What is fiat currency?
Simply put, fiat currency is legal tender that derives its value from its issuing government rather than from a good or resource. The power of the government that establishes the value of the currency is essential for this type of currency. Most countries use the fiat monetary system for the purchase of goods and services, as well as for investment and savings. Paper money thus replaced the gold standard and other commodity-based systems, establishing the value of legal supply.
The emergence of paper money
The state currency was born several centuries ago in China. Sichuan province began issuing paper money in the 11th century. At first it could be exchanged for silk, gold or silver. But eventually, Kublai Khan came to power and established a fiat monetary system during the 13th century. Historians claim that this currency was instrumental in the fall of the Mongol Empire, with excessive spending and hyperinflation being the cause of its decline.
Fiat currency was also used in Europe during the 17th century and adopted by Spain, Sweden and the Netherlands. In Sweden the system failed and the government abandoned it in favor of the silver standard. Over the next two centuries, New France in Canada, the American colonies, and then the American federal government also experimented with fiat currency with mixed results.
In the 20th century, the United States again used, on a smaller scale, a currency based on a physical resource. But in 1933, the government ended the practice of converting paper money into gold. In 1972, under President Nixon, the United States completely abandoned the gold standard, completing its disappearance internationally in favor of the fiat currency system. This ultimately led to the adoption of fiat currency worldwide.
Fiat currency versus gold standard
The gold standard system allowed the conversion of banknotes into gold. In reality, all paper money was backed by a corresponding amount of gold held by the government. In a monetary system based on a resource, here gold, governments and banks could only introduce more money into the economy if they held the equivalent value in gold. This system limited the government's ability to create money or increase the value of their currency based exclusively on economic factors.
In contrast, in the fiat monetary system, currency cannot be converted into anything else. With fiat money, authorities can directly influence the value of their currency and link it to economic conditions. Governments and their central banks thus have much more control over the monetary system and can react to different financial events or other crises using different tools, such as the creation of fractional reserves or the implementation of easing. quantitative (repurchase of debt securities for example).
Proponents of the gold standard argue that a commodity-based monetary system is more stable because it is backed by something physical and valuable. Supporters of the state currency, on the contrary, claim that gold prices have been anything but stable. In this context, the valuation, or value, of a commodity-based currency and that of a fiat currency can fluctuate. But with a fiat currency system, the government has greater flexibility to act in an economic emergency.
Some Advantages and Disadvantages of Using Fiat Currency
Economists and other financial experts are not unanimous in their support for fiat money. Defenders and opponents passionately debate the advantages and disadvantages of this monetary system.
Scarcity: Fiat currency is not affected or limited by the scarcity of a physical commodity like gold.
Cost: the production of paper money costs less than a currency based on a raw material
Responsiveness: Fiat money gives governments and their central banks the flexibility to deal with economic crises.
International trade: Fiat currency is used around the world, making it a form of currency suitable for international trade.
Practicality: State currency is not tied to physical gold reserves which require physical storage, protection, monitoring and other costly requirements.
No intrinsic value: Fiat currency has no intrinsic value. This allows governments to create money out of thin air (print money), which can lead to hyperinflation and the collapse of the economic system.
Historically risky: Historically, the implementation of fiat currency systems has generally led to financial crises, which therefore involves certain risks.
Fiat Currency Versus Cryptocurrency
Fiat currency and cryptocurrency have a little common ground in the sense that nothing connects them to a physical resource â but thatâs where the similarity ends. While fiat currencies are controlled by governments and central banks, cryptocurrencies are essentially decentralized, which is largely due to the decentralized digital ledger called the Blockchain.
Another notable difference between these two monetary systems is the way in which each of these forms of money is generated. Bitcoin, like most cryptocurrencies, has a limited and controlled supply - unlike fiat currency which banks can simply create out of thin air, based on their assessment of a country's economic needs.
As a digital currency, cryptocurrencies have no physical equivalent and are borderless, making them less restrictive in international transactions. In addition, transactions are irreversible and the nature of cryptocurrencies makes traceability more complicated compared to the fiat currency system.
Note, however, that the cryptocurrency market is much smaller and therefore much more volatile compared to traditional markets. Which is arguably one of the reasons why cryptocurrencies are not yet universally accepted, but as the crypto economy grows and becomes more mature, volatility will most certainly decrease.
Conclusion
The future of these two forms of currency is by no means assured. While cryptocurrencies still have a long way to go and will certainly face many challenges, the history of fiat currency demonstrates the vulnerability of this type of currency. This is an important reason why many people are exploring the possibility of switching to a cryptocurrency system to secure their financial transactions â at least, to some extent.
One of the main ideas behind the creation of Bitcoin and cryptocurrencies is to explore a new form of currency based on a distributed peer-to-peer network. There is a good chance that Bitcoin was not created to replace the entire fiat currency system, but to provide an alternative economic network that could create an improved financial system for a better society.
