Fiat currency is a form of government-issued money that isn’t backed by a commodity like silver or gold. Nation states adopted fiat currency as primary form of money after 1973.
In a monetary system based on fiat currency, the money supply is flexible, which means governments don’t need to acquire more silver or gold to create new banknotes and coins. Central banks can create new banknotes and coins without any backing requirements. This has benefits and downsides.
Until 1914, the world was on a gold standard. This meant, a certain amount of gold backed the circulating paper money supply. In the United States, the backing requirement was 40%.[1] Federal Reserve of St. Louis “The Federal Reserve Act of 1913 : History and Digest” Accessed March 1, 2022.
If the United States had $1,000 worth of paper money, it would need to back it with $400 worth of gold. Other countries had similar, sometimes even stricter backing requirements.
To understand why governments backed their paper money with gold, we have to go even further back in monetary history.
The world has a long history of using commodities such as gold and silver as money. The first reports of using gold as money go back as far as ancient Egypt, and later on the Roman Empire and ancient Greece.[2] UK Research and Innovation “Roman Coin Study Reveals Thriving Empire” Accessed March. 1, 2022.
The practice of using precious metal as money, such as silver and gold coins, continued until the 17th century. People used to deposit their coins and bullion at goldsmiths. In return for their deposit, they received a receipt.[3] World Bank: “The History of Banks” Accessed May 2, 2022.
People could redeem these paper receipts for gold and silver at the same gold smith. However, these receipts were so convenient that people began trading these money substitutes as if they were money.
Soon after, goldsmiths realized they could earn additional income by lending out people’s gold deposits. This way they could make money by charging a fee to safeguard the funds and earn interest by lending out the funds.
This is how the modern banking system was born. These gold smiths later on became known as banks and paved the path to the fractional reserve banking system that still exists today.
Starting in the 16th century in Sweden, governments created central banks to provide stability to the banking system.[4] Federal Reserve Bank of Cleveland: “A Brief History of Central Banks” Accessed May 2, 2022. Banks only kept a fraction of deposits at hand and lent out the rest. This could result in bank runs if many people withdrew their deposits at the same time.
The introduction of central banks allowed governments to take control of the issuance of paper currency, define reserve requirements for banks and provide struggling banks with money.
The traditional gold standard ended in 1914. The United States and several other countries tried to stay on a gold standard but abandoned it during the Great Depression to expand the money supply.
The Great Depression concluded with the beginning of World War II. After the war, the Bretton Woods system emerged as dominant monetary system around the world.[5] Federal Reserve History: “Creation of the Bretton Woods System” Accessed February 22, 2022.
As part of the Bretton Woods system, the United States pegged the US dollar to gold at a fixed exchange rate. All other countries pegged their currencies to the US dollar at fixed rates.
This allowed the United States and other countries to keep their currencies backed by gold without requiring a traditional gold standard.
However, the Bretton Woods system failed in 1973 after the Nixon Shock. The Federal Reserve had engaged in loose monetary policy.[6] Federal Reserve History: “The Great Inflation” Accessed March 18, 2022. And increased government spending on the Vietnam war led to an increase in the money supply.
The United States was unable to maintain its peg of $35 per ounce of gold. Despite efforts to re-peg the currency and reform the Bretton Woods system with the Smithsonian Agreement, the world abandoned a commodity-based monetary system in favor of fiat currencies with floating exchange rates.[7] Federal Reserve History: “The Smithsonian Agreement” Accessed May 4, 2022.
In 1973, all countries adopted floating exchange rates and their money became fiat currency.
The term fiat currency has Latin roots. Fiat means “let it be done”. In a monetary system based on fiat currency, governments don’t need to mine gold or acquire it through trade or conquest.
If a government wants to issue more units of a fiat currency, it can just create them. In the case of paper money, the government can print money. Since there is no backing requirement, governments can theoretically print an unlimited amount of paper money to finance government expenses or stimulate the economy during downturns.
On a gold standard, expanding the paper money supply meant that governments need to acquire more gold. They could mine gold, buy it, accept it for exports or confiscate it.
However, during the time when people directly used gold and silver coins as money, emperors and other profiteers began clipping small amounts of silver or gold off the edges of coins.
Some emperors also gradually reduced the amount of silver and gold in coins and added copper and other cheap metals to debase the coins. This devalued each coin and enriched those engaging in coin clipping and debasement.
In a monetary system based on fiat currency, governments can profit in a more direct way. When the government prints paper money or issues coins through its mint, this costs money. The paper itself, which is a special form of cloth, the iron in coins, the ink and engraving are expenses for the government.
But as long as the costs of producing a bank note or coin are lower than their face value, the government makes a profit. This profit is known as seigniorage.
Since the invention of the internet, most fiat currency exists in digital form. While governments still print money and mint coins, a majority of circulating money exists merely on a digital accounting ledger maintained by banks.
When people say the Federal Reserve has “printed” trillions of dollars, they really only added more digits in digital form.
In recent years, cryptocurrency has become increasingly popular among retail investors and institutions. Cryptocurrency has some similarities and key differences to fiat currency.
Bitcoin is classified as commodity by the Securities and Exchange Commission. Some people believe it is similar to gold in digital form.
Generating new bitcoin involves energy-intensive proof-of-work mining. Governments or central banks cannot issue bitcoin. This is why some view bitcoin as a digital commodity, or even a new form of digital commodity money.
Other cryptocurrencies rely on a programmatic, decentralized currency issuance as well. But some cryptocurrencies have been classified as securities by the Securities and Exchange Commission.
