What is Fiat Currency and is it better than crypto?

Andrew Carr
| Editor:
April 8, 2024
7 min read

To first understand fiat currency, we must first understand currency. Currency, in its simplest form, is a medium of exchange. The cowry shell was once a currency before metal coins replaced it. 

Currency, in its role as a medium of exchange, facilitates remittance for paying capital to someone in exchange for their labor. Currency also provides a means of settlement for two transacting parties exchanging goods or services. 

In modern terms, fiat currency is a medium of exchange used within a specific geographic region or country. It is administered by the governing body of an individual state to be used and transacted with by the citizens of that state. Since currencies are often specific to one state, they can’t always easily be transacted across international markets without accounting for foreign exchange rates. There are always exceptions, of course, just ask the Dollar and the Euro, two great examples of fiat currencies.

What is Money?

Now money is different from currency. Money is meant to serve three purposes:

  1. Act as a unit of account, 
  2. Be a store of value
  3. Operate as a medium of exchange.

Currency, on the other hand, is only capable of serving as a medium of exchange. 

According to Aristotle’s Principles of Sound Money, to fulfill the three purposes successfully, money must encompass durability, portability, divisibility, and intrinsic value. So, what did Aristotle really mean by that?

  • Durability: It must be able to withstand wear and tear or potential damage over time.
  • Portability: It must be portable and easily transported in large quantities from one location to another. 
  • Divisibility: It must be able to be divided and broken down into smaller fractional values of itself. 
  • Intrinsic Value: It must have an aspect that gives it inherent utility or an objective measure that won’t always align with its market price. 

Fiat Currency Limitations

Fiat currency cannot be used as a store of value because it is inflationary and holds no intrinsic value. A fiat currency’s supply is determined by the state that issues it; said supply is not fixed and can be arbitrarily expanded whenever necessary. Governments that control the supply of their state’s fiat currency can always increase the amount in circulation, endlessly diluting the currency’s monetary value. 

Fact: Fiat currencies hold no intrinsic value because they serve no utility beyond being used to buy goods and services within the states they represent.

Cultural and geopolitical factors like diaspora and war, and economic factors like price volatility also negatively impact a fiat currency's ability to act as a unit of exchange. During times of political instability, people may lose confidence in the reliability of their country's currency as a unit of account. 

Domestic instability in a country may inspire individuals and businesses to protect their assets by transferring funds abroad or converting them into foreign currencies. This capital flight can put pressure on the domestic currency and undermine its value as a unit of account. In response, governments may impose exchange controls or restrictions on capital movements, further complicating the use of domestic currency for transactions and reducing its portability.

“Specie” Currencies

Gold has always been used as a global money in history because as a commodity, its deflationary supply makes it an effective store of value. Gold’s supply is finite and there will always be a demand for it, making it consistently retain value and purchasing power, even during times of volatility. 

Gold’s finite supply makes the precious metal an effective unit of account because the approximate amount in circulation is known. Gold is easily divisible too; smaller coins can be cut from bars to enable portability across varying regions, making it an effective medium of exchange. 

Considering the Greek Drachma and the Roman Denarius, national currencies have existed for thousands of years. The difference between historical national currencies and the modern fiat currencies of today is that past currencies specific to one state held intrinsic value due to the metals they were made from. Gold is very malleable and silver is very conductive. Coins made from these metals, known as specie currencies, offered utilities beyond simply being transacted within the regions where they were issued. 

Specie currencies can take the form of coins or bullions. Coins are pieces of metal stamped by a government authority to indicate their weight, purity, and denomination. Bullions refer to bars or ingots of precious metal that have not been minted into coins but are still traded based on their weight and purity. 

Specie currencies and fiat currencies can both be specific to one state. However, specie currencies derive intrinsic value based on the material they are made from, while fiat currencies derive value from government decree. Throughout history, specie currency has been widely used as a medium of exchange, unit of account, and store of value, making it possible for specie currency to be sound money.

The Impact of Paper Currency 

With the introduction of paper currency came a significant dilution in coinage value and major changes to the global monetary system. We transitioned from primarily using coins and precious metals to primarily using paper. Paper currencies, however, do not hold the same properties as specie currencies - they can only fulfill the purpose of being a medium of exchange since they are not durable and hold no intrinsic value. 

