by Gary Christenson, Deviant Investor:
Summary: Timmy, a precocious ten-year-old opens a lemonade stand and learns about unbacked currencies.
“Dad, I’m excited and ready for business. Mom made me sign an IOU when she gave me sugar and frozen lemonade so I have stuff to sell.” Timmy looked up at his father and smiled in anticipation.
“Great job! This’ll be a learning experience. Here comes your first customer.” James, his father, wanted to be helpful, but expected Timmy to interact with customers.
A retired gentleman pushed his walker toward the lemonade stand and said, “Hi little fellow, I want a cup of that lemonade.”
Timmy poured lemonade into a twelve ounce plastic cup and handed it to his first customer. “That will be one dollar.”
The man handed Timmy a dollar bill, sipped his drink and shuffled away.
James said, “That was easy.”
Timmy examined the dollar bill and said, “It’s paper and says one dollar, but what is it worth?”
James groaned. This is what I get for raising an intelligent kid. “Timmy, the dollar bill is valuable because you can buy books, food, video games, or pay your mom back for the sugar and lemonade mix. And you can deposit the dollar into your bank account.”
Timmy looked puzzled and said. “So it’s monopoly money, but because other people will exchange it for goods, this dollar has value.”
James said, “That’s correct, but it’s better than monopoly money. The central bank of the United States, the Federal Reserve, issued this dollar and stands behind it.” That explanation should satisfy him.
“So the Federal Reserve puts ink on a piece of paper and makes it valuable? That doesn’t make sense.” Timmy sounded confused.
James tried again. “The Federal Reserve issued and backs this note, so people trust and accept it for goods. You took the dollar in exchange for lemonade as an example.”
Timmy frowned as he looked at the dollar bill. “It says ‘Federal Reserve Note’ and ‘This Note is Legal Tender’ but it doesn’t say it’s money. What does that mean?”
This is getting out of hand. “Well, Timmy, it isn’t money, it’s a debt or promissory note issued by the Federal Reserve. That dollar is similar to the IOU you gave your mom for the lemonade supplies. This is an IOU from the Federal Reserve. They acknowledge this dollar bill as a debt they owe to you. But it’s valuable because we know the Federal Reserve supports the debt.”
“So the Federal Reserve owes me a debt. What backs that debt?”
Uh-oh. Got in too deep. James sounded defensive as he said, “That dollar is backed by the ability of the government to collect taxes and issue debt, basically faith and credit.”
Timmy looked puzzled. “So what happens if people lose faith in these Federal Reserve debts, or they no longer trust the government?”
Definitely too deep! “Timmy, that’s a very astute question, but few people worry about the dollar. However, many other currencies became worthless because nothing real backed them, and everyone lost faith in their usefulness.”
Timmy looked satisfied. But a moment later he asked, “So people might lose faith in the dollar?”
“Well yes, I suppose they could.”
Timmy looked up at his dad and asked, “Why did those other currencies fail?”