What Is Fiat Money And What Are Its Characteristics?
Fiat money is currency established as money, often by government regulation, but has no intrinsic value.
It is the money issued by an authority whose value resides in the governmental decision and the public trust that it has value.
One of the characteristics of fiat money is that it has no use value. It has value only because a government claims it has value or because the parties to the exchange agree on its value.
Fiat money is probably the pinnacle of money products. It is the easiest form of money to use and one of the most reliable, although it is not without its problems.
Fiat Money vs Representative Money
Fiat money, also known as fiat money, was introduced as an alternative to commodity money and representative money. When we talk about representative money, we understand that it is similar to fiat money. But the representative is related to a claim on a commodity (which can be redeemed to a greater or lesser extent).
An example of representative money would be bonded redeemable for certain amounts of a commodity such as gold, wheat, etc.
Prehistory of fiat money
Economics of Gifts and Debts
To understand how we got to fiat money, you need to understand the history of money and why we humans created money. At the beginning of history, no currency was backed by a government or any asset that served as a reference value. Most transactions took place in an economy of debt and gifts. People gave each other free things or did favors for each other that were returned over time.
After the economy of gifts and debt, there is a transition to barter to obtain value. Early humans traded between tribes exchanging things they wanted or needed. This could include exchanging fruit for fish, slaves, furs, and in patriarchal tribes, women.
The economy of barter is followed by the economy of representative money.
Primitive societies used measurements to represent certain values. A certain number of units of money was exchanged for a certain previously agreed value. For example, ten mollusk shells could represent a fish, a hundred of these could represent a boar, etc.
Among the forms of representative money are the first coins. For example, one of the oldest coins, the silver shekel could represent a day’s wages.
The gold standard, although it included the first banknotes of the modern era, was a form of representative money. Because each note was backed by a fixed amount of gold in a national bank, the money could not be regarded as simply a deal value. Something was backing it up.
Another form of money used since ancient times is commodity money. Commodity money is often an object that has intrinsic value to a given community. Some examples of commodity money can be gold, silver, or copper.
Unlike what happens with representative money, with commodity money, no agreement is necessary since everyone recognizes that the commodity used as money has value.
Within the modern examples of commodity money, we can find cocaine, used in some remote regions of Colombia by rural communities as a means of payment.
Anthropologist David Graeber, points out in his book In Debt, that during the period of colonial empires, slaves were also used as commodity money. With the slaves, debts were paid or properties were acquired.
What makes fiat money unique?
What makes fiat money unique is not the fact that it is backed by something. Rather, the value of money lies in the fact that an authority assures that it has value.
Often called fiat money, this type of money responds to the will of an entity that created it.
The Fiduciary and the Fiat: Etymology
The word fiat, from the Latin, literally means let it be done and reminds us that someone has done it and their authority gives it value.
The first coins had on their faces the image of the emperors and kings who had issued them. These in themselves remembered what the origin of the money was.
The Bible (Luke 20, 25) relates that Jesus takes a denarius coin which has the image of Emperor Tiberius on its face. This image recalled the Roman authority as the issuer of money.
For its part, the word fiduciary, as well as Fiducia and fideicomiso, have their root in the Latin word fides. Fides means faith. In the case of money, it refers to the trust that people place in its value as a means of payment.
Why does fiat money have value?
One of the reasons fiat money has value is that states accept it as a means of payment for taxes. By compulsorily collecting money, the state imprints on money its character as a valuable agent and makes it legal tender.
Another aspect that makes fiat money useful is that people believe in it. The word fiducia originates from Roman law and means a contract in good faith. In other words, if money has value, it is because all of society has faith and believes that it has some kind of value.
The first banknotes
Government-issued banknotes were first used in 11th-century China. Since then, they have been used by various countries, usually concurrently with commodity currencies. Fiat money began to predominate in the 20th century.
Since the decoupling of the US dollar from gold by Richard Nixon in 1971, a system of national fiat currencies has been used globally.
Fiat money can be:
- Any money declared by a government to be legal tender.
- State-issued money that is not convertible by law to anything else, nor has a fixed value in terms of any objective standard.
- Inherently worthless money used as money due to a government decree.
- An inherently useless object that serves as a medium of exchange
The term fiat derives from the Latin fiat (“meaning to be done”) used in the sense of an order, decree, or resolution.
Treatment of fiat money in the Economy
In monetary economics, fiat money is an intrinsically worthless object or record that is widely accepted as a means of payment.
