In 1971, a financial crisis and declining gold reserves led United States President Richard Nixon to make a monumental economic decision that would forever change the international monetary system. On August 15, Nixon announced his New Economic Policy, a program that effectively ended the Bretton Woods Agreement and untethered the U.S. dollar from the gold reserves that had given it value for the last three decades.
The Bretton Woods Agreement was negotiated in July 1944 by delegates from 44 countries at the United Nations Monetary and Financial Conference held in Bretton Woods, New Hampshire. Under the Breton Woods terms, gold became the foundation for the U.S. dollar and other currencies were pegged to the U.S. dollar’s value.
Nixon’s controversial new measures effectively canceled the direct convertibility of the U.S. dollar into gold, leading to the global mass adoption of a new type of money called “fiat” currency. From now on, the U.S. money supply would be a legal tender whose intrinsic value was backed solely by the U.S. government.
Understanding Fiat Currency
Every person in the U.S. deals with fiat money because fiat currency is a term that describes the money we use every day. The U.S. dollar, as well as most of the other major currencies circulating in the world, can be described as fiat money.
Fiat money is not backed by a physical commodity, such as gold or silver, but rather by the central bank that issued it. Simply put, fiat currency has value because a government says it does. Because of this, the value of fiat money depends not on metal reserves, but on the political stability and competence of the government that issues it.
Where Does the Term Fiat Come From?
The word used to describe our current paper money did not arise randomly, but is derived from a Latin word that is translated as “it shall be” or “let it be done.”
Because of this, a “fiat” is also known as an official order or decree. As our new currencies are based primarily on government orders, it makes sense to refer to them as “fiat.”
Anyone who wants to find the actual U.S. government decree should look no farther than the dollar bill in their pocket, on which is written the following words, “This note is legal tender for all debts, public and private.”
History of Fiat Currency
Although “fiat” is a Latin term, the origin of fiat money dates back to 10th century China, where the Yuan, Tang, Song, and Ming dynasties implemented paper bills to deal with the high demand for metallic currency that exceeded the supply of precious metals.
However, despite the occasional adoption of fiat money in medieval China and select countries in the past, almost all currencies in recent centuries were made of a physical item with an agreed-upon value, with the most common metals being such as gold, silver, copper, and bronze.
It is often helpful to think of the British pound sterling, which is used today in the United Kingdom, but initially began as a silver coin that weighed one Troy pound. The coin had value due to the metals that composed it, which amounted to a literal pound of sterling silver. The value of these physical coins was in the coin itself.
From this point, governments began to issue paper currency or notes that were redeemable for physical bullion. For the British pound sterling, those who owned paper bills could redeem them for gold beginning in the 1700s.
Today, currencies are almost universally backed by the governments that issue them. Because fiat money is not linked to physical reserves, national stockpiles of gold or silver are unnecessary. Although this is more economically and politically expedient for governments, there are serious inflation risks due to the need to print more money. This practice has been the cause of severe cases of hyperinflation, such as in Germany after World War 1 and in Hungary immediately after WWII.
Fiat Currency in the U.S.
Like England, fiat money was not always a part of the U.S. banking system, and earlier in the country’s history, its currency consisted of metal coins.
It wasn’t until the late 18th century that the American colonies began to incorporate bills of credit that were used to make payments. The provincial governments issued notes that the holders would use to pay taxes to the authorities.
The adoption of paper bills only increased during periods of economic tension, such as the American Civil War. During the conflict, the federal government turned to a form of fiat currency dubbed “Greenbacks,” which helped provided much-needed war funding and ultimately led to the South’s defeat. To encourage mass adoption of the bills, the government halted the convertibility of its paper money to gold or silver during this war.
The path to fiat currencies further accelerated during the Great Depression, when the federal government passed the Emergency Banking Act. Just as in the Civil War, citizens were forbidden to exchange currency for government gold.
The gold standard finally ended in 1971, when Nixon’s order led the U.S. to stop issuing gold to foreign governments in exchange for U.S. currency. Today, U.S. bills are “legal tender,” rather than “lawful money,” which can be exchanged for gold, silver, or any other commodity.
What Gives Fiat Currency Its Value?
It’s important to remember that while fiat currency is backed by the resources of the government that issue it, its intrinsic value is determined by different factors such as supply and demand, the money supply, and interest rates.
Even though the U.S. Federal Reserve does not need to have gold underpinning its currency, it is still required to hold collateral equal to the value of the dollars in circulation, and it does so using government-issued debt.
Technically, dollar bills have value today because lenders and investors believe the U.S. government will repay its debts.
Fiat Currency vs Cryptocurrency
For many years, investors and bankers believed that the fiat system put in place by the federal reserve would never have any major competitor. But the financial crisis of 2008 and the political instability that followed led many to question whether the U.S. truly had a stable currency.
The advent of digital currency in the form of Bitcoin and Ethereum has raised further questions about the long-term feasibility of fiat money. The main difference between fiat currency and cryptocurrency is that cryptocurrencies don’t require government backing, while fiat currencies depend on it.
The Case for Decentralization
Cryptocurrency is often touted as a competitor to fiat currency as its supply is limited and it is not subject to excessive printing by dishonest governments. For example, Bitcoin is known as “digital gold” because there will never be more than 21 million bitcoin in existence.
Additionally, most cryptocurrencies are created using a computer networking technology known as the blockchain, which is essentially a digital ledger that eliminates the need for a central authority.
Many proponents of cryptocurrencies argue that “decentralization” will result in more efficient and less corrupt monetary systems.
Why do Modern Economies Favor Fiat Currency?
One interesting question that often puzzles many consumers is why fiat money is used so widely in the global economy and nearly all financial markets. The question takes on even more importance when considering that before the 20th century, nearly all countries relied on the “gold standard” by backing their currency with a physical commodity.
The answer lies with the rapid economic growth of most developed countries in the mid-twentieth century, which could not keep pace with the limited amount of gold coming out of mines throughout the world. The lack of precious metals available, coupled with the fact that central bank vaults could not keep up with the new value that was being created, caused disruptions in commerce in most countries without fiat money.
Governments began to implement fiat money for the greater flexibility it provided, which allowed them to set monetary policy and stabilize global markets. Today, fiat money gives politicians more economic power than previous governments could only have dreamed of.
Advantages of Fiat Money
Those who advocate for fiat currency claim that the current economic system meets the three main needs of the economy – storing value, providing a numerical account, and facilitating exchange.
Using fiat money also allows governments to dampen the worst effects of the boom and bust cycles that plagued the West in the past. Since fiat currencies are not a scarce or fixed resource like gold, central banks have much greater control over their supply, which gives them the power to manage economic variables such as credit supply, liquidity, interest rates, and money velocity.
Disadvantages of Fiat Money
No one who advocates for fiat money would deny that an untethered currency comes with potential downsides.
The mortgage crisis of 2007 and subsequent financial meltdown dispelled the belief by many that central banks could prevent recessions by regulating the money supply.
Additionally, pumping massive amounts of new money into the system during times of economic crisis has the potential to devalue the dollar and lead to severe inflation.
This only hurts a country’s economy and causes a loss of faith in institutions that are meant to safeguard the value of the nation’s currency.