January 4, 2019 Knowledge Center

What Is Fiat Currency?

Fiat currency or fiat money is what a government declares as legal tender: any medium of payment recognized by the law to meet financial obligations, such as paying for goods and repaying debts.

There is no physical commodity backing fiat money, so it has no real intrinsic value. It is only considered to have value because either the government maintains its value or two parties have agreed and declared that it is valuable.

Because fiat money has no physical commodity to back it, hyperinflation can make it worthless. It can also be rendered worthless purely by people losing faith in it as a currency.

A Brief History

The first recorded use of fiat money was in China around the 11th century. By the Tang Dynasty (618–907), a shortage of precious metals and high demand for metal currency had made the use of credit notes common. This made the idea of paper money familiar enough that the people would accept it when it was introduced.

The strong economy and shortage of copper coins continued in the Song Dynasty (960–1276). That situation forced traders to issue private notes backed by a monetary reserve, which became the first legal tender in history. During the Yuan (1276–1367) and Ming (1368–1644) dynasties, paper money became the only legal tender used.

The use of fiat money in the West started during the 18th century with the issuing of bills of credit as a form of payment. In the United States, fiat money became popular in the 20th century after the dissolution of the Bretton Wood Agreement between 1968 and 1973. At that time, the United States government issued a “temporary” suspension of the conversion United States dollar to gold.

How Fiat Currency Works

Before the use of fiat money, most currencies were backed by gold, silver, or other physical commodities. Governments also minted coins using physical commodities such as silver and gold. They also created paper money that had a certain amount of physical commodity backing it, and redeemable for the equivalent value of the commodity.

Fiat money is the opposite; it has no value – you can’t redeem it, and you can’t convert it. The value of fiat money comes from how a country governs itself, the credit of its economy, and the effects of these factors on the interest rates. Therefore, economic and political upheaval in a country can result in the weakening of that country’s currency and the inflation of commodity prices.

One example of this is what happened to Zimbabwe in the 1990s, during President Robert Mugabe’s term. The country’s economy deteriorated very quickly and did not get any better. The result was low wages, a low standard of living, and high unemployment. But the worst was the inflation rate – it went as high as 17 percent.

As Zimbabwe’s economy worsened, the central bank started to print money faster than it should have, instead of implementing a much better economic policy. It was used to pay the national debt, but that resulted in unimaginable inflation rates. In 2008, the inflation rate was between 230 and 500 billion percent, and the currency exchange rate was 1 trillion Zimbabwean dollars to $0.40 US.

With that said, fiat money must be backed not just by public confidence but also by the full credit of the government that has the power to create it as a legal tender.

Advantages and Disadvantages of Fiat Currency

The debate between supporters of fiat money and the gold standard is ongoing. Those who advocate for gold-backed currency argue that fiat currency is nothing but printed paper – worthless, valueless.

In defense of fiat currency, its value is more stable than currency based on commodities like silver and gold because the prices of commodities can fluctuate. It gives central banks the power to hold and print paper money; thus, they have control over interest rates and inflation as well.

With fiat money, a government can create inflation, which benefits the economy. When there’s inflation, people spend more and do more business before the currency loses its value. Deflation, on the other hand, stops people from spending while they see the currency’s value is still rising. This lack of economic activity is a far worse economic situation than inflation.

Moreover, a currency backed by a commodity can experience sudden natural deflation. For example, if gold mining is scaled back for a while, the amount of gold that is circulating will remain roughly steady. But if the population is increasing at the same time, the amount of gold per person will decrease. As a consequence, the value of gold will increase whether people intend it to or not.

On the other hand, a government that uses fiat money can quickly neutralize such a situation by printing more money. We call this process to combat recession and the possibility of deflation quantitative easing.  

The Difference Between Fiat Money and Cryptocurrency

Fiat money, as discussed in this article so far, has no value in itself. Its value comes from the people’s confidence in it, and because a central government backs it. The government regulates its supply, and you can use it to pay taxes.

Cryptocurrency is the exact opposite of fiat currency in these ways. It is not legal tender, no central government is backing it, and it is decentralized. You cannot use it to pay your taxes. However, cryptocurrency also has a form of regulation that controls its production – not a central government, but an algorithm.

These differences aside, both cryptocurrency and fiat currency are forms of money. You can use them to buy goods or services; they are both mediums of exchange; their value depends on various factors of their environment.