What is fiat money?

Fiat money is a payment method that was created artificially. Fiat currencies are not tied to the price of commodities such as gold or silver, but are based on trust in the value of the money issued by governments and central banks – they have no intrinsic value. These currencies differ from commodity money, which has an intrinsic value, such as precious metals (gold and silver), salt or mussels. These goods don’t just have an exchange value, but also value in the form of the items themselves. 

Fiat is the modern cash

Basically, fiat money is the payment method used in our everyday lives. We use it to pay for our purchases, to give value to materials and to save. Modern cash is fiat money – both notes and coins – and is a significant component of our modern monetary system.

A tried-and-tested model

The word “fiat” comes from Latin and can be translated as “let it be done”. The term alludes to the fact that a fiat currency can be created by states.

The use of fiat money has a long history, dating back to the early modern period. While goods such as gold and silver were previously used as money, over time the need arose for more flexible payment methods, which led to the introduction of fiat money. In the 18th century, various countries began issuing paper money. During the 19th century, many nations sought to unify their currencies. The introduction of fiat money paved the way for more stable currencies that shaped economic progress and ultimately the globalized financial world of the 20th and 21st centuries.

What fiat currencies are there?

All money created by governments is considered fiat currency. This means that all currencies – such as the euro, the Swiss franc, the US dollar and many others – are actually fiat money. Fiat money is therefore legal tender.

Currencies all work on the same principle – their value depends on state power and collective belief. We accept coins and banknotes as a valid medium of exchange for any materials. As soon as this human-imposed regulation is no longer accepted, cash loses all value and becomes just paper or metal. If you pay with a fiat currency, you have to place your trust in central authorities such as the Swiss National Bank (SNB) or governments, as they act as intermediaries and are responsible for the value of the fiat currency used.

This relationship is clear to see using the example of the introduction of the euro in 2002. The German mark, the Italian lira and other currencies were replaced as payment methods and lost their value. This demonstrates the role that central authorities and trust in them play when it comes to transferring value from one fiat currency to another. 

Fiat money is not the same as book money

Fiat money should not be confused with book money. Book money is the money in a bank account. So if you pay for a purchase with your EC card, book money is used. Unlike fiat money, the asset value of book money is not secured by the government, but by a bank. 

Advantages and disadvantages of fiat money

Fiat money is accepted all over the world as a modern payment method and has advantages and disadvantages. 

One clear advantage of fiat money is its availability. A country’s central bank can easily provide fiat currency and exercise control over its value, because it is not a scarce resource such as gold. This means that the supply of credit, liquidity and interest rates can be managed more reliably. The monetary system also makes our everyday lives much easier – it’s hard to imagine carrying around precious metals and other raw materials to serve as commodity money to barter for all our expenses.

The advantages of fiat currencies can, however, become a disadvantage. Since fiat money is not tied to a material asset, its value relies on responsible fiscal policy  In economics, fiscal policy refers to all measures taken by the state that can influence economic fluctuations through taxes and government spending. and regulation by the government. Irresponsible monetary policy and a lack of confidence can lead to stagflation, inflation or even a recession.

When central banks print more money, interest rates can be kept artificially low, encouraging borrowing and investing in various assets. This environment with cheap credit can entice investors to take on more risk than they would in a restricted monetary system, which can lead to excessive inflation of asset prices beyond their sustainable levels. When the bubble finally bursts, this can lead to serious financial crises, loss of wealth and economic instability. For this reason, careful regulation of the supply of money and prudent monetary policy are essential to mitigate the risks of economic bubbles associated with the use of fiat money.

Bitcoin, etc. – are they fiat currencies?

Bitcoin is not a fiat currency, but a cryptocurrency. Both Bitcoin and fiat currencies can be used as payment methods and as forms of investment. Other than this similarity, Bitcoin and fiat money are two different forms of currency with significant differences. Fiat money is a government-issued currency that maintains its value based on the trust and authority of the issuing government. Bitcoin, on the other hand, is a decentralized digital cryptocurrency for which trust is derived from blockchain technology. It is not issued by a central authority but relies on a consensus algorithm and cryptography for secure transactions. This point highlights the revolutionary nature of cryptocurrencies because, for the first time, direct transactions between two parties are possible without an intermediary.

The weaknesses of fiat money that cryptocurrencies aim to counteract

Protection from inflation

The fact that cryptocurrencies are not issued by any central authority makes them popular alternatives to fiat money when there is no confidence in those authorities. Example scenario: central banks influence the supply of fiat money because they are able to increase the money supply as needed. From an economic perspective, an increased money supply can lead to inflation, which means higher prices – so you get less for your Swiss franc or euro. Cryptocurrencies such as Bitcoin attempt to counteract this. For example, with Bitcoin the supply is limited to 21 million coins. Last but not least, there is the independence from government intervention. This means that cryptocurrencies in the above example are generally more stable, trustworthy currencies for the general public compared to fiat currencies.

Fast cross-border transactions

Cryptocurrencies enable faster cross-border transactions compared to traditional bank transfers or international money transfers. While cross-border payments with fiat money that go through intermediaries can take several days, cryptocurrencies usually only take a few seconds to reach the payee. The time saving is due to the direct transfer between payer and recipient, as well as the locational independence of the blockchain.

As of today, cryptocurrencies and fiat money are heavily intertwined. This is because the most common way to reimburse cryptocurrencies is to purchase them with fiat money. Over time, the extent to which fiat money and cryptocurrencies coexist, and the areas in which cryptocurrencies will increasingly be used, will become evident.