What Is Fiat Money?

Posted by Allison on 6 April 2009, 14:58

Do you have any coins in your pocket?  Take them out and look at them for a moment.  Regardless of what country you may be in, and what currency you therefore have in your hand, what you are holding is fiat money.

Compared to the long history of currency as a whole, fiat money is a relatively new item.  It came into existence gradually owing to changes in the way currency was made.

So what is it exactly?  What does fiat money mean?

In short, it has no real value.  The coins and banknotes are not made of components of any value at all, so the amount which is written on them is determined by other means; it bears no relation to the value of the metal or material the coin or banknote is made from.

As such, all modern currencies are essentially based on faith.  If you are carrying a one hundred dollar bill in your pocket, it only has that value because the government of the United States of America has deemed it to be worth that much.  Fiat money therefore, is nothing more than a representation of a unit of currency which is legal tender in a particular country.

In ancient times, money was a very different commodity to what it is now.  Gold coins were made of gold and 'pieces of silver' were just that.  Currencies were developed on the understanding that a certain size or weight of coin was worth its weight in gold – and it literally was.  That is where the modern saying comes from.  Coins were generally made from gold, silver and bronze, and the larger the coin was the bigger the value, generally speaking – although it is obvious that a large bronze coin would not be worth as much as a small gold one.

Some people today think that modern currency is in danger of falling flat on its face.  You may also have heard the saying that 'it's not worth the paper it's printed on'?  Well that also applies to fiat money.  One wonders whether it would survive if anyone challenged a government strongly enough as to how valuable their money really was.

We can see just how fragile fiat money really is by taking a look at the history of coins.  Firstly they were made from precious metals – at which point people used to scrape a certain amount of gold or silver from the edges of them to make themselves some extra money for no extra work.  Because coins were irregularly shaped this could be done, even though it was illegal.

Over time the amount of precious metal in coins decreased, and metals of far less value were used to bulk them out.  Eventually coins for common circulation had no gold or silver in them at all, but even at this point they still had a value far beyond what they have today.

Many currencies used to be pegged to the Gold Standard, which basically meant that even though the coins and notes of a particular currency had no intrinsic value, they were backed by gold.  But a few decades ago even this fell by the wayside.

You would be forgiven for thinking that fiat money seems fairly fragile considering the history that money has for being attached to gold in some way, and you would be right.  Indeed, many Americans are now calling for the Gold Standard to be brought back, since the country is going through some struggles of late, and inflation is causing some problems as a result.

And that is where the main weakness of fiat money lies.  If you start delving into the history of various currencies, it wouldn't take long before you found some reference to a currency which has had to be redenominated due to inflation.  This has happened continually throughout the history of fiat money, in order to prevent ludicrously silly amounts of money being paid for goods in that particular country.  For example, if inflation became a huge problem in Britain, you might end up having to pay a hundred pounds for a loaf of bread.  In this situation the pound sterling may have to be redenominated.

The fact is that redenomination would never happen if currencies were pegged to the Gold Standard, since gold always has a great value and currencies which are backed by it don't tend to fluctuate as readily or be affected by inflation anywhere near as much as fiat currencies are.  A currency which is backed by gold in this way is known as representative money, because it represents a certain amount of gold and can be swapped for that amount if you demanded it.

Given the sometimes volatile nature of relationships which exist between countries in modern times, it seems almost foolhardy to expect fiat currencies to last indefinitely.  It would only take the spectre of hyperinflation (where the value of a currency spirals out of control) to rear its ugly head in one of the world's strongest countries – like America for example – for the whole concept of fiat money to come into serious question over the world as a whole.

So we may yet see a return to the days where gold backed currencies and every coin and banknote we had in our pockets did have a real value, and didn't exist purely on trust.  But will it happen in our lifetimes?

It's true to say that Americans are clamouring for it to happen right now, but that could simply be as a result of the uncertainty over the economy in their country at present.  If that uncertainty goes away, will the desire to get rid of the fiat money system go away too?

Only time will tell.  But until then we have to carry on using the money which has no value, and perhaps even wondering whether our ancestors knew more about money than we do now.  They would certainly be surprised at how we have developed, and things may yet go full circle and return to those ancient times.