Fiat currency is money that is not fully backed by intrinsic value. Traditionally, this means the face value differs from the metallic worth. With coinage, it is typically created by governments and distributed by banks.
Paper currencies are an example of fiat currency. The face value is worth more than the paper it is printed upon. Under this scenario, no commodities are backing it in the sense of the material it is made from. At the same time, in most instances there is no backing agent such as gold.
This is common place under the central banking system most of the world operates under. These entities have control over monetary policy with the ability to change the monetary base. Value tends to be derived by the supply and demand function as opposed to the value of the monetary units themselves.
The governments place a further defense on the currency by defining it as legal tender. This means that it is to be accepted for repayment of debts along with tax obligations. A move of this nature does not outlaw other forms of money. It does, though, insulate the currency against competition.
Fractional Reserve Banking
When dealing with present day fiat currency, the banks are a vital component in the equation. The system is termed fractional reserve banking. It adds another layer to the monetary element that was not present in previous systems.
The central banks are responsible for the banknotes. This is true for the Bank of England, the Fed, and all other central banks. With the entry into the electronic age, and later digital, money took on a different form. Ledgers became the norm as physical currency was reduced in importance.
Fractional reserve banking became a vital element since it is the commercial banks that are in charge of the ledgers pertaining to the money supply. The monetary base is in the hands of the central bank. When it comes to the currency itself, this is where the expansion and contraction is in the hands of the banks.
In short, the currency supply is expanded when banks make loans and is reduced when principal payments are made or defaults occur. This is why the business cycle always comes into play when dealing with money. The boom times see expansion while the downward slope to the trough delivers contraction.
Central Bank Money
It is important to distinguish between central bank money and commercial bank money.
The central banks has two forms of money:
Since there are not physical commodities backing fiat currency, what gives it value? This is a question many struggle with.
The value of a currency depends upon the economic production tied to it. Those currencies that are in higher demand globally are the ones that have greater economic output. Simply look at the currencies of different countries. The lower output ones always will struggle against their more productive counterparts.
When dealing internationally, there are other components that factor in, especially with the reserve or vehicle currency.
To operate internationally, a currency needs:
All of these components add to a value of a currency. At present, the USD serves as the global reserve currency. Many have offered up alternatives. The challenge is in fulfilling the factors on that list. It is a process that takes time and lots of development.
Here we see the insulation comes not from government edict. Instead it is derived from accessibility, utility, and activity.
Even though these are all defined at fiat currencies, the value of each differs greatly.
Like anything economic and monetary, confidence is a crucial factor. Historically, the value of a nation's money collapse after confidence in the government and/or economic evaporated. This was often accompanied by the central bank trying to offset the effects by "printing money". Here is where hyper-inflation is often experienced.
Inflation and Price Increases
One of the core discussions surrounding currency, especially fiat, is the impact upon inflation and deflation.
Many associate this with price increases.
Here is how Milton Friedman framed inflation:
“Inflation is always and everywhere a monetary phenomenon, in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.”
Prices that increase due to an increase in the quantity of money is inflation. If there is no expansion of money, an increase in prices does not equate to inflation.
Many believe that fiat currency is responsible for hyper-inflation since central banks can simply print what they want. In the transition from cash to digital money, the control is now in the hands of the commercial banking system.
Ledger Based Money
The development of the Eurodollar System brought the concept of money to a different level.
This deals exclusively with ledger based money. The currency utilized does not operate in physical form. It is a monetary system that exemplifies accounting (ledger) and communications (digital network).
It is they way that global trade is funded.
Many also believe this was the system behind the Great Inflation of the 1970s.
One thing often overlooked is the fact that cryptocurrency does qualify as fiat currency. The fact value of a coin or token can be different from its intrinsic value. This is not out of character with history. Coinage also qualified as fiat since the metallic elements was worth less than the face value of the coin.
The biggest difference between cryptocurrency and the existing monetary system is the removal of government. Here it was replaced with blockchain and the belief that code is law.
Through various consensus and distribution processes, the currencies are created based upon the base layer coding. To alter this requires a hard fork, an updating of the software that is adopted by the majority of the block producers.
Cryptocurrency also operates outside the banking system. A digital wallet can serve the basic needs of a bank, i.e. the ability to send, receive, and store money. In addition to this, through the use of smart contracts, decentralized finance is starting to offer many of the financial services traditionally associated with banks.
The system is beginning to take on a similar framework to the Eurodollar System. This was a global platform of lending, financing, and borrowing that was developed by the commercial and investment banks but outside the central banks.
Cryptocurrency is mirroring this yet removing the banks from the equation.
The Evolution of Money
Money is constantly evolving. During the 20th century, we see how this is changing within generations. Every 20-25 years, the form of money used is altered. Fiat currency is the predominant form, especially since we still have economies that are geographically defined.
The introduction and expansion of the Internet is changing this. As it penetrates further into our individual lives and, as a result, the economies which we operate under, the monetary aspect of things is going to change again.
We see tens of trillions of dollars in transactions taking place daily. All of that requires settlement. Our monetary system is enhanced by the massive advancement in communication system. Today, that means digital networks that can communicate in milliseconds.