How Does Fiat Money Work?

When it comes to transactions of value, fiat money is the norm in today’s world. But it was not always like this. In fact, humanity’s collective transition to fiat money happened relatively recently.

Why was fiat money not the norm in the past? And why is it the norm today? To begin answering these questions, one needs to understand how fiat money works, and how it historically came to be.

In this essay, I will try to construct a story-based beginner’s framework for the notion of fiat money. But before I proceed, let me quote Investopedia’s definition of fiat money:

“Fiat money is a government-issued currency that is not backed by a commodity such as gold.”

— Investopedia

If that is all there is to fiat money, why should I bother writing an essay about it? Well, as often is the case with abstract concepts, the simplicity of fiat money turns out to be surprisingly deceptive. In short, there is more than what meets the eye here.

We will eventually uncover what is hiding underneath. But for now, let us begin with a fundamental underlying concept.

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The Notion of Barter

When two or more parties exchange goods or services, we call the act “barter”. The notion of barter existed long before the notion of money. I would even argue that barter emerges naturally in other animal species that live in social groups as well.

Let us say that there existed a caveman ‘A’ who gathered berries and wanted some meat. It just happened to be that he lived not far away from a cavewoman ‘B’ who was a hunter. And guess what? She loved berries.

In this scenario, it turned out to be a straightforward barter: A and B agreed on a specific quantity of meat in exchange for a specific quantity of berries. This is how things went on for a long time.

However, as all good things eventually come to an end, so did this relationship between A and B. One day, B decided that she was not into berries anymore.

The Downside of Barter

“I am not into berries anymore. I would like to try some cheese.”, said B to A. The caveman was devastated to hear this. How he wished that cheese grew on plants, but berries were all he had to offer unfortunately.

Luckily for B, there lived a cavewoman named ‘C’ nearby who raised a bunch of goats and had goat-cheese to offer. But at the same time, B being the kind person she was, did not want A to go out of business.

So, she asked C if she was interested in berries. When C revealed that she would like to barter cheese in exchange for berries, B structured the deal such that C got berries from A and A got cheese from C. Then, A gave the cheese to B and B gave her meat to A.

If you feel that this deal-structure is confusing, I am with you. This is indeed unnecessarily complicated and inefficient. Furthermore, what if C did not want any berries? We would have a big problem on our hands. If only there existed a more neutral store of value that all parties could use to trade goods with each other.

The Notion of Token Money

We now fast-forward to the fictional kingdom of Goldland, where the townsfolk solved this problem rather efficiently. As you might have guessed, these folks used gold coins to buy and sell goods.

This was significantly more efficient. There was one problem, however. The richest man in town wanted to buy a huge property. In order to pay for the property, he would need 1000 crates of gold coins. This would have been very expensive to organize.

To mitigate the effort-cost, he gave the seller 1000 custom-made bronze coins with his signature imprinted on them. He told the seller that each of these coins would amount to 1 crate of gold coins that the seller could collect at any time at the rich man’s castle.

I would like to pause the story here to explain something interesting. The notion of buying and selling using gold coins is known as commodity money. It is a form of token money. Another form of token money is representative money, where the token represents a certain quantity of some commodity (like how each bronze coin represents 1 crate of gold coins).

As we have travelled the time of cave folk to townsfolk, we have seen the efficiency of monetary transactions (and trade) increase from plain barter to transactions involving representative money. But can transactions get even more efficient? Let us continue the story to find out.

The Birth of Fiat Money

A few days after the richest man in town completed this unique transaction, King Goldard-IV came to know of this. With the counsel of his advisor, he wanted to improve the system even more. The wise counsellor came up with the following idea:

“Sire, what if we replaced coins altogether with small slices of printed wood to facilitate financial transactions?”

To this, King Goldard-IV replied:

“That is an excellent suggestion, counsellor. But how can we ensure that each slice of printed wood has value? Our folk may choose to not use the printed slices of wood for their transactions, after all.”

The clever counsellor took his time to think deeply about his King’s worry. After what felt like an eternity, he responded:

“That is easy, my Sire! The slices of wood shall not have any intrinsic value themselves. But as the King, you may hang any folk in our country who does not use these slices for trade.”

And thus, fiat money was born!*

How Does Fiat Money Work?

The word “fiat” comes from Latin, and translates roughly to “let it be done”, in the context of an order or decree from an authority such as a King or a government.

Fast forward to the present, fiat money is slowly transitioning from thin slices of wood to binary digits stored in solid state drives and processed by computers. But the underlying principle has not changed.

In the developed world, money (be it paper or digits) theoretically does not have any (intrinsic) value by itself. Its value is agreed upon by buyers and sellers in the market. In complex market systems, this value emerges naturally from market equilibrium — the market of buyers and sellers functions like an organism.

In case the market equilibrium breaks, the government or a similar authority (like the central bank) steps in and tries to stabilize the market artificially. These strategies and their consequences can be surprisingly very complex.

I would be happy to dive into the more complex topics (including the questions I posed in the introduction) in a later essay. But for now, I hope you found this beginner’s introduction to fiat money worthwhile. Thank you for reading!

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*Update Post Publishing: 

My intention here is not to convey that the use of fiat money is enforced by fear, but to point out that there is an enforcing function.

If you think about it, trust and fear are two sides of the same coin. If I give you a few notes in exchange for goods today, how will you know for certain that these notes will be accepted by someone else?

That is where trust in a central authority comes in. Sure, you trust me and others around you to do financial transactions with notes. However, your trust increases by the fact that there is an authority who will enforce the use of notes, should anyone choose to back out.

Once again, thanks for reading!

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Further reading that might interest you:

• How To Really Understand Pascal’s Wager?
• How To Really Understand Zero-Knowledge Proof?
• How To Benefit From Computer Science In Real Life?

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