How does fiat currency work?

Earlier this week, I discussed what is money, how it differs from currency, and the problems with the most current modern monetary theory (MMT).

I believe it’s also important to go a bit deeper into fiat currencies and explain why they were invented and are still in use, and the issues that arise from centrally controlling the printing of money.

What are fiat currencies and how do they work?

Fiat currency refers to any currency that a government declares to be legal tender. Legal tender in this context means that the money has the full backing of the government that issues it. Throughout history, fiat currencies have followed a cycle of rising and eventually collapsing, often due to devaluation.

The idea is that a central authority that can enforce human law and justice by power of force can demand its people to pay taxes in a single currency, which happens to be minted by said central authority.

Even though today that task is carried out by banks – not only central banks, but commercial and investment banks as well through loans and deposits – our economy is still facing the same risks the very first fiat currencies did, like the Roman denarius.

At the onset of the 1st century AD, the denarius was a Roman coin made up of pure silver. By 54 AD, during the reign of Emperor Nero, the denarius’ silver content had been reduced to approximately 94% silver. The silver content was further reduced to 85% by 100 AD, courtesy of all succeeding emperors. By devaluing the silver content of the denarius, the emperors could simultaneously pay off their debts and become rich too.

This idea caught on, and every succeeding emperor wanted to devalue the denarius to increase their wealth. By 218 AD, the silver content of the denarius was at 43%. In 244 AD, Emperor Philip the Arab further cut it to around 0.05% silver. By the time the Roman Empire was collapsing, the denarius contained 0.02% silver, and nobody used it as a store of value or medium of exchange.

What are the advantages over sound money?

Back in the day, most economists and financial experts would tell you fiat currencies are a great way of dealing “money” because they would be backed by multiple assets. Of course, we now know that statement is just a blunt lie, as fiat money is always backed by trust.

So, in theory, there could be an advantage in having an unlimited money supply controlled by a responsible and transparent central entity.

Imagine being able to add extra currency units to facilitate the exchange of goods and services. What about doing the same to build roads, hospitals, schools, and every other necessary infrastructure to improve living conditions?

That was the ultimate promise of fiat money: to free people from the shackles of sound money which cannot be created and which has a limited supply, meaning there would always be greater growth constraints for when there is no more currency to add into the market.

Fiat currency throughout history

I’ve discussed how Rome introduced the concept of fiat currencies by melting precious metals like gold and silver and mixing them with ordinary metals like copper – which would allow for more currency to be added into the market.

But what happens when prices catch up with the additional quantity of currency circulating? Let’s jump into centuries-old China.

China first started using fiat money in the 7th century. At first, the country used copper coins, but made the switch to iron coins as there was a copper shortage. Unfortunately, iron was easy to find, and soon enough, iron coins were overproduced, eventually leading to their collapse. In the 11th century, a Chinese bank situated in the Szechuan province of China suggested the use of paper as currency. For a brief moment, this was okay as people could trade the paper currency for silk and precious metals.

China entered into a war with the Mongols that proved to be too costly, eventually leading to China’s defeat and the collapse of the paper money. Kublai Khan assumed leadership of China. As told by Marco Polo, Kublai was able to unite China, and every year, he produced a vast amount of the paper currency. He continued to print vast amounts of the paper money to the point of exceeding demand. It eventually led to the fall of the paper currency which ruined even wealthy families and caused warfare and chaos.

Are you wondering what’s been happening more recently?

Argentina was among the top 10 largest economies in the whole world back in 1932. However, it dropped down the list as soon as its currency collapsed the same year. In that same year, Italy, Norway, and Finland experienced currency shock that spread throughout the whole of Europe. In 1994, Mexico too went through a currency collapse period whereby the peso lost its value, throwing Latin America into economic hardship. In 1997, the Thai baht collapsed, spreading its effects to neighboring countries such as the Philippines, Malaysia, Indonesia, Hong Kong, and South Korea.

In 1998, the Russian ruble brought the country into economic recession after its devaluation. Similar effects were witnessed in Turkey when the Turkish lira experienced hyperinflation. Currently, Zimbabwe remains top of the list of countries with the worst fiat currency failures. Through rampant money printing, the state created hyperinflation. The inflation hit 624% in 2004 and then rose to 11,000% per year after that. The Zimbabwe dollar lost value to the point that it became completely worthless.

Today, we have the US dollar, which has devalued more than 94% since its creation.

Why will fiat currencies always fail?

I’ve spoken of the greatest advantage of fiat currencies being the fact they introduce an unlimited money supply to facilitate growth and commerce.

However, as Adam Smith duly noted when he wrote “The Wealth of Nations”, human beings are self-interested and will always do what’s best for them. It becomes very easy to implement bad practices and protect one’s power in the current fiat system. This means there is no way a central entity will behave nicely when there’s no way to impose the will of the people on the decision-making process.

The reason why fiat currencies will always fail is because anyone coordinating the supply of money will get greedy and produce considerably more units of currency than needed, meaning at some point the economy will deflate or hyperinflate, destroying people’s accumulated value.

If we want to understand money, we should opt to use a form of sound money like Bitcoin: it’s easy to trade, we can store value in it, and it’s quite divisible. In a sense, it’s the new internet gold.

So now I ask you, why wouldn’t you want to get as much Bitcoin as possible, if its supply is limited, its fundamentals work, and it can’t be blocked?