Fiat currency is a currency backed by a specific government, which guarantees the validity of that currency for use in economic trade.
Fiat currency is necessary, as any currency has to be rooted in economic value. Individuals, companies, organizations, governments - anyone who engages in financial transactions and accepts a nation's currency needs to be assured a country's currency is viable and stable.
Fiat currency isn't backed by a physical financial standard, like the gold standard or the silver standard (both of which have been used the by the U.S. in the past, particularly in the period between 1830 and 1971.)
Instead, fiat currency is backed by the stability of the government that backs that currency, and its value is assessed by the country's ability to support that currency.
Historically, fiat money dates back to ancient China, where paper money was used in China's Szechuan province in the 11th century.
Individuals and companies engaging in commerce in the region could use paper money confidently, knowing that it was backed by government officials and could be traded at any time for valuable commodities like silk, jewelry, land, animals, or even vast amounts of foodstuff, like rice or wheat.
The History of Fiat Money in the U.S.
Historically, fiat currencies took a back seat to money backed by assets of tangible value, like paper currency and bank notes, or as noted above, by a precious metal like gold or silver.
During the infancy of the U.S., the federal government funded the war effort and build-up of the country via a continental currency, which was first issued in the late 1770s, just when the American Revolution was ongoing.
During that period, the fledgling U.S. government-backed any money flowing in and out of the country by its continental currency, as it similarly did 70 years later, when it backed its money via so-called "greenbacks", in the midst of the civil war.
By the end of the 19th century and through the first 70 years of the 20th century, Uncle Sam had turned to its precious metal currency systems, primarily using the gold standard to support its U.S. dollar, backed by gold at a fixed rate.
By the beginning of the 1970s, the federal government could no longer support a gold standard at a fixed rate.
In August of 1971, President Nixon basically abolished the nation's gold standard, turning instead to a currency platform based on the strength (and weaknesses) of the world's top currencies against one another, including the U.S. dollar, based on market demand for those major global currencies.That currency backing system is still in place today.
The Meaning of Legal Tender
By and large, governments used the term "legal tender" to define their intent to back their national or sovereign currency.
Legal tender is the money (i.e. currency) that is backed by the full faith credit of a specific country, so individuals, companies and others can go about the business of engaging in commerce in that country. When a federal government uses the term "legal tender," it is actually citing that currency (like the U.S. dollar or the British pound) that is backed.
Consequently, legal tender means that fiat currencies are legitimate and fully supported by the country where business and commerce is conducted.
Differences Between Fiat Money and the Gold Standard
Fiat currencies and the gold standard are different, and for good reasons.
Unlike a fiat currency system, a gold or even silver (commodity) standard placed limits on the amount of currency floating through a nation's economy.
Those limits were based, primarily, on the amount of gold stored by a central government. Governments held themselves (and their banks) to the standards, and would not issue new currencies unless they were backed by a specific amount of gold held in storage.
By doing so, governments knew that its currencies were fiscally sound and that trading and commercial activity with the nation was credible and stable, bringing even more business into the country as word spread that doing business in that country was reliable, based upon the use of the gold standard.
A fiat currency-based monetary system doesn't work that way.
Instead of a nation's currency being limited to a given store of gold, a fiat system isn't convertible.
It's based on the "good word" of a country's government and by extension, the good word of people who do business in that country, and return telling others that engaging in commerce in that country is reliable, based on the economic conditions in the region.
Upsides of a Fiat Economy
There are some decided advantages for countries in using a fiat currency, including:
With a fiat economy, a country has more flexibility than it would if it operated under a fixed amount gold standard. That's because a federal government could take unique action to combat threatening economic conditions, like a recession or excessive inflation, by using its central bank to tweak interest rates or flood the economy with much-needed financial credit, much like the U.S. did in the immediate aftermath of the Great Recession.
It Doesn't Depend on Scarce Resources
There's a good reason why gold is so valuable - it's hard to find and dig out of the ground. If, for whatever reason (like geopolitical instability in gold producing countries), gold grew scarce, a country that operates under a fiat currency has alternate resources to keep its own economy humming, and doesn't have to place limits on its currency.
Unlike the gold standard, where countries can spend billions on the gathering, storage, and vigorous defense of its gold, countries that use a fiat currency bear no such costs.
Downsides of a Fiat Currency
Fiat currencies, primarily because they have the ability to expand and contract when needed, do have some decided built-in disadvantages.
Fiat Currency Has No Concrete Value
With fiat currencies, countries know their currency holds no intrinsic value.
Thus, if a country to decides to inflate the amount of its currency, that move could lead directly to rampant inflation, and a resulting decline in economic health.
Unstable Currencies Lead to Unstable Economies
Fiat currency models only work as good as the economies that back them. In other words, if a country is experiencing economic instability (i.e., it's at war or the value of a major domestic expert like oil is in major decline), that country may likely preside over a lackluster, softer currency that leads to higher prices.
That, in turn, makes it hard to do business in that country.
Too Much Central Power
Fiat currencies may consolidate too much government power, especially with a country's central bank, reducing confidence in that nation's currency not only by outside parties, but also by the country's citizenry.
After all, a nation that controls how much money it prints is a nation that has an increased opportunity for hyperinflation and a souring economy.
Fiat Currencies - the Prominent Way Money Is Managed These Days
No matter where you land on the issue of fiat currencies and the gold standard, it's the former that rules the roost in major global economies.
That seems to be working out okay, as major currencies like the dollar, the yen, and the pound have proven to be major stabilizers over the years, and individuals and businesses are confident in doing business in those countries - and should be for years to come.
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