Fiat money. What is that? Why people often use this term talking about digital currencies? Does it have something to do with well-known brand of Italian cars? We are here to provide you with answers! Today, The Coin Shark will tell what are those colored papers that we use to buy things, how fiat money appeared, what is the logic behind our current economy and money and how all these things deal with virtual currencies.
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We all deal with fiat money nearly everyday. Well, yep, today a huge number of financial transactions is cashless, whether we buy coffee, top up our phone, pay bills or trade currency on the exchange. This is especially true for the developed countries where cash seems to fade away over the medium term. However, we still use cash. Our pockets still make coin sound and we still have some colored papers in our wallets. And these are fiat money.
Money can be cash or cashless. Cash money include coins and banknotes. While coins are made of metals (or their alloys) – mostly gold, silver, copper, but also brass, zinc, platinum, palladium, etc., banknotes are in fact just colored pieces of paper. Yes, they have protective elements, watermarks and so on, but, nevertheless, banknotes have no physical value. “Fiat” is a Latin word for “decree”, “instruction”. So fiat money is a means of payment, that has a value established by the state. In other words, the value of fiat money is not based on the value of the material that they are made of. The paper used to print 100 dollars banknote certainly is not worth 100 dollars. However, the state determines the face value of this paper, and tells everyone that this piece of paper should be worth 100, another one – 50, another one – 20 and another one – ten. So fiat is actually a symbolic money with no physical value that we are obliged to use as means of payment.
Fiat money is not only paper banknotes. There is also so-called token money or token coins. Their metal value is less than a legal value determined by the state. These are, for example, American coins with a nominal less than one dollar – daim (10 cents), quarter (25 cents) and half (50 cents).
Monetary systems of ancient states and communities were often based on coins that had the same value that the amount of metal they were made from. However, there are also many examples of token coins. Those were often silver coins that were minted with the use of some other metals, thereby actually reducing the physical value of the coin, while its face value retained. Scientists agree that the first known paper money appeared in China in the 8th century. Later, their use developed under the rule of the Song dynasty in the 11th century, and they became widely spread during the Yuan dynasty (13-14 centuries), when the Mongols led by Genghis Khan’s grandson Kublai conquered the Middle Kingdom.
Long after that fiat money close to those we have today started appearing in England. Bank of England started issuing paper banknotes. By that time banknotes already existed, however, they were not used as means of payment. In fact, they were bank bills that banks gave to depositors, taking a certain amount of money in gold coins. If that was not a nominal note, then it could pass from hand to hand and had no connected with its original owner. Later they became means of payment backed by an equivalent amount of gold. In such a system, the amount of money that was in circulation was equal to the amount of gold deposited in banks. But, as capitalist relations developed, England’s economy required bigger amount of money in circulation, so the central bank started issuing paper banknotes that were not backed by a supply of gold anymore. Nevertheless, in the middle of the 19th century, the government legislatively established the framework of such an issue. It was a certain ratio to the state’s gold reserve. Before World War I, there was a so-called gold coin standard – the amount of fiat money in circulation was provided by a certain number of gold coins stored in banks. Every banknote holder (every owner of fiat money) could potentially exchange their papers for an equivalent amount of gold. After World War I, most of the countries set a gold bullion standard, which meant that banknotes could be exchanged for gold bars weighing 12.5 kg. Everyone who had less money than the price of these amount of gold, had no opportunity to exchange their banknotes for the precious metal. However, banknotes were already backed by goods and circulated in the economy as a means of payment. In the new economic conditions that emerged after World War II, the gold bullion standard was replaced by gold exchange standard. The United States played a key role there. The country pledged to back the US dollar with a particular amount of gold, given that hundreds of tons of it were accumulated in American vaults. According to that standard only financial regulators of other states had the right to demand the exchange, while the US dollar became a reserve currency. The era of the gold standard ended in the early 70’s, when the US government refused to provide gold at the request of other states. Since then, the international monetary system “was let float freely”. Today, currencies are no longer pegged against gold, they can be freely converted, and the market (supply and demand for a particular currency) plays a significant role in the establishment of exchange rates.
Today the term “fiat money” is often used in the cryptocurrency community, and often opposed to digital coins. The state i s responsible for the issue of fiat money, it is carried out in a centralized manner by central banks and controlled by state bodies. The rate of fiat money is also set by the state. Cryptocurrency has been considered as an alternative to such centralized and regulated systems. Fiat transactions are managed by financial, tax, banking structures, while cryptocurrency transfers are carried out peer-to-peer without any regulators and intermediaries.
Fiat money and cryptocurrencies have one important common feature – both are not backed by anything. However, in fact, fiat is still backed by goods that can be bought for it. And here is the point where virtual coins have some problems. Even such major cryptocurrencies as Bitcoin or Ethereum still have low liquidity, while other digital coins cannot be used to purchase at least something at all. Anyway, the cryptocurrency community is confident that this problem lies in the absence of mechanisms, while the demand for digital currencies is and will be rather high, so and their full fledged liquidity is a matter of time.
Today, cryptocurrencies still amount to a relatively small percentage of global assets and cannot compete with fiat money.
So, fiat money is a currency that government agencies declare to be a legitimate means of payment and prescribe to use it at a fixed face value, despite the fact that it has no physical value. Almost all paper money, as well as many coins, are currently fiat money. Fiat is not backed by gold, and today the world economy is actually built on this principle. Cryptocurrency offers an alternative to fiat – decentralized and unregulated payment facilities. However the logic that cryptocurrency is based on is in a way similar to the one that fiat is based on. Unlike the old system, where payment means were pegged against gold, modern fiat money exists in the relatively free market paradigm. Cryptocurrencies went even further, eliminating those elements of strict regulation that remained in fiat money.
Anyway, there are different forecasts related to the future of digital currencies. The cryptocurrency financial system is only developing and can not yet compete with traditional economy and fiat money, of course. Will it be able to do so in the future? Well, the answer is “no” in the short term and “time will tell” in the long term.
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