What is Fiat Money?

 

What is Fiat Money?

If you collect gold and silver for a while, you’ll probably hear the term “fiat money” thrown around. The term “fiat money” describes currencies that are valued because of the backing of a government and public faith, rather than being backed by a physical, intrinsically valuable asset like gold or silver. Although every country in the world uses fiat currencies today, the use of fiat money did not become commonplace until the 20th century.

Before the 20th century, most countries’ currencies used the gold standard. Under the gold standard, currencies were backed by real, physical gold. Because gold has intrinsic value, the precious metal served as an ideal backing commodity for currencies that would otherwise be backed only by the faith of the government issuing them.

Among stackers, the term “fiat money” is often used pejoratively. That’s because the move away from the gold standard was highly controversial among precious metal collectors, as well as some economists. While the gold standard came with notable limitations, many Americans argue that fiat money carries no intrinsic value because it is not backed by a physical commodity like gold.

On this page, learn more about what fiat money is, what drove the transition from the gold standard to fiat currencies, and more.

The End of the Gold Standard  – A Brief History

For around a century, governments around the world valued their currencies using something called the gold standard. The gold standard refers to a system in which the value of a currency, usually a paper asset, is directly backed by physical gold. In some cases, a participating nation’s currency may be directly convertible to gold.

In the United States, a full gold standard with convertibility between gold and paper currency only really existed from 1900 until 1933. That year, President Franklin D. Roosevelt ended the convertibility of the United States dollar to gold. The United States dollar existed under a pseudo gold standard from 1933 through 1971. During this period, the dollar could no longer be freely exchanged for gold domestically, but the dollar was pegged to the price of gold at a rate of 35 dollars per troy ounce.

Executive Order 6102 Ends Domestic Gold-USD Convertibility (1933)

The beginning of the end for the gold standard happened in 1933, when FDR signed an executive order ending the longstanding convertibility of the United States dollar (USD) to gold. During the period between 1933 and 1974, Americans were even prohibited from privately holding gold entirely, aside from a small personal allotment. This law, Executive Order 6102, was part of a broader effort by the Roosevelt administration to respond to currency deflation during the Great Depression.

From 1933 until 1971, the United States operated under what economists call a “quasi” gold standard. While dollars were no longer redeemable for gold within the United States, the currency was backed by gold globally, with an exchange rate of $35 per troy ounce.

This quasi-gold standard ended in 1971 with an event commonly known as the “Nixon Shock.”

Nixon Shock – The End of the Gold Standard (1971)

On August 15th, 1971, President Richard Nixon ended the last vestiges of the gold standard for the United States, as well as most of the world.

In an event known as the “Nixon Shock,” the American leader introduced a sweeping series of economic changes. Most importantly for gold market history, Nixon suspended the convertibility of United States dollars to gold internationally. Because the USD was – and still is – the reserve currency of the world, this action functionally ended the gold standard on most of the planet.

In addition to eliminating the gold standard, the new financial directive led to an explosion in the price of gold. Prior to 1971, gold’s price was functionally pegged to $35 per troy ounce. But after Nixon suspended the convertibility of the USD into real gold, gold became a speculatory asset – and prices rose accordingly. By 1980, the spot price of gold peaked at $670 per troy ounce.

This event ended the Bretton Woods System, an economic agreement formed in 1944 that pegged the dollar to gold and limited the price of gold to 35 dollars per troy ounce. Both the International Monetary Fund (IMF) and the World Bank helped solidify the landmark agreement.

While the gold standard functionally ended in 1933, the Bretton Woods System allowed a quasi-gold standard to persist until 1971, at which point Richard Nixon put the final nail in the gold standard’s coffin.

The Era of Fiat Money (1971-Present)

The Bretton Woods Agreement collapsed in 1973, just a couple years after the Nixon Shock. Under the 1976 Jamaica Accord brokered by the International Monetary Fund, gold ceased its role as the global monetary standard. This ushered in the era of fiat money, or currencies backed exclusively by faith in the governments that produce them.

