What Is a Fiat Currency?

If you keep up with the latest financial news, you’ve probably come across the term “fiat currency.” While it sounds fancy, you’re already using it! So, what is a fiat currency? Is it the same as regular money? Let’s look into it.

What Is a Fiat Currency?

Fiat currency is the technical term for government-issued money that isn’t backed by a physical commodity, such as gold. The materials of fiat money also don’t carry much value; think of US dollar bills, for example. But as legal tender, the law recognizes it as an acceptable means to pay debts, taxes, and other financial obligations.

Because it isn’t backed by commodities, fiat currency gives central banks greater control over the economy. However, printing too much money can result in hyperinflation.

The earliest evidence of the fiat currency system was found in the 11th century in China. Since then, at least 775 fiat currencies have been created. Today, less than 200 are still circulating. 

On average, the life expectancy of a fiat currency is 27 years. The British pound sterling is the oldest fiat currency that still changes hands today, dating back to 1694. Despite its longevity, it’s not a success story. By 2011, the pound sterling had lost 99.5% of its original value.

How Does Fiat Money Work?

First things first, what is fiat money and how does it work?

Fiat money is the world’s current monetary system. Under the fiat money system, a government-issued national currency isn’t linked to any physical commodity. Instead, its value depends on how a country’s economy performs and how the people in charge manage it.

Fiat currencies have no intrinsic value. Therefore, they’re useless outside of their everyday role as legal tender. The worth of a national currency depends on public trust. As long as its purchasing power doesn’t decline significantly over a short period, people won’t lose faith in it.

Furthermore, central banks control the amount of money in circulation. Through monetary policy, these institutions can manipulate the money supply, inject liquidity into the market, and set interest rates to steer the economy in the direction they want.

The fiat currency system lets central banks print money out of thin air as they see fit. They usually do so to access more funds without raising taxes. Governments of countries whose economies are large, strong, and stable also resort to borrowing in order to spend beyond their means.

What Is the Difference Between Commodity Money, Representative Money, Fiat Money, and Cryptocurrency?

The world has seen several monetary systems over the centuries. Many have failed, some worked, and a few are either on the brink of collapse or in the position to change the financial system forever.

Let’s look at how commodity money, representative money, fiat money, and cryptocurrency differ.

Commodity Money

This monetary system uses physical commodities as currency. Precious metals, especially gold and silver, have been the most successful examples.

The properties of gold and silver share some traits with fiat currencies. But in addition, they’re excellent stores of wealth. Because of their lengthy and solid track records, the whole world believes in their value.

Scarcity is the reason why gold and silver never lose their financial worth. It’s hard to find large quantities of them in the wild, so their demand has historically exceeded their supply.

Unfortunately, commodity money isn’t safe from inflation. Like in a fiat economy, the entity that controls it can intentionally devalue to expand the currency supply.

Back then, governments melted gold and silver coins and mixed them with less valuable commodities like copper to produce more money. But once consumers and merchants caught on, the purchasing power of the newly minted coins dropped.

Representative Money

Also known as commodity-based money, this monetary system allows the use of items with no intrinsic value (like paper bills) as currency, as long as a commodity with unquestionable value backs them.

Holders of representative money could exchange it for the commodity supporting it on demand.

The gold standard was a product of the representative money system. It eliminated the need to use gold coins for everyday transactions. Instead, people could use bank-issued gold certificates, which served as claim checks for the physical gold they owned.

Representative money was supposed to prevent inflation, for the currency supply couldn’t be greater than the amount of the commodity in the custody of banks. Unlike the fiat currency system, representative money didn’t give policymakers the flexibility to produce more cash as needed.

After the first and second World Wars, European countries lost their gold reserves by financing their military efforts and importing foreign goods. That’s why the US held 75% of the world’s gold by the mid-1940s.

To help stabilize the post-war global economy, 730 delegates from 44 allied countries agreed to set fixed exchange rates between their national currencies and the US dollar. This way, gold would be the basis of the greenback’s value. This arrangement allowed the world to economically recover, while Uncle Sam enjoyed favorable exchange rates on its own currency.

However, the role of gold as a currency stabilizer diminished as the US exploited its unique privilege to print money. It flooded the market with more greenbacks than its gold reserves could support.

The world has been out of the gold standard for 50 years now. But representative money is still in use in the form of financial instruments like checks.

Fiat Money

So, what is fiat money? As mentioned previously, fiat currencies have made today’s financial world go round since 1971. That’s when US President Richard Nixon decided to stop pegging the value of the US dollar to gold.

Up until that point, the Bretton Woods Agreement of 1944 established that the value of most national currencies would be tied to the greenback. Back then, the US dollar was backed by gold. According to the Bretton Woods system, $35 was worth an ounce of the precious metal.

However, the agreement didn’t set any gold reserve ratio. Therefore, the US could print more money to create additional fiat cash. It enabled the country to borrow by offering US Treasuries to investors without accumulating more gold.

