A fiat currency, also called fiat money, is a legal tender whose value is secured by the government that issued it. This is how they differ from money, which is backed by some physical asset that sets the standard of their value, for example, gold.
A common misconception is that unlike the currencies of the past, based on gold, silver or other precious metals standard, fiat money has “nothing” to ensure their value. A more accurate description is that the fiat currency is provided with the resources of the state issuing it, and its value is determined by a number of factors, including supply and demand in the economy, interest rates and money supply.
How Does Fiat Money Work?
The fiat currency is not backed by any physical commodity, but only by the faith of its holders and the declaration of the government. Paper money acts as a carrier of purchasing power and an alternative to the barter system. They allow people to buy goods and services as needed, without resorting to exchanging goods for goods, as was the case with barter trading.
Thanks to the ability to store purchasing power, people can easily make plans and create specialized economic activities. For example, an enterprise engaged in the assembly of mobile phones can purchase new equipment, hire and pay employees, and go to other regions.
The value of fiat money depends on how the country’s economy develops, how it is managed and how these factors affect interest rates. In a country where there is political instability, the currency is likely to weaken and commodity prices will soar, which will make it difficult to purchase the necessary goods.
The fiat currency functions well when the population is sufficiently confident in its ability to perform the function of a store of purchasing power. In addition, it must be fully secured by a loan from the Government, which issues a decree and prints it as a legal tender for financial transactions.
The history of fiat money
Fiat money has not always been the standard. Although it is believed that China issued fiat banknotes already in the XI century, and fiat money was historically issued by local banks and credit institutions, it was only much later that fiat money was replaced by commodity currencies. Due to population growth, there was a problem of relying the state means of payment on gold and silver reserves, but the amount of gold and silver in state reserves did not increase. Building a strong economy was impossible if the entire currency was tied to commodity stocks.
Until 1933, the American dollar could be exchanged for gold. Then an Emergency Banking Law was passed in the country, aimed at restoring public confidence in the country’s financial system and suspending the exchange of dollars for gold. In 1971, President Richard Nixon decided to permanently suspend the convertibility of the US dollar into gold. Other countries, unable to back up their currency with gold or silver reserves, did the same, which triggered the emergence of fiat money on a global scale.
Since fiat money has become universally recognized, governments have been able to control the amount of available currency, as well as individual elements of their economy. The value of fiat money is determined by several factors, including supply and demand in the economy, interest rates, money supply and the stability of the issuing country. Almost all countries today use fiat money as a legal tender.
How well do fiat currencies hold their value over time?
Fiat currencies lose their value as more and more of them are issued over time, which leads to an increase in supply and inflation. The increase in the money supply in the financial sector is often referred to as “money printing”.
Commodity prices are moving in the direction of increasing the money supply. With an increase in the money supply, prices rise. On the other hand, with a reduction in the money supply, prices fall.
Although prices may decline for a while, which is called deflation, the more common condition for most economies is inflation. Deflation is generally seen as more harmful than inflation, although inflation reduces the purchasing power of paper money over time.
During the period of deflation, asset prices fall, which means a decrease in the profits of enterprises along with wages and prices of financial assets. Most businesses and consumers value this less than inflation, at which prices, profits and wages are likely to rise.
The trade-off is that without inflation and an increase in the money supply, the economy does not grow.
The pros of a fiat currency
The main reason why countries have stopped using the gold standard is that it limits the government’s ability to respond to economic events. For example, under the gold standard, the money supply is tied to the available supply of gold, and the demand for money in a country varies depending on the growth of its population and economy.
As an example, consider the United States. Since the dollar was untied from gold, the country’s population and economy have grown significantly:
If the United States and other countries remained on the gold standard, then the supply of money in the world would be limited by the available gold. And although the amount of gold on Earth has not increased much over billions of years, the number of mankind, its economic productivity and the demand for money have certainly increased.
In a fiat currency, the money supply can be increased much faster than demand increases, which helps to stabilize the purchasing power of the currency and prevent deflation, or a drop in commodity prices.
