Mutual credit and LETS

Different alternative currency schemes have been proposed over time, many of them are bogus or are only invented as scam. Fortunately also serious attempts to design an alternative currency have been made, one of the more interesting ones is mutual credit.

There are many types of mutual credit systems and in this post we will discuss the Local Exchange Trading System  or LETS as an illustrative example of mutual credit. The main feature of a MC system is that “currency” is created during a transaction in the way of an IOU. Consequently no stock of cash is required to perform transactions in this system. Here is how it works.

In a simple barter economy people exchange goods and services with each other. For instance,  Alice exchanges a book of hers for a dvd of Bob, is an example of plain barter in our world. A problem with ordinary barter is when Alice has something Bob wants, but he does not have something to offer she wants.

Barter becomes very complicated when such a mismatch is the rule rather than an exception, which is usually the rule. Well, people could accept as an exchange things they do not want, in order to exchange with other parties which do have the desired items. However, such system would be highly efficient as people need to spend much time at looking for the right trading partners.

A second issue with ordinary barter is mismatch in value. Suppose that Alice’s book a very rare copy and hence very valuable but that Bob’s dvd is just a common item. Though Alice wants Bob’s dvd and is willing to exchange it for her book, it would mean that she gives more than Bob is giving and hence there is a unbalance in the transaction. Such transactions seem to be quite unfair and with such conditions people will be quite reluctant to do any transaction.

One solution would be the introduction of a single, generally accepted standard means of exchange with a generally accepted value. And we usually call it money. But money requires that people has money before they purchase goods or services or borrow it (usually against interest).

Mutual credit, and hence LETS, solves the problem of barter in another way. In a local exchange trading system everyone starts at zero. Once Alice sells her book to Bob for a price of, say, 15 units, then Alice got +15 units on her balance sheet while Bob’s will read -15 units. In straight language this means that Bob owes 15 units worth of stuff to Alice.

However, within a mutual credit system it not required that Bob pays 15 units worth of goods or services directly. For instance, after the previous transaction, Alice hires Carol to walk her dog for 15 units. Now Alice balance sheet is decreased with 15 units [15 – 15 = 0], while Carol’s is increased with +15 units. Subsequently Carol let Bob repair her bike for 15 units.

We have summarized these transactions in the table below.

Alice Bob Carol
+15 -15 0
-15 0 +15
0 +15 -15

In this model we assume that all three did start at 0. A negative number here simply means “I have a debt of X units”. The table shows that one does need to pay his/her debt to the person they owe, but could be off their debts by offering their goods and services to the system. And people with a positive balance can claim it by purchasing services or goods from the system.

For this system to work any transaction within the system need to be recorded, on paper but in these days computers are more often used. Not very different from a normal bank account. In practice working with this system is not very different as a simple debit or credit card transaction or on-line banking.

The key difference between mutual credit and modern banking is that the former does not charge interests on credit. Nor will people with a positive balance receive interests.

As we started this post mutual credit and hence LETS are alternative currency schemes. Setting up and running a local exchange trading system does not require any direct government action as mutual credit is created (and cancelled) as result of private transactions and not through the issuance of money by governments or loans by banks.

Basically every group of people can set up such a system of mutual credit. Such group is called a circle and in essence individual are trading with the circle rather than with individual members. If you have a debt, you owe it to the circle and you can repay it any other member.

Since members of a circle starts at zero, and does require people to have a substantial amount of wealth to join, local exchange trading systems are championed as alternative for welfare benefits as a method of poverty relief.

Because of its rather informal nature LETS is often used for purchasing services people would not normally pay with “official currency”. For this reason the proponents of mutual credit argue that this system would create more jobs than formal money.

Another argument in favour of mutual credits, is that the “money supply” expands and contracts naturally according to the demand for credit. I put the word money supply between quotation marks, as one could actually speak of a money supply as one could see in the table above that in any transaction the total amount of credit is zero. Consequently the entire money supply in a local exchange trading system is always zero, or to put it transactions in a LETS are a zero-sum game: what one gains, another loses – at least in term of LETS units.

Mutual credit systems are not without problems, however. One weak point is that there is a strong incentive for free riding. Since one could purchase goods and services if one has a zero start balance, and there is an incentive to purchase these in unlimited quantities without adding something to the system.

This is a serious problem, as if a substantial number of people is purchasing goods and services while not selling anything, fewer people will be interest in offering their goods and services while free riders are buying anything. Without checks against free riders, the system could collapse.

The question is then how to fix this problem. One measure is imposing a limit on how much negative credit one could acquire. Once this limit is reached one could only sell goods and services while not being able to purchase anything. However, if a person does not improve his balance within a reasonable time, then it would be necessary to consider to expel this member from the community.

In normal economy, people with excessive debts and who are in default, could and will face the seizure of their property. There is no reason why asset forfeiture should not happen with defaulter in a mutual credit system. With the addition that in a LETS there is no interest which let the debt grow. Of course, such measure is an ultimate remedy when other have failed. But the threat of asset forfeiture would cause member to prudently purchase goods and services.

In our opinion LETS debts should be treated by the court system as any other debt.

Though mutual credit is usually described as an alternative currency, most proponents of LETS are actually arguing for using this system beside formal currency, and hence as a complementary currency. Our opinion is that mutual credit systems could be used in space settlements alongside government-issued debt-free money. Provided that the certain problems are addressed.

External links

An FAQ on the LETS system – an Australian site with information on LETS

6 thoughts on “Mutual credit and LETS”

  1. Do you think a barter economy as this would work as well as the money markets we have today in making it possible for financiers to make money by selling a service to people?

    1. This is quite a difficult question, but a good one. Current examples of LETS usually small number of people – up to 2,000 members – as these systems are vulnerable to abuse, i.e. people who take goods and services without adding anything themselves to the system.

      In a small group in which people know each other, people can hold each other accountable. Hence it is harder to free ride on the system. However, the larger the circle becomes, members will become anonymous and could easily rip the system.

      If certain counter-measures are implemented – such as asset forfeiture from people who free ride, then this type of barter could in my opinion work very well. Though there are additional problems like what to do if people die with debts or a positive balance – are these balances cancelled or inherited by their heirs?

      1. Do deceased people’s families inherit their liabilities or are they usually cancelled? If they are cancelled why do they claim the wealth

        1. I think it would be better if all balances, whether positive or negative, are cancelled at death. After all any credit is personal and further it’s reasonable to assume that each year about the same quantity of positive and negative credit would be cancelled as result of death. Hence the total balance will remain zero..

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