Currencies without any other commodity backing them are called fiat money. The Euro, Pound, Yen and other major currencies are all considered fiat currencies.
From Gold Standard to Fiat
In 1971, the United States officially ended the gold standard. Instead of a dollar representing a specified amount of gold, the US dollar is now valued based on supply and demand and trust in the US government.
Therefore, currencies from more developed economies like the United States, Japan, European Union, and others tend to be the most valuable. Countries that have unstable or underdeveloped economies usually have less valuable currencies.
In some cases, these smaller less developed countries do not even issue their own currency. And if by chance they do, they usually peg it to a more stable fiat from a developed economy. For example, most Caribbean countries peg their currencies to the US dollar since most of their economies are funded by US tourists. Lebanon pegs its currency to the pound sterling. Most African countries maintain a peg to the euro.
The side effect of Fiat
The objective is to maintain the stability of their economies. However, there is a flaw. The economic policy adopted by countries with reserve currencies like the United States or the European Union ultimately affects these small nations. They have little to say and are forced to manage the hand dealt to them.
Moreover, fiat currencies are always in a state of flux. Currencies become more valuable and less valuable. If you have traveled abroad and tried to exchange currencies, you know that your US dollar is not exactly equal to the same amount of euros or pounds or any other currency.
When currencies were backed by commodities such as gold or silver, this phenomenon did not exist. Centuries ago, the world agreed to facilitate the gold trade. Each country determined what an ounce of gold was worth in its own currency.
This standardization eliminated exchange rates. Therefore, if you were trying to convert your UK pounds to US dollars, all you would need to know is how many pounds and dollars the UK and US governments estimated an ounce of gold to be worth.
As World War II ended and a new geopolitical landscape developed, the victors of the war coordinated to unveil the new economic game plan. Originally, the plan called for the US dollar to be exchanged for gold at a rate of $35 per ounce. Then the currency of all other nations would be tied to the US dollar.
However, this system was abandoned in 1971 when President Nixon broke the convertibility of dollars into gold. At this time, fiats were born.
Fiat currency has grown in popularity because it grants governments, and specifically central banks, greater control over the economy. With fiat currencies at their discretion, central banks can monitor credit supply, liquidity, and interest rates.
The aim of this new approach was to minimize the effects of the boom and bust cycles that economies used to go through. Central banks could change interest rates or limit the money supply in order to encourage or limit growth.
Yet increased government control over the economy has not always been sustainable. Fiat currencies are not always reliable. They can be overhandled and once out of control it can be difficult to pull the reins.
Inflation is inevitable
One of the main pitfalls of fiat currencies is an increased risk of inflation. There are a handful of examples throughout history where central banks have abused their power.
Zimbabwe has experienced one of the worst inflation crises in modern history. To avoid an economic downturn in the early 2000s, the central bank of Zimbabwe has started printing money at an astronomical rate. At the end of this misadventure, the currency of Zimbabwe lost 99.9% of its value. It got so out of control that the central bank had to issue a $100 trillion note.
Today, a multitude of countries are faced with their own inflation problems caused by excessive government power. Venezuela is sitting at a 2000% inflation rate, while Lebanon hovers around 200%. Argentina’s currency lost half its value and Turkey’s a third.
Unfortunately, the average citizen of these countries suffers the most. Those who have their savings in a bank account could wake up one day and see their country’s currency lose half its value. This is exactly what happened in Yugoslavia in 1994. The country’s monthly inflation rate reached 313,000,000% and prices doubled every 1.4 days at its peak.
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Fiat Currencies vs Cryptocurrencies
Although not overnight, inflation can occur slowly over decades.
When governments print more money, they devalue the money in their citizens’ bank accounts, the value of their homes, and many other assets. On the contrary, the cost of goods and raw materials increases. People with low incomes are the most affected by inflation.
In the United States, there are almost twice so much money in circulation since the Great Recession of 2008. Not by chance, just after the Great Recession, the world’s first cryptocurrency, Bitcoin, was created. Bitcoin was born to try to fight against excessive central banks.
Today, there are thousands of cryptocurrencies. Calling some of these “currencies” might be a misnomer. Cryptocurrencies like Dogecoin, Shiba Inu and many other memecoins have no real use and do nothing to solve the fiat problem.
While some other cryptocurrencies serve different purposes, such as Ethereum and its smart contracts, Bitcoin’s original design was meant to serve as a haven for those who wanted to avoid central banks.
People who believe in Bitcoin see it as everything that fiat currencies are not: its supply is limited. It cannot be manipulated. And it does not rely on any government authority.