Demystification of fiat currency: from theories to economic reality

How does the current monetary system really work

Today, when we go to the store or make an online transaction, we don't think about the fact that the money in our wallet is not backed by anything physical. Fiat currency is simply a form of payment accepted by law, whose value depends on the trust we have in the issuing institution – usually the state and the central bank. The government's power to declare something as legal tender is the foundation of this system. All around the world, contemporary countries have turned to this form of monetarism to facilitate purchases, investments, and savings.

Where did this idea come from?

The surprise for many is that fiat currency is not a modern invention. Its origin can be traced back to China during the Song dynasty, where the province of Szechuan first experimented with paper notes in the 11th century – initially convertible to silk, gold, and silver. The real change came under Kublai Khan in the 13th century when a pure fiat currency system was established. Historians note a disturbing correlation: excessive money issuance and the subsequent hyperinflation significantly contributed to the decline of the Mongol Empire.

In Europe, experiments have been just as unstable. Spain, Sweden, and the Netherlands adopted fiat currency systems in the 17th century, but Sweden quickly abandoned it, reverting to the silver standard. When the American colonies and then the US attempted its implementation, the results were mixed. By the 20th century, America had returned to a version of the commodity-based standard. Only after 1933, when the convertibility of the dollar into gold was eliminated, and especially after 1972 under President Nixon, when the US completely ended the link to gold, did fiat currency become dominant globally.

The gold-based system: why did the world abandon it?

The gold standard operated on a simple premise: every paper note was convertible into gold, and governments could only introduce new money if they had equivalent gold reserves. This was a way to limit the power of governments to create artificial money and to control inflation. However, it also limited the flexibility of the response to economic crises.

With fiat currency, money cannot be converted into physical gold. Instead, authorities have direct control over the value and can adjust monetary policy based on economic conditions. Central banks can apply tools such as interest rates, quantitative easing, or the creation of fractional reserves. This provides adaptive capacity in economic emergency situations.

Gold standard advocates argue that a commodity-based system is more stable due to physical backing. Fiat currency defenders counter that gold itself has experienced price fluctuations. The reality is that both systems can experience volatility, but fiat currency allows for quicker intervention by authorities.

Advantages and Risks of Fiat Currency in the Modern Era

Benefits:

• Abundance without limitations: it is not tied to the availability of a physical resource
• Efficient production: cheaper than gold mining and processing
• Economic agility: allows for capital injections and anti-crisis measures
• Global acceptance: uniformly used for international transactions
• Practical convenience: does not require costly storage, security, or physical monitoring

Disadvantages:

• Lack of intrinsic value: opens the door to creating money from nothing and the risk of hyperinflation
• Worrying historical precedent: numerous financial collapses associated with the implementation of fiat currency
• Dependent on trust: if the credibility of institutions decreases, the system becomes destabilized.

Fiat currency and cryptocurrencies: rivals or complements?

At first glance, fiat currency and cryptocurrencies – such as Bitcoin – seem similar: neither is backed by a physical commodity. But the comparison ends there.

Fiat currency is centralized, controlled by governments and central banks. Cryptocurrencies operate on the decentralized architecture of Blockchain, a distributed digital ledger that does not rely on a single authority. This is a crucial difference.

The generation of money differs radically. Bitcoin and most cryptocurrencies have a strict and limited supply, encoded in the protocol. In contrast, central banks can issue fiat currency in amounts determined by their judgment of economic needs.

Cryptocurrencies, being digital and borderless, facilitate smoother global transfers than traditional systems. Transactions are irreversible and tracking them is considerably more difficult compared to fiat currency flows. On the other hand, the cryptocurrency market is much smaller and far more volatile than established financial markets. This partly explains why they are not yet universally accepted, although as the crypto ecosystem matures, volatility will likely weaken.

What direction is the monetary system heading?

The future remains uncertain. Cryptocurrencies still have major challenges to overcome, but the history of fiat currency shows vulnerabilities in the system. This motivates more and more people to explore crypto alternatives for a portion of their financial transactions.

Bitcoin and other cryptocurrencies were created on the idea of a decentralized peer-to-peer economic network – a fundamentally different construct. Although Bitcoin is unlikely to fully replace fiat currency in the near future, it could provide a complementary layer of financial infrastructure. The existence of an alternative money system built on decentralized principles opens up prospects for a more diversified and resilient financial society.