In some micro-founded money models, fiat money is created internally in a community that makes feasible exchanges that would not otherwise be possible, either because producers and consumers cannot anonymously write promissory notes, or due to physical restrictions.
History of fiat money
China has a long history with paper money, beginning in the 7th century.
In the 11th century, the government established a monopoly on their issuance, and around the turn of the 12th century, convertibility was suspended.
The use of such money became widespread during the later Yuan and Ming dynasties.
The Song dynasty in China was the first to issue paper money, known as jiaozi, around the 10th century AD. C. Although banknotes were valued at a certain exchange rate for gold, silver, or silk, conversion was never allowed in practice.
Initially, the notes were to be redeemed after three years of service, to be replaced by new notes for a 3% service charge to the government, but, as more notes were printed without withdrawing the old notes, inflation set in. made evident.
The government made several attempts to support paper money by taxing it in part in currency and making other laws, but the damage had been done and the notes fell out of favor.
Paper money, the predominant means of payment in China
The succeeding Yuan dynasty was the first dynasty in China to use paper money as the predominant circulating medium. The founder of the Yuan dynasty, Kublai Khan, issued paper money known as Jiaochao during his reign. The original notes during the Yuan dynasty were restricted in area and duration as in the Song dynasty.
During the 13th century, Marco Polo described the fiat money of the Yuan dynasty in his book The Travels of Marco Polo.
All of these pieces of paper are issued with as much solemnity and authority as if they were pure gold or silver…and, indeed, they are all taken with ease, as anyone who wanders the domains of the Great Kaan will find these pieces of paper. and he will be able to make all sales and purchases of goods through them, just as if they were pure gold coins. Marco Polo, The Travels of Marco Polo.
Washington Irving records an emergency use of paper money by the Spanish in a siege during the Conquest of Granada (1482–1492).
In 1661, Johan Palmstruch issued the first regular paper money in the West, under the royal charter of the Kingdom of Sweden, through a new institution, the Bank of Stockholm.
While this private paper money was largely a failure, the Swedish parliament eventually took up the issue of paper money in the country.
By 1745, its paper currency was inconvertible to specie, but the government ordered its acceptance. This fiat currency depreciated so rapidly that in 1776 it was returned to the silver standard. Fiat money also has other roots in 17th-century Europe, having been introduced by the Bank of Amsterdam in 1683.
New France 1685–1770
In 17th-century New France, now part of Canada, the universally accepted medium of exchange was beaver fur.
As the colony expanded, coins from France became widely used, but there was generally a shortage of French coins.
An urgent problem of money shortage
In 1685, the colonial authorities in New France found themselves seriously out of money.
A military expedition against the Iroquois went awry, and tax revenues dwindled, reducing the government’s money reserves. Usually, when there were insufficient funds, the government would simply delay payment to merchants for purchases, but it was unsafe to delay payment to soldiers due to the risk of mutiny.
Jacques de Meulles, the Intendant of Finances, devised an ingenious ad hoc solution: the temporary issuance of paper money to pay the soldiers, in the form of playing cards.
He confiscated all the letters of the colony, cut them into pieces, wrote the denominations on the pieces, signed them, and gave them to the soldiers as payment instead of gold and silver.
Due to the chronic shortage of money of all kinds in the colonies, these cards were readily accepted by merchants and the public and circulated freely at face value.
The cards were intended to be a purely temporary resource, and it was not until years later that their role as a medium of exchange was recognized.
Playing cards as fiat money
The first issue of playing card money occurred in June 1685 and was redeemed three months later. However, coin shortages occurred again and more problems with card money occurred in subsequent years. Due to their wide acceptance as money and the general scarcity of money in the colony, many of the playing cards were not redeemed but continued to circulate, acting as a useful substitute for France’s scarce gold and silver coins.
Finally, the governor of New France recognized its useful role as a circulating medium of exchange.
Final adoption of paper money in the French colonies
As the French government’s finances deteriorated due to the European wars, it reduced its financial support for its colonies, so the colonial authorities in Canada relied more and more on money cards.
By 1757, the government had discontinued all payments in currency, and payments were made on paper.
In an application of Gresham’s Law (bad money drives out good), people hoarded gold and silver, using paper money instead.
The costs of the war with the British led to rapid inflation in New France.
After the British conquest in 1760, paper money became almost useless, but business did not stop because the gold and silver that had been accumulated went back into circulation.
