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Breaking Down Fiat Money: Utility and Problems

Although fiat currency or money has proven an effective store of value, medium of exchange, and unit of account, there are disadvantages associated with its use. These hurdles originate from the need for centralized fiscal and monetary policy.

Gemini-Breaking Down Fiat Money- Utility and Problems

Summary

Although fiat currency or money has proven an effective store of value, medium of exchange, and unit of account, there are disadvantages associated with its use. These hurdles originate from the need for centralized fiscal and monetary policy. Although steady, predictable inflation is considered a positive indicator of economic growth, the rapid rise in prices known as hyperinflation results in currency devaluation. In addition to utilizing fiat money, central banks and governments can combat hyperinflation by minimizing the impact of economic crises that result from domestic and international market forces.

Although fiat currency — money that is detached from a tangible source of value — has proven its effectiveness as currency around the world, there are disadvantages associated with its use. Many of these challenges arise from the centralized oversight of fiscal and monetary policy. In an increasingly global economy, the ability to respond to economic shocks has become a challenge. If governments and central banks miss the opportunity to prepare for crises proactively, reactive solutions fail to prevent hardship, as indicators lag behind reality. To understand the disadvantages of fiat money, it’s important to start with understanding how money is meant to operate.

The Utility of Money

Money has taken many forms since first emerging in the 11th century. From livestock and cowrie shells to the earliest forms of metal coinage, money is crucial to facilitating economic growth. Although anything can be trialled as money, there are three main requirements it must fulfil to be effective.

  • Medium of Exchange: Money needs to be an effective medium of exchange. Consumers need to have confidence that they can easily exchange money for goods and services.

  • Store of Value: Money must retain its value over a reasonably long period of time. If it fails to protect consumer buying power, it’s unlikely to remain in use for long.

  • Unit of Account: Money needs to perform as a unit of account or a yardstick for financial transactions. For instance, money needs to express the value of a $100 bill versus a $20 bill.

Beyond the essential utility of money, fiat currency must also be durable, portable, divisible, uniform, and limited in supply. If fiat money fails to meet these criteria, it’s likely to fail as a variant of money. But even if the utility of fiat money is achieved, its inherent value is determined by several factors.

Fiscal and Monetary Policy

The value of fiat currency depends on the health of a country's economy and how its government manages interest rates, monetary supply, and inflation. Governments can increase interest rates to discourage borrowing and spending, thereby lowering the money supply. Conversely, governments can lower interest rates to encourage borrowing and spending, increasing the money supply.

Inflation, or the steady rise in prices, results from a surplus money supply. This means that more money is chasing the same amount of goods and services. Low, predictable inflation is considered a positive, as it maintains and protects the value of money in a steady trajectory. However, when fiscal or monetary policy goes awry, inflation can give way to hyperinflation or other economic crises.

Hyperinflation: The unchecked printing of money can trigger hyperinflation as supply expands without restraint, severely devaluing any currency. The worst known case of hyperinflation in history occurred in Hungary. When the Hungarian government began printing cash following World War II, the daily inflation rate eventually hit 200% or 13 quadrillion percent annually.

Fiscal Crisis: A fiscal crisis results when a government is struggling to cover its budget deficit. Government bond ratings decline as investors sell them, and markets won’t lend. The recourse is to slash spending to cover the deficit, causing the gross domestic product (GDP) to fall in line with tax revenue. The world saw this scenario unfold when Greece was on the brink of defaulting on its debt in 2010, necessitating bailouts from international creditors.

Currency Crisis: A currency crisis results when investors become leery of holding a country’s assets. This dynamic might evolve if a nation looks like it will default on bonds. A fiscal crisis can also trigger a currency crisis. When investors lost confidence in the Icelandic financial sector, the value of its currency fell 60% between the end of 2007 and the end of 2008.

Each of these economic crises results from government oversight of fiscal and monetary policy. As such, many say that the limited supply of gold makes it a more stable currency than fiat money, which has an unlimited supply. For governments and central banks, navigating the cyclical nature of free markets is even more challenging in an increasingly global economy.

The Future of Fiat: Decentralization

In the United States, fiat currency abandoned the gold standard in favor of legal tender in 1971. Although this system has been in place for almost five decades, there are now opportunities to improve on the latest iteration of money. Government monetary policy is never a perfect science, and the reliance on financial institutions and businesses acting as intermediaries that make up a vast network of infrastructure increases costs. 

However, technology has emerged that presents a path toward correcting these shortcomings. Decentralized technology like blockchain and cryptocurrency presents the clearest path forward, removing intermediaries through automation and utilizing digital currency to lower costs, improve efficiency, and bolster the mobility of money. The removal of a central issuing authority in favor of automated monetary mechanisms (as found in Bitcoin and Ethereum) presents the most substantial step forward in the development of money and value since the abandonment of the gold standard. 

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