Fiat money or fiat currency is a very popular term in the world of crypto. Instead of saying crypto traders are trading their dollars or euros for Bitcoin, they say they are exchanging their fiat currency for Bitcoins. However, what is fiat currency? Why are euros and dollars fiat money and Bitcoin not? Moreover, why is this such a well-known concept within the crypto world while it is almost not talked about outside?
The most important reason for the latter is that Bitcoin was born as a reaction to fiat money. While Satoshi Nakomoto may not have said it exactly in those words, he is obviously a significant opponent of the traditional financial system. The group which sees fiat money as a “hoax” is growing.
There are many advantages to fiat currency, such as its stable and reliable exchange rate, but it is people who finance it. In particular, since the economic crisis of 2008, the question is increasingly being asked whether the benefits still outweigh the sky-high bill we are paying for it.
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Fiat money explained in a nutshell
Fiat money is a form of money that does not derive its value from the material from which it is made (such as gold and silver) but whose value is purely based on people’s trust in it. The main problem with fiat money is that banks and the government can print as much of it as they want.
In fact, national currencies such as the dollar have not been based on the gold standard since 1971, as many people still think. The main advantage of this is that the government has a grip on the economy and any exchange rate fluctuations. The biggest downside is that we citizens pay a very high price for this.
We pay that price in the form of inflation and reduced purchasing power. Imagine your (great-) grandfather saved a lot of money and stopped working 60 years ago, in 1962. He decided that 1 million euros in an old bag would be enough for him and at least one generation after him not to have to work anymore.
However, he did not consider inflation and the CPI (Consumer Price Index). Today, his million euros is only worth a little over 111 thousand euros. In other words, the money has lost more than 89% (!) of its value in 60 years.
All this value has been directed towards the institutions (the government and banks) that have been allowed to print it for free. Therefore, it is logical that there is a lot of criticism of fiat money, but why does it exist? What are its advantages? We’re going to explain it all to you in simple language.
What is fiat currency?
As already mentioned, fiat money is a form of money whose value is based purely on people’s trust in it. Essentially, it can be created out of thin air. And the reason people trust it is based on the trust they have in the country or continent that the currency represents.
Voices opposed to fiat money (and there are quite a few) feel that the definition should be broadened to include the fact that fiat money is not voluntarily elected to the market as money, but rather where it is mandated by the government that people accept it as a means of payment.
The confidence in fiat money as a means of payment mainly derives from this as well. Furthermore, the government tries to make sure that the price of fiat money remains relatively stable and that there are not too large price fluctuations. The trust in fiat money is maintained mainly in the following three ways:
- It is established by law that everyone must accept it as a means of payment.
- Fiat money is acknowledged as a means of paying your taxes.
- The government ensures that the price of fiat money remains relatively stable.
So basically comes down to the government having a monopoly on fiat money. They decide that it must be accepted and when and how much may be printed. While this creates trust, opponents are not fans of the government having full central power over it.
How did fiat money come into existence?
Fiat money was born because, in 1971, the gold standard was abolished. Before that, money was connected to gold and derived its value from this. The first moves towards fiat currency were made when paper money was invented.
This came about as proof of debt for the gold that you left in storage at the goldsmith’s. For a full story of how gold ever came to be as money, you can read our article on what money actually is. For this article, we’ll jump directly to the time when gold was accepted as a general currency.
The goldsmith and paper money
The best way to explain the origins of paper money is with the example of William and Ashley. They still lived in the days when everything they bought was paid for with gold coins. Both of them lived in the same village, and Ashley was a wealthy woman, with William earning his living as a goldsmith.
It was widely known within the village that Ashley was a rich woman, which ensured that many robbers were targeting her. No longer comfortable at home with all that gold, Ashley was eager to have a safe place to keep it.
