What is Fiat Money?

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Definition:

Fiat money is currency that has value because it’s backed by a government, not because it represents ownership of a physical good, such as gold.

🤔 Understanding fiat money

Historically, currency had worth because it was made of valuable materials (like gold or silver) or could be traded for them. Fiat money has value only because it’s backed by a government and is not tied to anything other than the paper it’s printed on. We accept that it has value because we all agree that it does. The US Treasury Department prints money, and the Federal Reserve, the nation’s central bank, controls how much money is circulating. Hardly any of the money that changes hands in a modern economy is backed by anything tangible. In fact, most transactions today don’t even involve handing over paper and coins.

Example

In 1900, the US officially adopted the gold standard, which required that all printed money be redeemable for a specific amount of gold. That meant that the amount of trade that could occur in the US was limited by the amount of gold owned by the government. The Great Depression led people to hoard gold, making it difficult for the government to acquire enough to implement monetary policy (manage the money supply to influence the economy). By 1933, most developed countries had decided that the amount of gold in a vault was a silly limitation on the economy. If the economy needed more money to allow transactions to occur, the government could simply print it. The gold standard was abandoned, and fiat money became the new normal.

Takeaway

Fiat money is like a marriage certificate…

It’s a piece of paper created by the government that has value because everyone involved agrees that it means something. If nobody believed in what was printed on the paper, it would not have any value at all. But just because you can’t take your marriage certificate to a bank and receive gold doesn’t mean it’s worthless.

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What is fiat money?

“Fiat” is a Latin word that loosely translates to “by decree.” In simple terms, it means that something is real because the government says so. In the case of money, the government prints bills, stamps a value on the front, and tells everyone that these objects should be accepted as payment for goods and services. As long as people expect everyone else to honor this value, the currency facilitates trade and acts as legal tender (something required by law to be accepted as payment).

In 2019, all internationally traded currency is fiat money. There are around 180 fiat currencies in the global marketplace, including the US dollar, the euro, the British pound, and many others.

The practice of passing precious metals back and forth is now viewed as an outdated model for commerce. Until 1971, the value of foreign currencies was fixed relative to the US dollar, whose value was expressed in gold based on a price set by Congress. That year, President Richard Nixon dismantled that system in a move dubbed the “Nixon shock.” Now, global currency exchange doesn’t function based on gold at all. Rather than allowing all currencies backed by gold to move together, as a function of the supply and demand of gold, each fiat currency changes value based on the supply and demand of that currency. The relative value of one currency versus another is called the exchange rate.

How does fiat money work?

All money is a certificate of debt. Once upon a time, money was an IOU that could be collected at a later date. For example, a farmer might trade a dozen eggs today for 10 ears of corn at harvest.

To keep track of what was owed, the farmer giving up the eggs would receive a piece of paper indicating it could be traded for corn in the fall. At that point, the paper itself became worth 10 ears of corn, and the holder of the IOU could exchange it for milk, bread, or anything else.

Because this bartering system required each party to have what the other person desired, trade could only happen when there was a coincidence of wants. It became much more efficient to have a neutral thing that could act as the basis for trade. For a long time, shiny rocks (gold) served that purpose.

But weighing gold for every transaction was cumbersome. Governments began standardizing the process by minting identical coins, all containing the same amount of gold. They placed ridges around the edge of each coin to indicate that none of the gold had been shaved off. This allowed trade to occur more freely, as everyone understood the value of the currency.

But gold was heavy to carry around, and having all your money on your person was dangerous. So people began holding their gold in bank vaults for protection and convenience. Rather than going to the bank to get gold out of a safe each time they went to the market, people received certificates from bankers that served as proof that they owned a certain amount of gold. These pieces of paper could be redeemed for gold by turning it in at the bank. Suddenly, rather than gold physically changing hands, ownership of the gold could be transferred by giving someone the paper you owned.

