The rise of Bitcoin and cryptocurrency in general has elicited passionate debates about the future of money. This genuine spike in interest in how the world’s monetary system works is a positive development. As a result, a genuine understanding of fiat money and its mechanics is necessary to understand why cryptocurrency is appealing to so many.
What Is Fiat Money?
The word “fiat” comes from Latin and means something like "it shall be" or "let it be done." In modern economics, the definition of fiat money is essentially government-issued currency without the backing of physical assets. Money is printed by the “decree” of central banks.
Most governments rely on supply-demand metrics to print out the desired amounts of fiat money. In essence, central banks rely on market forces to determine the rollout of fiat money. That said, the fiat money is still printed on demand and has a high amount of supply flexibility.
Fiat money has origins in China’s Sichuan province in the 11th century. This was the first incidence of standard paper money in exchange for silk, gold, or silver.
In Europe, fiat money became prominent in the 16th century with a silver or gold standard. By the 20th century, most industrialized nations were already using fiat money.
What Is a Fiat Money System?
Let’s take a journey through the historical origins of money. Back when large, organized governments came about, such as in the Roman Empire, governments would mint coins out of valuable commodities like gold and silver. The scarcity of these precious metals gave the coins intrinsic value. In the event that the economic system collapsed, you would still have redeemable precious metal coins.
Later, a new form of currency came about: paper money. Paper, or fiat, money was essentially a piece of printed paper that had a value ascribed to it by the issuing authority. Ordinary people began to make transactions using the paper, which, for a long time, had gold reserves to back it up.
However, as time went on, governments began to abandon the gold standard and issue printed money that had only the confidence of consumers in the country’s economy to back it up. For example, the US abandoned the gold standard in 1971 and continued on with pure fiat money.
Remarkably, the world has continued to make transactions using fiat money ever since. Now, the world essentially operates using an interconnected global fiat currency system. The most prominent fiat currency is the US dollar, which has solidified its place as the world’s reserve currency due to the international oil trade.
Fiat money works if the central bank or equivalent issuing authority upholds the trust of the ordinary people. An irresponsible government can print excess fiat money, leading to hyperinflation. Since fiat money has no backing in physical assets, such a scenario leaves one essentially holding a piece of paper with low or no value. This is the primary problem with fiat money: An all-powerful centralized agency holds all the cards and can wreck the financial system overnight.
A fiat currency is legal tender that has value based on the issuing government rather than physical assets. In such a monetary system, the strength of the government that issues the currency in terms of its ability to maintain a coherent monetary policy is vital. This explains why most developed countries have stable fiat currencies while the opposite holds true for failed states.
Fiat currency as legal tender is about trust and confidence in the issuer of the currency. A stable fiat currency can support savings, investment, and the purchase of goods and services. This has been the basis of the global economy for decades now.
But is it all rosy? Let’s check out some of the advantages and disadvantages of fiat money.
Pros and Cons of Fiat Currencies
|Flexibility and responsiveness||Elastic supply is great to adjust to the needs of a growing economy.||The ability of fiat money to be printed in infinite amounts can be dangerous. An example is the Zimbabwe government, who printed staggering amounts of money in response to financial issues. This led to punitive hyperinflation, which the country has never recovered from.|
|Cost||Affordable and convenient to produce compared to gold and commodity money.||The ease of production of paper money is a risk factor when an irresponsible government is leading.|
|Store of value||Stable fiat currencies like the USD can serve as a store of value.||Fiat money loses value tremendously in the case of hyperinflation.|
|Control||A single issuing authority such as a central bank can guarantee stability in its monetary policy and has the power to manage variables like liquidity and interest rates. A prime example is the U.S. Federal Reserve, which manages interest rates.||The control of central banks can be catastrophic in creating financial crises like the housing market crash in 2007. The mismanagement of a fiat currency can lead to financial bubbles and devastating crashes.|
|Risk||Fiat money has a track record of occasional financial collapses. Therefore, there is always the risk that a fiat money system will collapse.|
From the above, it is clear that the inherent risk of fiat money is that it is very vulnerable to market shocks. As such, investors have explored alternative financial systems for decades. Gold has been a consistent safe haven globally, but not even gold can address some of the shortcomings of the fiat money model. In 2008, there was a remarkable development in finance. Blockchain technology was a revolutionary invention that is disrupting the world of finance significantly. Though initially low-key with little fanfare, cryptocurrency has risen dramatically to capture the conscious of financial experts across the world.
