The economic shutdowns, rising inflation and turbulent markets of the past two years have caused many to question the economic systems that have prevailed in the West.
No topic characterizes this malaise better than the current debate between fiat money and cryptocurrency as efficient means of exchange. As the public’s longstanding faith in fiat currency wanes, an increasing number of investors have switched to Bitcoin and other cryptocurrencies. However, each asset has unique advantages and disadvantages that are essential to understand when planning for the future.
The creation of Fiat
The rise of fiat money began in 1971 under Richard Nixon, when a financial crisis and dwindling gold reserves forced the US president to make a historic economic decision that would upend the international monetary system. . On August 15, Nixon announced his New Economic Policy, a program that ended the Bretton Woods agreement and separated the US dollar from the gold reserves that had given it value for the past three decades.
Under the Bretton Woods Agreement, which was negotiated in July 1944 by representatives of various world economic powers, the US dollar was backed by gold and other currencies were pegged to the value of the US dollar.
Nixon’s controversial new measures effectively nullified the direct convertibility of the US dollar into gold, leading to the worldwide mass adoption of a new type of currency called “fiat” currency. Henceforth, the US money supply would be a legal tender currency whose intrinsic value was backed only by the US government.
Understanding Fiat Money
Although fiat currency may initially seem like a complicated concept, the truth is that every person in the United States has experience dealing with fiat currencies, as it is the term that describes bills and coins (and electronic payment systems) that we use on a daily basis. Simply put, the US dollar, along with most other major currencies circulating around the world, can be described as fiat money.
Unlike many past currencies, whose value was derived from gold or another precious metal, fiat money is not backed by a physical commodity but rather by the central bank that issued it. Fiat currency only has value because a government says so – meaning that the value of fiat currency largely depends on the reliability and stability of the government issuing it.
What is bitcoin?
Despite the best intentions of central banks and governments in the era of fiat currency, fraud, incompetence, and abuse by those in power have often led to the devaluation and instability of fiat currency. One need only look at the rapid inflation in a number of emerging markets in recent years to see the pitfalls of a fiat-based economy.
In early 2009, a stranger by the name of Satoshi Nakamoto sought to provide an alternative to the current system by inventing the bitcoin blockchain, a decentralized virtual network that could record its users’ transactions in real time without the need for a central authority. Acting like a digital ledger, a blockchain can connect users across the world and verify financial transactions – eliminating the need for third parties such as banks and governments.
The creation of the blockchain eventually gave birth to Bitcoin, a cryptocurrency with a limited supply of 21 million fungible tokens (meaning every token is exactly the same), with only 19 million currently in existence. The final 2 million tokens are still being mined, a process in which programmers solve complex transactions on the blockchain, which is expected to be completed in 2140.
Fiat Currency vs Cryptocurrency
It is important to remember that while fiat and cryptocurrency are fundamentally at odds, the two mediums have many similarities:
- Both can be called money or currency
- Both are mediums of exchange which are used to store and transfer value
- Both can be used to purchase goods and services
- Both have their value governed by supply, demand, scarcity and other economic factors.
- Both can be traded on the exchange
While the two currencies have a number of elements in common, fiat money and cryptocurrency differ widely in how each medium derives its value. While it is true that the value of every currency is affected by many external factors, the primary source of value for fiat comes from the resources of the government that issues it.
Even though the US Federal Reserve does not need gold to back its currency, it is still required to hold collateral equal to the value of dollars in circulation, and it does so using government-issued debt.
Technically, dollar bills are valuable today because lenders and investors believe the US government will repay its debts.
On the other hand, Bitcoin is valuable due to its limited supply and its decentralization, which means it can never be manipulated by governments to print more of it.
Benefits of bitcoin
Cryptocurrency is often touted as a competitor to fiat money because its supply is limited and it is not subject to excessive printing by dishonest governments. For example, Bitcoin is known as “digital gold” because there will never be more than 21 million bitcoins in existence.
Bitcoin also holds promise for its fast transaction time and its ability to attract investors from all parts of the world. In theory, anyone with a digital wallet and a computer can buy and sell bitcoin, regardless of economic status or geographic location. Anyone who can transfer online can also acquire and own a digital coin of their choice.
Advantages of Fiat Money
Governments prefer fiat currency for the greater flexibility it offers, allowing them to set monetary policy and stabilize global markets. Today, fiat money gives politicians economic power that previous governments could only have dreamed of.
The use of fiat currency also allows governments to mitigate the worst effects of recessions that have plagued the West in the past. Since fiat currencies are not a scarce or fixed resource like gold, central banks have much greater control over its supply, giving them the power to implement controls such as quantitative easing. and stimulus payments that pump money back into the economy.
Fiat currency also has the advantage of being widely accepted by businesses. Although cryptocurrency acceptance has grown in recent years, many people would struggle to be able to buy real-world goods like groceries with Bitcoin.
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