Currencies without any other product to back them up are known as fiat currency. The euro, pound, yen, and other major currencies are considered fiat currencies.
From the gold standard to Fiat
In 1971, the United States officially ended the gold standard. Instead of a dollar representing a specific amount of gold, the US dollar is now valued based on supply and demand and faith in the US government.
Therefore, the currencies of more developed economies such as the United States, Japan, the European Union and others tend to be the most valuable. Countries that have unstable or underdeveloped economies often have less valuable currencies.
In some cases, these smaller, less developed countries don’t even issue their own currency. And if by any chance they do, they typically peg it to a more stable fiat from a developed economy. For example, most Caribbean countries peg their currencies to the US dollar, since most of their economies are financed by US tourists. Lebanon pegs its currency to the British pound. Most African countries maintain a parity with the euro.
The Fiat Side Effect
The goal of doing this is to keep their economies more stable. However, there is a flaw. Economic policy enacted by reserve currency countries like the United States or the European Union eventually trickles down to these smaller nations. They have little to say and are forced to deal with the hand that is dealt to them.
Furthermore, fiat currencies are always in a state of flux. Coins become more valuable and less valuable. If you have traveled abroad and tried to exchange currencies, you will know that your US dollar is not exactly equal to the same amount of euros or pounds or any other currency.
When currencies were backed by commodities like gold or silver, this phenomenon did not exist. Centuries ago, the world agreed to facilitate the gold trade. Each country determined the value of an ounce of gold in its own currency.
This standardization eliminated exchange rates. So, if you were trying to convert your British pounds into US dollars, all you would need to know is how many pounds and dollars the British and US governments said an ounce of gold was worth.
As World War II ended and a new geopolitical landscape unfolded, the winners of the war coordinated to reveal the new economic game plan. Originally, the plan was for the US dollar to be exchanged for gold at a rate of $35 per ounce. Then the currency of all other nations would be pegged to the US dollar.
However, this system was abandoned in 1971 when President Nixon cut off the convertibility of dollars into gold. At this time fiats were born.
Fiat currency gained popularity because it gives governments, and more specifically central banks, more control over the economy. With fiat currencies at their discretion, central banks can monitor credit supply, liquidity, and interest rates.
The goal of this new approach was to minimize the effects of the boom and bust cycles that economies used to go through. Central banks could alter interest rates or limit the money supply to encourage or limit growth.
However, the increased government control over the economy has not always been sustainable. Fiat currencies are not always reliable. They can be overly manipulated and, once out of control, can be difficult to rein in.
inflation is unavoidable
A key pitfall of fiat currencies is a higher risk of inflation. There are a handful of examples throughout history where central banks have abused their power.
Zimbabwe was home to one of the worst inflation crises in modern history. To avoid an economic downturn in the early 2000s, the Zimbabwean central bank began printing money at an astronomical rate. At the end of this mishap, the Zimbabwean currency lost 99.9% of its value. It got so out of control that the central bank had to issue a $100 trillion bill.
Today there are a multitude of countries facing their own inflation problems as a result of government overreach. Venezuela has an inflation rate of 2,000%, while Lebanon hovers around 200%. The Argentine currency has lost half of its value and Turkey’s a third.
Unfortunately, the average citizen of these countries suffers the most. Those who have their life savings in a bank account could wake up one day to see their country’s currency lose half its value. This is exactly what happened in Yugoslavia in 1994. The country’s monthly inflation rate reached 313,000,000% and prices doubled every 1.4 days at their peak.
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Fiat currencies vs. CRYPTOCURRENCIES
Even if it’s not overnight, inflation can take place slowly over decades.
When governments print more money, they devalue the money in their citizens’ bank accounts, the value of their homes, and many other assets. On the contrary, the cost of goods and raw materials increases. Low-income people are the most affected by inflation.
There is almost twice as much money in circulation in the US since the Great Recession of 2008. Not coincidentally, right after the Great Recession, the world’s first cryptocurrency, Bitcoin, was created. Bitcoin emerged to try to combat central bank overreach.
Today there are thousands of cryptocurrencies. Calling some of these “coins” might be a misnomer. Cryptocurrencies like Dogecoin, Shiba Inu and many other memecoins have no real utility and do nothing to solve the fiat problem.
While some other cryptocurrencies serve different purposes, such as Ethereum and its smart contracts, Bitcoin’s original design was intended to serve as a safe haven for those who wish to avoid central banks.
People who believe in Bitcoin see it as everything that fiat currencies are not: it is in limited supply. It cannot be manipulated. And it does not depend on any government authority.