Fiat Money: Everything You’ve Always Wanted To Know

Imagine you own a car. This situation is pretty straightforward: there is a vehicle you can use to get from point A to point B. This is an imaginary scenario (though I hope each of you does own a car), so let’s forget about cost of gasoline, parking tickets and other related costs. You own something that helps you moving, and there are spare parts in it, i.e. some underlying value.

And then a friend comes to you offering “a promissory note” on a car. Which means you won’t have a vehicle anymore but he guarantees you will be able to travel with the same level of comfort, speed and freedom as before, any time you want. Will you be willing to accept this form of cooperation? Will you think of this option as of a real car? Keep this example in mind when reading our today’s story about money and value.

Types of money

Before discussing fiat, let’s look into earlier types of money. Commodity money is the earliest form, and is money that has actual intrinsic value. The most popular commodity money is gold, and for a huge part of human history it was physically used in exchange.

Fiat money

Mankind’s attitude to gold is bizarre. Chemically, it is uninteresting — it barely reacts with any other element. Yet, of all the 118 elements in the periodic table, gold is the one we humans have always tended to choose to use as currency. The fact that gold is inert supported its role in jewelry because gold amulets, rings and necklaces caused no allergic reactions. Gold was rather hard to find and extract, thus it always had some production “cost” or value. 

Representative money is a variation of this, and refers to money that represents a commodity. For a brief part of the 1900s, the United States operated on the gold standard. Under the gold standard, each dollar could be exchanged for a set amount of gold.

In 1861, Treasury Secretary Salmon Chase printed the first U.S. paper currency. The Gold Standard Act of 1900 established gold as the only metal for redeeming paper currency. It set the value of gold at $20.67 an ounce​. European countries had wanted to standardize transactions in the booming world trade market. They adopted the gold standard by the 1870s. The gold standard was slowly phased out, until President Nixon completely abolished the conversion of gold for a fixed value in 1971.

You might have heard that the more conservative is someone’s portfolio, the more “cash” is has in it. Conservative investors employ risk-reduction strategies to curtail investing perils while growing and preserving their capital. Well, any financial advisor in personal finance means exactly government decree issued money as cash, not some metal coins, being those made of gold, silver or platinum etc.

The backing was in place for some time. Nearly all coins in history that people used as payment were either made of precious metals or secured by them. And all of them were issued by some authority, whether it was a king’s treasury or a country’s central bank. The word “fiat” (in many cases this money is also called “fiduciary”) comes from the Latin and is often translated as the decree “it shall be” or “let it be done.”

How fiat money works

Fiat money only has value because the government maintains that value, or because two parties in a transaction agree on its value. Remember our imaginary friend who proposed you his car as an opportunity? Well, as soon as you all trust him as a driver, or you believe he has sufficient car fleet, you can “forward” his “car” to anyone. Like, say to your girlfriend that you could pick her up at seven and go to the movies. You do expect your buddy arrive at nineteen sharp on his wheels.

How fiat money works

Basically, anything that buyers and sellers find mutually acceptable will do to facilitate trading or credit. At Micronesian tropical island of Yap, the region that had no ties to the Western civilization prior to XIX. People of Yap treated money as a means of payment. They used “Rai” stones, circular disks with a hole in the middle.

Historically, governments would mint coins out of a valuable physical commodity, such as gold or silver, or print paper money that could be redeemed for a set amount of some goods or a commodity. Fiat money is inconvertible and cannot be redeemed.

Fiat currency originated centuries ago in China. One of the country’s regions began producing paper money during the 11th century. At first, it could be exchanged for silk, gold, or silver. But eventually, Kublai Khan came into power and established a fiat currency system during the 13th century. Historians claim this money was instrumental in the downfall of the Mongol Empire, with excessive spending and hyperinflation at the root of its decline.

Most modern paper currencies, including the U.S. dollar, are fiat money. Because fiat money is not linked to physical reserves, such as a national stockpile of gold or silver, it risks losing value due to inflation or even becoming worthless in the event of hyperinflation.

Hyperinflationary episodes have appeared several times over the past century – 55, to be exact – as the world’s nations have experimented with fiat currencies backed by the full faith and credit of the governments that issue them. At times, that full faith and credit has been misplaced – and holders of unstable currencies have been caught empty-handed in countries all over the world.

If people lose faith in a nation’s currency, the money will no longer hold value. That differs from currency backed by gold, for example; it has intrinsic value because of the demand for gold in jewelry and decoration as well as the manufacture of electronic devices, computers and aerospace vehicles.

Genesis from ancient financial systems

Modern paper money are basically bills of the government or central bank. To some extent, they have originated from private bills issued by merchant banks of ancient societies. During the latter part of the 6th Century, social and economic stability gave rise to the accumulation of wealth from land revenues, rents, slavery, etc. With prosperity came merchant bankers. Private archives written on cuneiform tablets from the time period show a large sector of the population participating in commercial and financial operations, whose operations were based on a silver standard and modeled on promissory notes.

