Fiat money is a currency backed by the government that issues it.
Fiat simply means decree, and fiat money is a currency that is decreed and backed by the government that issues it. Most countries, such as the United States, issue fiat money or fiat currency. It is not based on the value of a commodity, such as silver or gold; rather, the value is based on the trust the citizens have in the country issuing it.
The printed money does not have any value on its own. Instead, the value is based on the performance of the issuing government's economy. Since countries perform differently economically, the value of one country's fiat money is different from another's. If a country’s economy is performing well, then its fiat currency is worth more.This is the reason you find conversion rates when traveling internationally, because your currency may have a lower or higher value compared to the currency in other countries.
Essentially, fiat money has value because the government says it does and lenders in other countries believe in the government’s ability to repay debts. It is considered legal tender and is accepted globally.
The history of fiat money
Fiat money was not always the standard. Although China is said to have issued fiat banknotes as early as the 11th century, and fiat currency has been historically issued by local banks and lending institutions, it was not until much later that commodity-based currencies were replaced by fiat money. Basing government legal tender on gold and silver reserves became an issue as the population exploded, but there was no increase in the amount of gold or silver in government reserves. Building a strong economy was impossible if all the currency was tied to the stores of the commodity.
Until 1933, the American dollar was redeemable for gold. The country then passed the Emergency Banking Act, aimed at restoring public confidence in the nation’s financial system and halting the exchange of dollars for gold. In 1971, President Richard Nixon made the decision to permanently suspend the convertibility of the U.S. dollar to gold. Other countries were doing the same since they were unable to back their currency with gold or silver reserves, prompting the beginning of fiat currency globally.
As fiat money became globally accepted, governments could now control the amount of currency available as well as parts of their economy. The value of fiat money is determined by several factors, including economic supply and demand, interest rates, money supply and the stability of the issuing country. Virtually all countries today use fiat money as their accepted form of legal tender.
Advantages of fiat money
We have already discussed the reasons for changing the U.S. dollar to fiat currency rather than tying it to gold and silver reserves, but there are other reasons fiat money is preferrable.
The main reason that most governments issue fiat money rather than commodity-based currency is that fiat currency gives a government flexibility in responding to a changing economy. By backing the money supply, the government can react to economic growth, recessions or population changes.
There is an unlimited supply of fiat currency. Whereas linking to a fixed supply of gold or silver places limits on a country's buying or borrowing power, fiat money is backed only by the trust that users have in the country's stability and economic status.
You can use fiat money anywhere. It is universally accepted, and its value is somewhat stable.
It is easier for banks and lending institutions to control interest rates, supply and liquidity since the value is determined by economic factors.
Disadvantages of fiat money
Perhaps the word that sticks out the most when it comes to the disadvantages of fiat money is trust. When confidence in a government or economy erodes, the fiat currency’s value can drop as the government struggles. When unemployment rises, government debt increases or governmental upheaval exists, the global worth of that country’s fiat currency can quickly diminish. Some countries print more money in an attempt to prevent their money becoming valueless, but this usually results in a higher rate of inflation. In order for fiat money to work, a government must have the means to manage the currency and determine its value effectively.
Though fiat money has its drawbacks, countries today need fiat money to manage their economies. You can look at global commerce today as opposed to just fifty years ago and see the need for money that can be used to satisfy borrowers' needs. Just consider if countries were based on a commodity-based currency, the effects of a global pandemic would have annihilated commerce and made supply and demand issues even more critical.
Fiat money and hyperinflation
Hyperinflation is when a country experiences rapid, out-of-control price increases. Hyperinflation occurs when a country’s inflation growth rate exceeds 50% or more on a monthly basis. This is far beyond the high inflation currently seen globally. Hyperinflation is rare, but one of the main causes is when a central bank prints excessive amounts of fiat money. The government prints more money in an attempt to stimulate the economy. Banks are encouraged to lend more, meaning consumers are encouraged to spend more and businesses can borrow more. But as the government prints more money, the money loses its value. Supply and demand for essentials grows out of control and the economy follows.
The problem rises when the increase in money is not supported by growth in the economy. As demand increases and supply remains the same, businesses must raise prices, forcing consumers to pay more. This creates rising inflation, which left unchecked could lead to hyperinflation.
The Federal Reserve will sometimes print more money in an effort to stimulate the economy. Case in point: the stimulus checks sent to U.S. citizens during the Covid-19 lockdown. Although the intent was to give the economy a boost, the free money caused demand for goods and products to rise, leading to supply issues, which sparked some amount of inflation. Some inflation is normal in a growing economy. Although the United States and other countries are experiencing record-breaking inflation rates, it is still short of being termed hyperinflation.
Fiat money and cryptocurrency
Is cryptocurrency the same as fiat currency? No. They are alike in that they can both be used for exchanges between two parties. Fiat money and cryptocurrency rely on consumer trust in order to be used as a form of currency.
But that’s where the similarities end. The main difference between the two is how they are backed. Fiat currency is backed by a government and valued by that government’s central bank. Cryptocurrency uses blockchain, a networking technology that does not require a central authority, but rather a central bank of computers. The value of fiat money is determined by economic factors, but cryptocurrencies are valued by supply and demand, which may be affected by economic factors. The price of cryptocurrency is the price people are willing to pay for it. As demand goes up, the price increases, and as demand falls, so does the price.
Cryptocurrencies have become popular with those who are wary of government control and manipulation of fiat money. As innovation increases, cryptocurrencies may become more widely used and more valuable. Governments are starting to study cryptocurrency and many experts believe that government-backed cryptocurrencies will arrive in the near future. There are already cryptocurrencies based on the value of fiat money, known as stablecoins. The future could hold more scenarios where the two types of currency become even more deeply intertwined.
Fiat money key takeaways
Fiat money is the most widely recognized form of legal tender. Although it has no intrinsic value, the government that issues fiat money determines its value based on the amount of trust placed in the government. Fiat money gives the government the ability to set financial policies, control inflation and stabilize the economy. However, fiat money is not without risk. Mismanagement of the money supply, usually by printing too much money or political instability, could negatively affect the currency’s value and, ultimately, trust in the government.