What is Money and Why are Fiat Currencies the Best?

Money is one of the oldest inventions of mankind, predating all written history. Although the money that we see today takes the form of cash in your wallet and the number in your bank account, this has not always been the case. Money is a medium through which goods and services can be exchanged. Because of this, money doesn’t have to be in the form of notes or coins. In fact, seashells, barley, vodka and whales’ teeth have all been used in the past. David Graeber, an anthropologist, says in his book “Debt: The First 5000 Years” that money is a quantified obligation. This means that the person who holds money is entitled to receiving goods and services from other people.

For most of Britain’s past, gold was used as the main currency, first as minted gold coins and then later as a backing to the Pound Sterling. However, modern economies now use ‘fiat’ money, which is money that is backed by ‘Government decree’. This means that money is money because the Government said it is money. This article explains why modern fiat currencies are preferred by all major economies compared to commodity systems used in the past.

Over 2000 years ago, gold coins were used in Britain as a result of trade with Gaul. Coins made from precious metals are called ‘commodity money’, worth as much as the value of the metal used to mint them. One immediate issue with commodity money is that there is a lack of divisibility. Although change can be given in commodity money, it is much more difficult to do so compared to fiat money.

In the past, it was normal for people to deposit and store their gold with the local goldsmith because they had facilities for safe storage. The depositor would receive a receipt. When he wanted to buy something, he would collect his gold from the smith and purchase the item from a local shop. The shopkeeper would then later redeposit the gold back with the goldsmith. Before long, the goldsmiths issued receipts payable to the receipt owner rather than the original depositor. This therefore meant that people could start using these receipts as currency, rather than the gold itself, thus saving lots of traipsing back and forth from the goldsmiths. This receipt system also saw the birth of ‘Fractional Reserve banking’ – where the goldsmith bankers issued a greater value of receipts than the value of their gold reserves, assuming that people would not cash in their receipts all at once. 

Thus a form of private credit creation was introduced. Fractional Reserve banking still happens today, albeit under Government regulation. There were two other methods that bankers used to create and facilitate credit. The first was the cheque book system and the other was the issuing of Bills of Exchange to businesses, which is another form of debt. The first recorded use of a cheque in the UK was in 1659.

It was as late as 1844, when Bank of England banknotes were officially backed by gold with the Bank Charter Act. From this point onwards the United Kingdom had officially adopted the ‘Gold Standard’. This meant that for every pound there was in the economy, there was a fixed quantity of gold backing it. One advantage to the gold standard is that Governments cannot cause price inflation with excessive issuing of notes, such as the disastrous hyperinflation in the Weimar Republic. Another benefit was to international trade, as exchange rates were easier to understand because different currencies could be compared by the amount of gold that backed them.

However, tying a currency to the price of gold can be problematic, as the currency becomes vulnerable to shocks in the economy, for instance if excessive gold discovery was to occur. An example is the California Gold Rush in the 1840s and 1850s which brought a huge increase of gold to the money supply in America. Unpredictable increases to the money supply can cause major instability to a currency. Furthermore, people tend to hoard gold in times of economic uncertainty. This is because Gold is viewed as a secure store of wealth that will always maintain its value. If people hold on to their gold, the available money in circulation decreases, and deflation ensues.

Britain officially left the gold standard in 1931 and the Pound Sterling became a fiat currency. The main advantage to a fiat currency is that a Central Bank can quickly control its supply. While fiat currencies can be printed in any quantity a Central Bank pleases, if it wants to increase the money supply, the only way to do this is to increase its quantity of gold by the same amount. Compared to fiat currencies, increasing its quantity of gold in reserve is a much longer process. Control of the money supply proves especially useful during crises when big economic stimulation is necessary, like Quantitative Easing. With QE, money is created when a central back buys bonds from the largest banks in the nation on an IOU basis, and this influx of money increases the money supply.

However, not all fiat currencies have been successful. Since these currencies are backed by nothing other than trust in the Government which oversees it, citizens will trust the currency as much as they trust the Government. This works well for stable countries like the UK, but it can be a problem for Governments that are not trusted by its citizens as much. Political corruption was partly the downfall of Venezuela’s Bolívar, for example. The former President of the country embezzled 250 million Bolívars, and the current Government is accused of assisting in drug trade, intimidation of the media, and manipulating the economy for personal gain. The usual way that a fiat currency collapses is when the central bank prints so much money that it causes hyperinflation and citizens are forced to use alternatives, such as the US Dollar. In the case of Venezuela, the Government printed excessive amounts of money to pay off the country’s growing debt, and its population often use the Colombian Peso instead.

In the modern world, all major economies use fiat currencies, and this is for good reason. The underlying advantage with fiat currencies is the power and control the issuing Government has over them. Whereas currencies on the gold standard are susceptible to significant changes in the price of gold, the supply and demand of fiat currencies can always be controlled. With fiat currencies comes significantly more flexibility, which has played an increasingly important role during the banking bust a decade ago and the pandemic of the present day.