Fiat money: A trust-based currency system instead of legality

What is fiat money really?

Fiat money is a legal tender that is not based on a physical commodity but rather on the economic authority of the issuing state and its international acceptance. This is the fundamental point: what is fiat money – a currency whose value derives from the trust of people and institutions, as well as the economic stability of the government. In the current global economy, this system is used almost everywhere – from the United States to Japan, every major economy relies on the fiat currency system.

The essence of this type of currency lies in the fact that there is no underlying physical value. Governments and their central banks can directly dictate the value of the currency based on economic conditions, which provides flexibility but also comes with potential risks.

The World History of Fiat Money: From East to West

The first fiat currency system appeared in China in the 11th century in the Sichuan province, where paper money was issued. Initially, it was indeed convertible to gold or silver, but this practice was abandoned during Kublai Khan's takeover in the 13th century. Historians say this measure significantly contributed to the later economic crisis and collapse of the Mongol Empire – uncontrolled money creation led to hyperinflation.

Europe followed this path in the 17th century: Spain, Sweden, and the Netherlands experimented with the fiat system. However, in the case of Sweden, it ended in failure, and the government returned to the silver standard. The American colonies and later the federal government of the United States also attempted it with mixed results.

The 20th century brought the definitive global victory of fiat currency. In 1933, the USA abandoned the convertibility of paper money to gold, and then in 1972, under President Nixon, completely eliminated the gold standard. This moment signifies that the world transitioned from a currency system based on physical commodities to purely state-supported money.

The Gold Standard vs. Fiat Currency: Two Opposing Worlds

Under the gold standard, paper money was always convertible into the underlying commodity. Every issued currency was backed by a specific amount of government-owned gold. This meant extremely strict regulation: states could only print new money if they had sufficient gold reserves. This limited economic policy flexibility, but some experts argue that it provided greater stability.

Fiat currency, on the other hand, can be considered much freer. There are no such constraints here – states can create new money almost without limits if they feel the need. This can be very useful in crisis situations when governments need to react quickly, but it carries inflationary risks in the long term.

Proponents of the gold standard argue that the existence of an objective value provides greater security. However, advocates of fiat money point out that the price of gold has never been stable either – it fluctuates over time, albeit for different reasons. In fact, both systems are sensitive to changes in value, just through different mechanisms.

The strengths and weaknesses of fiat money

There is a strong debate among economists about whether such a currency system is actually beneficial or dangerous.

The advantages:

• The production cost is low compared to commodity-based money.
• No scarcity limit – not tied to gold or other raw materials
• Quick and flexible intervention options in case of economic crises
• Globally accepted, the basis of international trade
• Can be managed without physical storage, insurance, and supervision

The disadvantages:

• It has no intrinsic value that can be referred to in the context of uncontrolled money creation by governments.
• Historical precedents show that fiat systems often finance excessive state budgets.
• Hyperinflation risk, which is indicated by several historical and contemporary examples.
• The system is entirely based on the trust of the state and the institutions, which can be broken once.

Fiat Money and Cryptocurrency: The New Chapter

An interesting parallel can be drawn between fiat currency and cryptocurrency: neither is backed by a physical commodity. But that is where the harmony ends.

Cryptocurrencies – such as Bitcoin – are managed by decentralized networks, often based on blockchain technology. In contrast, fiat money is centrally controlled by governments and central banks. Another key difference is the supply: the total amount of Bitcoin is limited and predetermined, while banks can create fiat money almost without limit.

In digital form, cryptocurrencies can be moved across international borders, and transactions are irreversible – this can be a significant advantage, but it also raises traceability issues. However, cryptocurrency markets are still much more volatile than traditional markets, and there is still a long way to go in terms of acceptance.

Closing Evaluation

The future of fiat money is still uncertain today, just like that of cryptocurrencies. Although the traditional currency system has a centuries-old history, history also shows that these systems are not free from risk. This is why many are investigating to what extent cryptocurrencies or mixed systems could be adopted.

Bitcoin and cryptocurrencies were not necessarily created to completely replace fiat currency – rather, they offer an alternative economic network. However, in the long run, they have the potential to create a more differentiated, multipolar financial ecosystem in which multiple forms of currency can coexist alongside each other.