Fiat money - What is it and what are its disadvantages? | Center of Gold (2024)

The word "fiat" in economics does not refer to a famous Italian car brand, but to a monetary concept that has completely changed the way people use money. The word itself comes from the Latin language and can be translated into Croatian as the phrase "so be it", and the whole concept of fiat money spread throughout the world in the 20th century.

What is fiat money?

Fiat money (or fiat currency) is money that does not cover its value in any concrete asset such as gold or silver, but its value is given by the guarantee of the institution that issues it. This means that fiat money has no intrinsic or use value, other than the value of the paper it is printed on or the metal used to mint the coins. Put simply, fiat money has value because central bank and the state say it is valid. All today's world currencies fall under fiat money, including the Croatian kuna.

History of fiat money

The global monetary system today is entirely based on fiat money, but it wasn't always like that. Namely, throughout the 19th and a good part of the 20th century, all important world currencies were tied to some specific commodity, and most often it was gold. In practice, this meant that the central bank issuing the currency guaranteed the exchange of paper money for a gold equivalent, which gave the money real and tangible value.

The first major change that affected the monetary policies of countries occurred after the First World War. Due to the enormous costs of the war, many countries were forced to borrow in order not to go bankrupt. In order to pay off that debt, some of the countries started printing additional money that was not backed by gold in order to pay off the debt with that money. The most famous example of this practice occurred in Weimar Germany, and due to public and creditor distrust, printed money plummeted in value, leading to one of the worst hyperinflation in history.

Another important change occurred during World War II, in 1944, when it was signed Bretton Woods agreement. This agreement arranged the monetary systems of the Western capitalist allies in such a way that every Western currency was backed by the US dollar, while the US dollar was backed by gold. In this way, the US dollar officially became the world's strongest currency, whose value is used to determine the value of other currencies.

The last significant change occurred in the early seventies of the last century. The then US President Richard Nixon implemented numerous economic reforms, the most important of which was the abolition of the convertibility of the dollar for gold in 1971. In this way, one Nixon executive order completely replaced the previous gold-based global monetary system with a system of floating exchange rates without real coverage, which we still have today.

Disadvantages of fiat money

Before the advent of fiat money, the amount of paper money a central bank could issue was limited by the amount of gold backing that money. After the abolition of the convertibility of money for gold and the introduction of fiat money, there was no obstacle preventing central banks from issuing large amounts of paper (and, more recently, electronic) money that has no real backing.

The possibility of carrying out such a practice led to many negative consequences, the most pronounced of which is hyperinflation. The main cause of many hyperinflation throughout history was the excessive supply of money in the money market, i.e. the excessive amount of issued money circulating in the economy. Issuing an excessive amount of money into circulation is not possible in a monetary system based on gold because the amount of gold is limited, which limits the amount of money as well. With fiat money, on the other hand, the quantity can increase rapidly, often leading to hyperinflation. Apart from the mentioned German hyperinflation, numerous others also occurred. For example, hyperinflation in China in the 1940s, in Yugoslavia in the 1980s, and in Zimbabwe in the 2000s was caused by an excessive money supply.

Apart from hyperinflation, fiat money has another drawback – it is not suitable for long-term savings. Namely, even when there is no hyperinflation and when the economy is functioning properly, as a rule, there is still low inflation of around 2%. This means that money loses its value by 2% every year and that the 100 kuna you have today is worth less than the 100 kuna you had last year. This fact has great implications for savers who, by saving in fiat money, effectively lose value, especially in a situation where they are interest rates on term savings record lows, like today.

Furthermore, fiat currencies are proven to be riskier than those linked to gold. Looking into history, we can see that only 177 currencies out of approximately 800 that have existed throughout history have survived to this day. The average lifespan of failed paper currency was only 17 years, and the average age of currently valid currency is 37 years. Most failed currencies were destroyed by hyperinflation or political decisions, and everyone who owned those currencies lost the value they held in them.

An alternative to fiat money

Although fiat money is the most widespread form of assets today, it does not mean that it is the only one. Large investors, as well as ordinary individuals looking to maximize the value of their assets, avoid keeping a large part of their assets in cash. Instead, investors seek to invest their assets in alternatives to money that can provide returns and thus ensure the investor that his assets do not lose value. The most well-known alternatives are securities such as shares and bonds and investment funds and real estate, but investing in investment gold is increasingly popular as a safe way to preserve value in the long term.

For a reason, gold was used for centuries as the main means of payment and as a cover for world currencies during the gold standard. Gold is scarce, which ensures its stable value; it is universal and valid anywhere in the world; it is tax-free, unlike stocks and real estate, and is portable and easy to store. Due to the above reasons, it is not surprising that the demand for this precious metal increases in times of recessions and crises, when people lose confidence in fiat money, which is increasingly in circulation, and many believe that gold standard he was never even allowed to leave.

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About the author:

Josip Kokanović, mag. father

Josip Kokanović is the operational director of Centra Zlata and a leading expert in precious metals in Croatia. Kokanović is also a prominent financial expert with many years of experience in the financial industry, as well as a columnist and frequent guest lecturer specializing in the topics of investment and financial literacy.

The texts on centarzlata.com serve exclusively to inform and educate about financial and precious metal markets and should not be considered as investment advice.