Fiat money is a type of currency that is established and backed by a government. It is made of paper or metal and is used as legal tender for all debts, public and private. Fiat money is not backed by a commodity such as gold or silver, but instead relies on the strength of the issuing government and the trust people have in it. This article will explain what fiat money is, how it works, and how it affects the economy.
- Fiat money is fiduciary, that is, based on trust, state currencies, not backed by any asset or physical commodity, having no intrinsic value.
- The fundamental basis of fiat money is the trust of users and holders of the currency to its issuer, which is the state. The value of fiat money is determined by the effectiveness of management and the development of the country’s economy.
- Fiat money has replaced gold-backed currencies. The so-called gold standard assumed that banknotes and other financial obligations of an individual sovereign state were backed by a standardized amount of the precious metal.
- The processes associated with the issue, the regulation of the amount of money in the open market and in the economy, are controlled by the state, depending on the financial situation in a particular country.
History of fiat money
The first attempt to introduce fiat into circulation was recorded in the third century. The Roman emperor Diocletian legislated the rate of the coin to be higher than the nominal price of the silver that was part of it.
However, the first fiat money close to modern is considered to be a currency introduced during the reign of the Chinese Tang Dynasty in the eighth century. The issue of such money was aimed at combating inflation and private issue of coins, as well as strengthening state control in the field of finance.
The modern financial system and fiat money emerged from the depegging of the US dollar to gold in 1971. The United States unilaterally refused to exchange the precious metal at a fixed rate and launched the process of “printing” unsecured currencies around the world.
The reason for the rejection of the gold standard in the United States is the long-term trade deficit and the discrepancy between the dollar exchange rate and its real purchasing power.
The gold standard as a generally accepted option for providing state currencies finally ceased to exist in 1973 at the Jamaica International Conference. From now on, all rates on the international market are set depending on supply and demand.
Benefits of fiat money
The abolition of the gold standard gave the state access to an unlimited supply of money. To do this, it is no longer necessary to replenish the treasury reserves with gold or other hard goods – currency printing can be timed to coincide with any events, plans and goals.
All this gives the state the opportunity to deliver investments in the form of cheap loans to any groups of consumers, contributing to the development of production and an increase in demand, thereby increasing the efficiency of the entire economy as a whole.
The quantitative easing (QE) program has become the main tool to support the economy. QE involves injecting additional liquidity into the markets through the purchase of assets from banks and other financial institutions by the state.
The goal of QE is to increase money reserves in the economy to ease monetary policy: lower the refinancing rate for banks, simplify consumer access to cheaper loans, reduce systemic risks, and improve the investment climate.
Disadvantages of fiat money
Flexibility and freedom in conducting monetary policy can be both a boon for the economy and turn into a number of problems. Consider the key risks.
Lack of intrinsic value
The loss of trust, as the fundamental basis of fiat money, can lead to the loss of value of all investments and savings, up to a complete stop of the economy as a whole.
The value of a particular fiat currency is determined by the effectiveness of public administration. Stability in the past does not guarantee its preservation in the future due to political risks within the country and abroad.
An example is the 1998 crisis in the Russian Federation and the volatility of the Russian ruble after the start of the war with Ukraine.
Government access to a virtually endless supply of currency entails the risk of creating a huge amount of unsecured debt. The USA is an example. The country has one of the most developed economies in the world and at the same time the largest debt, the amount of which in the first quarter of 2022 exceeded $30 trillion or 133% from the country’s GDP.
According to the US Department of the Treasury, the annual interest on debt accrued by June 30, 2022 made up 5% of the country’s budget for the same period. At the same time, the US budget deficit for 2022 amounted to $ 1 trillion – this difference is compensated by the issuance and sale of bonds.
According to the forecast of the US Congressional Budget Office, in 2031 only the interest on the principal amount to $914 billion. To pay off these obligations, the US government does not have enough money – it is forced to create new debts to pay off the old ones.
A prime example of the inefficiency of an economy based on fiat money is the 2006 mortgage bubble in the US, which led to the financial crisis of 2007-2008.
Banks improved the flow of capital by creating an artificial demand for housing. They issued loans and resold these obligations to other banks in the form of derivatives. As soon as borrowers stopped paying interest, and real estate prices stopped rising, the entire market collapsed like a domino.
Cryptocurrencies – an alternative to fiat money
Currencies backed by gold or other commodities are not the only alternative to fiat money. The cryptocurrency industry, as a young participant in the global financial system, can contribute to the emergence of more efficient economic models.
Cryptocurrencies are based on distributed ledger technologies, including blockchain and the concept of an acyclic graph. In the presence of the Internet, access to public cryptocurrency networks can be obtained by anyone without restrictions, including jurisdiction, age, time zone, gender, financial status and political affiliation.
Cryptocurrencies are developed on the basis of the principles of decentralization – no one should have the prevailing right to vote, all decisions to make changes to the system are made on the basis of public consensus.
Cryptocurrency emission mechanisms are laid down before the launch of the network or token. Each participant knows in advance how many and under what conditions intra-network settlement units (tokens, coins) will be created or destroyed.
To send cryptocurrency to a user located in the next room or on the other side of the Earth, intermediary companies are not needed – it is enough to know the address of the recipient and pay a small commission for the transaction.
To exchange one cryptocurrency for another, there are special decentralized exchanges and exchangers that operate autonomously from any part of the world – DEX.
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Fiat money is an important concept in modern economics and a key part of the global financial system. It is created out of thin air and valued by a government’s promise to accept it as a legal tender. Fiat money provides a reliable medium of exchange and serves as a store of value. It is important to understand how fiat money works in order to make wise financial decisions.