The world of currency is surprisingly vast. From precious metals as payments to digital cryptocurrency investments, the landscape has evolved dramatically over time. But at the heart of the current system sits one thing: fiat currency.
If you’re someone who invests in crypto or works in the field of economics, you’re probably quite familiar with the term “fiat currency” already. But it isn’t commonly discussed in most other circles, despite being a core element of the finance world. If you’ve come across this term and now find yourself wondering what fiat currency is, how it works and more, join us for a look into the history and function of fiat currency.
What Is Fiat Currency?
Fiat currency – also referred to as fiat money – is legal tender people can exchange for goods and services. You probably have some in your wallet right now; most paper bills and coins are fiat money. It’s backed by the government, not an underlying asset or a physical commodity like gold or silver. Essentially, this means it doesn’t have any value that’s based on the material it’s made from. Instead, it has value because its issuing government determined it does. In the United States, the U.S. dollar is fiat currency. In the United Kingdom, it’s the British pound, and, in China, it’s the yuan. These are just three of many examples of fiat currency found throughout the world.
Technically, the history of fiat money varies depending on the currency in question. For example, the first known use of what would become paper money dates back to 900 C.E., when Chinese merchants began issuing receipts for transactions. While these weren’t fiat currency, they show how long ago these trade mechanisms began evolving.
In the United States, the bulk of the journey began in 1690 when the Massachusetts Bay Colony started using paper notes to fund military expeditions. From there, the process of creating notes evolved; anti-counterfeiting measures were added as early as 1739, and imagery was adjusted based on recent (at the time) events.
While many early bills had questionable backing, a major stride occurred in 1900 with the passage of the Gold Standard Act. This created a system to ensure the value of government-issued currency. However, that era in the U.S. was surprisingly short.
In 1933, President Franklin Delano Roosevelt signed Executive Order 6102, requiring citizens to surrender their gold to the U.S. government and making the ownership of notable quantities of gold coins, bullion and certificates illegal. The goal was to ensure the Federal Reserve could print more money during a period of economic struggle — the Great Depression. It wasn’t until 1974 that owning gold became legal once more.
However, the formal severing of the connection between gold and the U.S. dollar occurred in 1971. President Richard Nixon formally ended the convertibility of dollars to gold, leaving the dollar without an underlying commodity.
How Fiat Currency Works
Fiat money is considered legal tender within a particular nation or set of countries and has secured full backing from the government(s) that issue it. Functionally speaking, fiat currency is simply a transfer mechanism that gives the population a way to conduct trade using a standardized system. People can exchange fiat currency for goods and services, and it’s also used as compensation for time and energy in the form of wages.
Many currencies were once backed by other assets like gold or silver, allowing the bills to serve as stand-ins for a particular amount of the underlying asset they represented. In those cases, the value of the currency was easy to discern, mainly because it was tied to an item that was broadly deemed to have worth. With fiat currency, there isn’t an underlying asset. So, understanding where the value comes from is a bit trickier.
Generally speaking, fiat currency has value because an issuing government says it does. The notes have no intrinsic value. Instead, they only maintain value because regulations make them legal tender and the population is willing to accept the currency’s associated worth as accurate. The public’s trust in the issuer – in this case, a national government – plays the most significant role in establishing the value of fiat money.
Often, some of the value of fiat currency is also based on the available supply. Governments can limit how much of a currency is printed or minted. By doing so, they can preserve worth by ensuring the supply doesn’t exceed a reasonable amount.
The Pros and Cons of Fiat Currency
All types of currencies come with pros and cons, including fiat money. As for the advantages, the biggest is standardization. Within a nation, the population generally agrees on its value, making activities like budgeting and shopping far easier.
Fiat currency is also inexpensive to create, easy to transport, and simple to exchange for goods and services. Because the government maintains control over the supply, fiat money can also help with the navigating of specific economic issues, such as inflation or liquidity. Additionally, fiat currency gives a government a mechanism for addressing (and minimizing) a potential financial crisis.
As for the drawbacks, fiat money isn’t a foolproof solution for ensuring financial stability within a nation. Additionally, its value can be somewhat volatile, as public and global perception can influence its standing.
How Fiat Currency Compares to Other Currency Types
As mentioned, the world of currency is surprisingly vast. While most people are familiar with a few types of currency, many aren’t aware of all of the kinds they may encounter.
For example, commodity money is a currency that has intrinsic value because there’s an underlying asset supporting the value. Usually, a commodity like gold or silver is used to back the currency, though any commodity could potentially work.
Representative currency is functionally a hybrid of fiat money and commodity currency. Along with being produced by the government, there’s also an underlying asset. Technically, bank checks are representative currency, as they’re backed by an asset – fiat currency in an account – and are viewed as legal tender from a government perspective.
When it comes to modern currency concepts, cryptocurrency is the most noteworthy. Traditionally decentralized, cryptocurrency isn’ backed by governments or other central authorities. As a result, the value of coin-style crypto is primarily based on public perception.
Spending fiat money to buy goods and services is its most common use. Many people also invest using fiat currency, as it’s the most widely accepted option for securing other kinds of assets, such as stocks, bonds and even cryptocurrencies.
Ultimately, fiat money gets everyone on the same page by simplifying the process of conducting a range of transactions. It’s essentially the basis for any nation’s financial system, making it critical for economies around the globe.