What is fiat money?
- Fiat money is a government-issued currency that isn’t backed by any physical commodity such as silver or gold.
- With fiat money, central banks have greater control over the economy as they determine how much of the currency can be printed. Modern paper based fiat currencies include the euro, pound sterling, the U.S. dollar, and other major currencies.
- The major caveat with fiat money is that government can print too much of it, resulting in hyperinflation.
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Fiat money or fiat currency is a type of currency that lacks intrinsic value. It is a legal tender and is issued by the federal government of a country. Before now, most currencies were backed by physical commodities like precious metals, but things have changed since then as fiat currency is now backed by the full faith and creditworthiness of the issuing government.
In terms of value, fiat money’s value is determined by the forces of demand and supply. More so, fiat money was introduced as an alternative to commodity money.
Understanding fiat currency
Fiat is a Latin word that loosely translates to “it shall be” or “let it be done.” This means that fiat money is only valuable because the government backing it, works to maintain its value.
Fiat money came into existence when different governments would mint coins from valuable commodities like gold or silver or print paper-based money which could be redeemed for a specific amount of a predetermined physical commodity.
Besides being inconvertible, fiat can also not be redeemed as there is no underlying physical commodity backing it.
Fiat money and its underlying value
Since fiat money is backed by physical commodities such as gold and silver, there is every likelihood that it would lose its value in the event of inflation. It can even become worthless when there is hyperinflation. A pretty good example is the Hungary hyperinflation that kicked in after WWII, with the country’s inflation rate doubling within a single day.
More so, if citizens begin to lose faith in a government-backed currency, it will no longer be valuable. This is quite different from a currency backed by physical commodities like gold or silver. And that’s because such money has intrinsic value as there would always be demand for gold and silver for making jewelry, building cars, decorations, and manufacturing electronic devices.
A brief history of fiat money: Case study, the U.S. dollar
The U.S dollar is both fiat money and a legal tender. For those just hearing about legal tender for the first time, it is a pretty straightforward term that refers to a recognised and legally approved currency for making transactions. Governments worldwide usually issue fiat money and declare it a legal tender by simply making it the standard for debt payment.
The U.S dollar used to be backed by physical commodities like gold and silver. However, the government later stopped accepting citizens’ money in exchange for the government’s gold, precisely after the assent of the Emergency Banking Act of 1933.
Similarly, the gold standard, which had hitherto backed the U.S. dollar with federal gold, ended in 1971. Since then, the U.S. dollars became backed by the full faith and credit of the federal government.
While the U.S. dollar was still a legal tender for debt repayment, it was no longer redeemable in lawful money from the Federal Reserve Bank or the United States Treasury. This simply meant that the U.S dollar is now a fully backed legal tender instead of lawful money that could be exchanged for gold, silver, and other physical commodities.
Fiat money vs. commodity money
Fiat money is the complete opposite of commodity money. The difference between the two of them lies in their intrinsic value. With commodity money, its value is derived from the materials it is made of, for instance, gold or silver coins. On the other hand, fiat money has no intrinsic value as it is essentially backed by the full faith and trust of the issuing government, who have mandated that it be used for debt payment.
What are the advantages of fiat money?
Since fiat money isn’t a scarce or fixed resource like gold and silver, it means that the central bank has significant control over its value and supply. What we are trying to point out here is that government can seamlessly manage liquidity, credit supply, and interest rate pretty reasonably.
- In contrast to commodity currencies that can easily be impacted by the discovery of a new gold mine, the supply of fiat money is entirely regulated and controlled by the government backing it. With this, there is little or no risk of an unexpected devaluation caused by the fiat currency supply. And that’s because any increase in supply is always a calculated decision by the government backing such currency.
Disadvantages of fiat money
Because fiat money isn’t linked to any tangible asset, its underlying value is mainly dependent on responsible fiscal policy and regulation. This means any irresponsible policy on the part of the government can result in inflation or even hyperinflation.
- There is a higher likelihood of bubbles with fiat money. A fiat bubble simply refers to an economic cycle that experiences a rapid price increase, followed by a rapid decline in price.
- The real reason why there is a sharp increase in bubbles with fiat money is because of the unlimited supply of fiat currency, which makes quantitative easing an option for governments. But even though quantitative easing helps boost the economy, it can also result in greater inflation rates.
Fiat money and hyperinflation
As you may already know, fiat money isn’t a foolproof way to protect the economy as is it is very prone to inflation. A good example of this is Zimbabwe, an African country that experienced one of the worst cases of hyperinflation in the early 2000s. Because of its severe economic problems, the country’s central bank thought it wise to start printing money at a staggering pace.
Unfortunately, it wasn’t a brilliant move as it resulted in hyperinflation. According to experts following the developments in the country, the Zimbabwean dollar lost 99.9% of its value during this period. This was closely followed by the sharp increase in prices, with consumers forced to carry bags of money to buy essential items.
During the worst period of the country’s hyperinflation, the government had to issue a 100- trillion dollar note to stop people from carrying bags of money around. Eventually, citizens began to turn their attention to foreign currencies for making purchases.
Why fiat money will continue to be valuable
- Unlike commodity-based money such as gold coins and paper bills that you can exchange for precious metals, fiat money is entirely backed by the issuing government’s full faith and trust.
- The real reason why fiat money has merit is that the issuing government has made it mandatory for citizens to pay their taxes via the fiat money it issues.
- Since all citizens are required to pay their taxes or risk going to jail or facing stiff penalties, it means that everyone will accept fiat money. Other theories of money, especially the credit theory, categorically states that since all legal tenders have credit-debit relation, fiat money will maintain its value even if it isn’t backed by anything.
Why do countries prefer fiat money?
- Before the 20th century, most countries used some sort of gold standard or backing by a physical commodity. But as international trade and finance gained momentum, it meant that the limited amount of gold and other precious metals coming out of mines and treasuries could not keep pace with the value being created. This gave rise to the launch of fiat money.
- With fiat money, governments worldwide had greater flexibility to manage their currency and implement monetary policies to stabilise global markets. This also provides opportunities for fractional reserve banking, where commercial banks can multiply the amount of money available to meet the ever-increasing demand from borrowers.
Are there any alternatives to fiat money?
Without mincing words, every country today has an official legal tender that is fiat money. And even though you can buy and sell physical commodities like gold, silver, and gold coins, these physical commodities are rarely used for everyday purchases. Most of these physical assets are mostly collectible items or speculative assets.
On the flip side, cryptocurrencies, especially big names like Bitcoin and Ethereum have emerged over the last decade and are now challenging the inflationary nature of fiat currencies.
Unfortunately, the overwhelming interest and adoption of these digital assets haven’t made them acceptable legal tenders in many countries. Hopefully, that may change in the future.