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What is Fiat Currency

8 minutes 10 months ago

What is Fiat Money?

Fiat currency is a government-issued currency not tied to a physical commodity like gold or silver. Fiat money derives value from the public's trust in the issuing government and the supply-demand relationship rather than the worth of a commodity backing it.

The central authorities or banks can have a lot of influence over the economy since they can determine the amount of money printed or the supply of fiat currency. Modern paper currencies, such as the Australian Dollar, U.S. dollar, the euro, and other global currencies, are fiat money.

Understanding Fiat Money

The term "fiat" means an official order or decree. Thus, when a government order creates a currency, it is created by fiat — making it fiat currency. An expression of such a fiat is written on the dollar bills: “This note is legal tender for all debts, public and private.”

In the past, governments would mint coins from valuable physical commodities like gold or silver or issue paper money redeemable for a specific amount of these commodities. However, fiat currency is not backed by any underlying commodity now, making it non-convertible and unredeemable.

Because fiat money isn't tied to physical reserves of gold or silver, it is vulnerable to lose value through inflation and even become worthless in case of hyperinflation. In addition, if people lose faith in a nation's currency, its value diminishes drastically. This starkly contrasts a currency backed by gold, which holds intrinsic value due to its demand.

History of Fiat Money in the U.S.

The U.S. dollar is both fiat and legal tender, and at the time of writting is the most widely accepted form of payment on the globe, accepted for settling private and public debts. Legal tender is any currency designated by a government as lawful means of payment. Many governments establish their fiat currencies and declare them legal tender, making them the accepted standard for repaying debts.

In the past, the U.S. currency was backed by gold and, occasionally, silver. However, this changed when the Emergency Banking Act 1933 prohibited citizens from exchanging money for government gold. The end of the gold standard came in 1971 when the U.S. stopped exchanging gold for foreign currencies.

Presently, the value of U.S. dollars is backed by the sole faith and credit of the U.S. government, being deemed legal tender for all debts. However, unlike the previous practice of claiming U.S. dollars as redeemable in lawful money at the U.S. Treasury or Federal Reserve Bank, such redemption for gold, silver, or any other commodity is no longer possible.

As a result, the U.S. dollar now has the status of "legal tender" rather than "lawful money" that could be exchanged for tangible commodities, signifying their reliance on government assurance rather than physical backing.

Pros & Cons of Fiat Money

Pros

Fiat currencies rose to prominence during the 20th century, partly driven by governments and central banks. They aimed to shield their economies from the severe impacts of natural business cycle fluctuations.

Unlike scarce resources like gold, fiat money is not limited or fixed, allowing central banks full control over the supply. This empowers them to manage essential economic variables, including credit supply, liquidity, interest rates, and money velocity. For example, the U.S. Federal Reserve has the dual mandate of keeping low unemployment and inflation and using fiat money aids in achieving these objectives.

Fiat money proves to be a robust currency when it fulfills the vital roles required by a nation's economy: acting as a store of value, providing a numerical account, and facilitating exchanges. It also exhibits excellent seigniorage as it is more cost-efficient to produce than currencies directly tied to commodities.

Cons

An exceeding amount of currency in circulation can lead to heightened inflation and even hyperinflation. For instance, in Zimbabwe, prices soared rapidly, and at its peak in 2015, 100 trillion Zimbabwean dollars were worth $0.4.

As the supply of currency increases, its value diminishes, causing consumers to buy less with the same amount of money. This phenomenon is evident in the declining purchasing power of the U.S. dollar, where $1 in 1913 now holds the equivalent purchasing power of $26.98 in 2021.

The value of fiat currencies is intricately tied to the stability of the governments that support them.

Examples of Fiat Money

The U.S. dollar, euro, British pound, Japanese yen, and Indian rupee are some examples of fiat money — currencies backed by the respective issuing governments, typically offering a degree of economic stability, although not guaranteed.

An example of the potential risks associated with fiat money is Zimbabwe's experience in the early 2000s. Faced with severe economic challenges, the country's central bank resorted to excessive money printing, leading to hyperinflation.

During this crisis, experts estimated that the currency lost an astonishing 99.9% of its value, resulting in rapid price increases and consumers needing bags of money just to buy necessities. At its peak, the Zimbabwean government had to introduce a 100-trillion Zimbabwean dollar note. Eventually, foreign currencies gained widespread use, displacing the Zimbabwean dollar.

Can Cryptocurrency Replace Fiat Currency?

Technological advancements have diminished the reliance on physical currency in developed countries. Electronic transfers and debit cards are increasingly prevalent, leading to a system where funds are exchanged via electronic ledgers managed by third parties. However, these intermediaries have trust issues and high financial system maintenance costs, which have sometimes caused unethical practices and global financial crises.

In contrast, cryptocurrencies, leveraging blockchain technology, operate without a central authority. Advocates argue that this decentralised governance facilitates more efficient and less corrupt monetary systems. Cryptocurrencies eliminate the requirement for a third party to verify transactions because automated consensus mechanisms and blockchain technology ensure accuracy and record transactions immutable.

Bitcoin, often regarded as "digital gold," and other cryptocurrencies, including stable coins pegged to commodities or fiat money, exemplify the diversity within the crypto market. Some cryptocurrencies serve utility purposes, facilitating payments or empowering decentralised networks and applications.

Cryptocurrencies have proven their worth as viable currencies, offering tangible benefits. For example, many Ukrainians relied on cryptocurrency to survive during the 2022 Russian invasion. It has also been used in countries facing severe fiat devaluation to preserve savings, facilitate remittances, and conduct business.

As cryptocurrency's adoption and versatility continue to grow, it demonstrates its potential to replace fiat currency and revolutionise the global financial landscape.

The Bottom Line

Fiat money is a government-controlled currency backed by the public’s faith in the central authority that issues it. Unlike commodity currency, fiat money lacks intrinsic value; rather, it is derived from the trust people put in the issuing authorities.

While fiat money has been the norm since the early 1970s, the emergence of cryptocurrencies, like Bitcoin, has garnered attention. Crypto proponents argue that these digital assets provide superior mediums of exchange and stores of value. They will eventually gain adoption in various government and business sectors.

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