Meanwhile, William, the goldsmith, was accustomed to all those robbers and had his property thoroughly protected against this kind of evil. Throughout the years, he heard of Ashley’s problems and thought that he could safely store 10 units of Ashley’s gold for a small fee. Obviously, Ashley was pleased about this and gladly paid a small fee to William for this effort. She was given a paper receipt by William stating that she could come and collect her 10 units of gold from William at any time.
Several weeks later, Ashley was out visiting Robert, and she fell completely in love with a beautiful horse. Basically, Robert is very attached to this horse and doesn’t really want to give him up. All the while, Ashley wants him so badly that, how coincidentally, she offers 10 gold units for the horse. Of course, Robert can’t believe his ears and immediately, but with a little bit of pain in his heart, he agrees to this excellent deal.
However, there is only one problem, carrying 10 gold units is very heavy to lift, and Robert and Ashley do not live very close to each other. Therefore, getting those 10 gold units to Robert will be quite a task. Thank goodness there is an easy solution.
Ashley has with her the debt certificate that will allow her to collect 10 gold units from William. It is extremely easy for her to pay with this. Robert already knows William and that he is a reliable goldsmith, so he is fine with her paying this way. And that is how the first paper money was created.
While this is a relatively simple example of the creation of paper money, it is not yet fiat money. In fact, the money from the example is still fully backed by gold. For this, we will go a step further and first explain fractional banking.
What is fractional banking?
We continue with the example of William, the goldsmith. By now, more and more wealthy individuals have discovered that they can store their money with William for a modest fee. This has resulted in William now managing over 100 units of gold. This is an incredible amount for that time, and it never happens that more than 20% of this money is retrieved at once.
In the village, several people have money problems. The wages are paid late, but the residents require money to buy food. They all know that William has a lot of gold in his control, so they turn to him for a temporary loan.
At first, the goldsmith is a little reluctant. For example, if he lends them the money, what if his customers come to collect it afterwards? However, he realizes that it has never been the case in all these years that more than 20% was collected at once. Therefore he can safely lend out the remaining 80% and charge a nice interest rate on it. In that way, he also earns something.
So now what happens is that 100 units of gold exist in the form of debt certificates. Still, William’s customers are using them as paper money. In addition, William is lending out another 80 units of gold. So suddenly, there is money worth 180 units of gold (100 gold units of value in paper money + 80 gold units of value in gold) rather than 100. Therefore, William has created a value of 80 units of gold out of thin air.
Now imagine that all these 80 units of gold are placed with another goldsmith, Jack. While Jack knows about William’s clever trick, he would also like to earn extra on interest. Thus, Jack decides to also re-lend 80% of the total gold supply, representing 64 units of gold.
This, in turn, causes the money supply to grow to a value of 244 units of gold. Continuing like this, the money supply can grow to a maximum of 500 units of gold, while it is backed by 100 real gold units.
The example shows what has actually been happening in our country and other countries since 1700. Goldsmiths/banks have cleverly created money very easily and charged interest on it. One could see this as a pure fraud because what will happen to the value of your gold if suddenly, five times this ‘exists’?
And what would happen if it is suddenly announced that not 21 million but 105 Bitcoins will exist in total? Their price would plummet all at once. Thus, the banks could make a lot of money on interest, while it was at the expense of their customers’ assets.
Rather than this being banned, a law came along that made it legal. It is unclear why this was done the way it was at the time, but it may be that the goldsmiths had gained too much power by then.
Problems of fractional banking
You may already have figured out for yourself that this can’t always go well, but let’s take a look at what can happen with a simple example. Imagine the following happens:
- A significant number of village members transfer a total of 100 units of gold to William.
- William issues 100 units of debt to these village members and, in addition, lends 80 units of gold to other village members.
- All of these 80 units of gold are lodged with Jack.
- Jack issues 80 debt certificates and again lends 64 units of gold on top of that to other villagers.
- Rumors spread that Jack is untrustworthy, and a crisis of confidence breaks out. Those who placed their 80 units of gold with Jack come to collect it all again.
