The history and use of the fiat monetary system

The term fiat money is used to define as any money declared by a government to be legal tender with no commodity backing. Legal tender simply means that there is a law requiring everyone to accept the currency in commerce. Besides, fiat money was state-issued money which is neither fixed in value in terms of any objective standard, nor legally convertible to any other thing that was demanded by someone else. In other word, fiat money is money without intrinsic value. In ancient times when money was not invented trade as a whole was on barter system. “Barter” basically means to pay for something you want with products or services instead of paying for what you want with money. Under this system, exchange only can take place between two persons only if each possesses the goods which the other wants. As an example, imagine you grow tomatoes and your neighbor grows corn. It’s possible to imagine a scenario where you and your neighbor agree to trade 25 pounds of your tomatoes for 25 pounds of his corn. Barter system will cause one party had to suffer at the end of trading because there was no measure of value, even if two persons met together who wanted each other goods, they could not find a satisfactory equilibrium price. This situation can be explained when you have each paid for what you want with something other than money. This system was possible only in a simple economy but after the development of economy, direct exchange of goods without the use of money, was not without defects. Even though barter was limited in its usefulness, it played a major role in developing the concept of money.

The term fiat money derives from the Latin fiat, meaning “let it be done”, which mean that money ordered into existence by a sovereign power as the money is established by government. Where fiat money is used as currency, the term fiat currency is used. Today, most national currencies are fiat currencies, including the US dollar, the Euro, and all other reserve currencies, and have been since the Nixon Shock of 1971. The term Nixon Shock is used to refer the two different policy measures taken by U.S. President Richard Nixon in 1971 and 1972 that eventually led to the collapse of the Bretton Woods system of international financial exchange. The Bretton Woods system dissolved between 1968 and 1973. The U.S. President Richard Nixon was announced the “temporary” suspension of the dollar’s convertibility into gold in August 1971. While the dollar had struggled within the parity established at Bretton Woods, this crisis marked the breakdown of the system. An attempt to revive the major currencies began to float against each other by March 1973 and the fixed exchange rates failed. The policies imposed and the actions taken by President Nixon included imposing a 90-day wage and price freeze in America, a 10% import surcharge and, most notably, closing the gold window, effectively making the U.S. dollar inconvertible to gold.

The term fiat money is used to describe currency that is used because of a government’s order, that the currency must be accepted as a means of payment. For instance, for the U.S., the dollar is fiat money and for Nigeria it is the naira. The gold standard is not currently used by any government of the country when comparing with fiat money. Britain stopped using the gold standard in 1931 and the United States abandoned the system in 1971 due to the economic depression. Economic depression result from the declines in the money supply induced by adherence to the gold standard. Under this situation, Britain and United Stated leaving gold earlier in order to have been able to avoid the worst of the Depression and begin an earlier process of recovery. Based on our research, the finding that the time at which a country left the gold standard is the key determinant of the severity of its depression and the timing of its recovery has been shown to hold for literally dozens of countries, including developing countries. The gold standard was completely replaced by fiat money.

There is one major difference when it comes to the standard price of fiat money and the standard price of gold. This difference is the amount of stability. The value of the money is decided on the basis of the confidence shown by the people instead of the face value. As a result, there is very little stability in case of fiat money. However, this confidence level is bound to keep varying from time to time and hence the value of the money would also vary every now and then which would turn out to be disastrous for any economy. Nowadays, the price of gold is determined by the demand for the metal, and although it is no longer used as a standard, it still serves an important use. For example, gold is a major financial asset for countries, central banks, and also used by the banks as a way to hedge against loans made to their government. The stability of gold is one of the major reasons why economies of the world prefer to convert their paper currency into gold rather than opt for fiat money. Hence, gold standard wins over fiat money.

2.6.2 Characteristic of fiat money

Fiat money or fiat currency, usually called paper money, is a type of currency whose only value is that a government made a fiat as the money is a legal method of exchange. This means that money that by law must be accepted as payment of debt. Currency and coins are legal tender because they are created directly by a government and by governmental decree must be accepted. To explain the legal method of exchange, example like people can use one of this money to buy something they want in order to meet their satisfaction. Fiat money make a trading become more successful if compare with barter system. Unlike commodity money or representative money, it is not based in another commodity such as gold or silver and is not covered by a special reserve. Commodity money is type of money with intrinsic value such as cows, corn, sheep and much more. Besides, store of value also is one of the characteristic of fiat money. Fiat money holds its value so long as holders of the currency feel that they can find an exchange partner for it at some later time. On the other hand, modern paper currency, coins, and checkable deposits are also considered as fiat money.

Moreover, fiat money does not have any intrinsic value and the return of fiat money is anything other than the confidence holders have in the economy which covered by the government. The government decrees the fiat money to have value. Furthermore, the values of fiat money result from the expectation of later use or the willingness of people to accept fiat money as a medium of exchange. More clearly, the value of fiat money comes from the public’s general willingness to accept it in exchange for other goods. This willingness is largely depends on the public’s confidence in the authority usually the government when issuing the fiat money. Fiat money is not valuable into itself but it is valuable for what it can buy. In year 2004, the currencies in the world are fiat monies. People around the world started to buy goods and services with fiat money. However, the situation with major currencies such as the euro, the United States dollar and the Swiss franc is more complex.

