What is Fiat Money?
Fiat money, simply put, is legal tender money whose value does not derive from being a physical good or commodity, but from being issued and backed by a government. The strength of the government that sets the value of a fiat currency is key to this form of money. Most countries in the world use the fiat monetary system to acquire goods and services, as well as to invest and save. Fiat money replaced the gold standard and other commodity money systems as a mechanism for establishing legal tender value.
The Rise of Fiat Money
Fiat money originated in China a few centuries ago. The province of Szechuan began issuing paper money during the 11th century. At first, this could be exchanged for silk, gold or silver. But eventually, Kublai Khan would come to power and establish a fully fiat monetary system during the 13th century. Historians believe that this form of money would be decisive in the fall of the Mongol Empire, with excessive spending and hyperinflation as the basis of its decline.
Fiat money would also be used in Europe during the 17th century, being adopted by Spain, Sweden and Holland. The system was a failure in Sweden and the government would end up abandoning it for the silver standard. Over the next two centuries, New France in Canada, the American Colonies, and later the US federal government would also experiment with fiat money with mixed results.
In the 20th century, the US would again use a commodity money system but in a somewhat limited way. In 1933, the government would end the practice of redeeming paper money for gold. Already in 1972, under the presidency of Nixon, the United States would definitively abandon the gold standard, which would ultimately represent its disappearance on an international scale, and the transition to a fully fiat monetary system that would extend throughout the globe.
Fiat Money versus the Gold Standard
The monetary system based on the gold standard allowed the redemption of paper money for gold. In fact, all paper money was backed by a finite amount of gold that was guarded by the government. Under a commodity money system, governments and banks can only increase the monetary mass of the economy if they possess an amount of gold equivalent to its value. This system limited the government's ability to create money and increase the value of its currency based solely on economic factors.
On the other hand, under the fiat system, money is not redeemable for anything else. With fiat money, authorities can directly alter the value of their currency and tie it to economic conditions. Governments and national central banks have greater control over their monetary system and can respond to changing financial scenarios and crises with different instruments, such as fractional reserve banking and the implementation of quantitative easing.
Proponents of the gold standard argue that a commodity money system is more stable because it is backed by something physical and valuable. Supporters of fiat money counter that the price of gold has been anything but stable. In this context, the importance or value of both commodity money and fiat money can fluctuate. However, with the fiat money system, the government has greater flexibility to act when there is an economic emergency.
Some Pros and Cons of Using Fiat Money
Economists and other financial experts do not present unanimous support for fiat money. Proponents and opponents often passionately argue about the pros and cons of this monetary system.
Scarcity: Fiat money is not affected and conditioned by the scarcity of a physical commodity such as gold.
Cost: Fiat money is more affordable to produce than commodity money.
Responsiveness: Fiat money gives governments and their central banks the flexibility necessary to correct economic crises.
International Trade – Fiat money is used by countries around the world, making it a suitable monetary mechanism for international trade.
Convenience: Fiat money does not rely on physical reserves of gold that require physical storage, protection, surveillance, and other costly requirements.
Lack of Intrinsic Value: Fiat money has no intrinsic value. This allows governments to create money out of thin air, which can lead to hyperinflation and the collapse of the economic system.
Historically Risky – The implementation of fiat monetary systems has historically led to financial collapses, suggesting that their use presents certain risks.
Fiat Money vs. Cryptocurrencies
Fiat money and cryptocurrencies have in common the fact that they are not backed by a physical commodity - but that is the only thing they share. While fiat money is controlled by governments and central banks, cryptocurrencies are essentially decentralized, largely thanks to a digital ledger called Blockchain.
Another notable difference between these two monetary systems is the way the currency is issued. Bitcoin, like most cryptocurrencies, has a controlled and limited monetary supply - unlike fiat money which can basically be created out of thin air by banks, according to what they consider the economic needs of the nation.
As a digital form of money, cryptocurrencies do not have a physical counterpart nor are they limited by borders, which favors their ability to be used in international transactions. Furthermore, transactions are irreversible, and the particular nature of cryptocurrencies makes them more difficult to trace than fiat money.
It should be noted that the cryptocurrency market is much smaller and therefore much more volatile than traditional markets - this is one of the reasons why cryptocurrencies have not yet been universally accepted, although as the economy “crypto” grows and matures, volatility will likely decrease.
Conclusion
The future of these two forms of money is uncertain. While cryptocurrencies still have a long way to go and will undoubtedly face many challenges; The history of fiat demonstrates the weakness of this form of money. This is one of the big reasons why many people are exploring the possibility of adopting cryptocurrencies for financial transactions - at least to some extent.
One of the ideas behind the creation of Bitcoin and the rest of cryptocurrencies is the exploration of a new form of money built on a distributed peer-to-peer network. Bitcoin was likely not intended to replace the entire fiat monetary system, but rather to provide an alternative economic network with the potential to create a better financial system for a better society.
