What is fiat money? How does it come into existence, and what are some of its fundamental pitfalls in practice? In basic terms, fiat money refers to a system of currency that is not a commodity, nor can it be exchanged for a commodity to the government; that is, the currency in itself does not posses any sort of significant value independent of its use as a medium of exchange, or a currency. Gold, for example, is a commodity, because in and of itself it is a desirable and valued material; whereas government-issued paper bills are considered fiat money because their sole purpose is as a medium of exchange.

It is important to first consider that introduction by government of a fiat money currency system out of nothing is impractical for a number of reasons. Rather, the need for and subsequent implementation of a money economy comes about naturally as society discovers the quandries associated with the default system of direct exchange, commonly referred to as a barter system.

Such a system is unlikely to be sustainable due to its fundamental limitations; if, for example, you were seeking a pair of shoes, and among your possessions, you have an item of similar value which you are willing to trade–a skateboard, for the sake of example–you would be faced with the unlikely task of locating someone who not only has the shoes you are seeking, but who also wants your skateboard; effectively, you are a shoes-wanting skateboard-haver seeking a skateboard-having shoes-wanter.

This dilemma alone is enough to justify some means of indirect exchange, but there are further ramifications of a barter economy that are worth exploring. Referencing the previous example, suppose you still desire the same pair of shoes, but you do not possess anything of reasonably similar value that you are willing to trade to facilitate a transaction. You may have something more valuable–a house, let’s say–but this would do no good in attempting to trade for a far less valuable item. A house is not divisible; you cannot trade a tiny fraction of your house equivalent in value to the pair of shoes you wish to obtain. What, then, are you to do?

This is where the need for a medium of exchange comes in. The process begins with a commodity, such as gold, that has intrinsic value. The desirability of such a commodity enables it to be of far broader value than, say, the skateboard in the above example. When society transitions from a barter economy to use of a commodity as a medium of exchange, government inevitably becomes involved as the distributor and certifier of the commodity.

In an economy in which a specific commodity is accepted as a medium of exchange, it therefore has an established value in terms of its purchasing power. Without this crucial step in the evolution of exchange, a subsequent implementation of a fiat currency–valueless but for its very existence as money–would have to be based on arbitrary values, rather than having numerical values corresponding to a commodity.

Upon the election of Franklin D. Roosevelt as President of the United States in 1933, the gold standard in America was abandoned entirely in favor of an economy based on a fiat currency. Under the new system, the fiat money could no longer be exchanged for a fixed amount of gold as it previously could.

A fiat money system poses a number of disadvantages that are worth considering. First, a fiat currency, having no use value unlike commodity money, has the potential of falling all the way to zero in value with inflation. For this reason, it is very difficult to save for the future in a fiat money economy, because the money is destined to go down in value as the government produces more of it. Due to the constant inflation of paper money, people are encouraged to consume rather than save; for saving a given amount of money for ten years would see its value diminish greatly compared to the purchasing power it posseses at present.

Moreover, the ability of the Federal Reserve to legally create money out of thin air–something that could not be done with a commodity like gold–grants the government excessive purchasing power in the private sector.🔹