What now? Jack has only 16 units of gold lying around because he has already loaned out the other 64. So Jack needs to go to all these villagers to ask for the money back. Sad to say, he finds out that these people have already spent it on all sorts of things like food, housing, etc. So what happens? Jack can no longer pay his debts and is declared bankrupt. This will mean two things:
- Those people who had deposited their money with Jack only get 20% back.
- Now William has a huge problem because he can only get back a maximum of 16 of the 80 gold units.
Thus, William only has available the 20 gold units that he has lying around, plus the 16 gold units that his customers have left. Therefore, if 40 gold units are retrieved, William also goes bankrupt. William’s customers learned about Jack, and his customers come to collect their money.
And yes, William goes bankrupt as well, and the next group of village members are greatly damaged. Bottom line, when the panic breaks out, the whole system crashes, and everyone loses their savings.
This is perhaps a great oversimplification of reality, but there are many real-life examples, besides the economic crisis of 2008, of how this system has nevertheless caused many people to lose out.
The Ugly Side of Fiat Money
The American government found this out in 1971 as well. The expenses for the Vietnam War, and therefore the debt to the central bank, had accumulated to such an extent that they could not possibly pay it back. There was a crisis looming, like the one in the example of Ashley, William and Robert. When the government couldn’t pay, a domino effect would result in bankrupting the entire country. In a nutshell, that gold standard had to be eliminated entirely for central banks.
While fractional banking still required a minimum amount of money to be covered by gold, in 1971,, US President Richard Nixon removed that requirement. To prevent one of the biggest economic crises ever, Nixon had no option but to abolish the gold standard completely. Sadly, it was the American citizens who paid for it.
Since America at the time was the largest economy by far and the dollar was the most powerful currency, many other countries soon followed America’s example. Because of this, the price of money was no longer determined by gold, but the amount of money determined the price of gold.
Benefits of fiat money
That immediately brings us to the advantages of fiat money. The first benefit is that it is absolutely no disaster for the government if money becomes worthless. After all, the government’s debt is expressed in fiat money. Therefore, if this becomes cheaper, it also means that the debt becomes cheaper. For example, a debt that was worth a million euros in 1957 would only be worth a little over 111 thousand euros today.
The second benefit is that fiat currency is the perfect tool to resolve economic crises or economic mistakes. Among the main arguments of supporters of fiat money is the fact that the economic crisis of 2008 would have been incomparably larger if governments had not had the ability to print money on top of it.
Basically, economics works very simply. If the economy is doing well, we are happy, have confidence and spend a lot of money. As we spend a lot of money, businesses make a lot of profit, they continue to grow and the number of jobs increases. Since everyone has a good job, people are happy, have confidence, and spend even more money.
Since we are spending even more money, companies make even more profit, continue to grow even more, and the number of jobs grows even more, and so on. Therefore, in good times we are in a virtuous circle (opposite of a vicious circle).
Unfortunately, in bad times this works the other way around. We are not happy; we do have not much faith in the economy and that things will ever get better, and so we stay on our money. As a result of our sitting on our money, companies make little money, they make losses, and they have to lay off people out of necessity.
As a result, we become less happy, have even less confidence in the economy and consequently spend even less money. This makes companies earn even less money, they make even more losses and have to fire even more people, and so forth. We are, therefore, in a vicious circle.
Breaking out of a vicious circle is not simple, so how do you solve it? The best solution is to start spending more money again and get back into that virtuous circle! So that is what the government is doing. When there is a crisis, the money machines run at full speed, and large amounts of money are ‘reprinted’.
This is subsequently reinvested in companies. As a result, they can still grow and do not have to lay people off. This is one compelling advantage of fiat currency. The only problem? It also usually creates crises.
Disadvantages of fiat currency
We already addressed most of the disadvantages in this article; however, let’s elaborate on them. The greatest problem that the opponents of fiat money have is the fact that the ordinary citizen pays for all this money creation. Today we live in a society where banks are “too big to fail” and in which the making of huge mistakes is no longer punished.