A typical contract listed the following:

  • Object of the transaction;
  • Names of lender and borrower;
  • Duration of the loan;
  • Method of reimbursement;
  • Interest to be collected;
  • Collateral to be held by the lender.

These elements are still standard parts of financial contracts today. However, ancient Babylonians didn’t have computers, programs and the internet. Nevertheless, accuracy in recording was still just as important to ensuring trust between parties.

The U.S. dollar is considered to be both fiat money and legal tender, accepted for private and public debts. Legal tender is basically any currency that a government declares to be legal. Many governments issue a fiat currency, then make it legal tender by setting it as the standard for debt repayment. Earlier in United States history, the country’s currency was backed by gold (and in some cases, silver). The federal government stopped allowing citizens to exchange currency for government gold with the passage of the Emergency Banking Act of 1933.

Some basics in chemistry

Coming back to the “why gold” question. If you dig down the Periodic Table, you dismiss the noble gases and the halogens, liquid element and alkaline metals. The radioactive ones are out of the scope as well (bye-bye thorium, uranium and plutonium, along with a whole bestiary of synthetically-created elements), so are rare earths.

This leaves us with the middle area of the periodic table, the “transition” and “post-transition” metals. This group of 49 elements includes some familiar names – iron, aluminium, copper, lead, silver. Some of them are too hard to smelt, others feel flimsy for coinage. Iron is good but too widely spread to bear some value. That is how everything naturally came to silver and gold.

The gold standard

The gold standard, which backed U.S. currency with federal gold, ended completely in 1971, when the United States also stopped issuing gold to foreign governments in exchange for U.S. currency.

In the meantime, the quiet campaign to reinstate the gold standard is getting louder. The once-fringe fantasy of a return to the gold standard is creeping back into the mainstream. It has long been dismissed as a fool’s errand, on par with abandoning the Federal Reserve and other trappings of the modern economy. Mainstream economists deride it almost without exception. Reintroducing the gold standard would “be a disaster for any large advanced economy,” they say.

This may look tough

Our car-renting friend helped us a lot today already, so let him step in once again. It’s been decades since you gave up on your car and began relying on your entrepreneurial friend. You are not alone in your hopes (and prayers, sometimes). There are thousands of people who expect their rides to take place once in a while.

The Car Man no longer covers this “demand” with the cars he own; he uses all sorts of replacements. Some guys keep their cars in his parking lot and let them be used, other owe some money to the man, and pay back with rides. So, he does his job, and as long as it happens, there is no discussion about any lack of trust to the carcoin, let’s call it that way.

The Federal Reserve System was established by Congress over a century ago to serve as the U.S. central bank. President Woodrow Wilson signed the Federal Reserve Act into law on December 23, 1913. Prior to the creation of the Fed, the U.S. economy was plagued by frequent episodes of panic, bank failures, and credit scarcity. The history of the Federal Reserve is bound up in the effort to build a more stable and secure financial system, and it is FED responsible for response to the needs of the nation’s economy, including issuing of the bills.

The fun fact is that some documents do mention American Colonies which are, in fact, the USA per se. American colonies, also called thirteen colonies or colonial America, the 13 British colonies that were established during the 17th and early 18th centuries in what is now a part of the eastern United States and have formed the country’s civil backbone.

Since that time, U.S. dollars are known to be backed by the “full faith and credit” of the U.S. government, “legal tender for all debts, public and private” but not redeemable. However, it remains the most trusted currency of all. Reserves held in U.S. dollars stand over $6.5 trillion, or 62 percent of allocated reserves. Global reserves are assets of central banks held in different currencies, primarily used to support their liabilities. Central banks sometimes use reserves to help support their respective currencies.

Major currencies

The major currencies are those in which most of the world’s foreign transactions are denominated. They are also the currencies that countries most commonly value their own currency against.

  • US Dollar
  • Pound Sterling (British Pound)
  • Euro
  • Japanese Yen
  • Swiss Franc
  • Canadian Dollar
  • Australian Dollar
  • Swedish Kronor
  • New Zealand Dollar

Pros and cons of fiat money

Fiat money serves as a good currency if it can handle the roles that a nation’s economy needs of its monetary unit: storing value, providing a numerical account, and facilitating exchange. It also has excellent seigniorage.

Pros and cons of fiat money

The most important feature of fiat money is the stability of its value, unlike commodity-based money like gold, copper, and silver. The use of fiat money became popular in the 20th century as governments and banks moved in to protect their economies from the frequent busts of the business cycle. Commodity-based currencies were volatile due to the regular business cycle and periodic recessions. The central banks can print or hold paper money as they may need, giving them greater control over the money supply, interest rates, and liquidity. For example, the Federal Reserve’s control over money supply and demand enabled it to manage the financial crisis of 2008 from causing greater harm to the U.S. financial system and global economy.


One Comment

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