In the past, precious metals, such as silver and gold, were the standard that backed most countries’ currencies. However, things are a lot different now. We all know that fiat currency has now become the norm or standard in the modern world.
If you keep up with financial markets or the latest financial news, you have probably heard the term “fiat currency.” Although it sounds fancy, you are already using it! What’s a fiat currency? And is it the same as standard money?
What is a Fiat Currency?
A fiat currency, such as the US dollar, is a form of money that a government issues. The currency derives its value solely or exclusively from the government’s backing. In most cases, central banks usually issue fiat currency in the form of coins and paper bills that are not made or backed by various precious metals.
Here are some examples of fiat money:
- Dollars, dimes, quarters, nickels, etc. in the United States
- The euro
- The Mexican Peso
- The British Pound Sterling
- The Chinese Yuan
There are two main reasons a fiat currency, such as the euro, has value. This is because the currency is backed and supported by a government, and the individuals who hold it agree on its worth.
The authority issuing the currency solely controls the fiat currency, and it doesn’t have a guaranteed exchange rate with any other asset, such as silver or gold.
So, the value of this currency, whether in the form of a coin or paper note, isn’t tied or linked to any physical commodity. Instead, it’s determined by demand and supply as well as the stability of the government that issues and backs it.
And the vast majority of famous or commonly used currencies, such as the U.S. dollar and euro, are forms of fiat currency.
Why Governments Use Fiat Currencies
Generally, governments prefer to use fiat currencies as it gives them a considerable deal of control and influence over the economy. This is because by controlling the main form of money, the government has significantly more power in order to influence the economy.
Surely, governments leverage monetary policies, like changing interest rates in the country and setting suitable reserve ratios for banks and financial institutions to affect and change how the country uses a specific local currency.
And that is not all; a government can print its currency whenever it wants, which is convenient. This is important as it lets the government repay debts or fund various new spending objectives.
Also, printing new money allows the government to spend more money than it collects through taxes and issuing debt.
Fiat Currency vs. the Gold Standard
Surely, the gold standard system is vital as it used to allow the conversion of paper bills to gold. Actually, all paper money, such as the Yen, was backed by a finite and specific amount of gold, which the government held.
However, the gold standard is a monetary system governments used in the past. Under this standard, the value of a country’s currency, such as the U.S. dollar, was directly linked to gold.
Also, under this standard, that country would determine and set a fixed price for gold, only buying and selling gold at that price.
As you can imagine, banks and governments could only introduce a new currency into their economy under a commodity-based currency system if they stored an equal amount in gold reserves.
However, this system limited and restricted the government’s ability to create money and increase the value of its currency based exclusively on economic factors.
People who advocate for gold or some similar standard usually argue that a fiat currency, such as the U.S. dollar, isn’t really “worth” anything. This is because there is not anything tangible, such as precious metals, which underpins its value.
In other words, the value of any currency is only relative to what people think it is worth, whether it is a commodity or fiat currency. In other words, the fiat currency has no intrinsic value.
Also, advocates and proponents of the gold standard think and argue that commodity-based currency systems are more stable and reliable because they are backed and supported by something physical and valuable.
On the other hand, you can’t convert money to anything else under the fiat currency system. And with fiat money, authorities and governments can directly impact the currency’s value, tying it to economic conditions.
As a result, governments and their countries’ central banks tend to have far more control and influence over currency systems with fiat money. This allows them to respond to varying financial and economic events and even crises with different tools, such as creating fractional reserve banking or the effective implementation of quantitative easing.
Benefits of Fiat Currencies
Currencies without any intrinsic value—or without any commodity backing—have indeed become the norm in our modern world.
And even as opponents and critics of the system point out various drawbacks, like Zimbabwe’s hyperinflation or the U.S. housing debacle in the 2000s, it is hard to deny the overall benefits of this system. Below are some valid arguments for fiat currencies.
They Help Accelerate Economic Recovery
One of the best things about fiat currencies is that they give policymakers and financial experts the ability to control the supply of money and help revitalize a weak and slumping economy.
