What is Fiat Money

Updated: Nov 1, 2016

What is Fiat Money?

The simplest definition of “fiat money” is, “Money that exists because a government says so,” fiat, of course, being a Latin word meaning, “an arbitrary order or decree”. Historically, most money was based on some commodity such as gold, silver, or other important goods, and had a value which could be expressed in terms of some amount of that commodity. Fiat money, by comparison, has no intrinsic value; its value is based on faith in the issuing government.

How Fiat Money Works

Fiat money is essentially a form of credit. When a government declares a currency to be “legal tender,” that means it can be exchanged for goods or services equivalent to the value of the currency, and the credit comes in the form of the assurance to the seller of the goods or services that the currency can be exchanged for further goods or services. From a purely theoretical perspective, fiat money reverses the relationship of prices and currency value.

With commodity-based currency, one unit of currency is equal to some quantity X of a backing commodity. The price of a cheeseburger (or other product or service) is an equivalent value of some quantity of the same commodity, expressed in terms of units of the currency:

So in other words, $1 might be worth 1/1000 ounce of gold, and a cheeseburger – after the maker of the cheeseburger considers his costs to make it, the amount of profit he must make, and what he thinks his market will be willing to pay for it – might be worth 3/1000 of an ounce of gold, which makes the cheeseburger worth $3. The backing commodity is what actually serves as the money, with the coins or paper bills simply representing a sort of “IOU” for a particular amount of it.

With fiat currency, there is no backing commodity to serve as a common frame of reference, so the value of the currency is expressed in terms of the goods and services purchased with it:

This is fine, of course, as long as everyone agrees that the currency represents a certain value. When the cheeseburger maker is reasonably certain that the $3 he charges for it will cover the costs of its production plus provide him a profit, then $1 is worth one-third of a cheeseburger. In turn, his suppliers must be reasonably certain that what he pays for the bun, meat, cheese, condiments, and gas or electric needed to cook it will cover their costs plus a profit, and so on. If confidence in the assumed value of the currency is lost at some point in the whole complex value chain that exists between wheat seeds, cow embryos, and the customer standing at the fast-food counter, the fragile system begins to break down, which we usually experience as price inflation.

Are There Any Advantages to Fiat Money?

Fiat money is a Keynesian economic concept, so the debate among economists about whether or not it’s a good idea, unfortunately, has a distinctly unhelpful sectarian tone to it. From the purely Keynesian perspective, fiat money provides the government a means to control prices – and by extension, consumption and production – by controlling the money supply. The more money available, the less each unit of money is worth, so prices inflate; remove money from the system and the unit value decreases, thus deflating prices. This is the basic idea behind “quantitative easing”; the government prints more money to encourage lending by banks and spending by businesses and consumers. If done properly, injecting money into the financial system should hypothetically boost lending and spending enough to increase production, which compensates for the inflation in prices caused by the availability of more money.

Commodity-backed currency, on the other hand, cannot be so easily managed because the amount of money is determined by the reserves of the backing commodity, usually gold, and by the price at which that commodity is being traded. Price inflation and deflation in a commodity-backed system are caused by fluctuations in the price of the commodity. For example, let’s say Country A has a reserve of one million ounces of gold and sets the value of its currency (the A$) at 1 A$ = 1/100 ounce of gold when the price of gold is 100 A$ per ounce. As the price of gold changes, the real value of the currency changes, resulting in inflation or deflation:

The price of Gold Value of 1,000,000 oz. Gold Reserve Amount of Currency Value of 1 A$ Inflation/Deflation Rate
100 A$ 100 million A$ 100 million A$ 1 A$ +/- 0%
105 A$ 105 million A$ 100 million A$ 1.05 A$ -5% (deflation; 1.05 A$ worth of goods are worth only 1 A$)
98 A$ 98 million A$ 100 million A$ 0.98 A$ +2% (inflation; 1 A$ only buys 0.98 A$ worth of goods)

The government can moderate inflation/deflation by either increasing or decreasing the money supply as needed to match the value of reserves, or by buying or selling the reserves themselves. Because the value of commodities changes rather quickly, and because adjusting either the money supply or a number of reserves also affects the price of the commodity, managing prices in a commodity-backed currency system is much more difficult than it is in a fiat money system.

The biggest problem with the Keynesian point of view towards fiat money is that the verdict of history is rather clear that fiat money systems are ultimately catastrophic. One of the earliest examples is the long collapse of Roman currency between 0 and 244 A.D., where “fiat money” took the form of progressively reduced proportions of silver in Roman denarii coins. In 11th-century China, a shortage of copper for coins led to the issuance of one of the world’s first paper currencies, which devalued quickly as more and more were issued (and in all likelihood, widely counterfeited). Three times in French history – after the death of Louis XIV in 1715, after the French Revolution in 1789, and during the Great Depression in the 1930’s – fiat currency was issued, rapidly over-supplied, and collapsed due to hyperinflation. Germany’s post-WW I Weimar Republic, the Asian Financial Crisis in 1997, Mexico’s “Tequila Hangover” in 1994, the severe devaluation of the Russian ruble in 1998, the Argentine financial crisis of 1999-2002, and the almost unfathomable hyperinflation in Zimbabwe under Robert Mugabe are also examples of financial calamities brought on, one way or another, by the use of fiat money. 

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