Fiat Currency

The term fiat money stands for a currency declared by the government as legal tender. Thus, it has value because of a law or government regulation and not an intrinsic value. This is so because fiat money is not backed by reserves. Given that there are no reserves linked to fiat money, it may become worthless due to hyperinflation. The money loses value if people lose faith in the paper currency of the country.

Throughout history, currencies were based on silver, gold, and other physical commodities. Fiat currency, on the other hand, is based on faith. The term itself comes from ‘let it done’ in Latin, and money is established by way of a government decree. Fiat money can be defined as state issued money, which is not fixed in value or convertible by law. It is also not linked to the value of a physical quantity.

Today, most of the paper money in circulation around the world is fiat money. Given that there is no legal connection between fiat money and commodity money, no economic costs are involved it its production. The value of money is linked to the political or economic stability of the issuer or is a matter of public confidence. Hence, money supply is not self-limiting. All fiat currencies have self-destructed historically because of hyperinflation caused by a loss of public confidence or an unlimited supply of money. Fiat money can lose value due to loss of confidence in the political or economic fortunes of the issuer, and sometimes both occur. Why is inflation a problem? It acts to wipe out the middle class. While prices go up for everyone, inflation prevents redirecting money toward the middle and lower class. The lower class suffers due to rising unemployment.

Ever since the creation of fiat money, it has been an object of criticism. Opponents of fiat money claim that when the currency is not backed up by a tangible commodity, the government allows an unjustifiable printing of money. According to the Austrian School of Economics, excessive debt is linked to printed money, which is wrongly taken for economic growth. Economists argue that printed money is not backed by an increase in productivity or any assets, which are the real causes of economic growth.

Fiat money is, in fact, a promise by the government for its currency value. However, there is a possibility that the government decides not to back up its money, for example, it may stop collecting taxes in this currency. Fiat money will retain its value only if there is a consensus among the general population and a stable private banking system. In fact, this happened after the 1990 Gulf Conflict in Iraq. The authorities did not back up the Iraqi Swiss diner, but the currency did not lose value and was exchanged thanks to the Iraqi people and the support of the banks.

With these in mind, are there any benefits to fiat currency? Fiat money is more stable compared to gold-backed currencies, which tend to increase volatility and create come-and-go recessions. In addition, fiat money is not subject to advances in technology or at least not to the extent a cyclical-type commodity currency may be. This stability allows creditors, capitalists, and investors to make firm and rational decisions on the basis of sound expectations. Thus, it is easier to avoid making subjective and risky investments. Finally, some empirical studies suggest that during recessions and in great falls, states that used fiat money were better off and more stable compared to those that used a commodity-based currency. Researchers claim that the findings are solid although the reasons for this phenomenon are not clear.