What is fiat money?

Gemma says…

Fiat money is a form of money that’s backed by a government. It is often used as the primary method to pay for goods and services as well as taxes.

As more and more transactions become digitized and physical currency is used less, the average person may be confused by the differences between fiat currency, digital fiat currency, and cryptocurrency. When considering the implications of cryptocurrency, it is important to understand the basic history of money. Before going into what fiat money is and how it differs from crypto, we must first underline the different types of money.

Money, in a Nutshell

Money can generally be described as a medium of exchange to purchase goods and services or to transfer value. Historically, there are three main types of money: commodity, representative, and fiat.

Commodity Money

Commodity money is the earliest form, and is money that has actual intrinsic value. The most popular commodity money is gold, and for a huge part of human history it was physically used in exchange.

Representative Money

Representative money is a variation of this, and refers to money that represents a commodity. For a brief part of the 1900s, the United States operated on the gold standard. Under the gold standard, each dollar could be exchanged for a set amount of gold. The gold standard was slowly phased out, until President Nixon completely abolished the conversion of gold for a fixed value in 1971. The last type of money is fiat money.

Fiat Money

Fiat money is money issued by a government to be legal tender, and is not backed by gold or other physical commodities. The value of fiat money is based on the strength and credit of the issuing body, and almost every country today issues fiat currency. While digital fiat money exists in every bank transaction or credit card purchase today, this money is still tied to physical fiat currency and thus controlled by governments.

How does cryptocurrency differ from fiat currency?

Like fiat currency, cryptocurrency can be used as a medium of exchange. The main difference is that unlike a fiat currency that is issued by a central bank or government, cryptocurrency is not issued or controlled by a central body. Governments and banks can decide to print new fiat money when times call for it. The Bitcoin network has a finite amount of coins to be issued over time, and this policy will never change.

What are the implications of cryptocurrency on fiat currency?

The strength of any fiat currency stems from the strength of the government or bank that issues it. While the intention of fiat currency is to be stable, we have seen in times of recession and rapid inflation that this is not always the case. In recent years, for example, the country of Venezuela has been struck with hyperinflation, recording an annual inflation rate of at least 60,000 percent in 2018. Compare that to the inflation rate of the United States for 2018 – estimated to be about 2 percent.

Some publications and economists even estimate the inflation rate in Venezuela is much higher, with the IMF estimating over 1 million percent. The reason for these drastic differences in estimates can partially be attributed to the huge magnitude of inflation. With hyperinflation, the magnitude of inflation is so intense that when calculating it, a small change in calculation can result in a huge difference in estimation. The difference can be also be attributed to the non-transparent nature of governments when it comes to financial policy. This is not the case with cryptocurrencies. One of the main value propositions of Bitcoin is its transparency. We know how many coins are in existence, and have a record of every transaction on the blockchain.

In times of rapid inflation, people need the ability to convert their wealth to a more stable store of value, or risk losing huge amounts of value just by letting their fiat currency sit. This represents another huge reason cryptocurrencies like Bitcoin are valuable. Since there is no central bank or government to change Bitcoin’s monetary policy, the digital currency serves as an escape from centralized currency that can be subject to poor monetary policy.

While it is not the case today due to Bitcoin’s long transaction times and huge price fluctuations, but it’s possible that during times of rapid inflation, citizens can run to cryptocurrencies like Bitcoin to secure their wealth, just like they already do with gold. Until Bitcoin matures and the price becomes a more stable store-of-value, stablecoins like Tether may prove to be valuable in this case. While Tether is tied to the US dollar, it at least represents an efficient way for people suffering from inflation to transfer value to a more stable government issued currency.