Give investment tips and advice.

Fiat Money Vs. Gold Standard: Summing Up the Key Differences

Fiat Money Vs. Gold Standard
The fiat money vs. gold standard debate has been doing the rounds for quite a while. The Buzzle write-up below explains the differences between the two.
Buzzle Staff
Last Updated: Jun 3, 2018
"The undermining of fiat money has been going on for over 40 years, and this has led to a lower standard of living, undermined social trust, and given far more power to the government. A weak U.S. dollar is a threat to the global economy and the only way to stop the greenback's decline is to reintroduce a gold standard."
Steve Forbes, Editor and Chief, Forbes Media
The economy of every country demands a method of money supply and management. Since centuries, people have been using different methods of financial exchange; for instance, in many countries, the earliest method has been reported to be the barter system or the exchange of goods. The method of exchanging physical commodities was considered to be efficient and systematic, as of those days. Today, however, many countries have been using paper money. This is what is called 'fiat money', which holds value only when the system declares it to be worth something. Gold reserves, on the other hand, will remain valuable, and their worth is not decided by the system. There have been intense economic debates all over the world regarding which method would be beneficial globally, as of the current date. Some points of difference between fiat currency and gold are given in the paragraphs below so that you can opine about the same as well.
Fiat Money
  • It is the money that doesn't have any intrinsic value, i.e., it is used as money by the government decree.
  • In order for it to be successful, the government must establish and regulate the currency responsibly.
  • This includes things like protecting against counterfeit bills and proper money supply management.
  • The West started to use paper money in the early 18th century. Eventually, France, the Continental Congress, as well as the American colonies started using these bills of credit to make payments.
  • Remember though, that the fiat dollar bills that you carry around are just pieces of printed paper. They become valuable only after the government declares that they have worth.
Gold Standard
  • It is a system in which the government allows its currency to be converted into certain amounts of gold.
  • The exchange rate under this system is determined by the economic difference between two currencies.
  • This method was mainly used in between the 19th and 20th centuries.
  • However, it required that countries need to have large gold reserves to keep up with the supply and demand for currency. Hence, the system was considered to be flawed.
  • In the early 20th century, the United States currency was based upon the gold standard. However, in 1971, the United States went off the gold standard and converted to fiat money due to declining gold reserves and a large deficit in its balance of payments.
Factors of Differentiation
Fiat Money Gold Standard
It is not convertible to anything; once issued, the government is not obliged to be responsible, any further. Generally, it is convertible to gold under certain circumstances.
Physical Reserve Backing
It is just plain, printed paper, and is not backed by gold or even debt. Gold-backed money is backed by a defined amount of gold, which is held by the issuer of the currency.
Government Control
The amount of fiat currency that a government can create is unlimited. The government can also alter the amount depending on the growth or stagnancy in the economy. The amount of currency that a government can create and put into use is limited by the amount of gold that the government holds, regardless of the growth or retention of the economy.
Value Linking
The values of different fiat currencies are not linked. Their values are allowed to spread over the international currency market. The values of different currencies are linked by the actual value of gold.
Trade Imbalances
Trade imbalances are dealt with by floating currency values and trading currencies on the foreign exchange market (FOREX). Currency values are determined by supply and demand. As of today, it is practically impossible to settle trade imbalances with gold. There will be shortage of gold-backed currencies, and the conversion would shrink the value of the total trade deficit.
Deficit Spending
The U.S. dollar is the universally-accepted currency. There are extra dollars that pile up in the other countries, which come from the trade deficits. These are converted into U.S. bonds, which become the main currency of international trade. Thus, when the government wants to increase the number of dollars in circulation, they need to only issue more fiat dollars, and not at real cost, i.e., there is no need to obtain gold or other resources (except for following legal constraints). If the government wants to spend more than they recover in taxes, they need to either obtain more gold, or borrow some of the dollars that are gold-convertible. If they do not do so, but borrow more instead, the government's liability in gold does not change; moreover, it is obliged to recover those bonds for gold-convertible dollars. Thus, they will have to issue more and more bonds, and these cost real resources.
Points to be Discussed
  • The current fiat monetary system is not at all democratic, because it empowers a Federal Reserve to monitor the supply and growth of money.
  • Returning to a gold standard might lower inflation rates and consumer prices, since gold retains a universal value.
  • It would also force the nation to reduce its military and prevent unnecessary wars.
  • It would reduce the risk of economic crises and recessions (these happened while using the fiat dollar system).
  • However, it could also create periodic deflation, which might destabilize the economy. It can cause financial panic and bank failures; moreover, the value of gold fluctuates widely and would not provide the price stability that's necessary for a healthy economy.
  • Though it would prevent the government from overprinting money to bail out financial corporations, in crucial situations, it also puts limits on government power by restricting its ability to print money at will.
  • As fiat money is not linked to physical reserves, it could become unworthy due to progressive rising prices.
  • If people lose trust in paper currency, the money will be of no value anymore.
  • A gold standard, on the other hand, is capable of making the money supply susceptible to the highs and lows of gold production.
The Consensus
  • Those favoring the gold standard argue that it provides long-term economic stability, restricts the government's ability to print counterfeit money, and lowers inflation.
  • Those in favor of the fiat dollars argue that the gold standard would create economic instability, interfere with the government's ability to better the economy, and reduce unemployment during recessions.
  • From a neutral point of view, it is not very advisable to return to gold, say economists. After all, gold reserves are a real source, and fiat money, if monitored legally, would prove to be better in today's world.
A well-managed fiat monetary system might be the best way to keep inflation down, not returning to a gold standard. The latter might harm national security by restricting the country's ability to finance national defense.