The economic shutdowns, rising inflation, and turbulent markets of the past two years have led many to question the economic systems that have prevailed in the West.
No subject more aptly characterizes this unease than the current debate between fiat currency and cryptocurrency as efficient media of exchange. As the public's longstanding faith in fiat currency wanes, increasing numbers of investors have transitioned to Bitcoin and other cryptocurrencies. However, each asset has unique advantages and disadvantages that are essential to understand when planning for the future.
The Formation of Fiat
The rise of fiat currency began in 1971 under the tenure of Richard Nixon, when a financial crisis and declining gold reserves forced the U.S. president to make a historic economic decision that would shake up the international monetary system. On August 15, Nixon announced his New Economic Policy, a program that ended the Bretton Woods Agreement and untethered the U.S. dollar from the gold reserves that had given it value for the last three decades.
Under the Bretton Woods Agreement, which was negotiated in July 1944 by representatives of various world economic powers, the U.S. dollar was backed by gold and other currencies were pegged to the U.S. dollar’s value.
Nixon's controversial new measures effectively cancelled the direct convertibility of the U.S. dollar into gold, leading to the global mass adoption of a new type of money called "fiat" currency. From now on, the U.S. money supply would be a legal tender whose intrinsic value was backed solely by the U.S. government.
Understanding Fiat Money
While fiat currency may initially seem like a complicated concept, the truth is that every person in the U.S. has experience dealing in fiat because this is the term that describes the bills and coins (and electronic payments systems) that we use on a daily basis. Simply put, the U.S. dollar, as well as most of the other major currencies circulating around the world, can be described as fiat money.
Unlike many past currencies, whose value was derived from the gold or other 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 it does - meaning that fiat's value depends largely on the trustworthiness and stability of the government that issues 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 money. One need only look rapid inflation in any number of emerging markets in recent years to see the pitfalls of a fiat-driven economy.
In early 2009, an unknown person using the name Satoshi Nakamoto sought to offer an alternative to the current system through the invention of the bitcoin blockchain, a virtual, decentralized network that could record the transactions of its users in real time without the need for a central authority. Acting as 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 rise to Bitcoin, a cryptocurrency with a limited supply of 21 million fungible tokens (meaning that 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's important to remember that while fiat currency and cryptocurrency are fundamentally at odds, the two mediums have many similarities:
- Both can be called money or currency
- Both are mediums of exchange that are used to store and transfer value
- Both can be used to purchases goods and services
- Both have their value governed by supply, demand, scarcity, and other economic factors
- Both can be traded on exchanges
While the two currencies have a number of elements in common, fiat and cryptocurrency diverge largely in how each medium derives its value. Although it's true that each currency's value is affected by numerous external factors, fiat's main source of value comes from the resources of the government that issues it.
Even though the U.S. Federal Reserve does not need to have gold underpinning its currency, it is still required to hold collateral equal to the value of the dollars in circulation, and it does so using government-issued debt.
Technically, dollar bills have value today because lenders and investors believe the U.S. government will repay its debts.
On the other hand, Bitcoin has value because of its limited supply and decentralization, meaning that it can never be manipulated by governments who want to print more of it.
Advantages of Bitcoin
Cryptocurrency is often touted as a competitor to fiat currency as as 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 bitcoin in existence.
Bitcoin also holds promise for its fast transactions time and its ability to attract investors from all parts of the world. In theory, anyone with a digital wallet and computer can buy and sell bitcoin, regardless of their economic status or geographic location. Anyone that can make an online transfer can also acquire and own a digital coin of choice.
Advantages of Fiat Money
Governments favor fiat money for the greater flexibility it provides, which allows them to set monetary policy and stabilize global markets. Today, fiat money gives politicians economic power that previous governments could only have dreamed of.
Using fiat money also allows governments to dampen the worst effects of recessions that 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, which gives them the power to implement controls such as quantitative easing and stimulus payments that inject money back into the economy.
Fiat money also has the advantage of being broadly accepted by businesses. Although acceptance of cryptocurrency has grown in recent years, many people would be hard pressed to be able to buy real-world goods like groceries with Bitcoin.