Before you say, “Falling prices is good,” remember that on the other side of every purchase is the manufacturer. Falling prices can be disastrous for producers, especially if it happens quickly. This can lead to serious economic shocks, forcing companies to cut costs, lay off workers or take other actions to avoid losses in the face of deflation. This could lead to a domino effect, as a result of which even more companies will suffer, as they will lose customers or their customers will spend less, which will lead to new cuts and job losses.
Here is an example of the first advantage of a fiat currency – the ability to manage the money supply in order to provide enough of it to prevent deflation destructive to the economy.
Another advantage of a fiat currency is that it can be used to maintain volatility in the economy, including to support debt markets. The central bank can take assets on its balance sheet, for example, the Fed buys US federal debt obligations and mortgages.
An increase in the money supply may seem that a central bank, such as the US Federal Reserve, can just magically make money appear out of thin air. To some extent this is true, but it is also an oversimplification. The Fed does not so much create money out of thin air, as it exchanges newly created money for some asset, for example, a loan to a bank, a treasury bond or a mortgage-backed security. In other words, when the Fed “creates” new money, it is because there is a real demand for it.
Cons of fiat currency
In fact, there are two main risks associated with fiat currency: political instability and mismanagement of the money supply.
Let’s talk about political instability. Money, whether fiat or backed by gold, is a common fiction: They are worth something because we all agree that they are worth something. In the case of a fiat currency, the basis is the confidence that the government that issued it will remain stable and in power, maintaining the value of the currency at the level that we all agree on. Without a reliable, well-managed and resourceful government, faith in the fiat currency may weaken, leading to sharp inflation as it loses its spending power.
Improper management of the money supply, especially its increase, is a risk that many fear when using fiat currencies. This is especially true for many in connection with large-scale government incentive measures during the COVID-19 pandemic in 2020 and 2021. Using the example of the USA, we can say that from the beginning of 2020 to December 2021, the money supply increased by almost 40%:
However, over this two-year period, the US economy and population did not grow by 38%. A significant portion of this new money was issued by the US government to pay for economic stimulus measures; similar growth occurred in other countries of the world.
Why does fiat money have value?
Unlike commodity money, such as gold coins or paper bills redeemable with precious metals, fiat money is fully secured by the faith and trust of the government that issued them. One of the reasons this makes sense is that governments require you to pay taxes in the fiat money they issue.
Why do modern economies prefer fiat money?
Until the 20th century, most countries used the gold standard or commodity security. However, as the scale of international trade and finance grew, the limited amount of gold mined in mines and stored in the vaults of central banks did not keep up with the new value created, which led to serious disruptions in the work of world markets and commerce.
Fiat money gives governments greater flexibility in managing their currency, determining monetary policy, and stabilizing global markets. In addition, fiat money allows commercial banks to increase the amount of money in the cash register to meet the demand from borrowers.
What are the alternatives to fiat money?
In almost every country today there is a legal tender, which is fiat money. Although you can buy and sell gold and gold coins, they are rarely used for exchange or everyday purchases and tend to be more of a collectible or speculative asset.
Cryptocurrencies such as bitcoin have emerged in the last decade as a challenge to the inflationary nature of fiat currencies, but despite the growing interest and proliferation, these virtual assets do not seem to be coming close to becoming “money” in the traditional sense.
Does fiat money lead to hyperinflation?
When a country prints its own currency, there is always the possibility of hyperinflation. However, most developed countries have experienced only moderate bouts of inflation. Moreover, the constant low level of inflation is seen as a positive factor of economic growth and investment, since it encourages people to invest money in business, rather than stand idle and lose purchasing power over time.
Having a relatively strong and stable currency is not only the mandate of most modern central banks, but also a rapidly depreciating currency harms trade and obtains financing.
In addition, it is unclear whether hyperinflation is caused by the “runaway printing” of money. In fact, hyperinflation has occurred throughout human history, even when money was based on precious metals; and all modern hyperinflations began with the fundamental collapse of the real production economy and/or political instability in the country.
The value of fiat money is determined by supply and demand, not the underlying physical commodity. Governments use fiat money to provide economic stability and protection against the booms and busts that are a natural part of the business cycle. However, overproduction of fiat money risks inflation or even hyperinflation as supply exceeds demand.