A brief definition is in order before proceeding further:
- a formal authorization or proposition; a decree
- an arbitrary order
Origin: late Middle English: from Latin, ‘let it be done’, from fieri “be done or made.’
Fiat currency derives its value from the authority of the body that issues it to be legal tender. It does not have any significant intrinsic value like commodity money (ex: gold coins) or representative money (ex: money with a stated exchange rate to gold coins).
Early Forms of Fiat Currency
As discussed in The History of Money – Part IV, Representative Money is money that can be converted on demand to something with intrinsic value such as a precious metal like gold or silver. The earliest forms of paper currency were often a type of Representative Money and were directly exchangeable for these precious metals. These early currencies, such as the huizi or the jiaozi used during the Song Dynasty in China were often notionally given an exchangeable value in gold, silk, or another precious commodity, however, in practice this conversion did not happen.
Fiat currencies have taken on many forms over history, typically becoming necessary during times of war or economic stress. Items such as tally sticks (originally used to record tax payments) were used in England in the 12th century and playing cards were used in New France (Eastern Canada) in the 17th century.
Throughout the 18th and 19th centuries, fiat currencies existed often at the same time as representative money, with the fiat currencies typically trading at a steep discount to the representative money. At this point in time, governments still widely promised to redeem their currencies directly for some type of underlying precious metal.
The Bretton Woods Agreement
In 1944, delegates from all 44 Allied nations met in Bretton Woods, New Hampshire. There it was decided that currencies would be valued on a regulated system of fixed exchange rates to one another, tied together by the US dollar which would have a direct conversion value to gold. As a result, the US would have to back every dollar sent to another country with physical gold. This conference also created global financial institutions such as the International Monetary Fund (IMF) and the World Bank.
The Bretton Woods system initially worked well in the aftermath of World War II, when the majority of European and Asian powers were rebuilding from the war and required US dollars to purchase US goods. However, from 1950 to 1969, America’s proportion of world economic output decreased from 35% to 27%, as countries like Germany, the UK, and Japan recovered from the war. In addition, the US debt increased from expenditures such as the Vietnam War and social programs. In 1966, the US had $13.2 billion in gold reserves whereas non-US central banks held $14 billion. Countries such as West Germany and Switzerland left the Bretton Woods system in 1971.
As a result, in 1971, US President Richard Nixon cancelled the direct convertibility of the United States dollar into gold. The system of previously fixed exchange rates tied to gold was thus replaced with an international system of fiat currencies with freely floating exchange rates.
Modern fiat currencies are created by a central bank (such as the US Federal Reserve Banking System) by purchasing financial assets (bonds, etc.) from banks or by lending money to banks. The value of a country's currency freely floats on the open market and is impacted by factors such as supply and demand, economic output and prospects, and the belief that the government will be able to continue to guarantee the value of its currency.
At times, fiat currencies have produced hyperinflation, such as was seen to a dramatic extent in Zimbabwe. Inflation and its effects will be the subject of a future article.