Fiat Money: The Money You Have Is Worthless Paper? Part 2
This article is in continuation of our first article on Fiat Money (Part 1)
Money is a financial asset and has almost become the major mode of transaction in today’s world. Some types of money are – commodity money ( that have intrinsic value, for e.g. Gold), commodity-backed money ( that can be exchanged on demand for a specific commodity, for e.g. Gold Standards) and FIAT money.
Currency that a government has declared to be legal tender, despite the fact that it has no intrinsic value and is not backed by reserves is called FIAT Money. In simple words, the currency which becomes legal because of the government saying so. It is declared to have value, even if it does not. Gradually the government and public starts using it for all the transactions in exchange of the goods and services. It is backed by nothing.
It is the same thing, how a cigarette based currency system works in the jail, where the cigarettes are used as a medium of exchange and they store value. Here, the government makes people believe that the currency holds value. So, mostly all the currencies that we see today is FIAT Money.
Ideally, a government should mint or legalize the currency that is backed by some commodities or the economy really have that many resources. Fiat money is a form of currency which is deemed valid and legal because the government says that it is, not because it is backed by a commodity such as gold or silver. The term “fiat” refers to a government decree. When a government creates fiat money, it declares that money produced by certain banks or mints is valid legal tender which will be accepted for all government debts, thereby making the currency legal. When the government is willing to accept a specific currency for payment of taxes and other government debts, this also means that everyone else in the society will be willing to accept it in exchange for goods and services. As a general rule, the money is minted by government-owned mints or banks, and it is marked with language which indicates that it is legal tender for both public and private debts.
Fiat money is also known as paper money, or electronic money. Most of the world’s paper money is fiat money. Because fiat money is not linked to physical reserves, it risks becoming worthless due to hyperinflation. If people lose faith in a nation’s paper currency, the money will no longer hold any value.
The history of fiat money has been one of failure. In fact, EVERY fiat currency since the Romans first began the practice in the first century has ended in devaluation and eventual collapse, of not only the currency, but of the economy that housed the fiat currency as well. The Greeks and the Chinese also experienced similar fate. This is because the currency basically ‘promises to pay’, backed solely by ‘the full faith and credit’ of the issuing country, or countries. They are based upon an elastic and constantly expanding money supply. Over the centuries, all paper money systems have eventually collapsed amid economic chaos, or, reverted to a commodity based system in order to avert economic disaster. The similar scenario is prevailing currently. The value of the dollars, pounds, yen is devaluing gradually and is said that this currency will gradually fall as well. However, it has been of much greater benefits as compared to the Commodity based currency or the Gold Standards.
About the Author:
Vipul Falor is a management graduate from NMIMS University, India. He is passionate about financial markets and is always enthusiastic about learning more in the financial markets.