Fiat Money Explained: History, Types, and Pros and Cons

Fiat money has been around for centuries, with the first recorded use dating back to China in the 7th century.

The concept of fiat money gained widespread acceptance in the 20th century, particularly in the United States with the introduction of the Federal Reserve System in 1913.

The value of fiat money is derived from government decree, not from any inherent value in the currency itself.

Fiat money has become the dominant form of currency globally, with over 90% of the world's currencies being fiat.

Fiat money has a long and complex history, dating back to the 18th and 19th centuries. The first form of fiat currency in the American Colonies was "bills of credit", which were notes issued by provincial governments that could be used to pay taxes and were denominated in the local unit of account.

These notes were sold at a discount to silver and were used for non-tax transactions, but they also depreciated in value, causing controversy. The middle colonies, where inflation was practically nonexistent, were often cited as an example of the successful use of bills of credit.

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Governments intentionally introduced fiat currencies backed by taxes to mobilize economic resources in their new possessions. The repeated cycle of deflationary hard money, followed by inflationary paper money, continued through much of the 18th and 19th centuries.

Here's a list of countries that adopted the gold standard during this time:

During World War I, governments suspended redemption by specie, leading to hyperinflation in some countries, such as the Weimar Republic.

The Latin root of the word is 'Fiat,' which translates to 'let it be done.' It's the passive voice of the Latin word 'Facere,' meaning 'to make, do.' This Latin phrase has been used to convey a sense of authority and command.

By 1750, the English word 'fiat' began to also mean 'a decree, order, command.' This shift in meaning laid the groundwork for the modern concept of fiat money.

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The 20th century was a pivotal time for fiat money. The United States dollar was pegged to gold from 1944 to 1971 under the Bretton Woods agreement, with 35 other currencies calibrated to the dollar at fixed rates.

The dollar traded for many years within a narrow band centred on $2.80, and the U.S. promised to redeem dollars with gold transferred to other national banks. Trade imbalances were corrected by gold reserve exchanges or loans from the International Monetary Fund (IMF).

In 1971, the Nixon shock ended the Bretton Woods system, and the U.S. unilaterally canceled the direct convertibility of the dollar to gold. This marked a significant shift towards a system of national fiat monies with variable exchange rates between major currencies.

The Weimar Republic experienced hyperinflation after suspending redemption by specie, a consequence of paying debts with newly printed cash not associated with a metal standard.

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Fiat money can take many forms, and understanding these different types can help clarify how it operates.

There are two main types of fiat money: commodity-backed fiat money and fiat currency.

Commodity-backed fiat money is tied to a physical commodity, such as gold or silver, which gives it inherent value.

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Commodity money has an intrinsic value derived from the materials it's made of, such as gold and silver coins.

Historically, commodity money was used as a medium of exchange, with its value tied to the value of the materials it contained.

Commodity money is the opposite of fiat money, which has no intrinsic value.

The materials used to make commodity money, like gold and silver, have inherent value that is recognized across different cultures and time periods.

Fiat money, on the other hand, is essentially a promise from a government or central bank that the currency is capable of being exchanged for its value in goods.

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Digital currencies are a type of currency that exists only in digital form, with no physical coins or bills. They're not issued, controlled, or backed by any central authority.

Cryptocurrencies like Bitcoin aren't fiat money because they aren't backed by any central authority. In fact, some cryptocurrencies have a total maximum supply that's designed to be capped at a certain amount.

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The price volatility of cryptocurrencies is a major concern, with some skeptics saying they're unlikely to supplant fiat money as the dominant medium of exchange. However, acceptance of crypto has been growing, with the SEC approving two spot crypto ETFs to be traded on the traditional stock market in 2024.

Stablecoins are a type of cryptocurrency that can be pegged to commodities or fiat money, intended to make them less volatile. Some cryptocurrencies have utility, such as transferring payments or powering decentralized networks and applications.

Edstrom explains that cryptocurrencies can be used transactionally but haven't been fully adapted as money due to their volatile nature. If Bitcoin reaches its potential over the next decade or two, it's likely that the volatility will reduce and it will become used commonly as money in the economy as it matures.

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Fiat money is created by central banks and is backed by the government's promise to honor its value.

The value of fiat money is derived from the trust people have in the government and its ability to control the money supply.

Central banks can increase the money supply by printing more money, which is essentially creating new fiat money.

This can lead to inflation, where the value of money decreases and the price of goods increases.

Central banks can also reduce the money supply by selling securities, which takes money out of circulation.

The money supply is managed by the central bank's monetary policy, which aims to control inflation and maintain economic stability.

Fiat money is not backed by any physical commodity, unlike commodity-backed currencies like the gold standard.

The value of fiat money is also not tied to the value of any specific asset, making it a more flexible and adaptable form of currency.

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Fiat money offers a range of benefits that make it a popular choice for governments. Governments have greater control over the supply and value of a fiat currency, allowing them to manage the credit supply, liquidity, and interest rates more reliably.

A country's central bank can regulate the supply of a fiat currency, reducing the risk of an unexpected devaluation. Unlike commodity currencies, which can be affected by external factors like new gold discoveries.

Irresponsible monetary policy can lead to inflation and even hyperinflation of a fiat currency. This is because the value of a fiat currency depends on responsible fiscal policy and regulation by the government.

Fiat currencies have a virtually unlimited supply, which can lead to bubbles in the economy. These bubbles can cause a rapid increase in prices, followed by a rapid decline, impacting various aspects of the economy.

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Fiat money is widely used around the world, with few exceptions. The pound sterling, the euro, and the US dollar are well-known examples of fiat currencies.

These currencies have no intrinsic value, unlike commodity currencies that are backed by a physical asset like gold or silver. The value of fiat money is determined by supply and demand in the market.

The euro, for instance, is a fiat currency that's used by 19 of the 27 member states of the European Union. Its value is not tied to any specific commodity or asset.

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