A fiat currency is money that is not backed by a physical commodity like gold, but instead backed by the government that issued it. Most modern currencies, such as the U.S. dollar, euro, pound and yen, are fiat money.
“Fiat” means “an authoritative or arbitrary order.” So in the case “fiat money,” it’s an order by the government that gives them value and makes them legal tender. The current fiat-money system came about during the 20th century when countries moved away from the gold standard, where currencies are directly linked to gold. There are currently some 180 fiat currencies in the world today.
The value of fiat currencies is driven by the marketplace forces of supply and demand. Central banks control the supply, gauging how much money is needed in the economy and printing accordingly. The biggest risk is that they print too much, triggering a bout of hyperinflation–rapid, out-of-control price increases that can lead to economic devastation.
Faith in a fiat currency hinges on the stability of the government that issues it, as well as trust in the central bank that manages its supply. Here’s a deeper dive into the fiat-currency systems that are fixtures of modern economies.
Fiat vs Crypto: What’s the Difference?
Currencies basically serve two main purposes: as a medium of exchange and as a store of value. The rapid rise of investing in cryptocurrency has raised questions about whether fiat currencies will continue as the dominant medium of exchange.
Cryptocurrencies were created in 2009 with the invention of Bitcoin. They are in essence virtual currencies that are managed by a decentralized network rather than by a single authority, like government-issued fiat currencies.
Transactions made with cryptocurrencies are permanently logged on a ledger known as blockchain. This ledger is viewable to anyone, therefore functioning as a public database. Cryptocurrencies afford a level of privacy to users because only details about transactions are viewable. Identifying information about the users themselves may be traceable but isn’t recorded.
Fiat vs Crypto For Payment
Some proponents of cryptocurrencies argue that one day digital currencies will take over fiat money as the main mode of payment, because of their ability to deliver instantaneous transactions. They argue that if trust vested in a fiat currency is in the government backing it, trust vested in crypto is in the blockchain technology.
But so far, cryptocurrencies like Bitcoin haven’t really taken off as a medium of exchange. While some vendors and businesses accept crypto as payment, most transactions around the world are made with fiat currencies.
Critics argue that the volatility of cryptocurrencies like Bitcoin make them less ideal as a mode of payment. Imagine getting a paycheck in Bitcoin–such market fluctuations could dramatically magnify or shrink a person’s income in a matter of days.
Fiat vs Crypto as Store of Value
Instead, while it’s still early days, cryptocurrencies like Bitcoin have arguably functioned more as a store of value, similar to how people have historically invested in precious metals.
Like precious metals, cryptocurrencies like Bitcoin need to be “mined,” which automatically limits its supply. In fact, Bitcoin was designed with a cap on the number of coins that could be mined: 21 million.
Meanwhile, with fiat currencies like the U.S. dollar, the supply is potentially limitless. As of December 2020, there’s about $2 trillion or so of U.S. paper currency outstanding in the world. The Federal Reserve’s balance sheet–a proxy for the amount of money in the system–has grown by a staggering amount since 2007, as the central bank fought off recessions during the financial crisis of 2008 and the Covid-19 pandemic of 2020.
Meanwhile, speculators and investors have put money into the crypto market with the hope that their coins will maintain their worth or ideally, increase significantly in value. However, many others cite volatility as a reason why digital coins are not a reliable store of value.
What Are Central Bank Digital Currencies (CBDC)?
One potentially interesting development could be the advent of central bank digital currencies (CBDC)–virtual currencies that are created and backed by a nation’s central bank.
CBDCs sounds to some people like an oxymoron because cryptocurrencies by definition are decentralized and don’t have an authority backing them, but a January 2020 survey by the Bank of International Settlements found that 80% of central banks were researching and experimenting with CBDCs.
Pros and Cons of Fiat Money
Pros of Fiat Money
A major convenience of paper currencies is that they are easy to produce, carry around, and consequently, good at facilitating exchange.
Another plus is not being reliant on a physical commodity market like gold. This means the money system isn’t as susceptible to the risk of outside players manipulating a metal’s supply and demand in order to distort currency prices.
Arguably, the most important advantage of fiat currencies is that they allow central banks to control money supply. Deciding how much currency to print is a valuable tool when trying to manage economic cycles.
For instance, the Federal Reserve has a dual mandate of keeping both unemployment and inflation low. In order to keep unemployment low, the central bank can boost currency supply, and when that starts to spark inflation, the Fed can raise interest rates to tame price increases.
Cons of Fiat Money
The biggest risk to a fiat-currency system is that the central bank miscalculates or mismanages and prints too much money–a situation that could result in hyperinflation, when the rate of inflation grows at more than 50% a month.
A 2012 study by the Cato Institute found that some of the worst cases of hyperinflation include Germany after World War I, from which there are photographs of German children playing with bundles of money as building blocks, and Zimbabwe from 2007 to 2008, when prices of bread skyrocketed and people carried cash in wheelbarrows.
Most recently, in 2019, hyperinflation in Venezuela reached 1,300,000%, pushing the government to issue 50,000 bolivar notes, which equaled $8.13 in U.S. dollars at the time.
Fiat currencies by themselves have no real intrinsic value. Instead, it is up to a government and its central bank to preserve their value, while also ensuring that there’s a healthy supply for an economy to grow. Former Fed Chairman Paul Volcker once said, “It is a governmental responsibility to maintain the value of the currency they issue. And when they fail to do that, it is something that undermines an essential trust in government.”
Some people argue that cryptocurrencies will challenge fiat as a store of value and medium of exchange. Cryptocurrencies like Bitcoin have seen their prices and popularity jump notably since 2017. However, they haven’t yet become a common way for people to pay for goods. Volatility in the market has also made some investors believe that digital coins aren’t a good store of value.
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