By Larry Wright
Fiat currency is the legal tender or the national currency of a country. Typically the fiat currency of a nation is controlled and issued by the relevant central bank. The citizens of the country are bound by the land of the law to accept the currency issued by their current government to purchase and sell their goods and services. Meanwhile, the central bank has the authority to issue more or less fiat currencies in the country at their discretion.
Definition of Fiat Currency
To develop a better understanding of the fiat currency, here are some definitions by academics and economists:
According to the Investopedia.com, fiat currencies are paper money that is not backed by any sort of physical Federal Reserve or trade commodity. The website also clarifies that the fiat currencies value is dictated by a centralized government system. Some good examples of fiat currencies are USD, GBT, Yen, and Euro among others.
The encyclopedia defines fiat currencies as any type of coinage or paper money that have been elevated to the status of legal tender by the elected government of the country. In the present day, fiat currencies are not redeemable by the Gold or silver standard and offer a much higher value in comparison to commodity currencies.
Nobel Laureate Economist Richard H. Thaler who is considered the father of modern behavioral economics can help understand fiat currencies better. He was one of the first economists to recognize and quantify psychological, cultural, and social forces that dictate the strength of an economy. It is worth noting that government institutions use economic measures like CCI or Consumer Confidence Index to determine the value of the fiat currencies.
What is Fiat Currency System?
The civilized world was not always familiar with the concept of money. The earliest human beings started out with barter system as a way to exchange goods and services. Barter systems allow people to trade goods that they possess in exchange for another good or service.
The remains of Mesopotamian tribesmen that walk the earth 6000 years BC show evidence of people using barter systems to trade everyday commodities like spices, weapons, and food amongst each other.
There are some other ancient civilizations where the masses used different money substitutes like Cacao beans as a standard for conducting trade. Such examples are found in both Mayan and Aztec civilizations where people were not only able to purchase goods as well as pay their taxes with literal beans. However, for expensive purchases, even the ancient people reserved commodities like Gold, Silver, Jade, and copper coins.
Origin of Fiat Currencies
The country that invented money in its present-day form and shape is China. Chinese inventors learned to procure paper from papyrus bark in 100 BC. The reigning Emperor at the time Ho-Ti, of the Han Dynasty ordered to set up an official paper-making industry backed by the government.
During the 7th Century Tang Dynasty rule, the first-ever paper currency was designed and conceptualized. However, Song Dynasty started to circulate the paper currency in public during the 11th century. When Kublai Khan assumed the throne, he appropriated an official paper currency system in the 13th century on state level.
Paper money first arrived in the Western world in the 17th century. The first countries to adopt the fiat currency system are the Netherlands, Spain, and Sweden. However, the Swedish government was unable to manage the paper currency system for long and restored to reintroducing the silver standard. Whereas, North American nations like Canada, American Colonies, and the Federal Government of the USA also kept implementing different types of fiat currency systems.
Fiat Currencies and Gold Standard
For the better part of the 18th and 19th centuries, most governments used the Federal Gold reserve as the standard for evaluating their legal tenders. It means that the Central Bank of a country will gather a considerable amount of Gold reserves and issue paper money equal to its market value. However, with time economists started to find issues with this system and tried to find alternatives.
Until late 20th century, the US banking system was still dependent on commodity-pegged currencies. However, in 1972 President Nixon abolished the Gold Standard wholly and replaced it with an independent fiat currency system. The government had already stopped pegging fiat currencies to their gold reserve in 1933. With the Nixon administration changes, most other governments in the world adopted a fiat currency system and discarded Gold Standard.
Limitations of Gold Standard
The main reason for discarding the Gold Standard is its limitations for the government. In the beginning, Central Banks and governments were under pressure to maintain a considerable amount of Gold reserves at all times to ensure that they can maintain the value of their currencies. Here are some of the reasons that Gold Standards was wiped out eventually:
- Wars and Competition for Gold
With gold at the center of deciding factor for the fiat currency value, the governments of different nations were always under pressure to acquire more of it. Wealthier nations started to focus on wars and other violent means to take possession of the Gold Reserves of smaller countries.
- Limitation of Government Autonomy
Commodity currency limits the government of any sovereign nation from issuing any more fiat currencies outside of their current Gold Reserves value. Under these circumstances, the government or the Central Banks were unable to exercise greater control over the monetary policies of a country.
