Fiat Money Explained

fiat money explained

Fiat money is a currency that is backed by a government or central authority but not backed by a valuable commodity such as gold or silver.

If you’re wondering if fiat money has anything to do with the famous Italian car manufacturer Fiat, the answer is no, although you would certainly use fiat money to buy one.

The term fiat money derives from the latin word ‘fiat’ which literally means, “let it be done” and when pronounced by a figure of authority could be interpreted nowadays as “consider it done” or “done deal”.

As a society, we have always needed some form of exchange of value, whether that be bartering where we exchanged one thing for another, for example, bread for vegetables or a commodity-based value of exchange like in a prison where cigarettes have been commonly used as a form of currency as once gold, silver, tobacco and other valuables were. 

We eventually switched away from using commodities to using a form of paper money or coins that have no intrinsic value but were instead backed by physical gold sitting in a vault, the gold standard. 

This gave people the required confidence to use this money as a means of payment and provided a far simpler, more portable means of storing and transferring value. 

The gold standard eventually came to an end in 1971 and led to our current fiat money system. 

The fiat money system is backed entirely by the government and this is sufficient for people to gladly accept it as payment without worrying that it will lose value or fail to be accepted.


What is fiat money?

Imagine you walked into a store, took out a blank piece of paper and wrote an IOU promising to pay for the goods at a later date. 

It’s very unlikely you will get very far unless you know the owner of the store very well and he or she trusts you. 

On the other hand, if you handed over a €50 note as a stranger, the €50 note is still a piece of paper, and you’ll no doubt walk out with the goods minutes later. 

So why is the second piece of paper acceptable whereas the first isn’t?

It comes down to one word, confidence.

The store owner or clerk will happily accept the €50 note as they have absolute faith that the €50 note represents 50 euros of value. 

There is no doubt at all. The reason for this absolute confidence is because the government has issued this note as legal tender and promises to honour the value of the €50 note.

It’s literally based on confidence in the government. 

Now, let’s imagine, we are in a war situation and the government is collapsing. 

The €50 note could actually become totally worthless very very fast. 

This example demonstrates the importance of confidence in the issuing entity, in this case, the government. 

Without this confidence, you are left with worthless sheets of paper and bits of metal.

Thankfully this is not a situation that we are in and we have faith in our government systems when it comes to our money at least. 

So, this is effectively what fiat money is, “let it be done” or if I receive this €50 note it represents a value of no more or no less than €50. 

The store owner or clerk accepts this piece of paper due to absolute confidence in what it represents as it’s backed by our government.

Nowadays we are moving further away from fiat notes and coins to entries in a bank account, we do not even see the actual money although we could. 

When we swipe or touch our card to make a purchase, our money in digital form is removed from our account and sent to the other person’s account, neither party will generally see the actual notes and coins. 

It’s not inconceivable to imagine a society where notes and coins are no longer used. We can already see glimpses of these in urban transport systems where cashless payment systems like the Oyster card in London are used and it’s actually no longer possible to pay a bus driver with cash money.


Fiat vs crypto?

As we have determined, the only reason fiat money is widely accepted and trusted is because it is issued and backed by the government as legal tender. 

We have absolute faith in its value. So how would crypto differ from fiat money?

Where fiat money is underpinned, supported, and backed by our government, crypto is instead underpinned by something known as a blockchain. 

There is no intrinsic value or any government supporting it, far from it in fact.

A blockchain is effectively very sophisticated software running on a decentralised network of computers that records transactions in a chain made up of something called blocks, hence the name. 

As this article is about fiat money we won’t go into the details of how crypto works and what blockchains are but in its simplest form, a blockchain is a digital ledger that has been designed to be decentralised, i.e. there is no central body in control and has been designed to make the blockchain virtually unhackable or tamper-able. 

These are virtues every financial system should have at its core.

So where the government and their respective central banks issue, guarantee and support our money, crypto is entirely decentralised and highly accountable as every single transaction is recorded on the blockchain and is there for anyone to see. No government or bank affords anywhere near this level of transparency.


The advantages of crypto when compared to fiat money

  • The fact that crypto is decentralised is a big deal, there is no central entity with an agenda or undue influence.
  • Blockchain technology is pretty robust and the risk of a complete failure is quite minimal.
  • Cryptocurrencies are unlikely to suffer from hyperinflation as unlike our fiat money there is usually a maximum amount of a cryptocurrency that will or can ever be produced. If we use bitcoin as an example, there will only ever be 21 million bitcoin produced. It’s not possible to create more. This creates a level of scarcity that can help to sustain the value. Fiat money on the other hand can be endlessly issued and this can lead to the currency losing some of its buying power, otherwise known as inflation.
  • Lastly, cryptocurrency transactions are relatively immediate, you don’t need to wait for days to get your money.

Crypto does make a pretty strong case, but for now, fiat money is still king!

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