Fiduciary money, also known as fiat money, is legal tender, the value of which is guaranteed by the government that issued it. It differs from money backed by a physical asset which sets the standard for its value, like gold.

A common misconception is that unlike currencies of the past which were based on a standard of gold, silver or other precious metals, fiat currencies have “nothing” to back them up. A more precise description is that a fiat currency is backed by the resources of the issuing government, while its value is determined by a number of factors, including economic supply and demand, interest rates, and money supply.

Image source: Getty Images.

A brief modern history of coins

In recent centuries, currencies consisted of a physical item of an agreed value, most often metals such as gold, silver, copper, and bronze. The best example is the British pound sterling, which started out as a silver coin weighing one troy pound. The description was literal: one pound of sterling silver. The value of these physical coins was in the coin itself.

From there, governments began issuing paper money or redeemable notes against a measure of the backing standard. For the British pound sterling, the answer was in fact gold, from the 1700s. In the United States, a single dollar was exchangeable for gold until 1933.

Governments over the past century have moved away from the gold standard. Currencies are now almost universally backed by the governments that issue them. An example of fiat currency is the dollar. The US government officially ended the relationship between gold and the dollar in 1976.

The advantages of a fiat currency

The main reason countries have stopped using a gold standard is that it limits a government’s ability to respond to economic events. For example, with a gold standard, the money supply is related to the available gold supply, while the money supply of a country request for money changes according to the growth of its population and economy.

Take the United States, for example. Since the dollar was decoupled from gold, the population and the economy have grown significantly:

U.S. Population Graph

US Demographics by YCharts.

If the United States and other nations had remained on a gold standard, the world’s money supply would be limited to the gold available. And while the amount of gold on earth has not increased much in billions of years, the human population, its economic output, and the demand for silver have certainly increased.

With fiat money, the money supply can be increased much more easily as demand increases, helping to stabilize the purchasing power of a currency and preventing deflation or falling prices of goods.

Before you say, “Lower prices are good,” remember that there is a producer on the other side of every purchase. Falling prices can be disastrous for producers, especially if they happen quickly. This can lead to big economic shocks, forcing companies to cut costs, lay off workers, or take other steps to avoid losses in a deflationary environment. And this can lead to a domino effect, hurting more businesses as they lose customers or their customers spend less, leading to more cuts and job losses.

And there you have an example of the first benefit of fiat money – being able to manage the money supply to make sure there is enough of it to prevent deflation that crushes the economy.

Another advantage of fiat currency is that it can be used to support the volatility of an economy, especially to support debt markets. A central bank can take assets on its own balance sheet, such as the Fed’s purchase of US federal debt and mortgages.

Increasing the money supply can make it seem like a central bank, such as the US Federal Reserve, can magically spawn money out of thin air. To some extent this is true, but it is also an oversimplification. The Fed isn’t so much creating money out of thin air as it is exchanging newly earned money for an asset, such as a loan to a bank, a US Treasury bill, or a mortgage-backed security. In other words, when the Fed “earns” new money, it is because there is a real demand for it.

Disadvantages of fiat money

There are really two major risks with fiat money: political instability and mismanagement of the money supply.

Let’s talk about political instability. Money, whether fiat or backed by gold, is a shared fiction: it’s worth something because we all agree it’s worth something. With fiat money, the basis is the confidence that the government that issued it will remain stable and in power, keeping the currency at the value of what we all agree on. Without a trustworthy, well-managed and resourceful government, confidence in a fiat currency can erode, leading to high inflation as it loses its purchasing power.

Mismanagement of the money supply – especially the increase in the money supply – is a risk that many people fear with fiat currencies. This is of particular concern to many given the government’s massive stimulus efforts during the COVID-19 pandemic in 2020 and 2021. Taking the United States as an example, the money supply increased by almost 40% between the start of 2020 and December 2021:

United States M2 Money Supply Chart

Data on M2 money supply in the United States by YCharts.

The economy and population of the United States, however, did not grow 38% over that two-year period. Much of this new money issued was debt issued by the US government to finance economic recovery; similar increases have occurred in other economies around the world.

The risk is that the massive increase in the money supply will lead to hyperinflation.

Cryptocurrencies and fiat money

Concerns about inflation and the government’s control over money and economic policy have led many to consider cryptocurrencies. As a decentralized digital asset, cryptocurrencies are very attractive to anyone who is wary of government manipulation of money. They are also becoming more and more useful as portable digital value stores. And, as we’ve seen over the past few years, because many have grown in value tremendously, they can protect your wealth against inflation.

Cryptocurrencies on the strongest, most secure, and capable blockchain networks could become more valuable for another important reason as well: innovation in the uses that occur on the blockchain.

We might also see fiat money become cryptocurrencies in the future. Many governments have started to study digital currency, and a government-built and supported cryptocurrency seems almost inevitable at some point. El Salvador adopted Bitcoin (CRYPTO: BTC) as legal tender in 2021.

Today, there are actually cryptocurrencies tied to the value of fiat currencies, known as stablecoins. Attached (CRYPTO: USDT), which is “pegged” to the US dollar, is the most important.