Under the Treaty of Paris (1763), the French government agreed to convert outstanding card money into bonds, but with the French government essentially bankrupt, these bonds fell into default and by 1771 were worth nothing.
The Royal Canadian Printing House still issues playing card money in commemoration of its history, but now in the form of 92.5% pure silver with a gold plate around the edge. Therefore, it has an intrinsic value that greatly exceeds its fiat value.
The Bank of Canada and Canadian economists often use this early form of paper money to illustrate the true nature of money for Canadians.
18th and 19th centuries
One of the earliest forms of fiat currency in the American colonies was “letters of credit.”
Provincial governments produced notes that were fiat currency, with the promise of allowing holders to pay taxes on those notes.
The notes were issued to pay current obligations and can be invoked by collecting taxes later. Since the promissory notes were denominated in the local unit of account, they circulated from person to person in non-tax transactions. These types of notes were issued particularly in Pennsylvania, Virginia, and Massachusetts. Said money was sold at a discount to silver, which would then be spent by the government, and would expire at a fixed point in future time.
Credit accounts have generated some controversy since their inception. Those who have wanted to highlight the dangers of inflation have focused on the colonies where bills of credit depreciated most dramatically: New England and the Carolinas.
Those who have wanted to defend the use of letters of credit in the colonies have focused on the middle colonies, where inflation was practically non-existent.
Taxes and their Role in supporting colonial money
Colonial powers consciously introduced tax-backed fiat currencies, for example, shack taxes, to mobilize economic resources in their new possessions, at least as a transitional arrangement. The purpose of such taxes was later fulfilled by the property tax. The repeated cycle of deflationary hard money, followed by inflationary paper money continued through much of the 18th and 19th centuries.
Nations would often have dual currencies, with paper trading at some discount to money back in kind.
During the American Civil War, the Federal Government issued United States Notes, a form of fiat paper currency popularly known as “greenbacks.” His issue was capped by Congress at a little over $340 million. During the 1870s, the withdrawal of the notes from circulation was opposed by the United States Dollar Party. This currency was denominated as ‘fiat money at a party convention in 1878.
After World War I, governments and banks in general still promised to convert notes and coins into their underlying nominal commodity (redemption in kind, usually gold) on demand.
However, the costs of the war and the required reparations and economic growth based on government loans later caused governments to suspend redemption in kind.
Some governments were careful to avoid sovereign default but were not wary of the consequences of paying off debts by sending freshly printed cash that was not of a metal-backed standard to their creditors, leading to hyperinflation, for example, hyperinflation in the Republic of Weimar.
The gold standard and its impact on the history of money in the 20th century
From 1944 to 1971, the Bretton Woods agreement fixed the value of 35 United States dollars in a troy ounce of gold. This was the last stage of what became known as the gold standard, which guaranteed the fixed convertibility of the dollar with gold.
Other currencies were pegged to the US dollar at fixed rates.
The United States promised to redeem dollars in gold to other central banks. Trade imbalances were corrected through exchanges of gold reserves or loans from the International Monetary Fund (IMF).
The Bretton Woods system collapsed in what became known as the Nixon crash. This was a series of economic measures adopted by the President of the United States, Richard Nixon, in 1971. Nixon also included the unilateral cancellation of the direct convertibility of the US dollar to gold. Since then, a global trust fund system has been used, with freely variable exchange rates between major currencies.
Precious metal coins
In the 1960s, the production of silver coins for circulation ceased when the face value of the coin fell below the cost of the precious metal they contained (whereas historically it had been higher).
In the United States, the Coinage Act of 1965 removed silver from circulating dimes and quarters, and most other countries did the same for their coins. The Canadian cent was primarily copper until 1996 and was withdrawn from circulation in the fall of 2012 due to the cost of production relative to its face value.
In 2007, the Royal Canadian Mint produced a million-dollar gold bullion coin and sold five of them. In 2015, gold in coins was worth more than 3.5 times its face value.
Money creation and regulation
A central bank introduces new money into the economy by buying financial assets or lending money to financial institutions.
Commercial banks then redeploy or repurpose this base money by creating credit through fractional reserve banking, which expands the total supply of broad money (cash plus demand deposits).
In modern economies, relatively little money supply is in physical currency.
For example, in December 2010 in the US, of the $8,853.4 billion in broad money supply (M2), only $915.7 billion (about 10%) consisted of physical coins and bills. The manufacture of new physical money is usually the responsibility of the central bank or sometimes the government treasury.
