What Is Fiat Money?
Fiat money is a government-issued currency not backed by a physical commodity, such as gold or silver, but rather by the government that issued it. The value of fiat money is derived from the relationship between supply and demand and the stability of the issuing government rather than the worth of a commodity backing it. Most modern paper currencies are fiat currencies, including the U.S. dollar, the euro, and other major global currencies.
KEY TAKEAWAYS
- Fiat money is a government-issued currency not backed by a commodity such as gold.
- Fiat money gives central banks more significant control over the economy because they can control how much money is printed.
- Most modern paper currencies, such as the U.S. dollar, are fiat currencies.
- One danger of fiat money is that governments can print too much of it, resulting in hyperinflation.
Understanding Fiat Money
The term “fiat” is a Latin word that is often translated as “it shall be” or “let it be done.” Thus, fiat currencies only have value because the government maintains that value; fiat money has no utility.
Fiat currency came about when governments would mint coins out of a valuable physical commodity, such as gold or silver, or print paper money that could be redeemed for a set amount of a physical commodity. Fiat is converted and cannot be saved simply because no underlying thing is backing it.
Because fiat money is not linked to physical reserves, such as a national stockpile of gold or silver, it risks losing value due to inflation or even becoming worthless in hyperinflation. In some of the worst cases of hyperinflation, such as in Hungary immediately after WWII, the inflation rate can double in a single day.
Furthermore, if people lose faith in a nation’s currency, the money will no longer hold value. This is much different from a currency backed by gold; for example, it has intrinsic value because of the demand for gold in jewelry and decoration and in manufacturing electronic devices, computers, and aerospace vehicles.
History of Fiat Money in the U.S.
The U.S. dollar is considered fiat and legal tender, accepted for private and public debts. Legal tender is any currency that a government declares to be legal. Many governments issue a fiat currency, then make it legal tender by setting it as the standard for debt repayment.
Earlier in U.S. history, the country’s currency was backed by gold (and, in some cases, silver). The federal government stopped allowing citizens to exchange money for government gold with the passage of the Emergency Banking Act of 1933. The gold standard, which backed U.S. currency with federal gold, ended entirely in 1971 when the U.S. also stopped issuing gold to foreign governments in exchange for U.S. currency.
Since that time, U.S. dollars are known to be backed by the “full faith and credit” of the U.S. government, “legal tender for all debts, public and private” but not “redeemable in lawful money at the United States Treasury or at any Federal Reserve Bank,” as printing on U.S. dollar bills used to claim. In this sense, U.S. dollars are now “legal tender” rather than “lawful money,” which can be exchanged for gold, silver, or other commodities.
Advantages and Disadvantages of Fiat Money
Advantages
Fiat money is a sound currency if it can handle the roles that a nation’s economy needs of its monetary unit—storing value, providing a numerical account, and facilitating exchange. It also has excellent seigniorage, meaning it is more cost-efficient to produce than a currency directly tied to a commodity.
Fiat currencies gained prominence in the 20th century partly because governments and central banks sought to insulate their economies from the worst effects of the natural booms and busts of the business cycle.
Since fiat money is not a scarce or fixed resource like gold, central banks have much greater control over its supply, which gives them the power to manage economic variables such as credit supply, liquidity, interest rates, and money velocity. For instance, the U.S. Federal Reserve has the dual mandate to keep unemployment and inflation low.
Disadvantages
However, the mortgage crisis of 2007 and subsequent financial meltdown tempered the belief that central banks could prevent depressions or severe recessions by regulating the money supply. For example, a currency tied to gold is generally more stable than fiat money because of the limited supply of gold. Due to its unlimited supply, there are more opportunities for creating bubbles with fiat money.
Pros
- It gives central banks more significant control over the economy
- Seigniorage
- Provides flexibility
Cons
- Not a fool-proof way to protect the economy
- Opportunity for a bubble
- Risk of inflation
Example of Fiat Money Gone Wrong: Hyperinflation
The African nation of Zimbabwe provided an example of the worst-case scenario in the early 2000s. In response to severe economic problems, the country’s central bank began to print money at a staggering pace, resulting in hyperinflation.
Experts suggest the currency lost 99.9% of its value during this time. Prices rose rapidly, and consumers were forced to carry bags of money to purchase basic staples. The Zimbabwe government was forced to issue a 100-trillion Zimbabwean dollar note at the height of the crisis. Eventually, foreign currencies were used more widely than the Zimbabwean dollar.
Why Is Fiat Money Valuable?
In contrast to commodity-based money like gold coins or paper bills redeemable for precious metals, fiat money is backed entirely by the full faith and trust in the government that issued it. One reason this has merit is that governments demand that you pay taxes in the fiat money it gives. Since everybody needs to pay taxes or face stiff penalties or prison, people will accept it in exchange (this is known as Chartalism). Other theories of money, such as the credit theory, suggest that since all money is a credit-debt relation, it does not matter if money is backed by anything to maintain value.
Why Do Modern Economies Favor Fiat Money?
Before the 20th century, most countries utilized some sort of gold standard or backing by a commodity. As international trade and finance grew in scale and scope, the limited amount of gold from mines and in central bank vaults could not keep up with the new value being created, causing severe disruptions to global markets and commerce. Fiat money gives governments greater flexibility to manage their currency, set monetary policy, and stabilize global markets. It also allows for fractional reserve banking, which lets commercial banks multiply the amount of money on hand to meet demand from borrowers.
What Are Some Alternatives to Fiat Money?
Virtually every country today has legal tender that is fiat money. While you can buy and sell gold and gold coins, these are rarely used in exchange or for everyday purchases and tend to be more of a collectible or speculative asset. Cryptocurrencies, such as Bitcoin, have emerged over the past decade as a challenge to the inflationary nature of fiat currencies. Still, despite increased interest and adoption, these virtual assets do not seem to approach being “money” in the traditional sense.
Does Fiat Money Lead to Hyperinflation?
There is always the possibility of hyperinflation when a country prints its currency; however, most developed countries have experienced only moderate bouts of inflation. Having some consistent low level of inflation is seen as a positive driver of economic growth and investment as it encourages people to put their money to work rather than have it sit idle and lose purchasing power over time.
A relatively strong and stable currency is not only a mandate of most modern central banks, but a rapidly devalued currency is harmful to trade and obtaining financing. Moreover, it is unclear whether or not hyperinflation is caused by the “runaway printing” of money. Hyperinflation had occurred throughout history, even when money was based on precious metals. All recent hyperinflation has begun with a fundamental breakdown in the actual production economy and political instability in the country.