The world took notice and realized that the additional US dollars could destabilize the financial system. As a result, other countries converted their greenbacks into gold to build up their reserves. Since there were more US dollars in circulation than bars of gold in the vaults, the States would have run out of gold before it could pay all of those who wanted to redeem their US dollars.

President Nixon had to untie the US dollar from gold to prevent the international financial system, along with the US economy, from collapsing.

That’s when Fiat money became the standard. Floating currency exchange rates have become the norm. And gold has been adopted as a hedge against inflation and downgraded as a safe haven. It’s now a type of investment that increases in value when the economy tanks.

Under the current money system, free-market forces determine the value of this type of currency relative to one another.

Cryptocurrency

Cryptocurrency is a digital currency that is created and stored on the blockchain. It lives on a decentralized network, keeping it out of government control.

“Crypto” refers to cryptography, a practice of making readable text unintelligible to unwanted parties. “Currency” is a bit of a misnomer, though, because not all cryptocurrencies serve as money. Cryptocurrencies are either coins or tokens. Coins have their own blockchains, whereas tokens are built on top of existing ones.

Advocates of cryptocurrencies see it as a positive force. Cryptocurrencies exist to challenge the prevailing notions surrounding money and provide an opportunity to help fix the flaws of the current financial system and the fiat economy.

This type of currency is about decentralization. On the networks, participants can verify whether transactions are legitimate without having to trust each other. They promote a system of rules without rulers.

Andrea Antonopoulos, one of the more popular crypto believers, has said that cryptocurrency is the first step toward separating state and money.

At the time of writing, more than 9,600 cryptos have been launched. Collectively, they have a market value of over $2.3 trillion. To trade or buy these digital assets, you can convert fiat into cryptocurrency on leading exchanges.

So, how do cryptocurrencies stack up against the traditional currencies?

Bitcoin is engineered to be like digital gold, except that it’s much scarcer. That’s why it has the potential to be the ultimate store of wealth and a viable alternative to the fiat dollar.

Blockchain platforms, such as Ethereum, Cardano, and Polkadot, lay the groundwork for decentralized finance (DeFi). DeFi is an umbrella term for financial services not controlled by a single entity like a fiat bank.

Similar to how fiat currencies are considered legal tender, many cryptocurrencies are used as mediums of exchange on specific platforms. The number of businesses accepting cryptos along with fiat payments and paying employees with them has been growing. But these digital assets aren’t as mainstream as fiat cash yet.

Advantages and Disadvantages of Fiat Currency?

So, what is fiat money good for? How has it lasted as the global monetary system for half a century? Can it maintain its status over the long term?

Here are the benefits it has brought to the table and the drawbacks that could end its reign.

Pros

Below are the arguments for fiat money.

• They can accelerate economic recovery. Fiat currencies give policymakers the ability to control the money supply and revitalize a weak economy, which has proven to work.
• They can promote economic growth. But what is a fiat currency useful for in a healthy economy? Helping improve the standard for living. When done in moderation and for the right reason, raising the quantity of a currency in circulation can further strengthen an economy.
• They’re practical. Printing money is less expensive, labor-intensive, and time-consuming than mining precious metals. In a country that experiences increased economic activity and rapid population growth, this money system can keep pace with the rising demand for cash.

Cons

Below are the arguments against fiat currencies.

• They can lead to hyperinflation. The Zimbabwean dollar and the Venezuelan bolivar are two of the more prominent examples.

In 2009, the inflation rate in the Southern African country reached 231,000,000%. The Reserve Bank of Zimbabwe even printed Z$1-trillion banknotes. It forced the government to adopt multiple foreign currencies to buck the trend.

Another example is Venezuela, whose economy saw sky-high inflation reach 1,000,000% in 2018. And things haven’t improved since. Its central bank began issuing 1,000,000-bolivar bills in March 2021.

Both countries didn’t experience hyperinflation overnight. It was the result of long periods of fiat currency mismanagement. Zimbabwe and Venezuela saw double-digit annual inflation rates for decades before things turned south.

While the US hasn’t been as bad as Zimbabwe or Venezuela, 35% of all the US dollars ever printed entered circulation in the ten months before December 2020. The US may face the consequences of its heavy money-printing activity sooner rather than later.

• They can blow financial bubbles. Fiat money has been instrumental in encouraging risky behavior among bankers, resulting in the Great Recession of 2008. But it’s probably nothing compared to the global debt.

Fiat money has made it super easy for wealthy countries to borrow money and spend more than they earn. The result: a post-2020 global debt of $277 trillion. Most countries owe themselves and foreign entities money, but the US is the leader with a national debt of $28 trillion.

The world has never been this indebted, so no economist could predict what would happen should this unprecedented financial bubble finally pops.

Wrap Up

History says that all fiat currencies fall, returning to their intrinsic value of zero. The US dollar is no exception, and it may be on its last legs.

There’s no denying that the negatives of the fiat money system are too unsustainable for the status quo to remain unchanged for another half a century.

While it’s far from maturity, cryptocurrency represents hope for the financial system to those who understand it. And it’ll be interesting to see how it could soften the blow to national currencies as the current money system collapses.