Bitcoin vs Fiat Currency
Blockchain technology brought with it a remarkable decentralized ledger that could add unprecedented transparency and speed to financial transactions. Bitcoin is a cryptographic digital currency that runs on blockchain technology. Instead of having a central issuing agency, Bitcoin is a peer-to-peer digital currency.
Bitcoin creates a unique financial system that is an independent alternative to fiat. The Bitcoin network eliminates the ability of a central bank to both control and print the currency in unlimited amounts.
In the years since Bitcoin became a global force, many other alternative coins (altcoins) have emerged with a similar decentralized cryptographic model. Examples of such cryptocurrencies include Ethereum, Ripple, Litecoin, and Bitcoin Cash.
Cryptocurrencies are now big financial entities. Bitcoin, for instance, has a market capitalization of over $200 billion. Incredibly, Bitcoin has retained its dominance in the crypto markets despite indications of potential future challenges from the likes of Ethereum.
Why has Bitcoin endeared itself to so many? Let’s compare it to fiat money to understand the distinct advantages of Bitcoin.
The following are some of Bitcoin’s unique characteristics:
- Cryptocurrencies have a fixed amount from their creation. Bitcoin has a finite ceiling of 21 million Bitcoins, which keeps the volume low. This obviously contrasts fiat money, which has no printing limit, thereby incurring the risk of inflation and hyperinflation. Most altcoins set up higher numbers of available mineable coins after establishment to improve scalability. Regardless, crypto is, in certain respects, similar to the “real asset” value of gold, given the cap on supply.
- Bitcoin is global and decentralized. Anywhere in the world, people can access and make transactions using Bitcoin. Fiat money normally involves certain procedures for transfers, and different countries have different currencies.
- Blockchain transactions are transparent. Bitcoin transactions are verifiable and irreversible thanks to the open and decentralized nature of the ledger. This removes the ability of a bank to restrict user accounts and prevent certain users from making transactions.
- Cryptocurrencies have no transfer limits. Unlike fiat money, with which banks can place artificial limits on transfers, crypto transfers are completely at the discretion of the parties in the transaction. The transfer is instantaneous, without the bottlenecks of approvals and waiting times.
- Cryptocurrencies are impossible to forge. Regardless of how secure fiat money is, the fact remains that it is paper money, meaning someone out there can counterfeit the currency. However, since Bitcoin is made of cryptographic units secured by mathematics in a blockchain network, it is impossible to counterfeit.
- Cryptocurrency cuts out excessive charges by banks. Charges such as maintenance fees and overdraft charges are not a feature of crypto transactions. The low fees in crypto transactions cover the network costs.
Bitcoin offers certain distinct features that cover the shortcomings of the fiat currency system. Most significant is the fact that Bitcoin’s supply depends on “market forces” such as fiat money. In fiat, a miscalculation of this supply can lead to inflation, sometimes going to extreme levels like in the case of Zimbabwe.
However, cryptocurrency still has to undergo significant maturity to replace fiat money rather than just being an alternative, as it is now. Nonetheless, the progress crypto has made in its 10 years of existence is astonishing.
Bitcoin is now a household name across the world, making it likely to be a long-term store of value (SOV) and a unit of exchange. Cryptocurrencies that solve the problem of scalability while retaining the immutability of Bitcoin will be the future of finance.
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