Fiat Money, what it is, and how to make it work for you.

Over the next few paragraphs, I will attempt to dive into the fascinating world of money and explore a concept known as "fiat money." A concept that I’ve found out through various encounters with my peers, is not well understood. Hence the inspiration for this blog!

Have you ever wondered why a piece of paper or a digital number on a screen holds so much value?

Well, that's exactly what I’ll be exploring today. Over the next few minutes, I hope you will have a clear understanding of what fiat money is and how it functions in our everyday lives. I will define what it is, explore its role in our economy, review the history of it and finally provide some examples how assets tend to appreciate alongside the money supply (defined as M2 for the purpose of this blog).

Definition and Characteristics of Fiat Money

Fiat money is a type of currency that has value because the government declares it as legal tender. Unlike commodity money, which has intrinsic value based on the material it is made of (like gold or silver), fiat money has value solely because the government mandates it. We the citizens use it willingly because we TRUST that it claims to represent what is written on it. That one dollar is actually worth that one dollar, but it is backed by trust and not an actual peg/commodity/asset.

One crucial characteristic of fiat money is that it is authorized and regulated by a government or central authority. The government establishes laws and regulations that give the currency its validity and ensure its acceptance as a medium of exchange.

Unlike commodity-based money which has inherent value, fiat money does not possess intrinsic worth. Its value is derived from the trust and confidence people have in the government that issues it and the belief that others will accept it in exchange for goods and services.

The Role of Fiat Money in Modern Economies

I discussed a few of the principles of money recently in my blog about Bitcoin, but I will briefly rehash some of those concepts. For money to be used it has to have three general properties:

Medium of Exchange: Fiat money serves as a widely accepted medium of exchange for goods and services in an economy. It facilitates transactions and eliminates the need for barter (trading my sack of potatoes for your cow), making trade and commerce more efficient.

Unit of Account: Fiat money provides a standardized unit of measurement for pricing goods and services. It allows for easy comparison of the value of different products and helps establish a common language of commerce.

Store of Value: While fiat money lacks intrinsic value, it functions as a store of value in the sense that people can hold and save it for future use. However, its value may be subject to inflation (to be covered in the next blog) or other economic factors.

Examples and Types of Fiat Money

Most modern currencies, such as the US dollar, Euro, or Japanese yen, are examples of fiat money. They are issued and regulated by their respective governments and are widely accepted within their jurisdictions.

Digital Currencies: With the rise of technology, digital currencies like Bitcoin have emerged. While not backed by a central authority, they also function as a form of fiat money as their value is based on people's trust and acceptance.

Remember, fiat money gains its value through government regulation and the trust and confidence of individuals. It serves as a medium of exchange, a unit of account, and a store of value. As you continue your journey of financial literacy, understanding the nature of money and how it functions will provide a strong foundation for navigating the world of economics.

A brief history of Fiat Money

Gold Standard Era: In the 19th and early 20th centuries, many countries operated under the gold standard, where the value of their currencies was directly linked to a fixed amount of gold. This system provided stability and confidence in the currency, as it ensured that paper money could be exchanged for gold on demand.

1. Great Depression and World War II: The global economic turmoil caused by the Great Depression and the financial strains of World War II led to a significant strain on the gold standard system. Governments faced difficulties in maintaining the convertibility of their currencies into gold as they printed more money to stimulate their economies and finance war efforts.

2. Bretton Woods Agreement: In 1944, representatives from 44 countries met in Bretton Woods, New Hampshire, to establish a new international monetary system. Under this agreement, the US dollar was chosen as the world's reserve currency, and other currencies were pegged to the US dollar at fixed exchange rates. The US dollar remained convertible to gold at a fixed rate of $35 per ounce.

3. End of the Gold Standard: In the 1960s and early 1970s, the United States faced a growing trade deficit, leading to an excessive outflow of gold reserves. This, coupled with domestic economic challenges, put pressure on the convertibility of the US dollar into gold. In 1971, President Richard Nixon announced the suspension of the dollar's convertibility into gold, effectively ending the gold standard system.

4. Rise of Fiat Money: With the termination of the gold standard, currencies became fully fiat money, deriving their value from government decree and the trust and confidence placed in them by the public. Central banks gained greater control over monetary policy, allowing them to adjust interest rates and money supply to manage inflation, employment, and economic stability.

Over the last 50+ years we have been operating in the world of fiat money which has given rise to a concept called M2.

M2 Money Supply

For the purposes of this blog, we will define the broad money supply as M2. For my real technical readers, let’s define M2 Money Supply.

M2 money supply is a measure of the money stock in an economy. It represents a broader definition of money than M1, which includes only the most liquid forms of money, such as physical currency and demand deposits (checking accounts).

M2 includes all the components of M1 (includes the most liquid portions of the money supply because it contains currency and assets that either are or can be quickly converted to cash ) 1, but it also incorporates additional types of money that are less liquid but still considered part of the money supply. These additional components typically consist of near-money assets that can be easily converted into cash or used as a medium of exchange. Some examples of assets included in M2 are savings deposits, time deposits (certificates of deposit), and money market mutual funds held by individuals.

The inclusion of these additional assets in M2 reflects the fact that they are readily available for spending or can be quickly converted into currency or demand deposits. While they may not be as immediately accessible as physical cash or checking account balances, they are still considered part of the money supply because they can be used to make payments or facilitate economic transactions.

M2 money supply is an important indicator for economists and policymakers as it provides insights into the overall availability of money and liquidity in the economy. Changes in M2 can influence interest rates, inflation, and economic activity. Central banks and monetary authorities often monitor M2 closely when formulating monetary policy to ensure the stability and proper functioning of the financial system.

Let’s see how M2 Money Supply Has Increased over the years.

You can clearly see that since the 1970s, the amount of circulating currency (US) has increased non linearly.

This is from the St Louis division of the Federal Reserve Bank of the United States. More recently since 2020 the money supply has increased a faster pace than years prior.

How does Gold Stack Up Against M2?

With M2 increasing, one may ask, how it affects gold. Afterall, prior 1971, the US dollar was backed one to one by gold.

It appears, that despite having some periods of uncorrelation, for the most part, as money supply has increased the price of an ounce of gold has followed in lockstep. Which means it costs more to purchase the same ounce of gold. Not because gold is more valuable, but because the money is worth less, and thus requires more of it to purchase the same amount.

Inflation in the money supply usually equals inflation in the value of assets.

How does the S & P Stack Up Against M2?

Speaking of lockstep, look at this correlation between the M2 and the S & P 500 over the last 15 years. They almost mirror each other.

This graph illustrates as there is more money in circulation it tends to flow into assets, one of which is the S&P 500. As liquidity (used sometimes interchangeably with money supply) decreases, so too does the value of the top 500 largest companies in the US.

Based on the above graphs, I have positioned my own portfolio into owning assets that have had a historical record of correlating with the money supply. I listen carefully to what the Federal Reserve says about its liquidity plans because history has shown that the circulation of money in the economy affects asset prices and in turn an individual’s net worth.

I discuss in depth the effects of inflation on your wealth in my beginner course. For those who have an uneasy feeling about fiat money (don’t worry I have the same feeling) and want to expand their knowledge base and likely their portfolio allocation to more sound money, consider taking the intermediate course.