Governments don’t issue cryptocurrencies like Bitcoin, Ethereum and XRP. This is a key difference between fiat currency and cryptocurrency.
Most cryptocurrencies are also based on different technologies than fiat currency. For example, fiat currency relies on central banks, commercial banks and certain inter-bank payment networks like SWIFT. Without them, digital payments and trade wouldn’t be possible.
Cryptocurrency relies on distributed ledgers, public-key cryptography and other technologies to facilitate payments and keep track of account balances and transactions.
The next evolution in fiat currency is the step towards governments adopting Central Bank Digital Currencies (CBDCs).
While these Central Bank Digital Currencies might follow different designs than currently existing cryptocurrencies, they look to update and reform the current fiat currency infrastructure.[8] Federal Reserve: “Central Bank Digital Currency (CBDC)” Accessed May 12, 2022.
Unlike private and decentralized cryptocurrency, Central Bank Digital Currency is issued by a country’s central bank.
Some people foresee a collapse of most fiat currencies due to excessive levels of government debt. When governments take on too much debt, this can lead to the need for central banks to monetize the debt.
When investors and nations are unwilling to purchase government debt, the country’s central bank might have to buy the debt.
This can lead to a vicious circle where trust in the fiat currency is lost. If the loss in trust is big enough, this can lead to a fiat currency collapse in the form of a government default or hyperinflation.
During the hyperinflation in Zimbabwe, the Zimbabwean dollar collapsed and lost most of its value. It was the first episode of hyperinflation in the twenty-first century.
A little less than a century ago, Germany struggled to repay its war debts. The government resorted to printing money, causing the German hyperinflation.
There is some debate over whether fiat currency is backed by something or not. While fiat money isn’t directly backed by a commodity, some argue that we entered a Petrodollar system after the collapse of Bretton Woods.[9] Lyn Alden: “The Fraying of the US Global Currency Reserve System” Accessed April 1, 2022.
Proponents of the Petrodollar theory believe that oil indirectly backs the US dollar. However, it doesn’t do so officially and not at a specific exchange rate.
Others believe that the faith and credit of the government that issues the fiat currency is what gives it value. For them, we are willing to hold paper money because the government promises to repay its debt.
Governments with a central bank that issue their own currency cannot default on their debt. In a worst case situation, the central bank can step in and print money to repay bond holders.
This creditworthiness and faith in the government to provide a risk-free return, and the ability of a government to manage its budget, provides trust. However, this trust only lasts if the government is strong and in good financial health.
Some argue that fiat currency is backed by military power and the government’s monopoly on violence. Through legal tender laws and requiring citizens to pay taxes in the government’s currency, the government can enforce widespread adoption. This is possible even if citizens would otherwise not choose to hold or trade the currency.
If a government is powerful enough, it can force its citizens and foreign nations to use its currency with the implicit or explicit threat of force, whether it be military intervention in the case of a foreign nation, or fines or imprisonment in the case of citizens.
Under legal tender laws, businesses are required to accept the government-issued currency in exchange for goods and services. And citizens and businesses need to pay taxes in the government-issued currency.
This leads to widespread adoption of the currency. Once every part of a country’s economy depends on it, this can lead to a network effect that gives the currency value as a medium of exchange and unit of account.
Critics of fiat currency point out that it gives governments a monopoly on money. Since they control the money production and can print an unlimited amount of money, governments can enrich themselves.
When central banks expand the money supply by lowering the federal funds rate or engaging in quantitative easing, this can cause inflation.
Critics of the current monetary system argue that inflation leads to a transfer of purchasing power from the general public to the government. When central banks create new money and lend it to the government, the government can spend the money before the money has circulated enough to cause inflation.
Once this newly printed money trickles through the economy, it may cause a long-term increase in consumer price levels. This means, governments can spend newly created money at pre-inflation prices. But once it enters the economy, it hurts the most vulnerable people that live paycheck-to-paycheck or rely on savings.
Some of these critics are in favor of reintroducing a commodity-based monetary system using gold, or more recently, Bitcoin to back currencies.
More extreme proponents of commodity money demand a return to gold and silver coins. They believe the Federal Reserve, fractional reserve banking and the government’s monopoly on money should be abolished. To them, market participants should freely decide what money they want to use.
This and similar views are mostly shared by proponents of heterodox schools of economy like the Austrian school of economics.
Mainstream economists that have a background in Keynesianism, as well as proponents of Modern Monetary Theory (MMT), believe that the abandonment of the gold standard was a good thing. Keynes himself called the gold standard a “barbarous relic”.[10] Keynes, John Meynard. A Tract on Monetary Reform (1923), pp. 172.
Those in favor of fiat currency argue that decoupling money from commodities and removing fixed exchange rates was a necessary step to counteract the Great Depression and subsequent economic downturns.
A flexible money supply allows central banks to intervene in the economy and expand or contract the money supply as needed.
Since the Great Depression, deflation and the possibility of another comparable economic downturn in the future, most economists believe that mild inflation is desirable to incentivize spending and borrowing and prevent deflation.[11] Federal Reserve History: “The Great Depression” Accessed April 28, 2022.
With a more rigid money supply, such as under a gold standard, the money supply is out of control of central banks and governments.
According to many mainstream economists, this can lead to periods of deflation without the central banks having the ability to do anything. The idea and necessity of counter-cyclical government spending remains one of the main arguments used by mainstream economists to explain why commodity money had to be abandoned.
They view a return to a gold standard or commodity-based monetary system as ineffective and dangerous.