- High Maintenance Costs
The Federal Gold Reserve calls for a high maintenance cost. The government institutions needed to provide enough storage, real estate, security, workforce, and other operating costs to maintain this massive Federal Gold Reserve.
- Economic Restrictions
During the Economic crisis and high inflation periods, the government was unable to influence the economy through commodity currencies that were backed by the Gold Standard. There were limited ways for the government to control factors like supply/demand and interest rates.
- Price Volatility of Gold
Gold is subject to price volatility. Over the years the prices of the yellow metal remained relatively unstable. The factors like Wars, Economic Recession, and the discovery of a new Gold mine unexpectedly could crash the price of the legal tender of a country at any given time by changing the supply/demand dynamics unexpectedly.
- Geo-political Exclusion
Some countries in the world have an abundance of natural Gold Resources. On the other hand, there are many other nations where gold is not readily available. Under these circumstances, keeping Gold as a Standard around the world for legal tender peg can create an air of injustice and inequality among many nations and give rise to international conflicts and political unrest.
Merits of Fiat Currency System
Thus far, the investors and economists have divided views on the success of the fiat currency system. Many believe that the fiat currency system is unsustainable in the long run while others favor the transition and deem it necessary. Here are some of the biggest winning points for the Fiat currency system:
- Stability
The fiat currency system is not susceptible to factors like the fluctuation of gold prices in the international market. The currency value in this manner becomes much more sustainable and stable in comparison to the Gold Standard system.
- Ease of Management
It is much easier to calculate the value of the fiat currencies and manage their circulation in the main markets without the presence of the Gold Standard. The government can make decisions like printing more money without needing to worry about increasing their Gold Reserves or the price fluctuations in the international markets.
- Cost Efficiency
Due to the absence of massive Gold Reserves, the government and Central Banks can save the heavy maintenance costs and keep operating with relative ease. Running a fiat currency system is many times cheaper and faster than comparison to the Gold Standard.
- Economic Lucidity
When the Central Bank of a country wishes to revamp the slowed pace of economic activity it can use methods like Quantitative Easing or Fractional Reserve Banking. Under Gold Standard, it would be impossible for the government to use such solutions.
- International Trade Standard
Today, countries around the world use economic factors to evaluate their fiat currencies. Even if a country does not inherit a massive Gold mine, it can still conduct viable trade with other countries using their legal tenders. The international fiat currency system allows the nations to decide the value of their currency using the Forex exchange system that makes the international trading process many times easier and faster for everyone.
Demerits of Fiat Currency System
There are more arguments discrediting the fiat currency systems as much as there are in favor of the new monetary standard. Here are some of the biggest downsides of implementing a fiat currency system:
- Lack of State Accountability
According to Robert Kiyosaki, the author of the international bestseller Rich Dad Poor Dad, money printing is a type of tax imposition on the people. Under the fiat currency systems, the government is free to print as much money as it wants at its discretion. Since the government is a sovereign of the nation, no one can hold the policymakers to explain their decisions.
- Government Biases
Fiat currencies are legal tender that is managed under a centralized form of government. The government can make policies that favor the citizens of the country. However, in capitalistic economies, the government is more likely to safeguard the interests of the blue chips and private organizations over people.
- A Catalyst for Economic Disasters
Taking a historical view of the fiat currency-based economic stability there have been several pitfall events. Some economists believe that fiat currencies have paved the way for the economic crisis and issues like the greater frequency of recession period. It can happen because the government opts to print more money in an attempt to mend the broken economy rather than implementing more lucid policies like Personal Wealth Taxes or increasing fiscal reforms.
- Hyper-Inflation
At several occasions, the mishandling of fiat currencies has resulted in creating an economic disaster for the people. After the COVID pandemic, the US government and Federal Reserve decided to print an exorbitant amount of money. As a result, the inflation rate reached its peak in 2021 for the first time in 40 years.
- Zero Intrinsic Value
Fiat currencies have zero or null intrinsic value. It means that the government of a country can print as much money as it like out of thin air. The results of such an unregulated and loose monetary standard can and do create a detrimental impact on the economy.
