There are many reasons why countries are opting for fiat money these days, but the primary one is that there is no limitation on putting a certain amount of money into circulation. By definition, fiat currency is not backed by any physical commodity (such as oil or gold), but it is nevertheless declared by the relevant government body as legal tender. This, in essence, allows governments to control the amount of currency in circulation.
One of the most important factors about fiat money is that it is not backed by any physical asset for example gold. When a currency is backed by gold, the government can only circulate an amount of money equal to the value of its gold holdings. This amount can change annually.
If we look at the United States of America, the connection between currency and gold has not always shown a complete correlation. There was a time in history when the country was on a 40% gold standard, which meant that only 40% of the money supply it had was backed by gold. The USA has also experimented with a bimetallic standard - this means that both gold and silver were used to back the currency in circulation.
When a country backs its currency by a physical commodity, it forces them to control the amount of currency in circulation. This limits the amount of money that the government can spend.
In using a fiat monetary system, a goverment body is allowed and able to circulate as much currency as they want. Fiat money helps the governments to spend as much money as they see fit and the excessive amount is added to national debt.
Is Fiat Really Faulty?
The problem with a fiat money system is that governments do spend money without restriction. Over time, more and more currency is printed, and the value of the currency currently in circulation is constantly diluted. This is called inflation. For example, since 2000 the Consumer Price Index (CPI) in the United States has increased 50%. This means that in 2018 you would need $30,000 to purchase goods that would have only cost $20,000 in the year 2000. This is not a good scenario for money left in a savings account at a bank.
This erosion effect is what inevitably happens when a nation uses a fiat currency. The slow drip-drip-drip of currency dilution eventually forces prices up, because leaders eventually succumb to the temptation to create more and more currency to solve their financial problems. Over time, almost all fiat currency scenarios fail.
No matter how much cash you save, your purchasing power will decrease over time. The decrease in purchasing power could be slow or quick over the years but if you look at your savings on a long-term basis, your purchasing power will decrease.
A Dangerous Trajectory in History
If you look at the long-term performance of gold versus fiat currency you would get to know that the gold’s performance is much better as compared to its competitor. This makes it quite clear that if you are using fiat currency your purchasing power will decrease over time. For one of the first times in history, almost all currencies are fiat currencies. There isn’t any standard commodity backing up currencies around the globe, and the impact of fiat currency will be quite clear in the coming years.