One of the many questions we are faced with in the current digital age is how much longer we will continue to rely so heavily upon fiat currency. This is especially true given the increasing utility and staying power cryptocurrency is proving to have.
As we enter an age where cryptocurrency becomes common currency, we are forced to ask ourselves and our institutions; how are our money and investments working for us? We must also ask; how can things be improved?
It is fair to say that for many of us in the West, things are going fairly well. However, things could be improved. And there is increasing dissatisfaction with big banks and traditional institutions that depend on fiat currency. That fact is, our financial systems and bureaucracies could use a little shaking up. Satoshi Nakamoto was able to do just that when he created Bitcoin in 2008 and proved that digital currency could be securely used.
So what exactly is fiat currency and what are some of its limitations?
Investopedia describes fiat currency as the following:
“Fiat money is government-issued currency that is not backed by a physical commodity, such as gold or silver.”
The term Fiat derives from the Latin phrase allow me and translates to an authoritative decree. The etymology of fiat is helpful because it underscores where the value in fiat money comes from. Fiat money is valuable because it has been so decided by the reigning authority. In this case, governments.
The value of the U.S. dollar, for example, comes from supply and demand, the relative stability of the government, and the overall perception and acceptance of the currency as a means of settling debts.
The important takeaway is that fiat money is not backed by a commodity or security. Another way to look at fiat currencies is that they have value because of a mutual agreement of their value.
That might sound like an odd description of money, but it is true in many cases. Money is not on its own valuable; we, its users, dictate its value. There are some things that have more obvious value, such as food and shelter, but the money we use every day to buy those things is nothing more than an agreement on its value. The government and institutions that uphold those agreements provide the security of that agreement.
A History of Gold and Money
Inflation is a relatively new invention, it occurred around the Industrial Revolution. This is the first point in history where we begin to see the rise of the middle class and the creation of new wealth. So rather than fighting for territory and resources in a gruesome battle, the Industrial Revolution created new value through the proliferation of consumer goods and new commerce. With the Industrial Revolution’s new wealth also came the creation of inflation.
Let’s look at how that works.
The gold standard is a monetary system that was devised to avoid inflation and deflation. It worked by setting a standard for which money was valued; a proportional relationship to a quantity of gold. Basically, this system works to avoid the travails of present-day money, such as overspending and unpayable debts. It worked by simply relating the dollar amount to a physical object, in this case, gold. One of the reasons gold works is because of its value as a raw material, as well as its limited global supply.
As fiat currency is not backed by anything, therefore it cannot be redeemed for anything. It can only be used by others who accept the currency in order to settle debts. However, if the economy or government behind a fiat currency collapses, rampant inflation or deflation can happen.
Post World War I Germany experienced this very crisis. Due to the debts they owed from the war, their currency quickly became completely worthless. This not only made day to day purchases a crisis but also made trade itself impossible with neighboring nations.
Even the gold standard, where the currency is backed by gold, is an imperfect system. The gold standard merely aims to prevent inflation by encouraging responsible spending. But it doesn’t resolve other issues that arise when using gold as the basis of a currency. Such as the lack of liquidity, the difficulty in the actual transport of gold, and the accompanying security issues.
In 1971 the U.S. federal government, under the 37th President Richard Nixon, removed the U.S. dollar from a gold standard. This move was part of a series of economic events that are now referred to as the “Nixon Shock.” What followed was a steady cascade of deregulations in the financial services industry.
Most of us will remember the American mortgage crisis of 2007 and the financial decline that followed. The crisis eroded people’s trust in banks and government institutions by shedding light on the reality of the country’s financial system. It also undermined the value of the U.S. dollar, which is meant to be the world’s strongest currency. A currency that is backed by a limited supply, such as the gold standard, however, is less subject to these “bubbles.”
Venezuela and Bitcoin
A contemporary example of the problems that can arise with fiat currencies comes from Venezuela. The last 20 years have seen the devastation of the remains of the Venezuelan economy.
The formally oil-rich nation is now in a full-blown crisis due to a myriad of poor political decisions and authoritarian oppression. One economic policy remains in infamy, when former President Hugo Chavez began printing Venezualian Bolivars to pay off the country’s debts, destroying any remaining value of the fiat Bolivar.
And all while the Bolivar has been sinking into the trenches, Bitcoin has been accumulating value.
Check out this graph from crypto data tracker CoinDance. In 2019, the amount of Bitcoin traded in the oil-rich but cash-poor country soared by 30% to 2,454 Bitcoins.
Another way to look at this is that Bitcoin is filling a need. The cryptocurrency is poised to work the same way as the gold standard. In the wake of a broken economy, cryptocurrency is creating a profitable and successful black market since the government has all but destroyed the economy.
A similar phenomenon is happening in China where we’re seeing a capital flight of fiat to Bitcoin. In reaction to an oppressive government and looming trade wars, retail investors are trading in their fiat for cryptocurrency on a large scale. The circumstances have fostered an environment in which Bitcoin offers an excellent solution.
Recap On Fiat Currency
- Fiat money is a government-issued currency. It does not rely on the gold standard, which means its value comes from institutional backing, such as central banks and government authority.
- Fiat money is subject to inflation and deflation as it is directly tied to the stability of the economy and political system.
- Bitcoin is designed to have the same security as the gold standard. This means that it is valuable because of its scarcity and inability to be forged.
The bottom line of fiat currencies is that when people lose faith in its value, the currency loses value. As I mentioned, the faith people have in fiat currencies is tied to the functionality and stability of other institutions, like governments and banks. However, when that is eroded, so is the value of the fiat.
Moreover, when a currency is not backed by something physical like gold or silver it can encourage reckless spending. The mortgage crisis was an excellent example of this. Fiat currencies are also more susceptible to political upheaval, as is the present case in both China and Venezuela.
I am doubtful that fiat currency is headed for extinction. What I think is more likely is that more and more we will see a resurgence in the use of value-based currencies, like gold and silver, and even more likely, cryptocurrency.