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Concepts: Fiat Currency

Gunnar Jaerv
Gunnar Jaerv 28 August 2020

Fiat money is money that government has decided is legal tender. Unlike a currency based on assets, fiat money is backed by a country’s whole economy.

You can exchange it for goods and services, or for more fiat money, but not for a specified amount of, say, gold.

Fiat currency vs gold

Here’s a fifty-dollar bill from the 1800s:

Fifty-dollar bill from the 1800s

It promises that the Canal Bank ‘will pay fifty dollars to the bearer on demand.’ In other words, this note is like a check. Behind it lies the gold reserves of the Canal Bank; it’s worth fifty dollars of gold.

Here’s a one-dollar bill from the 2000s:

One-dollar bill from the 2000s

‘This note,’ says the text in the top left, ‘is legal tender for all debts, public and private.’ It’s a note by fiat.

In other words, behind this lies the word of the United States government and the national economy. It’s worth one dollar of money, goods or services. You can buy gold with it, obviously; but it’s not ‘worth’ one dollar of gold.

This is the crucial difference between a fiat currency and ‘representative money’ — a currency backed by assets.

But there’s another form of currency we need to consider.

This is an 1854 gold dollar:

1854 Gold Dollar

Source

This doesn’t promise to pay anything, because it doesn’t represent anything: it is one dollar’s worth of gold (at the time, obviously; it’s worth a lot more now).

This is the oldest type of currency: precious metals coinage, basically a standardized quantity of precious metal, sometimes referred to as ‘commodity money.’ The government franking isn’t a promise to pay, but a promise that the metal is the right weight and purity.

Fiat currency: a brief history

Fiat currencies originated in China in the 11th century and spread only slowly to the rest of the world. During the 18th and 19th centuries much of Europe and America moved from relying mostly on gold and silver coinage to representative currencies based on gold. This was referred to as the gold standard.

Following the Second World War, the world financial system operated on the Bretton Woods system, named for the Bretton Woods agreement of 1944. The US dollar was convertible to gold, and other currencies were pegged to the dollar. In 1971, the US government ended the dollar’s convertibility to gold and removed the last relationship between most of the world’s currencies and gold, creating an international financial system based on fiat currencies.

Fiat vs cryptocurrencies

How does a fiat currency compare with digital assets that were intended to be used as currencies, such as Bitcoin?

Bitcoin was created to be a decentralized payment tool and value store, without intermediaries or oversight. It’s not a fiat currency or a representative currency. It’s the equivalent of the gold coin. It doesn’t require any approval once it’s been created and it can be spent like cash.

The crucial differences between fiat and digital currencies are centralization, finiteness, forgeability and intrinsic value.

Fiat’s value can be changed — by quantitative easing (printing more money), by altering the interest rate, and by fluctuating performance of the underlying economy from which it derives its value. Because of the way economies operate, most fiat currencies are subject to degradation over time in the form of inflation. Money stored in bank accounts therefore loses value over time even if the currency is otherwise unchanged. Fiat notes can also be forged, though this is a minor concern for investors in most cases.

Digital currencies’ values are determined by their users, and the number of coins is finite and known in advance. In the nature of the network that supports the currency, the number of coins can’t be changed and coins can’t be counterfeited. Inflation doesn’t operate on digital currencies because their value is inherent rather than being derived from the wider economy.

Fiat to crypto exchanges

When we talk about the ‘price’ of Bitcoin, we’re talking about the exchange value in dollars (almost always). Many digital assets are purchased in and sold for other digital assets, but since the majority of money is fiat there needs to be an ‘on-ramp’ to the digital assets ecosystem. This takes place on fiat-crypto exchanges where users can spend fiat currencies for digital assets.

Currently, only a very small number of full-fledged exchanges offer this facility. It’s normal to buy from a small selection of digital assets on a dedicated exchange, transfer those assets to a wallet on a larger exchange with more listed assets and then begin trading. This process can be time-consuming and increases the attack surface available for bad actors.

This may change as several exchanges are working to supply an all-in-one service; changes in this area could have profound implications for investors but must be carefully assessed.

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