A fiat currency is typically backed by two things:

1. Public faith in the government that issues it.
2. Stability within that government’s economy.

If the public has faith in its government and that government runs a stable economy, the currency it issues carries value that exists both domestically and internationally. The United States dollar, for example, is considered one of the world’s strongest currencies due to faith in the strength of the U.S. government and stability in the American economy. Today, every sovereign nation uses a fiat currency.

The fiat money system replaced the gold standard, but the move was not without controversy. Let’s take a look at some of the most commonly cited pros and cons of the fiat money system that arose beginning in the 1970s.

Fiat Money Overview: Pros and Cons

The collapse of the gold standard and subsequent rise of fiat money internationally were largely due to the need of governments to have more control over their monetary systems. During the Great Depression in the United States, FDR cited private gold hoarding as an obstacle preventing the government from printing more money to combat the deflation causing the crisis. Because gold is a finite resource, a gold standard that required currency to be backed by physical gold made it more difficult for governments to print more money to respond to emerging financial crises.

However, several criticisms exist of the fiat money system, and some of these critiques have a basis in actual economic history around the world.

Most notably, the value of a fiat currency is entirely dependent on public trust in its issuing government. When this trust fails, the currency can quickly lose value. In countries where corruption takes hold in government, for example, a currency can – and does – quickly lose its value. Even more troubling, a combination of currency devaluation and falling trust in government can trigger a vicious cycle. Currency loses value, people trust their government less, currency loses more value. Rinse and repeat.

This happened in post-WW1 Germany. Because the German government owed so much money after the war, it was forced to print enormous amounts of unbacked money to pay its debts. This massive money printing process further decreased the value of the currency. Public faith in the German government decreased as a result, driving the value of the currency even lower. This cycle continued, triggering hyperinflation. 

Fiat currency systems can also make inflation worse. Unlike the gold standard, which pegged currencies to a scarce, tangible asset, a fiat economy allows governments to print as much money as they see fit. With each new United States dollar printed, the value of an individual unit decreases slightly. If a government overcorrects when attempting to address a crisis by printing money, this system can spiral out of control.

Zimbabwe is the most notable example of hyperinflation resulting from the excessive printing of money under a fiat currency system. In 2008, the Zimbabwean dollar saw its highest inflation rate ever at 79.6 billion percent each month. During this period, a single loaf of bread cost as much as $550 million Zimbabwean dollars. Today, most Zimbabwe citizens use the United States dollar.

Critics of fiat currency argue that the gold standard was an important step in preventing inflation, since it pegged the value of a currency to a limited, tangible asset.

Why Was Gold Used to Back Currencies?

Gold was used as the backing asset for currencies for several reasons.

First, gold has an inherently limited supply. It cannot be created by governments or institutions, unlike paper currencies. Because of this, gold was ideal for backing currencies with a tangible and limited asset.

Second, gold is a universally accepted asset. Mankind has appreciated the scarcity and value of gold for thousands of years. In modern human history, gold has always held value for its use in jewelry, coins, and other items. Since gold has intrinsic value and is recognized as valuable by every nation on the planet, it functioned as an “objective” marker of value for other items.

Gold was also used to back international currencies because of earlier precedents set by countries like Great Britain. While working at the Bank of England in 1717, physicist Isaac Newton pegged the value of the gold guinea, a British gold coin, to 21 shillings. Because this made the gold coin worth more than its silver equivalent, Newton accidentally created a gold standard in the country.

Because gold had already been used naturally to back the currency of England, it was a natural choice for countries a century later.

Final Thoughts: What is a Fiat Currency – And Why Should You Care?

Whether you’re a new precious metals stacker or a seasoned investor, you’ve probably heard the term “fiat” thrown around. “Fiat money” describes a currency that is not backed by gold but instead derives its value from public trust in the government that issues it. Gold is the opposite of fiat currency; it has intrinsic value and cannot be created by governments, making it an excellent shield against the effects of inflation.

Many gold stackers view holding precious metals as a way to avoid the pitfalls of the fiat currency system that has dominated the economies of the world since the 1970s. Unlike fiat currencies, gold has intrinsic value, scarcity, and is universally accepted as a store of value.

You might also be interested in:

• History Lesson: What Happened to the Gold Standard?
• Should You Buy Pre-1933 U.S. Gold Coins?
• Is Gold Still an Inflation Hedge?