The origins of fiat.
1, Aug 2020
By Daban Aryan
"The term 'fiat' is derived from the Latin "fieri," meaning an arbitrary act or decree."
Firstly, before currencies were ever a medium of transactions for goods and services, we had what we call the Barter Economy. This was essentially an out-dated method of purchasing goods/services by exchanging for other goods/services. For example, if I needed rice, I would offer the individual who is selling rice some fruits I may own in return for the amount of rice I needed. This method wasn't sustainable and there were many logistical issues such as the fact that sometimes I would want to buy a goat, but I would have to carry over kilos of rice and what if that individual didn't want rice? Then I would have to keep searching until I found an individual who would agree to my terms. Furthermore, some individuals were not able to purchase anything because of seasonal changes that didn't allow them to produce any goods to be exchanged; for example, a farmer may not be able to buy goods because his crops may not be ready yet. We had very obvious issues with this economy here and we required a new medium of exchange that people would value and trust. After all, money as we know it now; in the form of banknotes and coins are used because we know everyone else will accept it as payment and they have trust in the note as a storage of value. In very rare cases of hyperinflation, such as Germany around 1922, money can become worthless and not possess and purchasing power and in those extreme cases, the Barter economy can be reintroduced.
Over time, people began to realise that this method wasn't sustainable, and they needed storage of value that they could use for their transactions and so gold came about. Due to the metal’s scarcity and limited supply, it meant that the value of it would increase over time as more and more would be mined. Gold became a symbol of wealth and those who had a lot of it quickly began to expand their trades and accumulate more wealth as they took payment in gold. The demand would increase as people have high trust in gold as a storage of value due to its stability and as a globally accepted medium for transactions.
Soon enough, currencies or fiat developed, and notes and coins became much more common as the masses adopted it. It was useful because gold had such high value that people did not want to carry around their extremely valuable metals, so they wanted a paper note which was a physical representation of the gold that they owned. The note has value because it promises the bearer that their note would acquire them a certain amount of gold should they want to exchange it. This quickly built trust in the notes and coins that were circulation and drastically increased its adoption.
The Gold Standard was introduced which was essentially a monetary system that linked paper notes' value to gold directly. This strengthened trust in the notes as people would now, for example, be able to purchase an ounce of gold for $500. This meant that people had faith and trust in the notes they were carrying around and people were more likely to use it because if gold's value increases then, so does the paper note they carry. This was a good system to use because the power of money can't be violated; the physical quantity of gold meant that governments were unable to print more paper notes and create wealth out of thin air because they wouldn't have the gold to back it. The Gold Standard prevented economic situations such as inflation as the notes would be stable and the economy would be so too. However, the downside of this was the economy and growth of a country was solely dependent on the amount of gold that they had. This made it difficult for smaller countries to develop their economy as it was not reliant on productivity or resourcefulness of their workforce.
In 1913, the Federal Reserve was created to stabilise gold and currency values. When WW1 happened, the world powers suspended their link to gold to print paper money to fund their war efforts. The power of gold as a means to uphold the global economy through tough periods was magnified and people lost trust in its ability to provide for them when times were tough. This led smaller countries to look at other reserve currencies such as the British pound and the U.S. Dollar and even held more of their currency rather than gold which made the gold supply fall into the hands of the few.
"We have gold because we cannot trust governments," President Herbert Hoover. The U.S. decided in 1934, to revalue the price of their gold per ounce to $35. This essentially increased its value and increased the strength of the paper notes they had as it took more of it to buy gold. A lot of people converted their gold into U.S. dollars which gave the U.S. unprecedented power in the gold market. After WW2, war-torn Europe had immense debt; a crippling economy, and didn't have enough gold to stabilise their economy and rebuild their country. So, some of the world's leading powers and families came together at the Bretton Woods Agreement. They developed a system whereby European countries would value their currency in relation to the U.S dollar which was still using the Gold Standard (so many countries were not indirectly using the Gold standard too). They made the members convert their currencies into gold which the U.S. was holding the majority of (75%). Central Banks would now control the exchange rates between their currency and the dollar by buying their own currency if their value was too low in relation to the dollar. If it was too high, they would print more of their currency and sell it. This became extremely convenient as countries no longer needed gold as the U.S essentially replaced it. The U.S. Dollar became a dominant force in the global economy at this point because they imported more goods and paid in dollars.
We soon faced issues, as the gold reserves dropped and inflation rose due to the high U.S. imports and increase of armaments and wars; European countries started to cash in their dollars for gold as members of the Gold pool became reluctant to support the upholding of the dollar in relation to its value to gold. Countries began to ask for payments in gold and the value of the dollar dropped drastically to the point that in 1976, the dollar's value was officially no longer valued by gold so that they could freely print without being weighed down by their gold storage.
The 'fiat system' stated that the value of a currency should not be based on a physical commodity (gold) and that it should be able to be valued and traded in the free market against other currencies of other countries. This is what ended up happening since the U.S. dropped the gold standard; countries were no longer dependant on their supply of gold and were no longer fixating on keeping their gold supply and people continued using the paper notes as if it was still backed by gold. The Federal Reserve could control the supply of money through fixing interest rates and could also increase the supply of money through tough financial climates such as the Covid crisis to support their economy. World currencies now trade freely in the open market and central banks work together to manage the monetary policy. The government is now able to freely print an unlimited amount of money which in return means that fiat currencies will always lose value as time passes. This is how the 'fiat system' came about as we know it and how we gave unlimited power to a selected few.