Fiat Money

Fiat money is currency, which is declared by a government to be legal tender, i.e. it is not backed by a physical commodity and has value solely because a government accepts it for payments of taxes and debts. Virtually, almost all of the world’s currency today is fiat money with the most popular ones being the US Dollar, the Euro, the Japanese Yen, and the British Pound.

The origin of the fiat money system dates back to early 11th century when the Chinese Song dynasty issued paper money subject to be redeemed for gold after three years. In reality, though, the banknotes were never redeemed, which created an enormous amount of inflation due to printing money exceeding production levels, and the system was soon abandoned.

Fiat money has made appearance on the world economic scene on several occasions but it was not until the beginning of the 20th century that its universal application became a topic of serious debates. By this period, most nations already had a government monopoly on printing money, which were to be redeemed in gold upon request. However, with the outburst of World War I and the escalation of military expenditure, governments suspended the redemption of the already printed banknotes. Furthermore, country officials could not be held directly responsible for the eventual negative consequences of creating money with no intrinsic value and as a result, the increased supply of money devalued the currency of the countries.

Following this economic shock, at the Bretton-Woods Conference in 1945, the world’s leading countries decided to take precautionary measures against the frivolous government printing. The US Dollar was pegged to the gold at a fixed rate per troy ounce, and a guarantee to redeem US dollars for gold was provided by the US government. This change proved to be beneficial for the trade balances of countries, but the whole system collapsed 26 years later when, during President Nixon’s fiscal policy reforms, the gold standard was removed. With the US dollar being declared legal tender, the government was again able to print currency in order to support its increasing spending needs. This process combined with the slow economic growth at the time (caused by the Oil Crisis) led to the US falling into one of their most serious financial downfalls – the period of stagflation, which encompassed the whole 70s decade.

Fiat money has been an object of severe criticism ever since its creation. Opponents of the system argue that by not backing up their currency to something tangible, governments facilitate unjustifiable printing of money, which has been proven to generate inflation. Furthermore as the Austrian School of Economics points out, printed money creates an explosion of debt, often mistaken for a symptom of increased economic growth. Instead, they argue, the newly released money is not backed up by any assets or an increase in the productivity of the country which, according to Austrian economists, is the real cause of economic growth.

With fiat money being virtually a government promise for the value of its currency, there exists a possibility that the government may decide to no longer guarantee for its own money (e.g. through refusing to collect taxes in that currency). In such case, the currency may still retain its value if a strong private banking system and consensus among the population are present in the country. An example of this occurred in Iraq right after the Gulf Conflict in 1990. Then, the local government refused to back up for the Iraqi Swiss dinar. However thanks to the support by local banks and the Iraqi people, the currency was still exchanged effectively and did not lose its value.

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