Why is fiat money valuable?
Unlike commodity money, such as gold coins or paper notes, which can be exchanged for precious metals, fiat money is fully backed by faith and trust in the government that issued it. This makes sense because governments require people to pay taxes in the paper money they issue. Since everyone has to pay taxes, people will accept the fiat money in return. Other theories of money, such as credit theory, suggest that since all money is a loan-debt relationship, it doesn't matter if the money is backed by something to maintain value or not.
What are some alternatives to fiat money?
Almost every country today has a legal tender, which is fiat money. While you can buy and sell gold and gold coins, they are rarely used in exchange or for everyday purchases and tend to be more of a collectible or speculative asset. Besides, cryptocurrencies like bitcoin have emerged over the past decade as a challenge to the inflationary nature of fiat currencies. However, despite increased interest and acceptance, these virtual assets don't seem close to "money" in the traditional sense.
Does fiat money lead to hyperinflation?
There is always a possibility of hyperinflation when a country prints its currency. However, most developed countries experience only moderate bouts of inflation most of the time. Persistently low inflation is a positive factor for economic growth and investment, as it encourages people to put their money to work rather than leave it idle and lose purchasing power over time.
Most modern central banks mandate a relatively strong and stable currency because a rapidly devaluing currency is detrimental to trade and obtaining finance. Moreover, it's unclear whether hyperinflation is caused by the "runaway printing" of money. Periods of excessive price growth had occurred throughout history, even when the monetary system was based on precious metals; all modern hyperinflations started with a total collapse of the real manufacturing economy and political instability in the country.
What is fiat currency?
Fiat money is a government-issued currency. The value of fiat money is determined by the relationship between supply and demand and the stability of the issuing government, not by the value of the commodity that supports it. Most modern currencies are fiat currencies, including the US dollar, euro, and other major world currencies.
"Fiat" is Latin for "it shall be" or "let it be done." Thus, fiat currencies only have value because the government says so. Fiat money itself has no utility.
China was the first country to use fiat currency around 1000 AD, and then this currency type spread to other countries of the world. In the 20th century, US President Richard Nixon removed the direct convertibility of the US dollar into gold, known as the “gold standard”. Currently, most countries use paper-based fiat currencies that only serve as payment methods.
Unlike traditional commodity-backed currencies, fiat currency can't be converted or redeemed. It's inherently useless and is used by government decree. For fiat currency to be successful, the government must protect it from counterfeits and manage the money supply responsibly.
Fiat currency is the opposite of commodity money. The difference between them is their intrinsic value. Historically, commodity money has an intrinsic value that is determined by the materials it is made from, such as gold and silver coins. Fiat money, by contrast, has no intrinsic value — it's essentially a promise from a government or central bank that a currency can be exchanged for its value in goods.
Advantages of fiat currencies
Fiat money is excellent as long as it performs the functions that a national economy requires of its currency — store value, provide a numerical account, and facilitate exchange. It also has excellent seigniorage, which means it's more cost-effective than a currency directly linked to a commodity.
Fiat currencies rose to 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.
Because fiat money isn't a scarce or fixed resource like gold, central banks have much more control over its supply, allowing them to control economic variables such as credit supply, liquidity, interest rates, and the velocity of money. For example, the US Federal Reserve has a dual mandate to keep unemployment and inflation low.
Disadvantages of fiat currencies
Since fiat money isn't pegged to tangible assets, its value is subject to responsible fiscal policy and government regulation. Irresponsible monetary policy can lead to inflation and even hyperinflation of the fiat currency.
On top of that, there is more room for fiat currency bubbles — an economic cycle in which there is a rapid rise before an equally rapid fall in price. The risk of bubbles is high because fiat currencies have a virtually unlimited supply, meaning that governments can do quantitative easing. While quantitative easing help to stimulate the economy, it may also trigger an increase in the inflation rate. Rising price pressure may affect anything from housing market to government debt levels, and financial markets.
Let's look at the case that happened in the African country of Zimbabwe in the early 2000s. In response to severe economic problems, the country's central bank began printing money at a staggering rate causing hyperinflation. As a result, the currency lost 99.9% of its value. Prices rose rapidly, and consumers were forced to carry bags of money to buy groceries. At the peak of the crisis, the Zimbabwean government had to issue a 100 trillion Zimbabwean dollar note. Eventually, people started using the foreign currency more widely than the Zimbabwean dollar.
Even if people nowadays try to find an alternative way of money, fiat currencies will still be necessary until it has demand and supply.
2023-05-08 • Updated