What Is Fiat Currency?
Currencies with no other commodity backing them are known as fiat currency. The euro, pound, yen, and other major currencies are all considered fiat currencies.
From the Gold Standard to Fiat
In 1971, the United States officially ended the gold standard. Instead of a dollar representing a specified amount of gold, the U.S. dollar is now valued based on supply and demand and faith in the U.S. government.
Therefore, currencies of more developed economies like the United States, Japan, the European Union, and others tend to be the most valuable. Countries that have instability or undeveloped economies typically have less valuable currencies.
In some cases, these smaller less developed countries don’t even issue their own currency. And if by chance they do, they typically peg it to a more stable fiat of a developed economy. For example, most countries in the Caribbean peg their currencies to the U.S dollar since most of their economies are funded by U.S. tourists. Lebanon pegs its currency to the British Pound. Most African countries maintain a peg to the euro.
The Side Effect of Fiat
The goal of doing this is to keep their economies more stable. However, there is one flaw. Economic policy enacted by countries with the reserve currency like the United States or European Union ultimately trickles down to these smaller nations. They have little say and are forced to deal with the hand they are dealt.
Additionally, fiat currencies are always in a state of flux. Currencies become more valuable and less valuable. If you’ve traveled abroad and tried to exchange currencies, you know that your U.S. dollar is not equal to exactly the same amount of euros or pounds or any other currency.
When currencies were backed by commodities like gold or silver, this phenomenon didn’t exist. Centuries ago, the world agreed to facilitate trading in gold. Each country determined what an ounce of gold would be worth in its own currency.
This standardization eliminated exchange rates. Therefore, if you were attempting to convert your British pounds into American dollars, all you would need to know is how many pounds and dollars the British and American governments said one ounce of gold was worth.
As World War II concluded and a new geopolitical landscape developed, the winners of the war coordinated to unveil the new economic game plan. Originally the plan was for the U.S. dollar to be exchanged with gold at a rate of $35 per ounce. Then every other nation’s currency would be tied to the U.S. dollar.
However, this system was abandoned in 1971 when President Nixon severed the convertibility of dollars into gold. At this moment, fiats were born.
Fiat currency rose in popularity because it grants governments, and more specifically central banks, greater control over the economy. With fiat currencies under their discretion, central banks can monitor credit supply, liquidity, and interest rates.
The goal of this new approach was to minimize the effects of boom and bust cycles that economies used to go through. Central banks could alter interest rates or limit money supply in order to either incentivize or limit growth.
Yet increased government control over the economy has not always been sustainable. Fiat currencies are not always reliable. They can be overmanipulated and once out of control, it can be difficult to pull in the reins.
Inflation Is Inevitable
One key pitfall of fiat currencies is an increased risk of inflation. There are a handful of examples throughout history when central banks have abused their power.
Zimbabwe was home to one of the worst inflation crises in modern history. To stave off an economic downturn in the early 2000’s, the central bank of Zimbabwe started printing money at an astronomical rate. By the end of this mishap, the currency of Zimbabwe lost 99.9% of its value. It got so out of hand that the central bank had to issue a 100 trillion dollar note.
Today there are a multitude of countries dealing with their own inflation problems as a result of government overreach. Venezuela is sitting at a 2000% inflation rate, while Lebanon hovers around 200%. Argentina’s currency has lost half of its value and Turkey’s has lost one-third.
Unfortunately, the average citizen in these countries suffers the most. Those with their life savings in a bank account could wake up one day and see their country’s currency lose half of its value. This is exactly what happened in Yugoslavia in 1994. The country’s monthly inflation rate hit 313,000,000% and prices doubled every 1.4 days at its peak.
Fiat Currencies vs. Cryptocurrencies
Even if not overnight, inflation can slowly take place over decades.
When governments print more money, they de-value the money sitting in their citizens’ bank accounts, the value of their homes, and many other assets. Contrarily the cost of goods and commodities increases. Lower-income people the brunt of inflation most.
In the U.S. nearly there is nearly twice as much money in circulation since the Great Recession of 2008. Not by coincidence, right after the Great Recession, the world’s first cryptocurrency, Bitcoin, was created. Bitcoin came about to try and combat overreaching central banks.
Today there are thousands of cryptocurrencies. Calling some of these “currencies” could be a misnomer. Cryptocurrencies like Dogecoin, Shiba Inu, and many other memecoins have no true utility and do nothing to solve the fiat problem.
While some other cryptocurrencies serve different purposes, like Ethereum and its smart contracts, Bitcoin’s original design was meant to serve as a safe haven for those wanting to avoid central banks.
People who are believers in Bitcoin see it as everything fiat currencies aren’t: It has a limited supply. It cannot be manipulated. And it does not rely on any governing authority.