Fiat currency is a kind of legal tender or government-issued currency that is not backed by physical commodities like gold or silver. This includes money declared to be legal tender that must be accepted for payment of debts and other forms of payment without intrinsic value that serve as a medium of exchange.
Until the 1900s, most currencies worldwide were backed by a commodity like silver or gold. Most currencies today, including the U.S. dollar, Canadian dollar, euro, and many others, are fiat currencies.
Unlike historical currency backed by commodities like precious metals, fiat currency has no intrinsic value, and its value is based on supply and demand and confidence in the issuing government.
What Currencies Are Still Backed by Gold?
A currency that is backed by a precious metal like silver or gold is known as a commodity currency.
When the U.S. ended the gold standard in 1971 to curb inflation, the U.S. dollar shifted from a commodity currency to a fiat currency.
Switzerland was the final nation to end its gold standard in May of 2000 when the Swiss franc became a fiat currency.
Benefits of Fiat Currency
Fiat currency provides issuing governments the ability to protect their economy from recessions.
Since there is no precious metal backing fiat currency, central banks can regulate the number of circulating dollars and coins by withdrawing them from circulation or issuing more of both. The greater control that fiat currency provides for an issuing government allows it to manage interest rates, credit supply, and liquidity.
Risks of Fiat Currency
One of the risks of fiat currency as a monetary system is the risk of inflation from over-printing. Hyperinflation occurs when inflation increases by more than 50% monthly.
Political instability can also be risks to fiat currency. As trust in an issuing body or government is eroded by political instability, there is a grave potential for the country’s fiat currency to lose value.
A global risk for any nation’s fiat currency is for noteholders to doubt the ability of the issuing authority to recapitalize their central bank.
Failures of Fiat Currency
One of the most notable failures of fiat currency was the demise of the Weimar Republic mark after World War I. In 1923, the Weimar Republic (Germany) experienced hyperinflation so severe that the German mark depreciated to one trillion marks to one U.S. dollar. An actual wheelbarrow of marks could not buy a newspaper at that time.
Since then, there have been several other failed fiat currencies.
Most recently, Venezuela has been battling hyperinflation amidst government mismanagement and economic crisis. In 2021, the inflation rate for the Venezuelan bolivar was 686%, but as of 2023, it was inflated to 404% and worth 30 units per American dollar.
Zimbabwe has experienced ongoing inflation since 2007. In 2009, the nation stopped printing its own currency. By 2016, nine currencies were considered legal tender in Zimbabwe, although 90% of transactions were in the U.S. dollar and 5% of transactions were in the South African rand.
Zimbabwe’s Reserve Bank (RBZ) has been working to establish a gold-backed currency, but as of the time of this writing, it is still in the works.
Alternatives to Fiat Currency
One of the alternatives to fiat currency is investing in precious metals like gold, silver, and platinum. Many investors see these metals as a hedge against inflation and a terrific method for storing wealth.
While a sizeable book could be written about the struggle between gold and silver dominance in the United States alone, gold is often considered the greater store of wealth. Gold tends to increase in value when the value of the U.S. dollar declines.
As more investors are drawn to precious metals, more businesses may accept voluntary local currency like Goldbacks. As of the time of this writing, nearly half of the United States have recognized silver and gold as legal tender.
Some investors prefer a multi-pronged approach and invest in government-issued bonds since Treasury Inflation-Protected Securities (TIPS) offer what is seen as greater protection against inflation. These are low risk but still have distinct disadvantages, including lower returns that may not keep pace with inflation and early calls.
Cryptocurrency is a recent financial development but one that has attracted significant attention as an alternative to the inflationary nature of fiat currency. Cryptocurrency like Bitcoin is not considered money in the classic sense of the word, but its scarcity drives demand and value, though it is still subject to fraud and inflation.
