In this article, we will explore the key differences, including how they are created, their uses, and their underlying technologies. By understanding these differences, you can better understand the pros and cons of each type of currency and make informed decisions about the role crypto can play in your portfolio.
A Brief History of Money
Before we explore what fiat currency is and how it works, it’ll be helpful to see what came before fiat, how it was used, and why economists and politicians decided that fiat currency was a superior alternative.
Before the invention of money, we bartered for trade. In a barter system, people negotiate directly with each other to determine the value of the goods or services they are trading. For example, if a fruit farmer has too much produce, he may offer to exchange it for a carpenter’s help to build a new barn.
Barter works, but it has many limitations. What happens when the farmer has excess produce to pay the carpenter, but the carpenter is busy? Either the farmer finds someone else to trade with, or the fruit rots. This is a specific example of a general problem with barter called the lack of double coincidence of wants. Two people in the same place rarely have wants that result in a timely and satisfactory trade.
Other limitations of barter include the lack of a common measure of value—it’s challenging to decide on a fair exchange value for different goods. Then there’s the lack of deferred payments—loans and credit arrangements are tough to coordinate. Plus, there’s no store of value—the farmer’s wealth is locked into his fruit, which will quickly rot. He can’t put a little fruit aside every season to buy some land and build a barn when he has saved enough.
As you might have guessed, physical money solved all of these problems. The early history of currency is complex, but most parts of the world eventually settled on commodity money. Commodity money uses coins or other objects made of precious metals like gold and silver. The coins have an intrinsic value equivalent to the substance they are made from.
If our farmer sells his excess fruit for gold coins, he can pay the carpenter to build a barn when the carpenter has the time; he doesn’t have to worry about his fruit going rotten because he has exchanged it for a durable store of value. He can put a few coins aside each season to save for his barn. He might even be able to borrow some gold coins to build his barn today and pay the lender back with a bit of interest.
However, commodity money isn’t perfect as a currency. For a start, it’s not easily divisible. A gold coin might get you 100 lbs of wheat, but what if you only want to buy 5 lbs? You can’t hand over 5% of a coin. Volatility is also an issue: the prices of precious metals rise and fall with supply and demand. In the 16th century, Spain suffered damaging inflation because gold imported from the New World radically increased gold supplies.
Another limitation is that governments and central banks can’t create money at will to deal with economic problems; they can’t magic gold out of thin air. Slow growth in the money supply can restrict an economy’s ability to grow.
The next major currency advance was commodity-backed money. In a commodity-backed money system, the commodity is not directly traded. Instead, individuals use money that can be exchanged for a commodity. For example, the farmer might sell his fruit for a bundle of notes, each of which he can redeem for a certain amount of gold. Commodity-backed money solves the divisibility problem because central banks can issue coins and notes of any value.
The gold standard, used by the U.S., Britain, and many other countries until the early 20th century, was a commodity-backed currency system. The U.S. dollar and the pound sterling could be exchanged for gold held by Fort Knox and the Bank of England. Economists thought the gold standard was the best way to manage a currency because it prevented governments from attempting excessive economic intervention. They could not, for example, print money on a whim and thereby cause excess inflation. The gold standard also allowed countries to settle trade balances with gold.
The First World War disrupted international trade and the gold standard, although it was still officially in place throughout subsequent financial crises and government revaluations. It was the Second World War that put an end to the gold standard as it had been for many centuries. Following the Bretton Woods agreement in 1944, the U.S. dollar was pegged to the value of gold, and many other currencies were pegged to the value of the dollar.
The Bretton Woods monetary system lasted until the early 1970s when countries worldwide became less interested in cooperating to maintain the dollar’s value. Britain and other countries tried to make good on the convertibility of their dollar assets into gold. After 1976, the ability to exchange dollars for gold was removed, and the era of commodity-backed currencies ended. From then on, most major currencies became fiat currencies, including the U.S. dollar, the euro, and the Japanese yen.
What is Fiat Money?
Fiat money is issued and backed by a government, but not by a physical commodity. The value of fiat money derives from the relationship between supply and demand and the stability of the issuing government. Fiat money is used as a medium of exchange in transactions. Individuals and businesses accept it as a means of payment because it is issued by the government and is legal tender.