Nations all over the world use fiat currencies. They are an acceptable and ideal form of currency, especially for international trade.
They Help Promote Economic Growth
How is a fiat currency useful or valuable in a healthy economy? A fiat currency helps improve the standard of living. And when done for the right reasons and in moderation, increasing the quantity of a fiat currency in circulation can further strengthen and boost the economy.
Using fiat currencies is beneficial for another reason. Printing money is less labor-intensive, expensive, and time-consuming than mining precious metals, such as gold. This is why in a country that often experiences increased economic activity or rapid population growth, the fiat money system can easily keep up with the increasing demand for cash.
Shortcomings and Drawbacks of Fiat Money
Fiat money is not without its shortcomings and drawbacks. As most fiat currencies in the world don’t have “tethers,” they tend to carry a couple of risks.
For example, one of the main pitfalls is a considerable loss of value due to hyperinflation triggered by an economic crisis or even political unrest in a country.
Lack of Concrete Value
With a fiat currency, a country knows its currency has no intrinsic value. This is why if a government decides to inflate or increase the amount of its currency, this move may lead directly to rampant inflation, as well as a resulting decline in the country’s economic health.
Unstable Currencies can Lead to Unstable and Unsteady Economies
As you can see, fiat currency models tend to work as well as the economies or governments that back them.
This means that if a country is experiencing considerable economic instability (i.e., the value of an essential domestic export such as oil is in significant decline or the country is at war), that country might have a lackluster and softer currency, leading to higher prices in the process.
One of the famous examples happened in the German Weimar Republic from 1921 to 1923. After WWI, German residents burned down their cash for warmth and comfort. This was because money was cheaper than using the money in order to buy firewood.
Why People Use Fiat Currencies
It is evident that fiat currencies, such as the euro, become the central money of an economy because of many financial and legal incentives. First, the government’s issuance, as well as the backing of a currency, helps create and foster a great deal of trust.
So, a fiat currency that a stable government issues, such as the U.S. dollar, can usually be expected to have a considerable deal of stability itself. On top of that, the government also has a strong interest or incentive in protecting its currency, aligning its incentive with citizens who hold that currency.
Secondly, governments often use more direct methods to make and persuade people to use their currency. For example, many governments usually declare their fiat currency legal tender but do not give the same privilege to other currencies.
As a result, it creates a legal mandate for individuals to accept the fiat currency. Also, governments require their citizens to pay taxes, such as sales tax, in their fiat currency, which creates demand for the currency as the primary means of settling debts with the government.
Characteristics of Fiat Currencies
One of the primary characteristics of fiat currencies is their tendency to undergo consistent inflation. Since governments continue to print currency to fund expenses, the supply of that currency keeps increasing.
Inflation decreases the value of that currency over time; as a result, the price of the same goods increases.
Fiat currency has no intrinsic value, which is in stark contrast to commodity money – where the value is derived from the underlying commodity.
For instance, gold and silver have other uses other than money. This is why they have intrinsic value. In contrast, fiat money has just one use – to act as a currency.
Also, fiat currency is only a fiat money if the government backs it. And without governmental approval, it’s not ‘fiat’ – which is usually defined as formal authorization.
Businesses and companies are legally obligated to recognize and accept the fiat currency, helping establish consumers’ trust and confidence in its value.
It is typical for fiat currencies in healthy and growing economies to experience yearly inflation rates of around 2%. However, economic events and conditions affect the inflation rate and reshape the demand and supply of the currency.
For instance, many countries considerably increased the supply of their currencies in the market in response to COVID-19. This may ultimately lead to dramatic inflation. In some cases, a fiat currency may even cause hyperinflation.
Fiat currencies, such as Yen, by themselves, don’t have any real intrinsic value. Instead, it’s up to a government, relevant authorities, and central bank to maintain or preserve their value. They also have to ensure that there is a healthy supply of the currency for an economy to improve and grow.