- Quantitative Easing
Governments can use quantitative easing due to the freedom of the fiat currency system. With QE, the government buys more bonds and securities with borrowed money. When the debt and interest payments are due, the government prints more money to write them off. As a result, the value of the money that people hold or save starts to dwindle.
Fiat Currencies and Cryptocurrencies
Fiat currencies and cryptocurrencies have some similarities. It is best to start by understanding crypto or digital currencies first. The flagship cryptocurrency Bitcoin is a digital ledger based on blockchain technology. When a person conducts a transaction on the Bitcoin network, the details of the transaction are shared with all the ledger holders around the world.
Similarities Between Fiat and Digital Currencies
Here are some ways that cryptocurrencies resemble their fiat counterparts:
- Medium of Exchange
Cryptocurrencies and fiat currencies can be used as a medium of exchange. Many companies in the world have allowed digital currency users to purchase their services or goods with the help of cryptocurrencies. However, the Central Banks of many nations have banned the option to curb the damage to the local legal tender.
- Intrinsic Value
Both cryptocurrencies and fiat currencies do not have any intrinsic value. The price of the fiat currency is decided by the stability and capability of the government. On the other hand, cryptocurrency prices depend on factors like network effect, popularity, and the relative performance of its issuing blockchain.
- Not backed by a Commodity
Neither cryptocurrencies nor fiat currencies are backed by any sort of Commodities like Gold or Silver. It is worth mentioning that stablecoins are also covered under the cryptocurrency umbrella. However, stablecoins are an exception and they use pegs like fiat currencies rather than commodities like Gold, Copper, or Silver.
Differences Between Fiat and Digital Currencies
Cryptocurrencies share more differences with the fiat currencies in comparison to the things that both have in common. Here are some of the important distinctions listed:
- Regulatory Authority
All fiat currencies operate under the regulatory guidelines issued by a centralized government authority like Central Bank. Due to the fiat currency system, the government also dictates the value of the legal tender and has complete autonomy over the demand and supply of fiat currency.
Meanwhile, the fiat currencies are decentralized that does not require a dedicated bank operator to supervise their flow. Most cryptocurrencies like Bitcoin have limited supply but there are also some exceptions to the rule. The cryptocurrency miners and investors automatically validate every financial transaction that cannot be hacked or changed.
- Government Influence
Fiat currencies cannot operate without the presence of centralized government regulators. However, cryptocurrencies can remain functional with a relatively lesser amount of government intervention. While blockchain technology is wholly decentralized, the cryptocurrency organizations like wallet services providers, lending platforms, and exchange markets are expected to register with a centralized financial regulator of the country.
- Supply and Demand Dynamics
Bitcoin has a limited supply of 21 million tokens that can never increase or decrease. Furthermore, the amount of mined tokens is halved every four years which controls the possible price crash due to abundant supply in the market.
On the contrary, a government or state regulator can issue as much money as they want at any given time. The state can print money in the lieu of quantitative easing and devaluate the currency at the expense of its people without offering any accountability.
- Privacy and Security
Fiat currencies are paper money but almost every person today gets paid through banks. It means that the citizen of a country cannot receive or send money without providing complete information to the government. The institutions like IRS have bound banks to report additional details about any financial transaction greater than $10,000.
On the other hand, cryptocurrencies use decentralized channels like blockchain for conducting financial transactions. In this manner, despite wiring money online a person does not need to share personal information or share their financial transaction history with the government.
Conclusion
Fiat currencies are paper money or legal tender in any country that has been authorized by the local government. Human beings invented money for the first time to improve the barter system of trading and exchange. Ancient civilizations have used items like Cocoa beans as a most rudimentary form of currency.
Eventually, Chinese dynasties revolutionize the international financial system of the world by inventing paper in the 7th Century and circulating the first-ever paper money by the 11th century. Paper money made it into Western countries in the 11th century. In 1972, President Richard Nixon established a wholly independent fiat currency system by discarding the Gold Standard.
Before Nixon, central banks used their federal gold reserves to measure the value of their legal tender or fiat currencies. Fiat currencies are another economic trade-off that poses a considerable threat to the economy by posing dangers like hyperinflation, economic crisis, and government bias. Cryptocurrencies are a decentralized form of currency that is relatively faster, more secure, trust-based, and free from government influences.