A fallacy that I am increasingly seeing in the cryptosphere is the comparison between fiat money and cryptocurrency. Crypto enthusiasts are quick to point out the seemingly unlimited supply of Fiat (As opposed to the fixed/ deflationary supply of most cryptocurrencies), its inflation, the very low yields one gets from Fiat savings deposits etc. Sadly, these remarks show a very limited understanding of what Fiat money is, and what its purpose is.
Fiat has a very specific purpose in the world. It is a Medium of Exchange (MoE).
What does that mean? It means that Fiat currency is widely accepted in exchange of goods and services. So how did it come into existence?
Going back thousands of years, mankind devised the barter system.
You had some goods, you exchange them for some other goods.
Simple in concept, and it worked to an extent. But the barter system soon ran into limitations.
Say, you had a Donkey. You want to exchange the donkey for 10 chickens. But the only chicken seller in the village accepts only 2 goats in exchange for 10 chickens. This means, the donkey seller will have to find a goat seller who is willing to sell 2 goats for the donkey, take the goats to the chicken seller and buy the 10 chickens.
This was the birth of the Medium of Exchange (MoE). The earliest civilizations minted coins out of precious metals to act as a bridge between goods. The seal of the administration marked the coin as official tender, and was accepted by everyone in the kingdom as payment.
Fast forward to the modern era, many countries had currencies backed with precious metals. This meant that every coin or currency note the government issued was backed with an equivalent value in precious metals. This was a great solution. Printed currency notes and mass minted coins are very liquid and can exchange hands fast (Velocity, a concept we will visit later in the article). And they were always backed with precious metals, so their validity was never out of question. However, this solution also ran into its limitations.
When an economy prospers, more participants enter. Kids grow up into adults and start working salary paying jobs, prosperous individuals would want to spend their disposable income on non essential goods & services, and so on. With a currency that has only a fixed circulation, this means that more participants start chasing the same supply of money. This is Deflation (Too many goods chasing too little money).
To the uninitiated, this sounds like a great thing. My money is now worth more, so I am richer! Sadly, that is not the whole truth. Money is an MoE not just for luxury items, but also for essential goods. If severe deflation hits even essential goods will go up in price.
Consider a village of 3 people. One of them is a baker, and the other two, normal residents. The whole village has an economy of 3 dollars. one of the residents has 1 dollar and the other has 2 dollars.
The baker sets a price of 1 dollar for a loaf of bread. The first resident pays 1 dollar for a loaf. The baker puts this dollar into his deposit box and takes it out of circulation, because he currently has no need to spend it. This contracts the economy of the village to 2 dollars. One would think that the second resident is now “Richer”, because he how has the entire circulating supply of the economy. However, this is not how it works in practice.
The baker knows that no new money is entering the economy. So he raises the price of a loaf of bread to 2 dollars. The second resident absolutely needs a loaf of bread (Essential goods), so he has no alternative, but to pay the higher price. This is what deflation does.
Deflation tilts the market extremely in the favor of the seller; and this ends up pricing many participants out of even essential services. Deflation also leads to hoarding of wealth, which demolishes the liquidity of the MoE. This is why most economists consider deflation a bigger evil than Inflation, and advocates a small, healthy amount of inflation to cater to the new participants who enter the economy. The rate of this inflation is governed by the monetary policy of the nation, and is usually implemented by the central bank. Controlled inflation ensures that all participants, new and old; have the same purchasing power, and that the MoE stays liquid. (This is very different from hyperinflation, which is beyond the scope of this article)
However, the backed nature of the currencies brought with it additional challenges.
The Bretton Woods system was originally put in place to negotiate financial relations between the leading world currencies, all of which were to be backed with gold. However, after two world wars, most economies were devastated and the US Dollar found itself to be the bridge currency of the world; which led to the Triffin Dilemma : Simply put, the US had to print more dollars than it needed for domestic use; because the US dollar was the international bridge currency; and they had to keep building their gold reserves to match this. I.E. The government needed to keep adding a deflationary asset (Gold) to their reserves to back an inflationary asset, the currency. As you can probably guess by now, this was not sustainable in the long run.
This led to the controversial decision to unpeg the US dollar from gold. I.E. It became a Fiat currency. A Fiat Currency is backed with nothing other than faith in the government that issues it. Other countries followed suit, and we ended up in the Fiat era.
Contrary to the urban legends that surround the cryptosphere, there was no grand conspiracy to unpeg currencies from precious metals. It was simply a necessary step taken to ensure that money could continue to do its job; i.e. be a Medium of Exchange.
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