The Bank for International Settlements published a detailed review of the evolution of the payment system in the G10 countries in 1985 in the first of a series known as “red books”.
The adoption of fiat currency by many countries, from the 18th century onwards, made possible much larger variations in the money supply.
Since then, there have been large increases in the supply of paper money in several countries, producing hyperinflations, and episodes of extreme inflation rates much higher than those seen in previous commodity periods. Hyperinflation in the Weimar Republic of Germany is a notable example.
Economists generally believe that high inflation rates and hyperinflation are caused by excessive growth in the money supply.
Monetary policy as a way to control the value of fiat money
Today, most economists favor a low and constant rate of inflation. Low inflation (rather than zero or negative) reduces the severity of economic downturns by allowing the labor market to adjust more quickly in a downturn and reduces the risk that a liquidity trap will prevent monetary policy from stabilizing the economy.
However, growth in the money supply does not always cause increases in nominal prices. Instead, growth in the money supply can lead to stable prices at a time when they would otherwise be falling.
The task of keeping the inflation rate low and stable is usually given to the monetary authorities. In general, these monetary authorities are the central banks that control monetary policy by setting interest rates, through open market operations, and by setting bank reserve requirements.
Loss of fiat money backing
A fiat currency largely loses its value if the issuing government or central bank loses the ability or refuses to further guarantee its value. The usual consequence is hyperinflation. Some examples where this has happened are the dollar from Zimbabwe, and China in 1945, and the mark in the Weimar Republic in 1923.
But this does not necessarily have to happen; for example, the so-called Swiss dinar continued to retain value in Kurdish Iraq even after its legal tender status was withdrawn by the Iraqi central government that issued the notes.
Fiat money challenges
Fiat money, being the quintessential modern form of money, has great challenges ahead. Since the abandonment of the gold standard and then the dollar standard as the world’s reference currency in the 1970s, the world economy has had a genuine fiduciary system. Coins have value because of the faith in money that people have.
However, the current system is not based exclusively on faith. Elements such as the supply and demand for money play a fundamental role.
Currencies float freely in the foreign exchange market and traders or operators demand and sell money taking into account the projections of the value of an economy.
In other words, although gold or the dollar no longer supports other currencies, people believe in a currency because of the strength of its economy. For example, if the US economy is doing well and producing a large number of goods and services, the US dollar will be in higher demand and therefore worth more.
Inflation and devaluation as a challenge and technological responses
Despite this, and due to the continuous issuance of currency by central banks, currencies register a phenomenon called inflation. In this sense, the value of a currency cannot be trusted forever. The currencies will gradually begin to lose their value and with this their power to buy more goods and services. This phenomenon of loss of value of money is known as devaluation. Sometimes, when inflation is exacerbated, the economy enters a process of hyperinflation, in which prices grow rapidly and uncontrollably. In these cases, devaluation is also accelerated and exacerbated.
The arrival of cryptocurrencies
Since many people do not trust fiat money, due to the loss of value of money, recently many investors have been switching to cryptocurrencies as a means of haven. More than being a means of payment, those cryptocurrencies with a limited issue, such as Bitcoin or Ethereum, or even Cardano, are considered a refuge against inflation.
The main problem with cryptocurrencies is that they are hardly used as a means of payment, people acquire them mainly as a means to speculate and expect future returns on account of their appreciation. In this sense, fiat money has enormous advantages. People use it as a means of exchange frequently, its value does not lend itself to exacerbated speculation as in the case of cryptocurrencies. And although in the long term, it is devalued, it maintains great stability.
For all these reasons we can expect fiat money to remain the preferred form of money in the future. Although of course, history can always surprise us, for now, it is the best we have.
Common Forms of fiat money in Modernity
Another element that we must take into account when analyzing the present and future of money is that most money today is digital. But this is not to say that people have switched to cryptocurrencies.
The vast majority of digital money that circulates in the world today is fiduciary money, it is money that only appears in bank records, and that arises for two reasons:
The issuance of central banks that lend it to commercial banks, and
The money multiplier effect of commercial banks, can lend fiat money and create it based on the loans they generate. This is the form of money that most of us use in our online purchases or our digital wallets when making transfers or account movements.
When we make a Visa or Mastercard transfer, even if we don’t use physical money, we are using fiduciary money. Without a doubt, fiat money is still king, but it continues to evolve and adapt to new contexts.