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Fiat currency: what it is and how it differs from the gold standard

septiembre 14, 2022
Fiat currency: what it is and how it differs from the gold standard

Probably the term Fiat money it doesn’t tell you anything by itself. But in reality it refers to a daily activity of the whole population: the use of cash.

In fact, fiat money is currently the monetary system that It is mainly used around the world to control and issue money in circulation.. But what is fiat money and how is it different from the gold standard? We explain.

What is fiat currency?

Fiat money, from the Latin «to be» or «thus to be», is that which is not backed by any tangible asset, such as gold or other precious metals. Basically, it exists through the legal imposition of governing authority, being the legal and enforced currency of a state.

Its value is based on the trust of the citizens who use it, since it is guaranteed only by the creditworthiness of the issuing government. In fact, it is the government itself that forces its citizens and businesses to use this money, requiring the payment of taxes in this currency.

Basically, fiat currency is the money you use in your daily life. To know, euros that you carry in your wallet when shopping in the European Uniondollars held by a US citizen or yen used by a Japanese citizen.

Today, every country in the world they use fiat currency as currency in circulationalthough some parts of the world already legally allow other forms of currency, such as El Salvador, which on June 8, 2021 adopted bitcoin as legal tender.

Fiat money and the gold standard

To understand fiduciary money, we must first go back to the very origin of money, which is originally the element of it facilitates the exchange of goods and merchandise and thus avoids barter. At first, some goods began to be used, such as cattle, shells or even salt.

However, these goods had difficult problems to solve, such as the fact that they are perishable or difficult to transport. For this reason, they were gradually replaced by precious metals such as gold or silver, which perfectly fulfilled the characteristics of any good currency: medium of exchange, store of value and unit of account, in addition to be non-perishable metals and easy to transport.

With this, the first banks began to operate, which initially served as clearinghouses. save the gold of its depositors. Instead, they received a bearer paper which acted as a credit note and certified that the depositor had a certain amount of money in the bank.

Gradually, these banknotes became the items used as a medium of exchange, as they were more convenient to transport and could be converted into gold which the banks kept at all times.

Thus was born, in essence, The gold standardwhich operated more or less stably until 1971, Richard Nixon decreed the end of the convertibility of the dollar into gold. Since then, the value of gold has steadily increased, while the value of fiat money, in this case the dollar, has fallen by 95% due, among other things, to the expansionary monetary policy of the Federal Reserve, which has the power to create unlimited uncovered money in the United States.

Advantages and disadvantages of fiat currency

The advantages of fiat currency are:

  • It does not depend on or rely on any physical asset and therefore its issuance is free, which gives central banks the flexibility to mitigate macroeconomic imbalances, such as a recession or high unemployment.
  • Under this model, economic stability of a country it does not depend on the gold reserves they hold, which promotes the growth of small countries.
  • international use: all nations, with a few very specific exceptions, use fiat money, which promotes international trade

Some of the major disadvantages of fiat currency include the following:

  • Inflation: Since any central bank can issue its currency almost without limits, fiat money can cause inflation if its issuance is not controlled. Moreover, in recent years there have been major hyperinflations due to monetary expansion, such as that of Robert Mugabe’s Zimbabwe or that of Venezuela today.
  • limited confidentiality: The government can quickly identify and track any transaction, especially if it is done electronically.
  • state regulations: Its use depends on government regulations, which can often be arbitrary. For example, they can put limits on their use or withdraw certain banknotes or coins.
  • high costs: Commercial banks control the flow of fiat money, so they may charge certain fees for certain transactions.

Cryptocurrencies: an alternative to fiat money?

In recent years, the booming emergence of cryptocurrencies has somewhat threatened the future of fiat money, worrying governments and central banks. And it’s not for less, since they have all the hallmarks of good moneyuntil improving somewhat on those of fiat money.

Although cryptocurrencies share some properties of fiat money, such as the fact that not be supported by a physical asset, the truth is that they have more in common with gold from a monetary point of view: they have a controlled money supply, their issuance is totally decentralized and they are not limited by national borders. And moreover, they have lower costs than fiat currency.

There is no doubt that the success of cryptocurrencies It will depend on the expansion of its use as currency in national and international commercial transactions.. And although cryptocurrencies like Bitcoin were not designed to replace fiat money, the truth is that they have already been used as currency in many international commercial transactions, and their use is already beginning to increase. be regulated in many countries.