The Problem With Too Many Currencies

Matt Yglesias muses about the possibility of a Brooklyn-based currency:

Here's a random paragraph from Paul Krugman's opus on the Euro:

I think of this as the Iceland-Brooklyn issue. Iceland, with only 320,000 people, has its own currency -- and that fact has given it valuable room for maneuver. So why isn't Brooklyn, with roughly eight times Iceland's population, an even better candidate for an independent currency? The answer is that Brooklyn, located as it is in the middle of metro New York rather than in the middle of the Atlantic, has an economy deeply enmeshed with those of neighboring boroughs. And Brooklyn residents would pay a large price if they had to change currencies every time they did business in Manhattan or Queens.

I guess I wonder how inconvenient this would really be in 2010 as opposed to 1970. Individuals wouldn't, after all, really need to "change currencies" every time they went to Manhattan. You could buy things with your credit or debit card, and if you only had Brooklyn Bucks in your pocket, American dollars are only an ATM visit away. I think the real issue here isn't so much that it would be too inconvenient as that it wouldn't be inconvenient enough--getting US dollars and dollar-denominated financial assets would be so simple that US dollars would circulate widely in Brooklyn and Brooklyn Bucks would wind up being marginalized.

Eh, the currency exchange problem is pretty big, as long as you're forward looking. Ordinary people who don't operate businesses, and travel mostly for pleasure, don't tend to think about this so much. For us, the major problem with operating in different currency zones is the hassle of changing money. But for anyone who enters into contracts, currencies are a major problem. After all, what happens if the exchange rate changes?

As a general rule, people want to get paid in the same currency in which their obligations are denominated. Matt would not like a ten-year contract that paid him in Brazilian reals while he lived in the United States, even if pulling the money out of his bank account in dollars was a painless transaction. What if the real dives 40% against the dollar? How would he make the mortgage?

This is why the annual reports of multinational corporations so frequently contain discussions of currency risk, and currency movements that either boosted or deflated their profits. When you're dealing with developed countries, this isn't usually an enormous effect, because multinational operations rarely sell something in a currency zone without incurring expenses in that currency zone; since those move together, it mitigates the problems. But companies who are exposed to currency risk do try to hedge it where they can.

The European borrowers in places like Iceland who started thinking about currency like tourists--as mostly an issue of convenience--got themselves into big trouble. A lot of people in Iceland took out loans denominated in other currencies, expecting that their biggest risk was a fairly minor movement in the relative exchange rates. When there were big swings, they were hammered. Of course, that has happened to exporters, too, but it's not the sort of mistake anyone makes twice.

So having a unified currency really does enhance economic transactions, by removing the currency risk that people face: it's now much less dangerous to enter into forward-looking contracts with people in other countries. But as Krugman and others have documented, it also has substantial thoughts.