Furthermore, Fiat money emerged from commodity money when people realized that value in use was not a requirement for a medium of exchange. It is hard for everyone to doing their business by using commodity money because they are not able to measure the value of commodity money when comparing with fiat money. Moving away from money with value in use made it possible to use items that better fit the durability, divisibility, transportability, and non counterfeit ability characteristics of money.

In addition, fiat money becomes most important to modern economies. This is because that fiat money can help to control business-cycle instability in the country when more and more people start using fiat money in exchange with other goods and services. Fiat money gives rise to the active use of monetary policy. Besides, it is more convenience and easy for us to bring along if compare with commodity money. For example, people need not to bring the cows to other party in exchange with the good they want when they start using fiat money. At last but not least, fiat money can easily controlled by the issuing authority. It can help people to determine the upper class and lower class people in a society. Lastly, fiat money also avoids unanticipated and uncontrollable fluctuations in the value of commodity money, which can wreck havoc on the economy, that result from market shocks of the commodity.

Money by Decree

The word fiat is came from Latin word that brings a meaning of an arbitrary order or decree, such as what government might lay down. The government set the fiat money as legal tender and from the rule set by government, its mean that fiat money has value as money. Other than that, government issues an order, decree, or law stating that fiat money is valuable. This statement can only being work is depend on the amount of people who regularly violate other government laws and decree. Not only this, it also work when government decree that people can use fiat money to pay their taxes. Any item that is accepted by government for tax payment is well on its way to being the generally accepted medium of exchange.

Two Values

There are two type of value that can help us to better understand the fiat money and how to differentiate fiat money from commodity money which is value in use and value in exchange.

Value in use: This type of value meaning that the satisfaction of consumer toward wants and needs is provided by the direct consumption of goods and services. The extreme goal of economic activity is acquiring value from the use of goods and services. Value in use is the final step in the production, allocation of purchase price, and consumption activities that are undertaken to address the basic problem of scarcity. This value is needed in order to avoid the expensive of startup cost and risk. Besides, the term should be differentiated from market value and value in exchange in order to avoid the confusion in the market place, which understands fair market value to reflect the value in the open market.

Value in use pricing => It is a situation where establishing a price based on a product’s value to the customer as opposed to the manufacturer’s cost of production. This method of pricing is effective only when consumers have no effective substitutes. For example, a pharmaceutical company may price a specialty cancer drug at a very high level, regardless of the firm’s cost of production, based on the drug’s value to the limited number of people who have few alternatives. On the other hand, a product may be sold at a lower price because of the competitive pressures due to the product has a very high value for many people.

The Emergence of Fiat Money

In the transformation from commodity money to fiat money seems clear, a logical next step in the historical progression that moved from self-sufficiency to barter to commodity money. However, the separation of value in exchange from value in use was a major conceptual breakthrough that made continued economic progress possible. Human made the transformation from commodity money to fiat money in three steps:

Fully Backed Paper Currency: This was the first step of transition from commodity money to fiat money. Under this step, the paper currency issue was backed completely by the commodity money, which at this stage of development was usually gold or silver. Basically, this paper currency could have been traded for equivalent amount of gold or silver, which was cautiously hid away in a safety location. As an example, the United Stated issued gold and silver certificates in return by actual amounts gold and silver stored in large storeroom. However, the public took to using paper currency over the actual commodity money because the paper currency generally fit the money characteristic better than the metal, especially transportability.

Paper Currency Exchange Rate: The second step was the achievement by the money issuer that very few people actually traded paper currency for commodity money. Actually, there was very few people used gold or silver as money due to it problem occur in commodity money. The public willing to used paper currency as the medium of exchange. This means that the money issuer need not to maintain an definite equality between the amount of the commodity money hideaway and the amount of paper money in circulation. For instance, they could have $10 billion worth of paper currency which will backed by only $1 billion worth of gold. In nature, the exchange ratio between the paper currency and the commodity money was really needed. They could set and fix the price of gold and the price of silver. So that, if anyone wanted to retrieve their currency for gold or silver, they could have done so at the fixed prices.

Fiat Paper Currency: This is the third step in transform commodity money into fiat money. This step are apply in order to full-fledged fiat money was easy once people grew cozy using paper currency rather than the actual gold or silver commodity money. The price of commodity money will stopped fixing due to the money issuing authorities. Disconnecting the price of the commodity from the value of the fiat paper currency meant that the money was no longer backed by the commodity money which is gold and silver. The paper currency wan said as valuable by the government is depend on the decree of government, its general acceptability, its ability to purchase goods and services. In addition, this also made it easier for the money issuing authority to control the total amount of money in circulation.