The largest holder of gold was usually the government. The government began printing its own paper currency that could be redeemed for gold held in the national treasury. In reality, hardly anyone ever went to the bank or the treasury to redeem the notes for gold. The paper itself became the currency that was traded.

The gold standard (the direct tie between currency and gold) had its downsides. For one, the value of gold could be manipulated by others. This meant that the value of a country's assets, as recorded on its balance sheet, could suddenly fall if another country released a lot of gold into the market, or if a major new source of gold emerged.

Most countries abandoned the gold standard in the 1930s. From that point forward, currency became worth the amount printed on it rather than the value of gold it represented. This detachment from a physical commodity turned these IOUs into the official source of money (fiat money) within a country. From then on, money would have value “by decree” rather than based on ownership in an underlying asset.

What are the pros and cons of fiat money?

Trading money with no intrinsic value has its advantages and drawbacks:

Pros:

The value of anything depends on its scarcity. When money is pegged to something — whether that’s gold, silver, or cigarettes — the value of the currency changes when outside forces alter how common it is. In this way, the government has far less control over a currency that’s backed by a commodity.

With fiat currency, the government isn’t as susceptible to outside forces – It can easily change the relative value of the currency by printing more of it or removing some from circulation. That gives the government far more power to influence the economy. If it needs to stimulate the economy, it can print more money. If it needs to fight off inflation, it can pull some money out of the market and put it in a vault. These tools of monetary policy (influencing the money supply) are important levers in a modern economic system.

Fiat currency also gets rid of the absurd practice of moving gold between bank vaults. Gold is heavy and inconvenient to transfer. With fiat currency, the process of tracking and exchanging money becomes a lot easier.

Cons:

Leaders having more control over currency can backfire. An undisciplined government can print too much money. When that occurs, each unit of currency becomes less valuable (this is called inflation). If things get really out of hand, a currency can become nearly worthless through hyperinflation (extremely fast inflation). That’s what occurred in Germany after World War I, and more recently in Bolivia and Zimbabwe.

Unlike fiat money, if a currency is pegged to some outside good, the government is far less able to spend more money than it can afford. For some people, that is a vital attribute that limits government spending and provides some stability to a currency.

What is the difference between fiat money, representative money, and commodity money?

Commodity money is a currency made from a resource that has intrinsic value (which means you can use it for something other than money). For example, gold coins have exchange value – But you can also melt the coin down, and the gold still has value on its own.

Historically, most forms of currency bore the value of the things they were made of. A US nickel, for example, was made out of five cents’ worth of nickel. But over time, currency came to represent the value of exchange rather than of the material. When the gold standard was still in place, a US dollar was worth a certain amount of gold. That is what people mean by “representative money” — The money represents some other valuable thing.

Of course, a US dollar can’t be traded for a set quantity of gold anymore. It can only buy a dollar’s worth of the shiny stuff, based on the value of an ounce of gold. That is what it means to have “fiat currency.” A dollar is worth a dollar –- Nothing more, nothing less. The number of goods that it can buy changes based on what is happening in the market for those goods.

Is the end of fiat money coming?

The emergence of cryptocurrency (a digital currency traded on a peer-to-peer network that is not managed by a government) has the potential to change the way we think about money. No government mints these electronic forms of money, and because of the way these currencies are mined and tracked (using blockchain technology), the ability to print too much goes away.

Some people believe these digital alternatives may provide more trust and security than current forms of money. A private currency managed by the masses has appeal for those that are skeptical of the central banking system or the regimes in their countries.

But cryptocurrencies aren’t perfect. Servers can be hacked, and data files on your computer can be lost. Even if cryptocurrencies become widely accepted as payment, it would probably take a long time before they could fully replace fiat money as the way we all do business. Plus if these alternative forms of money reached the point where they were preferred to US dollars and euros, governments would likely intervene. Suddenly, bitcoins might become the new gold standard.

It seems unlikely that cryptocurrencies will replace fiat currency anytime soon. But we only need to look at how significantly money has changed over the last century to appreciate how different the future may look.

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