation. It is probable that we will never be able to dig ourselves out of the present morass of debt and still operate the economy within the framework of a free capitalistic system.

  • Ray Lopez

    Methinks Sir George is a bit harsh here about local currencies. The logical fallacy Dr. Selgin makes is to equate tradable goods (international goods, like oil, like cars, like PC chips) with non-tradable goods and services (haircuts). Since in big economies (Japan, US) the non-tradable goods and services market is still about 85% of the total GDP, then 'local currency' is probably 'ok' for most people. I recall in an email with the eminent economist Sir Dr. Tyler Cowen of George Mason University that the component of stuff imported from China is but a tiny fraction of US GDP. I don't recall the exact number (George would know this number) but it's not 15% as I thought for the USA, but a mere fraction, since they are not counting 'value add' but some other metric. Anyhow, the larger point being local currency or script would 'work' since most people mostly buy food (much of it grown locally) and services rather than cars, oil, uP chips and foreign goods.

    • George Selgin

      "The logical fallacy Dr. Selgin makes is to equate tradable goods (international goods, like oil, like cars, like PC chips) with non-tradable goods and services (haircuts)." No, Ray: the fault is yours for erecting a false dichotomy or "local" vs. "international" exchange. That leaves out plenty! Most local currencies are valued only in single towns and perhaps some immediately-surrounding areas. So it isn't the case that they are useful for all save "international" exchange. Instead, they are also useless in national and regional exchange, or even exchange with most other communities within the same region.

      • Ray Lopez

        Well thanks for that clarification George. I suppose a certain portion of goods, be that X%, come from say a 100 km = 62 mile radius of a city? So the argument would be that local script is good for goods within that radius? Even the other day, at the local DC Whole Foods, I saw that certain produce was designated "locally grown" (not seen that before, but I've been outside the USA for the better of 10 years, just visiting now). I say X is very high, but you say X is not that high. I'll just leave it at that, as this is not my field. (Thanks for reading me; in a future post, I will expound why the feed-forward system of the 'real bills doctrine' was not that bad a monetary rule.)

        • George Selgin

          Yes, I'd say that, for most communities today, X is pretty darn small, though there are certainly places where it isn't, especially in the developing world.