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Soapbox: What is ‘fiat’ money?

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‘Fiat’ money is very simple.

It’s what we all use as our medium of exchange – a currency such as US dollars and cents, or pounds sterling – which has been established by government to be legal tender, but which has no intrinsic value.

‘Fiat’ is Latin for ‘let it be done’.

A lesson from Marco

In his Book of Marvels of the World the 13th century traveller Marco Polo expresses his astonishment that in China the emperor had decreed that officially stamped mulberry tree bark was ‘money’.

Any trader bringing into China gold, silver, gemstones or pearls, was banned from selling them to anyone but the emperor – who paid them promptly with ‘Mulberry money’. It was illegal to use gold and silver coins. No fool, that emperor.

Fooling all the people

We’ve come a long way from Marco Polo – except we haven’t.

The confidence trick played by the Chinese emperor is still playing out today.

Today we have all become adjusted to carrying bits of paper (and coins) which are colourful and sometimes crisp. Some are even made from plastic. How up-to-date can you get?

But these notes are just like ‘Mulberry money’ in one key respect – their ‘value’ depends on the government responsible for issuing them.

As one notable commentator says: “The money we use today all over the world is created by central banks and it’s backed by nothing in particular except the promises to replace old notes with fresh ones”.

Which makes me uncomfortable. Particularly right now, when uncertainty has become almost endemic.

History’s examples

Fiat money is perfectly fine as a means of exchange, so long as one is confident that it is stable and not losing value.

We all want to know that today’s dollar (or Pound, Euro or Yen) will be able to buy the same amount of stuff next year as today.

Sometimes though that confidence is badly misled.

In 1920s Weimar Germany, or more recently Venezuela or Zimbabwe, fiat money’s value was swept aside in a torrent of consumer scepticism. In Hungary, in 1946 prices trebled each day for a while.

Those terrifying examples of hyper-inflation are but distant memories today of course.

The fate of fiat money

When governments build into their thinking an inflation rate of 2%, as many do today, no sensible person holds onto a banknote today in the hope it will have the same purchasing power tomorrow.

In a world where governments monopolise money production, currency competition is suppressed. The rise of bitcoin (and other digital currencies) is in part a resistance against government monopolisation of money production.

Governments across the world have produced astounding action in the wake of the Covid-19 virus. They have put into their economies an additional $11 trillion in an effort to avert economic collapse.

This additional debt can be sustained so long as interest rates are low and/or governments are somehow able to re-finance them.

Some argue that there is no limit to the amount of debt-financed spending governments can tackle. On this view one might ask why governments have borrowed so little to tackle the global recession we now face.

In the end, economists will argue over how much debt governments can shoulder without creating a sense of vertigo and creating a massive loss of confidence in their ability to manage this crisis. We are in a kind of limbo right now, awaiting the judgement of history.

Will fiat money survive this crisis? It’s bound to, if only because governments will not give up their monopolisation of the money supply. But fiat – government-controlled – money will look very different in a decade’s time. If you want a truly stable form of money, one over which nobody can exert control – and who doesn’t? – then gold is still the best candidate.

 

 

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