Quite the contrary. Throughout the economic crisis of 2008, which had been caused by major errors made by the banks, an unbelievable amount of money was printed to help get the banks back on their feet.
On the one hand, this was very good because if it hadn’t been for this, you would have had the same story of Ashley, William, Robert and Jack on a global scale. Then virtually everyone would have lost their money. The entire economy would have been completely reset.
Sadly, the flip side of this is that the banks can keep doing whatever they want without being punished for it. They cannot fall down anymore anyway. They would always help each other out, or the government would give them a helping hand. Now the question is, what happens when the biggest players in the economy cannot be punished for their mistakes? Also, how are we ever going to fix that without the whole economy collapsing?
The other drawback of fiat money is that the annual inflation rate ensures that we have less purchasing power with the dollars we have earned in previous years. Thus saving is not really attractive anymore because of the low interest rate. It feels unjust that the value of our money goes to the banks ‘for free’.
One further disadvantage that we have not yet addressed is that government intervention is not always necessarily good for the economy. Obviously, there is nothing wrong with paying taxes to ensure that lampposts are on the streets.
Health care is well taken care of, but we may also ask ourselves whether this would not have gone just as well or even better if we had been allowed to take care of this ourselves? That is something we will not know any time soon, but the one thing we do know can be summarized in 3 conclusions:
- The more government involvement there is in providing a good or service, the larger the price increases have been relatively in recent years. As an example, here is medical and hospital costs, college tuition, child care, and textbooks. One example of an industry seen as “rotten” by a large part of the population is the pharmaceutical industry.
- Prices for manufactured goods (clothing, furniture, TVs, cars, appliances, etc.) have dropped sharply in recent years compared to prices for services (education, medical care, child care).
- The more international competition there is for certain goods, the more strongly they have fallen in price.
From this, therefore, the question arises whether it is a smart idea to give the government a monopoly on money, or would it be better to leave it to the people and market forces? How about if we let companies compete with each other to offer the best education or the best books? Alternatively, what if we let global currencies compete with each other so that the people themselves have the power to choose the best currency? There is only one way to find out.
Here comes Bitcoin
How would it be if there existed a currency that belonged to no one or, on the contrary, belonged to everyone? A currency that has no country borders? A currency with a maximum number so that everyone can benefit equally from economic growth and its rise in value? And which would you rather have: a currency that will continue to rise in value or one that will only decline in value?
If you trust Bitcoin, you are essentially saying that you have faith in the network and the future of the Bitcoin economy. When you have confidence in the euro or dollar, you are essentially saying that you have confidence in the European or American economy. Trust in these economies, however, has not been so strong lately.
More and more opponents of Europe are coming out, and the group of people who want to get rid of their fiat money is also growing. The American economy does not seem to be an overflowing source of confidence. Would you trust an economy where the debt literally shoots up by tons every minute?
On this page, you can see live how high the debt of America is and how fast it is rising. Therefore, the most important question is: do you have more confidence in the Bitcoin economy or in that of Europe and/or America?
The future of fiat money
The chances are slim that fiat currency will disappear because of Bitcoin and cryptocurrencies. It is something that the government and the banks will not allow to happen, as it would mean a complete collapse of the traditional economy. The breakdown of this economy would mean that many people would lose all their savings, and civil wars would not be out of the question.
In addition, we are not at all convinced yet that Bitcoin is a better solution than fiat money. At the moment, it is still a mega-experiment. The only thing we know is that it feels a lot more honest. The crypto world (the new economy) will essentially coexist with the fiat world (the old economy) for the next few years.
Nevertheless, the more people will see the benefits of crypto and the more countries will move over and accept their taxes in crypto, the more likely it is that we will reach the so-called “tipping point.” It is possible that in the (distant) future, people will withdraw their money from the banks and put it on the blockchain.
You wouldn’t want to be the last one to suffer when your bank can no longer pay out the money because it simply doesn’t have it anymore. Again, let’s say this doesn’t have to happen, and it’s absolutely not wise to put your entire savings account on the blockchain. However, what is wise is to spread your risk. Undoubtedly, crypto means risk, but putting your savings in a bank might be an even more significant risk.
