Fiat Money Explained: Benefits, Risks, and Global Examples

What Is Fiat Money?

Fiat money, a currency not backed by a physical commodity like gold, relies on government backing and supply-demand dynamics. Most modern currencies, such as the U.S. dollar and euro, fall into this category. This article explores the concept, detailing its benefits and risks, and how it plays a critical role in today's global economy.

Key Takeaways

Fiat money is a government-issued currency not backed by a physical commodity like gold, deriving its value from supply, demand, and the stability of the issuing government.
The flexibility of fiat money allows central banks to control economic factors such as money supply, interest rates, and inflation, but it carries risks of inflation or hyperinflation if overprinted.
Examples of fiat currencies include the U.S. dollar, euro, and British pound, with historical instances like Zimbabwe highlighting the danger of hyperinflation when mismanaged.
The shift away from commodity-backed currencies provides governments greater ability to manage economic policy and adapt to global market demands.

Insight into the Mechanics of Fiat Money

The term "fiat" is a Latin word that's often translated as "it shall be" or "let it be done." Fiat currencies only have value because the government maintains that value. There's no utility to fiat money in itself.

Governments would mint coins out of a valuable physical commodity such as gold or silver before fiat currency came about. They might have printed paper money that could be redeemed for a set amount of a physical commodity. Fiat is inconvertible, however. It can't be redeemed because there's no underlying commodity backing it.

Fiat money isn't tied to national reserves like gold or silver, so it can lose value through inflation. It can become worthless during times of hyperinflation. The rate of inflation can double in a single day in some of the worst cases of hyperinflation, such as in Hungary immediately after WWII.

Fiat money loses value if people lose faith in it, unlike currency backed by gold. This currency holds value because gold is needed for jewelry, electronics, computers, and aerospace vehicles.

Evolution of Fiat Money in the United States

The U.S. dollar is considered to be both fiat money and legal tender. It's accepted for private and public debts. Legal tender is any currency that a government declares to be legal. Many governments issue a fiat currency and then make it legal tender by setting it as the standard for debt repayment.

The country's currency was backed by gold and in some cases silver earlier in U.S. history. The federal government stopped allowing citizens to exchange currency for government gold with the passage of the Emergency Banking Act of 1933. The gold standard backed U.S. currency with federal gold but it ended completely in 1971 when the U.S. also stopped issuing gold to foreign governments in exchange for U.S. currency.

U.S. dollars have been backed by the "full faith and credit" of the U.S. government since that time. They are "legal tender for all debts" but aren't redeemable in gold or silver, as older U.S. bills stated. U.S. dollars are "legal tender" rather than "lawful money" in this sense, which can be exchanged for gold, silver, or any other commodity.

Pros and Cons of Fiat Money

Advantages

Gives central banks greater control over the economy
Is cost-efficient to produce
Provides governments with flexibility

Disadvantages

Isn't a foolproof way to protect the economy
Creates an opportunity for a bubble
Provides risk of inflation

Advantages Explained

Fiat currencies became popular in the 20th century because governments wanted to protect their economies from booms and busts.

Fiat money isn't a scarce or fixed resource like gold so central banks have much greater control over its supply. This gives them the power to manage economic variables such as credit supply, liquidity, interest rates, and money velocity. The U.S. Federal Reserve has the dual mandate to keep unemployment and inflation low and using fiat money can help it meet those goals.

Fiat money works well if it can store value, provide a numerical account, and facilitate exchange. It also has excellent seigniorage. It's more cost-efficient to produce than a currency that's directly tied to a commodity.

Disadvantages Explained

The 2007 mortgage crisis showed that central banks can't always stop depressions or recessions just by regulating money supply. A currency tied to gold is generally more stable than fiat money because of the limited supply of gold.

Important

There are also more opportunities for the creation of bubbles with fiat money because of its unlimited supply.

Real-World Instances of Fiat Money

The U.S. dollar, the euro, the British pound, the Japanese yen, the Albanian lek, and the Indian rupee are all examples of fiat money. It's a currency that's backed by an issuing government so fiat money usually provides some economic stability, but not always.

The African nation of Zimbabwe provided an example of the worst-case scenario in the early 2000s. The country's central bank began to print money at a staggering pace in response to serious economic problems, resulting in hyperinflation.

Experts say the currency lost 99.9% of its value then. Prices rose rapidly and consumers carried bags full of money just to purchase basic staples. The government of Zimbabwe was forced to issue a 100-trillion Zimbabwean dollar note at the height of the crisis. Foreign currencies were eventually used more widely than the Zimbabwean dollar.

Why Is Fiat Money Valuable?

Fiat money is backed entirely by the full faith and trust in the government that issued it in contrast to commodity-based money such as gold coins or paper bills redeemable for precious metals. This has merit because governments demand that you pay taxes in the fiat money it issues. Everybody must pay taxes or face stiff penalties or prison so people will accept it in exchange. This is known as chartalism.

Other theories of money such as the credit theory suggest that all money has a credit-debt relation so it doesn't matter if money is backed by anything to maintain value.

Why Do Modern Economies Favor Fiat Money?

Most countries used some sort of gold standard or backing by a commodity before the 20th century. The limited amount of gold coming out of mines and in central bank vaults couldn't keep up with the value that was being created, however, as international trade and finance grew in scale and scope. This caused serious disruptions to global markets and commerce.

Fiat money gives governments greater flexibility to manage their currency, set monetary policy, and stabilize global markets. It also allows for fractional reserve banking which lets commercial banks multiply the amount of money on hand to meet demand from borrowers.

What Are Some Alternatives to Fiat Money?

Virtually every country has legal tender that's fiat money. You can buy and sell gold and gold coins but these are rarely used in exchange or for everyday purchases. They tend to be more of a collectible or speculative asset.

Cryptocurrencies such as Bitcoin have emerged as a challenge to the inflationary nature of fiat currencies. These virtual assets don't seem to approach being "money" in the traditional sense, however, despite increased interest and adoption.

Does Fiat Money Lead to Hyperinflation?

There's always the possibility of hyperinflation when a country prints its own currency but most developed countries have experienced only moderate bouts of inflation. A low level of inflation is seen as a positive driver of economic growth and investment because it encourages people to put their money to work rather than have it sit idle and lose purchasing power over time.

Maintaining a strong, stable currency is a key goal for modern central banks. A rapidly devalued currency is harmful to trade and in obtaining financing.

It's unclear whether hyperinflation is caused by the "runaway printing" of money. It's occurred throughout history, even when money was based on precious metals. All contemporary hyperinflation has begun with a fundamental breakdown in the real production economy and/or political instability in the country.

Key Takeaway on Fiat Money

Fiat money, which includes major currencies like the U.S. dollar and the euro, derives its value from government backing rather than a physical commodity like gold. This system allows central banks to exercise control over economic conditions, influencing variables such as liquidity and interest rates. While fiat money offers flexibility and cost-effectiveness, risks such as inflation and hyperinflation persist if not carefully managed. Understanding fiat money's role can empower individuals in making informed financial decisions, considering its advantages in economic stability and its potential drawbacks.