Modern Fiat Money

Paper currency was the first type of fiat money widely used by people in traded goods and services. Modern fiat money comes in four basic varieties which are paper currency, metal coins, checking accounts, and electronic money.

Paper Currency: This currency consists of pieces of paper, and is generally issue by government or central bank authority. This type of money consisting of printed paper that can circulate as a substitute of specie. For example, the Federal Reserve System in United Stated has issued $1, $5, $10, $20, $50, $100 bills. On the other hand, paper currency was also issued by the U.S. Department of Treasury, some state government, and more than a few private banks in the past. Paper currency is consider as fiat money because the value in use of the paper, but the value in exchange of the currency is only on the small fraction.

Metal Coins: A coin is generally a piece of hard material, this include shiny metal and shape in disc that make from relatively cheaply metals and metal alloys which is used as a form of money. While metal coins have been around for centuries and it were a key component of commodity money, modern use of metals for coins result predominately results in fiat money. This is because that the value of metals used in the coins is less than the face value of the coins. The market exchange value of a coin come from its historic value and intrinsic value of the metal component. For example, gold and silver. Sometime, metal coins that which serves as payment.

Checking Accounts: The checking account was the most common type of fiat money in modern economies, or more precisely checking account balances maintained by banks. Checking account allow its customer easy access to the fund in those account by writing check and allow them to use this fund to pay bill and doing other financial transaction in the shorter time. Furthermore, the money from checking account is two-part systems which consist of the bank account and the paper check. Basically, the balances of checking account are barely accounting entries in a bank’s computer database. The energy used to store this information has significantly less value in use that the values in exchange of the fund in the bank account. Otherwise, the paper checks also less valuable than what the balances can buy. Lastly, the checking account pay interest sometime depend on how large the balance in the account and the monthly service fee will be charge when the account balance fall below a present level.

Electronic Money: This type of money is the emerging use of electronic bank account balances without the use of paper check. These balances will access directly through ATM machines, debit card and also store computers. Besides, this electronic money also included as part of checking account balances because the computer technology are quickly transforming this money into a unique type of fiat money.

Paper currency metal coins checking account electronic money

2.6.3 How fiat money system work

In the fiat money system, the money is not backed by a physical commodity. Instead, the scarcity of fiat money and the fact that people seem to want it is the only thing that gives the money value. Besides, people want fiat currency has been the subject of much debate. For instance, if you were an alien and visiting the earth for the first time, you would certainly be amazed at how the earthlings seem to prize little pieces of paper with paint on them.

Debt is one of the ideas that can use to explain the value of fiat money. As an example, if you are in debt, you have no alternative but try to obtain the pieces of paper in order to pay your debt, and if the paper is scarce, you have to compete for it. Interestingly, indebtedness seems to go hand in hand with fiat money, but that is no conclusive evidence for this theory.

Moreover, another way that can be use to explain the want for money is that people got used to paper money in the fractional reserve system. Once the metallic backing was removed, people continued to use money as they had become accustomed to. One argument for this thesis is that the fiat money systems that have worked best historically are the ones where the physical backing was removed slowly and secretly.

A third way to explain the value of fiat money is that it is valuable because the government says so. This theory has often been tested in practice, and it can be rejected with confidence. Nevertheless, government still tries to inject value into paper by law and price control from time to time. This situation does not work in the long run and it usually lead quickly to the next step, which is hyper-inflation. Hyper-inflation is the destination stage of any fiat currency. During hyper-inflation, money loose most of its value practically overnight. Besides, hyper-inflation occurs due to the increase regular inflation to the point where all confidence in money is gone. Confidence is one of the important factors that use to determine the value of money in the fiat monetary system. Once the confidence is gone, money irreversibly becomes invaluable, regardless of its scarcity. For the past 3000 years, the gold standard replaced every fiat currency.

Although a fiat monetary system often evolves out of a fractional reserve system, this is not always the case. Sometimes the fractional reserve period has been skipped altogether. The Roman Empire is one of the most well known example where the silver based metallic system gradually evolved into a fiat monetary system based on token coins. The silver content in coins was slowly lowered until coins consisted almost entirely of tin. This situation took place over a period century, and that is probably the longest lasting fiat monetary system in the history of the world.

In the fiat monetary system, there is no such physical restrain on the amount of money that can be created. Whereas, in a fractional reserve system, the amount of money that can be created is still limited by the amount of metal available. This also allow unlimited credit creation. Initially, a rapid growth in the availability of credit is often mistaken for economic growth, as spending and business profit grow and frequently there is a rapid growth in equity prices. In the long run, the economy tend to suffer much more by the following contraction than it gained from the expansion in credit.

In most cases, a fiat monetary system comes into existence as a result of excessive public debt. When the government is unable to repay all its debt in gold or silver, the temptation to remove physical backing rather than to default becomes irresistible. This was the case in 18th century France during the Law scheme, as well as in the 70s in the US, when Nixon removed the last link between the dollar and gold.

In addition, for fiat money to work, the government must demand it in payment of taxes and say that it be used as a tender to pay all debts.

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