Fiat money refers to a government-backed currency that is not backed by a physical commodity like gold or silver and is instead backed only by the government that issued it. For fiat money, the value of the currency is derived from the balance between supply and demand, the stability of the issuing government and not any underlying commodity of real value. Most global currencies are fiat currencies, including the U.S dollar, the euro, and other major global currencies.
Fiat money was first introduced as an alternative to commodity and representative money. Commodity money refers to money created from metals like gold and silver, while representative money is a claim on a commodity that can be later redeemed.
Unlike commodity-backed currencies, fiat currencies are intrinsically valueless and used solely by government order. China was the first country to employ the use of a fiat currency in 1000 AD, with the currency later being adopted by other countries. The currency became popular when U.S President Richard Nixon created a law that cancelled the direct convertibility of the U.S dollar to gold.
History of fiat money.
The currency traces its history back to ancient China during the Yuan, Tang, Song and Ming dynasties. In the ancient Tang dynasty, a problem arose when the demand for metallic currency far exceeded the supply of precious metals. The people in that time were quite familiar with credit notes, and therefore proceeded to utilize these in place of the metallic coins.
A shortage of coins created the perfect opportunity for the community to move from coins to notes. During the Song Dynasty (960- 1276), a successful business in the Sichuan region led to the copper money shortage. Traders of the time began issuing private notes protected by a monetary reserve, which was thus considered the first legal tender. Paper money eventually became the only legal tender permitted in the Yuan Dynasty (1276- 1367), with the issuing of notes handed over to the Ministry of Finance during the Ming Dynasty (1368-1644).
American colonies, France and the Continental Congress, began issuing bills of credit that were used to make payments. Paper money didn’t catch on in the west until the 18th century. During these early days, the rules that currently govern the money supply were yet to be created, which led to the issuing of too many bills of credit.
In certain areas such as New England, the bills completely depreciated and lost value owing to their high supply. In times of war and in an attempt to preserve precious metals, countries turn to fiat currencies; for example, the Federal Government of the United States turned to “Greenbacks” during the American civil war to preserve natural resources.
Understanding Fiat Money.
“Fiat” is a Latin word to mean “it shall be” or “let it be done.” On this basis, fiat currencies owe their value to the fact that issuing governments create their value by decree. Because a fiat currency is not backed by any physical commodity such as national stockpile, gold or silver, it stands the risk of losing its value or even, in some cases, becoming completely worthless- in case of hyperinflation.
In cases of hyperinflation, citizens quickly lose trust in the national currency and search for other means of storing value; this situation often leads to the springing up of black markets and general chaos in the country. However, if a currency is backed by a valuable commodity such as gold, the money derives its value from the underlying asset, which makes it a more stable currency.
Advantages of fiat money.
Fiat currency though controversial, is a good currency if it can serve the objectives a nation wishes to achieve from its national currency, such as storing value, providing numerical count, and facilitating trade. Another advantage of the currency is that it’s production is cheaper than a commodity currency.
Fiat currencies became popular partly because governments and central banks wished to protect their economies from the devastating effects of booms and busts that characterize regular business cycles. Because the currency is not fixed or even scarce, like in the case of natural minerals, central banks can exercise much greater control over their supply, liquidity and interest rates. For example, through the control of money supply, the Federal Reserve attempts to keep inflation and unemployment levels low.
Disadvantages of fiat money.
Fiat currency is inherently without any real value, making it susceptible to the ebbs and flows caused by various market forces. In contrast, a currency whose underlying value is derived from a physical commodity such as gold is a far more stable store of value because of gold’s finite and limited supply. The mortgage crisis of 2007 and its effect on the U.S economy was all the proof central banks needed to realize that they cannot always prevent depressions or deep recessions by simply regulating the money supply.
Why is fiat money valuable?
For fiat money, its greatest support is the fact that it is backed by the government. Taxes paid to the government are paid exclusively in the fiat currency, thus creating some notion of its value. As long as the government is fully functional, the currency will be recognized by all who do business with or within the country’s borders.
Some theories of money, such as credit theory, assert that since all money is technically a credit-debit relation, the fact of whether or not the money is backed by anything doesn’t matter.
Why do modern economists favour fiat money?
Before the 20th century, many countries used variations of the commodity currency- a gold standard or backing of some sort. However, as international trade and finance scaled up, the limited physical commodities coming out of the mines, most notably gold, created disruptions to global markets and commerce. With fiat money, governments gain greater flexibility in managing their own currencies, setting monetary policy, and stabilizing global markets.
Fiat currencies also make fractional reserve banking possible, allowing commercial banks to multiply the amount of money on hand to match demand from borrowers.
What are alternatives to fiat currency? Because most countries across the globe use fiat currencies as their legal tender, the actual exchange of value is typically conducted in those trusted and known currencies. While a person can buy and sell gold coins, these are almost never used in everyday purchases. However, cryptocurrencies have come closest to unseating the known fiat currencies. Cryptocurrencies such as bitcoin have gained popularity over the past decade as possible remedies or alternatives to the highly inflation-prone fiat currencies. There is still a long way to go before these currencies can be fully adopted as naturally as fiat currencies still, the fu