At its core, money represents value. If I do some work for you, you give me money in exchange for the value I gave you. I can then use that money to get something of value from someone else in the future. Throughout history, value has taken many forms and people used a lot of different materials to represent money. Salt, wheat, shells and of course gold have all been used as a medium of exchange.
However, in order for something to represent value, people have to trust that it is indeed valuable and will stay valuable long enough for them to redeem that value in the future.
Up until a hundred years ago or so we always trusted in someTHING to represent money. However something happened along the way and we’ve changed our trust model from trusting someTHING to trust in someONE.
Over time, people found it too cumbersome to walk around the world carrying bars of gold or other forms of money, so paper money was invented. Here’s how it worked: a bank or government would offer to take possession of your bar of gold; let’s say worth CHF 1000, and in return, that bank would give you receipt certificates, which we call bills, amounting to CHF 1000.
Not only were these pieces of paper much easier to carry, but you could spend a dollar on a cup of coffee and not have to cut your gold bar into a thousand pieces. And if you wanted your gold back, you simply took CHF 1000 in bills back to the bank to redeem them for the actual form of money, in this case that gold bar, whenever you needed…
And so, paper began its use as money as an instrument of practicality and convenience. However as time progressed, and due to macroeconomic changes, this bond between the paper receipt and the gold it stands for was broken.
Now, to explain the path that led us away from the gold standard is extremely complex, but suffice to say that governments told their people that the government itself would be liable for the value of that paper money.
Basically we all said “let’s just forget about gold and trade paper instead”. So people continued to trade with receipts that are backed by nothing but the government’s promise. And why did it continue to work? Well, because of trust. Even though there is no actual commodity backing paper money, people trusted the government and that’s how fiat money was created.
Fiat is a Latin word that means “by decree”. Meaning the Swiss Francs, or euros or any other currency for that matter have value because the government orders it to. It’s what is known as “legal tender” – coins or banknotes that must be accepted if offered as payment.
So the value of today’s money actually comes from a legal status given to it by a central authority, in this case, the government. And so the trust model has changed, from trusting someTHING to trusting someONE (in this case, the government).
Fiat money has two main drawbacks:
- It is centralized – You have a central authority that controls and issues it. In this case the government or central bank.
- It is not limited by quantity – The government or central bank can print as much as they want whenever needed and inflate the money supply on the market. The problem with printing money is that because you’re flooding the market with more money the value of each dollar drops, so your own money is worth less. When you see prices rising throughout the years it’s not necessarily that prices are rising as much as that the purchasing power of your money is dropping. You need more dollars to buy something that used to “cost less”.