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What is Fiat Money?

June 20, 2020
9 min
What is Fiat Money?
Beginner
You will learn

    The fiat currency is subject to a number of forces that affect its price, such as inflation and deflation. These forces, however, do not affect cryptocurrencies, thus representing an alternative to the current monetary system.

    Money is the cornerstone of our daily lives: it concerns people, businesses and our relationship with institutions. The decisions we make in managing our money determine our future.

    A currency, to be such, must fulfil three functions:

    fiat money

    Fiat Money

    A fiat currency is legal tender fiduciary currency. “Legal tender” means that a government chooses the official currency for its territory and this by law must be accepted as a means of payment.

    The word “fiat” in Latin means “let it be done” and indicates an order given by the government. Since ancient times, the central authority has established what is valid as a means of exchange, put it into circulation and control it. As long as all citizens agree that a currency has validity and value, it maintains it. 

    There are about 180 fiat currencies on the global market, including the Euro, Dollar and Pound.

    Each of these currencies has its own value based on the law of supply and demand.
    Therefore, they are not pegged to any precious metal or physical asset. The value of one currency against another is called exchange rate.

    Exchange rate

    The exchange rate is the price of one currency against another. It is usually calculated using the local currency as a reference. For example, the exchange rate of the Euro against the dollar (EUR-USD pair) is among the top four in terms of volume of daily transactions. This means that it is the pair where investors are able to make a higher margin.

    How is Fiat Money Issued?

    The Circulating Money

    As far as the European economy is concerned, circulating money comes in two forms: metallic and paper money or bank deposits

    Currently bank deposits represent a large part of the circulating money in the main European countries, and the use of physical money is decreasing. In fact, out of 60 trillion dollars, which is the total amount of money in the world, only 6 trillion are banknotes and coins. This means that 90% of all money exists only on computer servers, in electronic form, visible on our bank accounts.

    As a result, most business transactions are done by transferring electronic data from one computer to another without any exchange of tangible money.

    Money issuance: central banks and commercial banks

    The Central Banks, as is well known, produce only paper or metallic money. The real question is: is new money created also in the form of bank deposits? If yes, how?

    And who regulates the circulation of the digital money that passes through credit cards, ATMs or prepaid cards, which we use to make online purchases or to upload our Young Platform Wallet?

    This process is not handled by central banks, but rather by commercial banks. Commercial banks are private banks that you can open a checking account on.  

    Commercial banks create money in digital form every time they provide a loan. The money they deposit in the borrower’s account is not money already in circulation on other accounts, but brand new money. This money will disappear when the loan is repaid with interest. 

    The debt system is still at the origin of many debates. These start from the assumption that banks would create money “from nothing”. In reality, the new money given on loan corresponds to another asset. This asset is the future balance of this loan plus interests. 

    Moreover, banks have many constraints on the very granting of loans , since they involve actual risks. Both loans and the creation of new money, being tied together, involve common risks that go against the interests of the banking institution. It goes from the trivial risk that many loans will never be paid out to the risk of national inflation due to the excessive money created.

    Inflation and Deflation

    The value of any asset depends on its scarcity. For this reason, the model of creation of new currency and the control of the circulating currency are essential.

    Inflation

    Two values linked to the production of new money are the inflation rate and the deflation rate. Inflation is the progressive increase in prices caused by the decrease in the purchasing power of money. It is a situation that occurs when too much paper money is printed or too much new digital fiat currency is issued.  

    In 1923 Germany experienced one of the most dramatic inflationary crises in history. After the end of the war, it was forced to pay the war expenses of all the winning nations. In order to pay off the debt, the German government decided to print excessive amounts of banknotes. This decision led to unparalleled inflation known as Weimar Republic inflation. In January 1923, 35,000 marks corresponded to one dollar. By November of the same year, 25,000,000,000 marks were equal to one dollar. The Germans went so far as to have to carry wheelbarrows full of banknotes to buy bread. 

    Deflation

    The opposite process is called deflation. Deflation is a gradual decline in the prices of goods and services due to the general decline in demand and low propensity to spend. Deflation leads to an increase in the purchasing power of money which creates an apparent benefit to consumers. In reality, it is the trigger of an economic recession, which manifests itself in a progressive lowering of average income and finally in the stagnation of the economy. Italy went through a period of deflation in 2009 for the first time in 50 years, causing more than 1000 unemployed people a day.

    Deflation, for example, implies that companies sell their products at a lower price. To balance an inevitable decrease of the turnover they try to reduce the costs. For example, costs are cut for commodities and services from other companies, on employees and deferring payments owed for loans and financing. These interventions tend to compress the aggregate demand for goods and services, thus aggravating the situation and bringing new deflationary pressures.

    The growth of unemployment resulting from the cut in labor costs, forces the new unemployed to reduce their expenses, negatively affecting the demand. Deflation, however, also tends to result in an increase in savings, which can provide the basis for a healthy economic recovery.

    Both scenarios, when brought to excess, are dangerous. However, the right balance between inflationary and deflationary policies can keep the economy stable even in the most difficult situations.

    Monetary Policies and Quantitative Easing

    In the case of countries that are part of the EU’s Economic and Monetary Union, the ECB, together with representatives of the National Central Banks, establishes the monetary policies. National governments, on the other hand, are only concerned with implementing directives and establishing tax and welfare policies.

    The central bank can regulate the level of inflation or deflation of the economy. It can do it mainly through changes in interest rates and the amount of money in circulation. 

    We have seen that central banks can create money simply by printing new money. However, there is another way that has often been debated in recent years: Quantitative Easing.

    Quantitative Easing is an unconventional method of creating new money used by central banks in times of economic crisis. With Quantitative Easing a central bank proposes to purchase long-term securities on the market to increase liquidity. One example is the purchase of government bonds from commercial banks on advantageous terms, so that they have more liquidity and are more likely to lend to their customers at lower interest rates. 

    Monetary Policies during Economic Crises

    Fiat currencies, as fiduciary currencies, allow governments to have greater control over their value, by regulating their issuance and exploiting the exchange rate. 

    Until the 1970s, when currency was pegged to gold with a fixed exchange rate (representative currency), such management of money by the state or banks was not possible. The performance of gold on the market, in fact, could not be controlled and its price directly influenced the value of the official currency. 

    This current regulatory power could be a double-edgedged weapon in the hands of an inefficient government, causing hyperinflation or the creation of insurmountable debts. 

    A recent case of currency management failure is, for example, that of Venezuela.
    In 2019, it led the country to hyperinflation, also caused by the continuous issuance of new money as the only response to the crisis.

    The crisis trigged by the coronavirus, still in its early stages, not only is sui generis for Europe but also puts a strain on governments still recovering from the 2008 crisis. However, it could bring radical changes in the management of the economy.
    One of the strategies adopted has been that of placing a massive amount of new money on the market through Quantitative Easing.

    For many crypto experts, the failure of traditional markets such as the oil market during the coronavirus emergency highlights, the resilience of bitcoin. The cryptocurrency, in fact, after the initial collapse of March 2020 that marked the beginning of the lockdown in Italy, had an immediate recovery in prices with a constant positive trend. This umpteenth test of strength consolidates it as a valid alternative and safe-haven asset.

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