What is a fiat currency?

Simply put, it is a paper currency, which is a legal tender, and its value is determined by the issuing state and not by a physical commodity. The strength of the government that sets the value of the fiat currency is a critical factor for this type of money. Most countries use the fiat currency system to buy goods and services, invest and save. Fiat currency has replaced the gold standard and other commodity-based systems in determining the value of the legal tender.

Growth of the fiat currency

The fiat currency originated many centuries ago in China. Sichuan Province began issuing paper money in the 11th century. At first, they could be exchanged for silk, gold, or silver. But eventually, Kublai Khan came to power and established a fiat money system in the 13th century.

Historians claim that this money played an essential role in the fall of the Mongol Empire, which was based on excessive spending and hyperinflation.

Fiat money was also used in Europe in the 17th century; Spain, Sweden, and the Netherlands adopted it. In Sweden, the system proved unsuccessful, and the government eventually abandoned it in favor of the silver standard. Over the next two centuries, New France in Canada, the American colonies, and the U.S. federal government experimented with paper money with mixed results.

By the 20th century, the U.S. had returned to using commodity currency on a somewhat limited basis. In 1933, the government stopped exchanging paper money for gold. By 1972, under President Nixon, the United States had completely abandoned the gold standard, completing its decline on an international scale by switching to a fiat currency system. This has led to the use of fiat currency around the world.

Fiat Currency vs. Gold Standard

The gold standard system made it possible to convert paper banknotes into gold. All paper money was backed by a finite amount of gold held by the government. Under the commodity currency system, governments and banks could introduce a new currency into the economy only if they had the same amount of gold reserves. This system limited the government's ability to create money and increase the value of its currency solely based on economic factors.

On the other hand, money cannot be converted into anything else in the fiat currency system.

With the help of paper money, the authorities can directly influence the value of their currency and link it to economic conditions. The governments and central banks of their countries have much more control over the currency systems. They can respond to various financial events and crises with the help of multiple tools, such as creating a fractional reserve banking service and the introduction of quantitative easing.

Proponents of the gold standard argue that the commodity currency system is more stable because it is backed by something physical and valuable.

Supporters of the fiat currency object that gold prices are far from stable. In this context, the value of both commodity currency and paper money can fluctuate. But with a fiat currency system, the government has more flexibility to act in an economic emergency.

Some pros and cons of using fiat currency

Economists and other financial experts are not unanimous in their support for fiat currency. Defenders and opponents passionately argue about the pros and cons of this currency system.

• Scarcity: Fiat money is not affected or limited by the scarcity of a physical commodity such as gold.
• Cost: Fiat money is more affordable for production than commodity money.
• Responsiveness: Fiat currency gives governments and their central bank flexibility in overcoming economic crises.
• International trade: Fiat currency is used in countries around the world, making it an acceptable form of money for international trade.
• Convenience: Unlike gold, paper money does not depend on physical reserves that require storage, protection, monitoring, and other expensive tasks.
• No intrinsic value: A fiat currency has no inherent value. This allows governments to create money out of nothing, leading to hyperinflation and the collapse of their economic system.
• Historically risky: Historically, the introduction of fiat currency systems has usually led to financial collapses, which indicates that these systems pose certain risks.

Fiat Currency vs. Cryptocurrency

Fiat currency and cryptocurrency have little in common in that a physical commodity supports neither of them, but the similarity ends there. While governments and central banks control fiat money, cryptocurrencies are decentralized due to a distributed digital registry called Blockchain.

Another notable difference between these two currency systems is how these forms of money are generated. Bitcoin, like most cryptocurrencies, has a controlled and limited supply. On the contrary, banks can create paper money out of nothing according to their judgment about the country's economic needs.

As a digital form of money, cryptocurrencies have no physical counterpart and no borders, making them less restrictive for transactions around the world. Moreover, transactions are irreversible, and the nature of cryptocurrencies significantly complicates tracking compared to the fiat system.

It is noteworthy that the cryptocurrency market is much smaller and more volatile than traditional markets. This is probably one of the reasons why cryptocurrencies are not yet universally accepted, but as the crypto economy grows and develops, volatility is likely to decrease.

Final thoughts

The future of both of these forms of currency is by no means certain. Although cryptocurrencies still have a long way to go and, of course, they will face many more problems, the history of fiat currency demonstrates the vulnerability of this form of money.

This is a big reason why many people are exploring the possibilities of switching to a cryptocurrency system for their financial transactions - at least to some extent.

One of the main ideas of creating bitcoins and cryptocurrencies is to explore a new form of money based on a distributed peer-to-peer network.

Most likely, Bitcoin was created not to replace the entire fiat currency system but to offer an alternative economic network. Nevertheless, it certainly can create a better financial plan for a better society.