Paper currency has been used in various forms for centuries. It was used initially for receipts or promissory notes, both issued by banks or merchants to represent deposits of precious metals to be held in reserve. These early forms of paper money were redeemable IOUs that could be exchanged for specie (precious metals) upon demand. 

As banking systems developed in medieval Europe, banks began issuing banknotes as a more convenient alternative to carrying large amounts of specie. These banknotes were initially backed by reserves of gold or silver held by the issuing bank, but over time, banks started using fractional reserve banking. This is where they kept only a fraction of their deposits in reserve, allowing them to issue more banknotes than they could back with specie.

Governments also began issuing paper money, initially as bills of credit or debt certificates, to finance wars or other government expenditures. These early government-issued paper currencies were often backed by promises to redeem them in specie upon demand. However, governments sometimes abused their power to print money, leading to inflation and loss of confidence in paper currency.

History of the Gold Standard

In the 19th and early 20th centuries, many countries adopted the gold standard, where the value of their currency was directly linked to a specific amount of gold. Under the gold standard, paper currency could be exchanged for gold at a fixed rate, providing stability and confidence in the value of money.

During World War II, many European countries faced significant economic challenges, and some opted to send their gold reserves to the United States for safekeeping. This was a common practice during times of war or geopolitical instability, as the US was seen as a relatively stable and secure repository for gold because of how difficult it would be to invade.

As the war progressed and Hitler's forces advanced across Europe, even more countries sent their gold reserves to the US for safekeeping. The United States accumulated vast amounts of gold during this time, making it the de facto custodian of much of the world's gold reserves. 

After the war ended, some countries sought to repatriate their gold reserves from the United States. However, they encountered difficulties in doing so. The US government had used much of the gold it received to finance its own military expenditures. During the postwar period, it couldn’t afford to pay back the countries that had stored their gold on US soil.

The Bretton Woods Agreement

To appease the nations that the US owed gold to, they proposed the Bretton Woods Agreement in 1944. This sought to establish a new global monetary framework based wholly on paper.

The Bretton Woods Agreement established a system of fixed exchange rates, where currencies were pegged to the US Dollar, which in turn was pegged to gold. The US pledged to maintain the Dollar's value at $35 per ounce of gold, fostering a new global gold standard. Under this new gold standard, USD became the world’s defacto reserve currency as countries could convert their currencies into US dollars at a fixed rate, and the US would redeem those dollars for gold upon request. 

By the 1960s, the United States was experiencing persistent trade deficits and an accumulation of dollars held by foreign central banks. This accumulation, known as the "dollar overhang," raised concerns about the sustainability of the new gold standard brought on by the fixed exchange rate system. 

As doubts grew about the US's ability to maintain the value of the dollar at the agreed-upon gold price of $35 per ounce, foreign governments and investors began to speculate against the dollar. This led to a loss of confidence in the Bretton Woods gold standard and a further drain of US gold reserves as foreign countries sought to again exchange their dollars for gold. 

In 1971, US gold reserves were so dry that President Richard Nixon abandoned the gold standard initiated by the Bretton Woods Agreement in favor of a completely fiat currency-based system. The US would no longer redeem dollars for gold. This decision, known as the "Nixon Shock," marked the end of the Bretton Woods system and the transition to today’s inflationary fiat currency regime dominated by paper currencies.

Final Thoughts on Fiat

The evolution from specie currencies to fiat currencies has been a complex and multifaceted process shaped by economic, political, and technological factors throughout history. Specie currencies, backed by precious metals, provided inherent value and stability, serving as a medium of exchange, unit of account, and store of value. 

The introduction of paper currencies, initially representing claims on precious metal reserves, marked a pivotal shift towards a system where currency issuance was decoupled from physical commodities and controlled by governments.

Fiat currencies, while offering flexibility and adaptability to economic needs, also pose challenges such as inflation and loss of purchasing power. Additionally, cultural, geopolitical, and economic factors can further impact a fiat currency's stability and utility as a medium of exchange.

While the transition to fiat currencies has facilitated economic growth and globalization, it has also raised questions about monetary stability and the role of central banks. Understanding the historical context and factors that have shaped the evolution of currencies provides insights into the challenges and opportunities facing modern monetary systems.

In 2008, a man known as Satoshi Nakamoto introduced the concept of Bitcoin, and the new era of cryptocurrency began. That, however, is a story for another day. 

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