Bitcoin vs Fiat Money

What is Fiat Money?

The term, fiat money, is derived from the Latin word fiat, which means a determination by authority. Fiat money is a form of currency that is considered legal tender by a government and is not backed by a physical commodity or financial instrument. It includes paper money and coins, as well as money in the form of loans, bonds, and credit. 95% of all fiat money is not physical money. It’s mostly accounted for in bank and government ledgers. Examples of fiat money include the US dollar, the Euro, or the Japanese Yen. 

Fiat money’s value is determined by the government and the stability of the nation’s economy rather than the material it is made of. After the U.S. abandoned the gold standard in 1971, fiat money became the norm. However, because it is not tied to gold, it is at risk of inflation and loses value as the government prints more money. Before 1971, the global economy operated on the gold standard, where individuals could exchange their money for a fixed amount of gold. Countries that followed the gold standard established a fixed price for gold, which was used to determine the value of their currency. This meant that the amount of money in circulation was directly linked to the country’s gold reserves. Now that the world is off the gold standard, governments can print money without any real value added to the economy.

Banks can also create more fiat money out of thin air. They do this through fractional reserve banking. This is where banks can loan out a significant portion of the money that people give to them. Watch this quick video to get an idea of how this contributes to inflation.

Today, governments try to keep the value of their money from diminishing by increasing interest rates among other tactics. This reduces the amount people will spend which creates the appearance that money is more scarce. In reality, people’s purchasing power is still decreasing which is how inflation steals wealth from those who have saved money. Keynesian economics would have you believe that inflation is a good thing because it promotes spending which helps promote and expand the economy. In reality, the economy is expanded by adding true value in the form of new technology, goods, and services. It is not magically expanded by increasing the money supply.

Increasing the money supply actually hurts the average person because it raises the price of goods disproportionately to how much more money they receive after an inflation event. This is because it takes time for newly created money to trickle down to the common person. When it is created, it goes first to the people who are closest to where the money is created. This money goes to people like high-ranking politicians and big companies. These people and companies get to spend this new money first, which means their purchasing power is much stronger compared to everyone else who didn’t receive this new money. This is known as the Cantillon effect. If you need more evidence of who gets most of the new money printed read here.

Here is a simplified analogy of the Cantillon effect. Imagine there are one million dollars in total circulation. A house costs one hundred dollars. Everyone is content with this price in comparison to how much money exists. Now, the government decides to print an extra half a million dollars. If all of this money was equally distributed, then everyone should now be happy with a house costing one hundred and fifty dollars. But instead what happens, is this money is only given to a select few people. For the time being, a house remains one hundred dollars, but the select few have this new money, so houses are extra cheap to them. They can buy as many houses as they want. This brings house prices up. All this extra spending of new money actually brings the price of houses up to two hundred dollars because that’s what the select few can afford. Eventually, this new money trickles down to the rest of the people, but by now houses are more expensive than they can afford. This leaves the select few with houses they got for cheap, and everyone else with prices of goods increased more than what the total new money supply would suggest. This is obviously an oversimplified analogy, but this is essentially what happens when a select few from the population get to spend new money before it is equally distributed to everyone.

Today, governments try to keep the value of their money from diminishing by increasing interest rates among other tactics. This reduces the amount people will spend which creates the appearance that money is more scarce. In reality, people’s purchasing power is still decreasing which is how inflation steals wealth from those who have saved money. Keynesian economics would have you believe that inflation is a good thing because it promotes spending which helps promote and expand the economy. In reality, the economy is expanded by adding true value in the form of new technology, goods, and services. It is not magically expanded by increasing the money supply.
Increasing the money supply actually hurts the average person because it raises the price of goods disproportionately to how much more money they receive after an inflation event. This is because it takes time for newly created money to trickle down to the common person. When it is created, it goes first to the people who are closest to where the money is created. This money goes to people like high-ranking politicians and big companies. These people and companies get to spend this new money first, which means their purchasing power is much stronger compared to everyone else who didn’t receive this new money. This is known as the Cantillon effect.
Here is a simplified analogy of the Cantillon effect. Imagine there are one million dollars in total circulation. A house costs one hundred dollars. Everyone is content with this price in comparison to how much money exists. Now, the government decides to print an extra half a million dollars. If all of this money was equally distributed, then everyone should now be happy with a house costing one hundred and fifty dollars. But instead what happens, is this money is only given to a select few people. For the time being, a house remains one hundred dollars, but the select few have this new money, so houses are extra cheap to them. They can buy as many houses as they want. This brings house prices up. All this extra spending of new money actually brings the price of houses up to two hundred dollars because that’s what the select few can afford. Eventually, this new money trickles down to the rest of the people, but by now houses are more expensive than they can afford. This leaves the select few with houses they got for cheap, and everyone else with prices of goods increased more than what the total new money supply would suggest. This is obviously an oversimplified analogy, but this is essentially what happens when a select few from the population get to spend new money before it is equally distributed to everyone.

How is Bitcoin Different?

Bitcoin doesn’t have a government or a small group of people who get to make the rules. The value of Bitcoin is not determined by a government, it’s determined by everyone who chooses to buy or sell it. Bitcoin is much more similar to the gold standard than it is to fiat money. Gold requires work, specialized equipment, and energy to mine from the ground. There is a limited amount of gold in the Earth’s crust. To mine Bitcoin, one must have specialized computers which solve complicated mathematical problems. This process requires energy. There are only twenty-one million Bitcoin that will ever exist. Every four years, the amount of Bitcoin rewarded to these mining computers is cut in half. So in reality it’s becoming harder to make more Bitcoin.

Critics of Bitcoin argue that it isn’t backed by anything. They think that because it’s digital, it has no inherent value. They worry that because it isn’t controlled by a government, there is no one to defend it. Let’s respond to each of these three concerns separately.

Bitcoin vs. Fiat in Summary

Bitcoin and fiat money both exist digitally. While fiat money does have some physical dollars and coins, this is a small fraction of fiat money. Most fiat money exists in banks or government ledgers. In order to make more fiat money, all the government needs to do is change some numbers in its database. Governments use money printing to give money to people in power while leaving everyone else with less purchasing power, which is known as the Cantillon effect. Banks can also create money out of thin air through the use of fractional reserve banking. Neither of these situations is possible with Bitcoin. No one can magically create more Bitcoin at will. Nor can someone have Bitcoin in their hardware wallet and simultaneously loan the same Bitcoin to others. These corrupt systems of inflation using fiat money are not possible with Bitcoin.