Commodity-backed money gave monetary systems a degree of independence from centralized control. Governments and central banks controlled the reserve but could not manufacture new reserves at will. Fiat currencies, in contrast, are wholly under the control of governments and central banks, which can make as much new money as they see fit.
That’s why fiat currencies are described as centralized. Centralization refers to the fact that a central authority, such as a government or central bank, has the sole power to issue and regulate the supply of currency. This central authority is responsible for setting monetary policy and deciding how much currency to produce and distribute via the financial system.
The Pros and Cons of Fiat Currencies
Fiat currencies offer several advantages compared to commodity currencies.
The central bank can influence the supply of money. By manipulating the money supply, central banks try to keep inflation within acceptable levels and maintain price stability.
Fiat currency economies are less prone to boom and bust cycles because the government can attempt to control credit supply, interest rates, money velocity, liquidity, and other factors.
Fiat currencies are cost-effective: it costs almost nothing to create fiat money because it’s typically just a number in a bank account. Commodity money and commodity-backed currencies are significantly more expensive to manage (that is, fiat currencies offer better seigniorage).
As you can see, many of these advantages are directly related to fiat currencies being under centralized control. However, from the perspective of many in the cryptocurrency and web3 communities, centralization is also fiat currency’s major weakness.
Centralization gives governments and central banks total control over monetary policy. If monetary policy is ineffective or misguided, there can be significant economic damage, including inflation that destroys the value of citizens’ savings.
Fiat’s value depends entirely on confidence in the issuing government. If that confidence is eroded, so is the value of fiat money.
There is little privacy or confidentiality in a centralized monetary system. Banks and government agencies can track every transaction.
These disadvantages of fiat currency inspired the creation of cryptocurrency, which aims to retain many of the advantages of fiat currency without the requirement of centralized control.
How are Cryptocurrencies Different?
Cryptocurrencies have some of the same qualities as commodity money and fiat money. There are different cryptocurrencies with varying purposes, but many can be used as a medium of exchange—you can buy things with them. They are also used as a store of value in the same way as traditional currencies and assets like gold. They can be used to transfer value from one individual or organization to another, including cross-border transactions.
However, in spite of the similarities with fiat currencies, most cryptocurrencies are not centrally controlled. Instead, they are based on a blockchain distributed across a peer-to-peer network. A blockchain is a ledger—a type of database—shared across many different computers. No single computer, person, or organization has control over a decentralized cryptocurrency, which helps them overcome the fiat disadvantages we outlined in the previous section.
We wrote in more depth about how cryptocurrencies work in What is Cryptocurrency? Understanding Cryptocurrencies and How They Work. If you’re interested in a deeper dive into blockchains, take a look at What is a Blockchain and How Does It Work?
Before we move on to the benefits of cryptocurrencies, it’s worth mentioning that although we’re focused on decentralized currencies like Bitcoin and Ether in this article, there are centralized cryptocurrencies and cryptocurrencies that centralize some features.
Why Choose Decentralized Cryptocurrencies?
Cryptocurrencies are flexible, decentralized digital money. That lack of centralization brings many benefits.
A single authority or organization does not control cryptocurrencies, giving users control over their financial transactions and making the system more resistant to censorship and interference.
Cryptocurrencies use cryptographic technology to secure transactions and protect against fraud and tampering.
Cryptocurrency transaction fees are often lower than traditional bank fees, particularly for international transactions.
Cryptocurrencies are based on a public ledger, which records all transactions and makes them transparent to all users.
Despite the transparency of distributed blockchain technology, cryptocurrencies promote privacy because the ownership of coins and tokens is linked to cryptographic keys, not personal names and addresses.
Cryptocurrencies offer faster transaction speeds than fiat currencies.
How To Exchange Fiat Money for Cryptocurrencies
If you’re new to cryptocurrency, getting started can seem a little daunting. However, cryptocurrency exchanges like Bittrex make creating an account and buying cryptocurrency with U.S. dollars straightforward.
Complete your profile.
Verify your identity. Identity verification protects our platform and users from fraud and ensures that we comply with Know-Your-Customer (KYC) regulations.
Deposit funds. You can deposit dollars via a wire transfer or cryptocurrency from your wallet.
Now you’re ready to buy leading cryptocurrencies. The quickest way to get started is with our Instant Buy & Sell feature, or you can visit our list of cryptocurrency trading pairs to access the full power of the Bittrex platform.
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