7 differences between fiat currencies and cryptocurrencies
Fiat currencies and cryptocurrencies have one thing in common: they serve as a medium of exchange. A physical commodity backs neither – but all similarities end there. This part of our article will talk about some differences between fiat currencies and cryptocurrencies. Stay tuned!
Government has no control over crypto
Bitcoins and other cryptocurrencies are decentralized. Unlike traditional currencies, the government has absolutely no control over them. At first, Bitcoins are owned by the miners. After that, the crypto coins become the property of anyone who receives a transaction.
Most cryptocurrencies are not recoverable; fiat money sometimes is
Sometimes decentralization also brings disadvantages. This is because when a user loses his or her crypto coins, there are no rights to a refund. Well, did you know that about 20 percent of existing Bitcoin tokens are lost? Although fiat money is still occasionally recovered, this is not the case with Bitcoin and other cryptocurrencies. There is no central financial authority in place to help.
There are various stories about investors who have embarrassingly lost their Bitcoin. In 2013, for example, an IT worker from Britain threw away an old hard drive of his computer containing Bitcoin assets. The current value of the hard drive would be hundreds of millions of dollars!
Counterfeiting Bitcoin is Impossible
Not only halving but also the so-called blockchain is one of the fixed elements of Bitcoin. It stores ownership data in a distributed ledger. This means that every user owns a copy of another user’s transaction history.
Nobody can change or delete these transactions, making Bitcoin counterfeiting practically impossible. Unfortunately, counterfeiting is a problem that traditional currencies face regularly.
Bitcoin is not subject to inflation
The second problem that traditional currencies face is inflation, but not Bitcoin. This is because of the fact that there will be a maximum number of Bitcoins released. Only a total of 21 million can be mined, of which 18 million are at present in circulation. Almost every market functions based on supply and demand. The price will rise whenever there is a scarce supply and a rising demand.
Bitcoin has a halving every few years; fiat money does not
The third halving of Bitcoin took place on May 11, 2020. From then on, delvers, who use computing power to generate Bitcoin, were paid a lower reward per block. While Bitcoin creator Satoshi Nakamoto has never explained the exact reason for the halving every few years, one possible reason is that scarcity and growth in the network ultimately increase the value of the cryptocurrency. The theory is as follows:
The reward is halved → half inflation → lower supply available → more demand → higher price → incentive for miners to continue their work despite smaller rewards
The halving occurs every four years. In 2008, a successful miner still received 50 BTC, while on May 11, 2020, this was only 6.25 BTC. The math shows that it could take long before all 21 million Bitcoins are mined. We won’t live to see it, as it could take as long as 2140.
Also Read:
- Binance Review (2022): Is It the Best Crypto Exchanges Out There?
- The Secret Formula of the Profitable Bitcoin & Crypto Trading
- All You Need to Know about Bitcoin and Other Cryptocurrencies: Mining, Buying, Understanding
Bitcoin is not dependent on the stock market
Bitcoins are a part of a free and decentralized market in which supply and demand play a leading role. Unlike fiat currencies, they do not depend on currency traders and the stock market.
Bitcoin owners are always anonymous
One major difference between Bitcoin and traditional currencies is how privacy is handled. Blockchain is open and transparent. Any person with an Internet connection can view transactions on the public blockchain. While Bitcoin trading is very transparent, Bitcoin owners always remain anonymous.
One major drawback is that if you trade cryptocurrencies on a bitcoin exchange and have verified your identity, you are anonymous to a certain extent. Nowadays, many exchanges are required by governments to perform KYC (Know Your Customer).
Bitcoin investors’ anonymity is guaranteed by the Bitcoin address, which is made up of a protected string. These are derived from a public key of an asymmetric key pair generated by a Bitcoin user. Any user can have several of these key pairs in his or her digital wallet. Some users create a new address for each transaction to enhance anonymity even further.
