Sunday, May 4, 2008

Local Currencies

Tim Harford thinks local currencies are a bad idea. Tyler Cowen thinks they're not that bad. I'm with Harford on this one. Cowen gives two reasons for his favorable disposition on local currencies, but I want to focus on his first reason:

First, local currencies blossom when the nominal money supply is too low and wages and prices are sticky downwards. A boost in the real money supply is needed and the private sector will do it -- albeit at high transactions costs -- even if the government will not. That's why so many of these local currencies blossomed in the 1930s but then disappeared. They did good but then they were stamped out or ceased to be necessary.
It's true that a boost in the real money supply is needed when the nominal money supply is too low and wages and prices are sticky downwards, but should that boost come in the form of local currencies or the government currency (i.e. dollars)? Cowen believes the government will be too slow in boosting the real money supply -- the community might need a boost in its real money supply now, but it'll take around 6 months for a cut in the Fed funds rate to reach the community. A local currency could fill in for dollars while the community waits for the Fed's rate cut to take effect. But how much of the local currency should be printed? It's impossible to know ex ante how much a Fed funds rate cut will increase the money supply in a specific community, because the money has to work its way through the money multiplier. Presumably the community would forecast how much a Fed funds rate cut would increase its money supply, and price its local currency accordingly. But do we really trust local communities to accurately predict the amount that a Fed funds rate cut will increase the community's real money supply? There's a good chance the community will overshoot in one direction or the other, and I think the costs of overshooting will outweigh any benefits accruing to the community from an immediate boost in the money supply. Also, how will the community know when the local currency has ceased to be necessary? The process of fazing out a local currency would necessarily be governed by guesswork and intuition (not to mention currency arbitrage), and the inefficiency of such a process would also reduce the net efficiency of the local currency. On balance, I don't think the marginal benefit of an immediate boost in the community's real money supply would outweigh the real administrative costs.


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