A story in The Oregonian last Sunday discussed the efforts of a group of people to bring local currency to Portland. The idea is pretty straightforward: with local-only currency (i.e. accepted nowhere else) it can never leave the community, so through the use of such currency you ensure that money you spend remains in the community. This, in turn, helps the local community through increased investment, fostering local connections, enhancing local businesses, etc. The system works on an advanced form of barter where a group of individuals and businesses agree to accept the local currency for goods and services provided. However, you can only use the currency within that group - so only if the group has a good or service you need will an exchange be made.
I want to like the idea, I really do, in fact I lived in Ithaca, New York for five years while in graduate school where perhaps the most successful example of local currency exists: Ithaca Hours. But the economist in me just won't let me get excited about the idea. I certainly don't think there is anything wrong with having a local currency, but I think that claims about the benefits are just not very credible - I don't think it really makes a difference.
The first idea, that this keeps money circulating locally seems to me to be countered by the much lower velocity in the circulation of this money. Even though dollars may quickly leave the Portland market, chances are they will have changed hands locally many times first (on average). The problem with local currency is that it does not solve the barter problem very well unless there are a huge number of participants. If the velocity is quite low, then it may even cause a drag on the economy - slowing down the rate of transactions.
I also don't think that local is the way to think about economic vitality. Most Portland artisans, I imagine, are very happy to fill orders from across the US and the world and would be much worse off if they tried to satisfy only local demand. On the other hand if I take a dollar I earn from my job and spend it at the Corvallis farmers market, I hope that that dollar is spent by the farmer in a way that yields the most benefit to him or her. Maybe it is buying seeds from a wholesaler in another county, or perhaps in a new piece of equipment from Japan, or a cool iPod for the kid that cannot be bought with local currency. I am not clear on how a purchase with the local currency (and apparently there is one in Corvallis but I had never heard of it prior to its mention in the article) helps the local economy if it prevents these purchases by the local farmer.
Finally, the hypothetical extreme is a completely closed off economy. What would I expect from such a place? Lower variety, less efficiency (including higher energy usage) and poorer quality. So why should we want such a world, even in part? I like the idea of lots of goods a services both flowing out of Portland and flowing in - I don't see it as a leakage but as a virtuous cycle of exchange.
As a coda: two of my classmates in graduate school actually wrote and published an economics paper which argued that local currencies could serve as a signal of demand for local goods and thus spur investment in local productive activities. With all due respect to my esteemed colleagues, I think in reality local currencies are so minor a part of the economy (even in a hugely successful system in a tiny upstate NY town), that though theoretically correct, the real effect is negligible.