Hard Money Diploma · Module 3: What Is Fiat Money?

3.0 Introduction

We saw in the previous module how money evolved over time and how our monetary system transitioned from sound to unsound money, shaping the world we live in today. This module dives deeper into how these developments led to today's fiat system and how that fiat system works.

So how did the fiat system we use today come into existence?

To understand it, we need to look at the US dollar. Today, the dollar serves as the world's main reserve currency, meaning many countries rely on it for trade, savings, and financial stability. Because of this, decisions about the US dollar affect economies all around the world.

3.1 Brief History of Fiat Money

In the 19th century, many societies used a sound money system based on precious metals. As trade increased, carrying large amounts of metal became inconvenient, so banks began storing gold and issuing paper certificates representing the exact amount deposited.

Over time, banks started issuing more paper certificates than the gold they actually held. This practice, known as fractional reserve banking, created the risk of bank runs. To stabilize the banking system, governments became more involved. In 1913, the United States created the Federal Reserve, a central bank that could issue new money and support struggling banks.

During the 1930s, the U.S. government also required citizens to surrender their gold in exchange for paper dollars. Soon after, the government reduced the dollar's value relative to gold, which decreased the purchasing power of people's savings.

After World War II, the Bretton Woods system linked global currencies to the U.S. dollar, and the dollar could still be exchanged for gold. This system ended in 1971, when the United States stopped allowing dollars to be redeemed for gold. Since then, most countries use fiat money.

3.2 The Fiat System

A Monetary System by Decree

The fiat system is characterized by its mandatory nature, imposed on people through legal tender laws. The Latin term fiat means "by decree." Unlike money backed by tangible assets such as gold, fiat derives its value from its enforced monopolistic position and the public's trust in the system. In that sense, fiat money is comparable to a concert ticket: its value lies not in the paper itself, but in the assurance that the band (the government and central bank) will deliver a great show (economic stability).

Pros of Fiat Money

Cons of Fiat Money

In the fiat system, it is more like having Monopoly money: paper issued by the central bank, its value influenced by government policy. The government and central banks act like the "bankers" of the Monopoly game.

3.2 The Fiat System (continued)

A System Fueled by Debt

Fractional reserve banking means banks are legally allowed to lend out a significant portion of their clients' deposits, so at any given time the bank actually holds only a tiny percentage of the money clients think they have deposited.

Banks generate revenue in many ways

Example: banks borrow from depositors at 5%, lend it to borrowers at 9%, and keep the 4% spread as profit.

The Imaginary Bikes

Imagine you lend your bike to a banker. Instead of just using it, the banker promises the same bike to many other people at once. Each believes they can use it whenever they want, but in reality there is still only one bike; the rest are just promises. At first this seems fine, since not everyone wants the bike at the same time. But one day everyone shows up wanting to ride, and the problem becomes clear: there is only one real bike. Most people cannot get what they were promised. This is a bank run.

Activity: Fractional Reserve Banking

A class exercise exploring individual actions by people and banks using fractional reserve banking, to experience firsthand how this tool increases the money supply.

3.2 The Fiat System (continued)

Who Controls the Fiat System?

The Government: funded by tax collection and new debt (bonds) issued by the Treasury; when bond demand runs short, the central bank buys the remainder. Government debt is a promise to tax the people more in the future.

Wealthy Individuals: their savings are mostly held in assets, so their purchasing power can rise as the currency loses value, and they can use appreciating assets as collateral for cheap debt.

Financial Sector (banks): do not directly control the fiat system but benefit from it, since the central bank will bail them out to prevent collapse, which incentivizes riskier lending.

Too Big To Fail

Financial institutions so large and interconnected that their failure would have catastrophic effects on the entire system. During the 2008 financial crisis, the failure of Lehman Brothers set off a domino effect that nearly collapsed AIG and caused a massive stock market drop; the U.S. government intervened with bailouts. This was later codified in Basel III (2011) with the creation of the G-SIBs (Global Systemically Important Banks).

3.3 Central Bank Digital Currencies

Central Bank Digital Currencies (CBDCs) are the next step of fiat currencies: fully digital forms of fiat currency issued by governments and controlled by central banks, with no physical bills or coins.

What sets CBDCs apart is the heightened level of control and monitoring they offer to governments and central banks, giving authorities unprecedented visibility into financial transactions. Governments and central banks can more readily adjust the form and supply of CBDCs, manipulate interest rates, and deploy monetary and fiscal policy tools with greater precision.

While CBDCs seem to be the future of fiat money, the world's current monetary system already operates on a pure fiat standard, no longer tied to gold, resulting in a significant expansion of the monetary supply without any real restriction.

Wrap-Up and Check for Understanding