Fiat currency is money issued and backed by a government. Fiat currency valuation is based largely on the stability of the issuing government rather than a physical commodity such as gold, silver, or agricultural products. Because fiat money lacks intrinsic value, its worth is dependent upon supply and demand.
When was fiat currency first introduced?
The first known use of fiat currency was in China during the Song dynasty. In 1024, the government decided to abandon the use of bronze or brass coins in favor of paper currency issued by a government currency bureau. The system used fixed denominations and circulation was limited to just two years, after which time the paper bills were no longer valid. Chinese officials quickly realized that the only sustainable way to maintain the value of the government-backed currency was to require all tax payments to be made using fiat money.
In Europe, fiat currency was printed by the Spanish between 1482 and 1492, and Sweden started printing government-backed paper money in 1661. By 1776, Swedish fiat money was virtually worthless, triggering a return to the silver standard. Later examples of fiat currency include the “greenbacks“ issued during the American Civil War and the paper marks printed in Germany during the 1920s.
The United States adopted a true fiat currency system under President Nixon in 1971, when the U.S. dollar was fully decoupled from the gold standard after the process was started back in 1933. The British pound, which was originally backed by one troy pound of sterling silver, was decoupled in 1931.
The risks of fiat money
Because fiat money isn’t linked to actual physical commodities such as precious metals, the valuation of fiat currency is vulnerable to dramatic fluctuations. Political instability and poor economic performance can weaken the value of fiat currency, leading to devaluation. In extreme circumstances, fiat currency can be devalued to the point where it becomes worthless, triggering a catastrophic economic collapse in the issuing country.
Fiat currency failures
Throughout history there have been a number of major fiat money failures, and these failures have usually lead to widespread hyperinflation, instability and social unrest.
As Latin America’s third-largest economy based largely on oil exports, Argentina was in a relatively good financial position up until the 1970s OPEC oil embargo. This set of a period of civil and political unrest, trade deficits and economic downturn, and the government responded by printing fiat currency, triggering hyperinflation, a military coup, and a dramatic drop in the nation’s GDP.
The German mark
In the 1920s, Germany’s fiat currency dropped dramatically due to rampant unemployment, government instability, and massive war debts from WWI. Germany began expropriating commodities from domestic producers to repay the Allies while the German government continued printing paper money. These internal and external economic pressures triggered a period of hyperinflation. In the first quarter of 1922, 160 German marks were worth one U.S. dollar. By Q4 of 1923, it took 4,200,000,000,000 German marks to purchase a single U.S. dollar.
Banknotes that were once valuable became virtually worthless overnight. Prices for basic staples such as bread skyrocketed. The post-war depression only stabilized in 1924 when a newly-formed coalition government introduced a new, temporary currency known as the Rentenmark (later re-named the Reichsmark), the value of which was backed by gold.
The Zimbabwean dollar is another example of a catastrophic fiat currency failure. First introduced in 1980 when the former British colony of Southern Rhodesia gained its independence, Zimbabwean currency was initially valued higher than the U.S. dollar due to strong economic growth fueled by agricultural commodities such as wheat and tobacco. A series of government programs launched in the early 1990s disrupted domestic food production, leading to the subsequent collapse of the banking sector, mass unemployment, and economic sanctions imposed by foreign governments.
The African nation was thrust into hyperinflation, surging to a rate of 231,000,000% by Q4 of 2008, when one U.S. dollar was worth about $2,621,984,228 Zimbabwean dollars. As a result, 8 out of 10 Zimbabweans became severely impoverished, and nearly half suffered chronic malnutrition. The government was forced to allow the use of the South African rand and U.S. dollars as the Zimbabwean dollar became worthless.
By 2009, the Zimbabwean government stopped printing money altogether and endorsed the use of foreign currencies, mostly the U.S. dollar. The country is once again suffering hyperinflation following the re-introduction of a new Zimbabwean fiat currency, and by April 2020, the annual inflation rate in Zimbabwe reached 765.6%, up from 676.4% in March, and 230.54% in July, 2019.
The Venezuelan Bolivar
One of the most recent cases of fiat currency failure occurred in Venezuela during the mid-2010s, peaking in 2018 when the national inflation rate reached a staggering 80,000%.
The collapse of the Venezuelan bolivar began in 2010 when then-President Hugo Chavez took steps to try reducing shortages of consumer goods and raw materials throughout the country. Fueled by political unrest and the fall of oil prices in 2015, at a time when over 90% of Venezuela’s export earnings came from oil, the valuation of Venezuelan currency was further devalued when the government flooded the market with trillions of bolivars.
Printing more money simply meant there was more money circulating in the country, setting the stage for hyperinflation. By 2018, the value of the bolivar had created a demand for U.S. dollars, which were seen as the safe option. At that time, it took about 250,000 bolivares to by one U.S. dollar.