What is fiat currency?

Simply put, fiat currency is legal tender that is not backed by a physical commodity and derives its value from trust in the issuer, such as a government or central bank. The power of government to set the value of fiat currency is key in this type of money. Most countries in the world use a fiat currency system to buy goods and services, invest and save. Fiat currency has replaced the gold standard and other commodity systems in establishing the value of legal tender.

The rise of fiat currency

Fiat currency originated many centuries ago in China. Sichuan Province began issuing paper money in the 11th century. At first, they could be exchanged for silk, gold or silver. But eventually Kublai came to power and in the 13th century established a system of fiat money. Historians argue that this money played an important role in the fall of the Mongol Empire, which was caused by excessive spending and hyperinflation.

Fiat money was also used in Europe in the 17th century, and was adopted by Spain, Sweden and the Netherlands. The system failed in Sweden, and the government eventually abandoned fiat in favor of the silver standard. Over the next two centuries, New France in Canada, the American colonies, and then the US federal government also experimented with fiat money, with mixed results.

By the 20th century, the US had returned to a somewhat limited use of commodity currency. In 1933, the government stopped the practice of exchanging paper money for gold. By 1972, under President Nixon, the U.S. abandoned the gold standard entirely, ending its international decline by switching to a paper money system. This led to the use of fiat currency around the world.

Fiat currency versus the gold standard

The gold standard system allowed paper banknotes to be converted into gold. In fact, all paper money was backed by the limited amount of gold that the government held. Under the commodity currency system, governments and banks could introduce new currency into the economy only if they had gold reserves equal in 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, in a fiat currency system, money cannot be converted into anything else. With fiat money, the government can directly influence the value of its currency and tie it to economic conditions. Their countries' governments and central banks have much more control over their currency systems. They can respond to various financial events and crises with the help of various tools, such as the creation of partial banking reserves and the implementation of quantitative easing.

Proponents of the gold standard argue that the commodity-currency system is more stable because it is backed by something physical and valuable. Proponents of fiat currency deny that gold prices have never been stable. In this context, the value of both commodity currency and fiat money can fluctuate. But with a fiat currency system, the government has more flexibility to act in the event of an economic emergency.

Some pros and cons of using fiat currency

Economists and other financial experts are not unanimous in their support for fiat currency. Proponents and opponents passionately debate the pros and cons of this currency system.

• Scarcity: Scarcity of physical goods such as gold is not affected or limited by the scarcity of fiat money.

• Value: Fiat money is more readily available for production than commodity money.

• Operability: Fiat currency gives governments and their central banks flexibility to deal with economic crises.

• International Trade: Fiat currency is used in countries around the world, making it an acceptable form of currency for international trade.

• Convenience: Unlike gold, fiat money does not depend on physical reserves that require storage, protection, monitoring and other requirements.

• No Intrinsic Value: A fiat currency has no intrinsic value. This allows governments to create money out of nothing, which can lead to hyperinflation and the collapse of their economic system.

• Historical Risks: Historically, the implementation of fiat currency systems has typically led to financial crashes, indicating that these systems present certain risks.
  
  

Fiat currencies vs cryptocurrencies

Fiat currencies and cryptocurrencies have a bit in common in that neither is backed by a physical commodity, but that's where the similarities end. While fiat money is controlled by governments and central banks, cryptocurrencies are essentially decentralized, largely through a distributed digital ledger called the blockchain.

Another notable difference between these two currency systems is how each of these forms of money is generated. Bitcoin, like most cryptocurrencies, has a controlled and limited supply. Conversely, banks can create fiat money out of thin air based on their assessments of a country's economic needs.

As a digital form of money, cryptocurrencies have no physical counterpart and are borderless, making them less restrictive for transactions around the world. Moreover, transactions are irreversible, and the nature of cryptocurrencies makes it much more difficult to trace compared to a fiat system.

Notably, the cryptocurrency market is much smaller and therefore more volatile than traditional markets. This is probably one of the reasons why cryptocurrencies have yet to gain mainstream acceptance, but as the crypto-economy grows and develops, volatility is likely to decrease.

Results

The future of both these forms of currency is by no means certain. While cryptocurrencies still have a long way to go and will certainly face many more challenges, the history of fiat currencies demonstrates the vulnerability of this form of money. This is an important reason why many people are exploring the possibility of switching to a cryptocurrency system for their financial transactions (at least for a certain percentage).

One of the main ideas behind Bitcoin and cryptocurrencies is to explore a new form of money based on a distributed peer-to-peer network. Most likely, Bitcoin was not created to replace the entire system of fiat currencies, but to offer an alternative economic network. However, it certainly has the potential to create a better financial system for a better society.