What Is Fiat Money?

Late in the 1200s, a Venetian traveler named Marco Polo described something in the capital of Kublai Khan that he expected his readers in Europe would not believe. The Khan's mint did not strike coins from metal. It took the inner bark of mulberry trees, pressed it into black sheets like paper, cut the sheets to size, and stamped them with the royal seal in red ink. Those pieces of paper were the money of the empire.

Polo was struck by two things. The first was how the paper was enforced: "nobody, however important he may think himself, dares to refuse them on pain of death." The second was how much of it there was. The Khan, he wrote, had made "such a vast quantity of this money, which costs him nothing, that it must equal in amount all the treasure in the world." You might say, Polo added, that the Khan "hath the Secret of Alchemy in perfection."¹

Polo was describing fiat money, more than seven centuries before the dollar in your wallet became the same kind of thing.

Money by Decree

Fiat is Latin for "let it be done." Fiat money is money because an authority declares that it is, not because it is made of something valuable or can be exchanged for something valuable. Its value depends on people accepting it, and on trust that the people issuing it will not make too much.

It helps to compare it with the two other kinds of money people have used. Commodity money is valuable in itself: a gold coin is worth its weight in gold whether or not any government stands behind it. Representative money is a claim on a commodity: a paper note that the issuer promises to swap for a fixed amount of gold or silver on demand. For most of its history the U.S. dollar was one of these two kinds. Since 1971, when the dollar's last link to gold was cut, it has been fiat, and so has every other major currency in the world.

Why Anyone Accepts It

Nobody is threatened with death for refusing dollars. Part of their standing comes from law. Federal law makes United States coins and currency "legal tender for all debts, public charges, taxes, and dues."² That makes dollars a valid offer of payment for any debt owed in dollars. It is less sweeping than many people think: the Federal Reserve points out that there is no federal law requiring a store to accept cash for a purchase.²

Most of the force is practical. Your taxes must be paid in dollars. Your mortgage, your car loan, and your paycheck are written in dollars. Everyone you trade with uses them, so you use them too. And underneath all of that sits a quieter kind of trust: that the dollar you are paid this year will still buy roughly what it buys today. Fiat money's value rests, in the end, on a promise of restraint.

Where New Dollars Come From

Very little fiat money is paper. Most of it exists as numbers in bank accounts, and most of those numbers are created when banks make loans. In 2014 the Bank of England, Britain's central bank, put it plainly: "the majority of money in the modern economy is created by commercial banks making loans."³ When a bank approves your mortgage, it does not hand you someone else's savings. It credits your account with new money.

Above the banks sits the central bank, the Federal Reserve in the United States. It sets the interest rates that make borrowing cheaper or dearer, and in an emergency it can create money directly by buying bonds, as it did on a vast scale in 2020. Who receives that new money first, and who pays for it later, is the subject of the Cantillon Effect. What matters here is the design: there is no fixed limit on how much fiat money can exist. The limit is a policy, set by people.

The Case For, Fairly

Most economists see that flexibility as fiat money's great strength. In a financial panic, when people rush to pull their money out of banks, a central bank can supply as much money as it takes to keep banks open and credit flowing. A money tied to a fixed amount of gold cannot do that. Economists Barry Eichengreen and Jeffrey Sachs found that in the 1930s, the countries that devalued their currencies against gold were helped by it, and they tended to recover from the Great Depression sooner than those that held on.⁴ On this view, fiat money is not a flaw but a tool, and a modern economy would be more fragile without it.

The Case Against, Fairly

The same flexibility is the risk. A tool with no limit is only as safe as the people holding it, and history is full of issuers who could not resist using it. The United States learned that before it was even a country. The Continental Congress paid for the Revolutionary War largely by printing paper money with no gold or silver behind it, and by the end of 1779 the Continental dollar had fallen to below one-eighth of its original value, with further to fall.⁵ Americans have said "not worth a Continental" ever since.

Most fiat money fails more quietly than that. It does not collapse; it simply buys a little less each year, a cost that falls hardest on savers and wage earners. The dollar's own record since 1913 is the subject of why everything costs more.

Whose Inscription

"Show me the coin for the tax." And they brought him a denarius. And Jesus said to them, "Whose likeness and inscription is this?" They said, "Caesar's." Then he said to them, "Therefore render to Caesar the things that are Caesar's, and to God the things that are God's."

Matthew 22:19-21

Jesus was not giving a lecture on monetary policy, and the passage should not be stretched into one. But it notices something true about money that bears a ruler's image: it is the ruler's instrument. A fiat currency carries its issuer's inscription in a deeper sense than a portrait on a coin. How much of it exists, and how fast more is made, is the issuer's decision, and everyone who holds it lives with that decision.

Where Bitcoin Fits

Bitcoin does not fit neatly into either old category. It is not fiat: no government declares it money, and nobody is required to accept it. It is not a commodity in the usual sense either, since a bitcoin has no use as a metal or a crop. It shares one thing with fiat money: nothing physical stands behind it, which is why critics say it is "backed by nothing," a charge Lesson 8 of the course takes up directly.

The difference is who decides the supply. Fiat money's supply is set by a central bank and the lending decisions of commercial banks. Bitcoin's supply is set by public rules that run the same for everyone, with a hard limit of 21 million, and no authority that can issue more by decree. Whether that makes it better money is a question people are still arguing about. How the dollar went from gold coin to pure fiat, and what that has meant for the people who save in it, is the story the free first lesson tells.