Fiat currency: Here's what its position is in the modern economy

And how is it not be so volatile?
Ameya Paleja
Dollar banknotesLightFieldStudios/iStock

Imagine walking into the Apple Store to pick up your new smartphone with a lump of gold in your pocket to fund your purchase. Not just that, weekly groceries, gym memberships, and even dining in a restaurant would all require you to carry gold in some form to pay for the transaction. That would be a world without fiat money

What is fiat money?

The word fiat has a Latin origin, which means "it shall be" or "let it be done." In other words, the currency has value because the government maintains that value; the money has no value in and of itself. Fiat currencies are backed by the government of the land and the public faith in the currency. Fiat currency cannot be redeemed, because there is no underlying commodity backing it. 

However, it wasn't always so. For thousands of years, human civilizations used coins made from precious metals such as gold and silver. In theory, all coins of a particular denomination weighed the same, and so were worth the same amount.

Some countries have also followed a system called the gold (or silver) standard. In this case, the value of a country's money is directly linked to a physical commodity, such as gold, and the country agrees to convert paper money into a fixed amount of that commodity on demand. The country also set a fixed price for the commodity and buys and sells the commodity at that price. 

The U.S. used a gold standard from 1879 until 1933 (except for a period during WWI), when bank failures during the Great Depression led people to hoard gold and made the system unstable and the gold standard was dropped.

The U.S. dollar became the official reserve currency of the world in 1944. This was a result of a decision made by a delegation from 44 countries, called the Bretton Woods Agreement. Even then, the dollar was convertible to gold at a fixed rate.

It was 1971 when foreign-held dollars exceeded the amount of gold in U.S. reserves before the country finally stopped the practice of issuing gold to foreign governments in exchange for U.S. currency.

How does fiat money work?

Fiat money is issued by a central bank of a country. Unlike commodity currency, the value of the currency is not determined by the material it is made up of, or by a commodity that is held in reserve, but by the "good faith" of issuing government.

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Being delinked from a commodity puts fiat money at the risk of inflation. For example, with a gold standard, the amount of money that can be issued is limited by the amount of gold held in reserve. This creates stability. However, fiat money is not based on a fixed resource, so central banks can print more money when they wish. This can increase the risk of inflation or even hyperinflation, where the value of the currency can drop by a huge amount and create severe instability. 

Advantages of Fiat Money

Unlike money made from precious metals, fiat currency can be easily banked and regulated. It is also easier to trade in, carry around and exchange with other fiat currencies. 

Fiat currencies can also give central banks much greater control over the monetary supply, which in turn can help them to manage economic conditions such as credit supply, liquidity, and interest rates. This is why it is central banks who decide how much money should be printed and use this to control the rate of inflation.

Over the years, the system of fiat money has shown that when a country's economic policies are sound, fiat money can be quite stable and can provide a safe cushion against economic shocks. 

However, since the currency is centrally controlled, critics argue that the control of the economic system and the power to make financial decisions that affect everyone rests in the hands of a very few. And, while printing money can help to control inflation rates, printing too much money can lead to hyperinflation and the creation of an economic bubble. This risk of inflation due to the action of a central bank is one of the big criticisms of fiat money. 

Critics of fiat money have, therefore, argued for an alternative that uses blockchain technology in order to allow the decentralization of financial transactions and create greater accessibility.

Fiat Money vs. Cryptocurrency

Unlike fiat money, a cryptocurrency does not exist in a physical form. It exists only on a computer network that is not owned by a government or central bank. However, there is always an individual or organization behind the creation and (often) the continuing management of each cryptocurrency.

The record of all transactions that occur in a cryptocurrency is placed in a digital ledger called a blockchain. Unlike fiat money, where money either physically changes hands or is exchanged digitally and verified by a financial institution, a trade using cryptocurrency is complete only when it is recorded on the blockchain. This involves the generation of a unique hash to validate the transaction, which is achieved by solving incredibly complicated encryptions.

Since there is no central authority to do the hard work of confirming transactions, cryptocurrencies have relied on technology enthusiasts and crypto miners to do this job, rewarding them with a certain amount of cryptocurrency per transaction confirmed. This has led to the establishment of large-scale cryptocurrency mines, which use hundreds or thousands of high-end computing devices. The need for specialized equipment, and for huge amounts of energy, effectively places mining in the hands of a few.

Although, with more than 1,800 cryptocurrencies existing to date, there is no shortage of transactions that need to be validated. 

Another advantage is that because cryptocurrencies do not require a bank account, which usually requires identification, an address, etc, it could also be a solution for the world's unbanked - which number around 1 billion.

In addition, since cryptocurrencies exist only in the digital realm, they can be subdivided into a large number of units. Of course, for many, the biggest advantage of cryptocurrency is privacy - the use of blockchain and lack of international regulations allows those making transactions in crypto to remain anonymous, while still ensuring that the transaction takes place. This makes crypto very useful for criminals, money launderers, tax evaders, and corrupt officials - as well as for legitimate uses.

Why Do Modern Economies Favor Fiat Money?

Since their arrival on the scene over a decade ago, cryptocurrencies have seen major price fluctuations. Bitcoin, accounting for a third of the crypto coin market cap, has seen many upheavals and is going through a major one even now. In the year to May 10, bitcoin’s value has ranged from $28,893.62 to $68,789.63. This volatility makes it very difficult to use a crypto coin as a reliable medium of exchange or investment in the larger markets, which continue to be dominated by fiat money. 

Price volatility, tied to a lack of inherent value, means that buying cryptocurrency can resemble a stock investment more than a currency. This can possibly be overcome by linking the value of a cryptocurrency directly to tangible and intangible assets, although we have recently seen that this cannot prevent a run on the cryptocurrency and subsequent erosion of its value.

Another reason that fiat money is a preferred choice for modern economies is that cryptocurrency transactions require users to have access to digital technology. From crypto mining to wallets and crypto exchanges, everything in the cryptocurrency world is digital. While physical fiat money issued by a government will serve its purpose even in remote areas where digital connections are slow or non-existent, a crypto transaction requires a stable internet connection to be completed. 

There have also been a growing number of issues with security in the use of cryptocurrency. Because crypto exists in a digital-only realm,  cryptocurrencies are vulnerable to breaches and hacking, and it can be difficult to prove that money was even stolen. 

Is Bitcoin a Fiat Currency?

Bitcoin is not a centrally issued currency but its valuation is backed only by the faith people have put in it. So, in some ways, it can be considered a fiat currency, although not within the strictest definitions of the term. The problem is that public faith waxes and wanes, something that is reflected in crypto prices as well.

Considering the popularity of cryptocurrency and the advantages of blockchain technology, a number of governments are planning to introduce their own digital currencies, or have already. Called centrally backed digital currencies (CBDC), these are digital currencies issued by the central bank of the country but function using blockchain technology. This currency will carry the same value as the national currency and can be used to carry out transactions in a digital fashion. Almost 100 countries are actively evaluating CBDCs, according to the IMF.

Since the underlying technology would be controlled by the central bank, a CBDC could ensure that transactions do not remain anonymous, and so are more difficult to use for money laundering. This also allows the central bank to protect the asset holders, which does not happen with decentralized crypto transactions. 

Many countries are still exploring the framework and structural changes needed to introduce CBDCs into their financial systems and retain control of their monetary policies. A digital currency that follows a public ledger system also needs measures for ensuring cybersecurity and protecting individual privacy. 

Nevertheless, widespread CBDCs could bring together the best of both worlds. We will have to wait to few years to see how well this works in real life.  

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