Fiat currency is a means of payment, which value is artificially established by the highest governing bodies. What is important, the value of this currency is not provided by pegging to specific assets. If earlier, for example, the value of the currency of a particular country was determined by its gold reserves, now the only guarantor of value is the government authority.
Paper money secured by certain valuable goods was first actively used in China. In Sichuan, for example, they have been actively used since the 11th century. Silk, gold and silver served as guarantors of value. The system turned out to be quite effective, so when in the 13th century, Kublai Khan subjugated vast territories, including China, he established a system of fiat currencies in his empire. It is only a pity that the state did not cope with hyperinflation.
In Europe, the first fiat money began to be used in the 17th century. Spain, Sweden and the Netherlands were the first. However, the Swedes did not do very well, so the government returned to the silver standard. However, the idea was successful, so more and more countries began to experiment with fiat currencies. The results were not so stable.
The USA, for example, tried to switch to fiat currency in the 19th century. However, at the beginning of the 20th century, it was necessary to return to commodity currency again. By 1933, the government, however, again stopped exchanging paper money for gold, having finally abandoned the gold standard by 1972. Following the “economic flagship”, other countries refused to provide commodity security for the currency.
Fiat currency or gold standard?
The gold standard made it possible to use not currency made of gold for currency transactions but paper money provided by this very gold. Therefore, it was impossible to simply issue a new batch of banknotes since this meant that the value of each existing banknote became lower. This significantly reduced the ability of the government to respond to extreme situations.
Moreover, with the advent of the fiat currency, more effective mechanisms of economic interaction appeared — the same bank reservation, which allowed for the implementation of an effective credit policy and increased the purchasing power of ordinary citizens.
In addition, gold prices were also unstable, so the value of the currency secured by the gold standard could also fluctuate over a wide range. However, due to the difficulty of operating with large masses of metal, it is much easier to respond to sudden changes in the exchange rate and emergency economic situations by managing fiat currency.
Pros and cons
Fiat currency pros:
- Not subject to deficit, unlike any other pegged to specific goods.
- Simpler to manufacture.
- The ability to more effectively respond to crisis situations by controlling release.
- Since most countries in the world use fiat currency, it is easier to carry out international trade with it.
- There are no costs for storage and security of the “material basis”.
- Lack of intrinsic value. Because of this, rapid depreciation in case the confidence in the government is compromised.
- Historical risks. There have been repeated cases of financial collapses due to the use of fiat currency.
Comparison with cryptocurrency
In fact, the only similarity between fiat and cryptocurrency is both are not backed with real assets. In all other respects, they differ, and quite a lot.
- Regulation. A central, trustworthy body (banks and public financial systems) against distributed digital registry and automation.
- New money generation. Issuing new money, based on the economic situation, against a predetermined limited supply.
- The physical counterpart. Material form versus digital version.
- Volatility. Small due to external regulation versus high due to small volume and relatively short period of use.
In addition, cryptocurrency transactions are much faster, and the additional costs are lower. Plus it’s much harder to track where the cryptocurrency transfer is carried out.
Despite the generally effective implementation of the very idea of fiat currency, it has some drawbacks. Actually, Bitcoin was created precisely to overcome them. What is important, not as a full replacement but as a possible alternative. More and more people are seriously considering using cryptocurrency as their main means of payment. However, there is no talk of a complete transition to alternative means of payment. Will the situation change in the future, time only knows.