fiat money

DEFINITION: The phrase “fiat money” refers to currency that cannot be exchanged for a given amount of a physical commodity like gold or silver, but rather whose value is guaranteed by nothing more than the trust that people place in the issuing government.

That is to say, fiat money lacks any of the intrinsic value that commodity-based money enjoys.

Today, most modern paper currencies—such as the US dollar, the euro, the Russian ruble, the Chinese yuan, and other prominent global currencies—are fiat currencies.

ETYMOLOGY: The English term “fiat” in the financial sense is attested from the early seventeenth century. It derives from the Latin verb fīo, fieri, meaning “to become,” “to happen,” or “to be done.” (Fīo, fiere is used as the passive voice of the verb facio, facere, which means “to make” or “to do.”)

The word fiat is the third person singular, present subjunctive form of fīo, fieri; thus, it means “let it be done,” “let it happen,” or simply “let it be.”

The idea is that, say, a one-dollar note counts as currency because the US government, in effect, says “let it be so.”

The most famous occurrence of the term comes from the Latin Vulgate version of the Old Testament, where it is written (Gen 1:3):

dixitque Deus fiat lux et facta est lux

 [and God said let there be light and there was light]

Perhaps this celebrated text lay in the back of the mind of the Englishman, whoever he was, who first used “fiat” in its present financial sense: i.e., with the Crown standing in the place of God.

USAGE: Prior to the adoption of fiat money, governments used to mint coins from precious metals like gold or silver, which were commodities with a certain inherent value that fluctuated according to supply and demand.

When they began to issue paper money for its greater convenience, governments stipulated that the notes were redeemable for a specific amount of gold or silver. In this way, the value of a government’s currency rose and fell along with the price of gold or silver, as the case might be.

In contrast, fiat money cannot be automatically converted into a particular amount of any physical commodity.

Fiat money can, of course, to be used to pay for gold and silver, but that is a completely different matter. The point is that a currency note is not redeemable for a particular fixed amount of any commodity metal.

Since it lacks such backing, the physical piece of paper that a one-dollar note is printed upon has a specific monetary value (namely, $1.00) only because of US government has decreed that the piece of paper should count as a one-unit note of the national currency, which is called the “dollar.”

If this seems a little like pulling a rabbit out of a hat—creating something out of nothing—in a sense, it is.

The magic trick works so long as people will accept dollar bills in payment for the goods and services they sell. And they will only do that as long as they have a certain level of trust in the fundamental political and financial stability of the US government (or whatever government has issued the currency they are being asked to accept).

Thus, fiat money is always at risk of losing its value. This can happen is several ways.

The most common way is through inflation, which basically occurs when governments print more currency notes than the country’s economy requires to function well. When there are “too many dollars chasing too few goods,” in the standard maxim, the law of supply and demand requires that the value of the dollars (measured by the amount of stuff it will buy) must decrease. This principle usually manifests itself in increased prices.

If the government persists in the folly of simply “printing money” (without issuing any offsetting debt), eventually, inflation will become hyperinflation, in effect destroying that government’s credibility and, with it, its fiat money.

None of this would happen if the government’s currency were backed by gold or silver, because in that case the requirement of convertibility would place an absolute limit on the government’s profligacy—simply continuing to run the printing presses would be illegal.

But printing too many currency notes is not the only threat to fiat money. Trust in government may also dissipate as a result of political instability and strife.

In such cases, the decline in faith in the government will translate into a suspicion of the government’s fiat money, which will once again manifest as a decline in that money’s decline in value—i.e., in inflation.