The short answer is that fiat currency is backed by the government that issues it.
The government declares the fiat currency to be legal tender and mandates that its population pay their taxes in that currency.
This requirement, alongside the recognition that the currency is given by the market as a means of exchange and store of value is what gives the fiat currency its value.
It is backed by the degree of faith (however misplaced) that the users of fiat currency have in the government issuer maintaining its solvency and creditworthiness and maintaining the soundness of the currency.
However, fiat currency is also backed by the reserves that a central bank owns.
While this is not something that governments and central banks like to acknowledge, fiat currencies are given more credibility by the hard assets that central banks own.
What is Fiat Currency?
Fiat currency is a type of currency that is not formally backed by a commodity or hard asset.
In his book The Fiat Standard, Saifedean Ammous defines it this way:
“Fiat is a compulsory implementation of debt-based centralized ledger technology monopolizing financial and monetary services worldwide.”
Central banks administer fiat currency by dictating monetary policy and setting short term interest rates.
Why Is It Called Fiat?
In Latin, the word fiat means “let it be done.”
In the Bible, Mary’s statement, “let it be done to me according to thy word” is known as Mary’s fiat.
In monetary terms, fiat has come to mean decree or authority.
Fiat currency comes into existence by decree and under the government’s authority, just because they allow it.
As Saifedean explains:
“Value on fiat’s base layer is not based on a freely traded physical commodity, but is instead dictated by authority, which can control its issuance, supply, clearance, and settlement, and even confiscate it at any time it sees fit.”
How Fiat Currency Works
People often think that fiat currency means governments and central banks simply print money.
While that has happened in the past, most famously with the Weimar hyperinflation of 1923, that is not how modern fiat currency works.
The creation of new units of fiat currency is primarily done through the commercial banks.
When a loan is issued, the money does come from depositors or from bank reserves. New units of fiat currency are created in order to fund the loan, thereby increasing the money supply.
However, the central bank does have a role to play. They influence the money supply by buying government securities from commercial banks, which has the effect of increasing their reserves and injecting money into the banking system and expanding the supply.
What Gives Fiat Currency Value?
All fiat currencies are losing value against gold.
It may appear like the value of gold is going up but it is more accurate to say that the value of the fiat currency is going down.
That is to say that you can buy less with one unit of fiat currency tomorrow than you can buy today.
Nevertheless, the market still assigns some value to fiat currencies, otherwise they would not be used.
Fiat is an effective medium of exchange and a somewhat useful short term store of value.
The value of a fiat currency is also affected by the money supply, central bank interest rates and the economic strength of the nation.
Is Fiat Currency Backed By Gold?
Technically speaking, fiat currency is not backed by gold because it is not convertible into gold.
If you wanted to trade your fiat currency for gold you could do so at a market rate. But a gold backed currency has to be able to be converted to gold on demand at a specified rate. That is what a gold standard is. No fiat currency has this function.
The world has been on fiat currency standard ever since the Nixon Shock of 1971 when President Nixon ended the last remnants of convertibility of US Dollars into gold.
However, the existence of gold as central bank reserves suggests that actually the presence of gold gives credibility and therefore backing to the global fiat system.
In The New Case For Gold Jim Rickards calls this the shadow gold standard.
“The confidence of the entire global financial system rests on the U.S. dollar. Confidence in the dollar rests on the solvency of the Fed’s balance sheet. And that solvency rests on a thin sliver of … gold.”
Saifidean Ammous makes the point that fiat currency did not emerge purely through government fiat.
An understanding of monetary history reveals that the current fiat system developed gradually from the gold standard over several decades and that even though convertibility to gold was ended, the gold remains as reserves. While governments and central banks like to pretend there is no link to gold, the reality is that there is, even though it is obscure.
As Saifedean Amous explains:
“All central banks back their currencies with international reserve currencies they cannot print. For most countries, this is the US dollar, and for the US, it is gold.”
“There has never in history been an example of a form of money that emerged purely through government fiat. While statist economists like to speak of the state’s ability to decree what money is, central bank reserves’ existence strictly debunks that. No government is able to decree its own debt or its own paper as money without holding other assets it cannot print in reserve, and using them to make a market in its paper and debt obligations…Even through the century of fiat and supposed gold demonetization, central banks have massively increased their gold holdings, and they continue to add to them at an increasing pace. The fiat standard’s main reserve currencies are used to settle trade between central banks, but evidently central banks themselves don’t believe they have demonetized gold, and don’t trust in their ability to hold value into the future, and so they continue to include increasing quantities of gold in their reserves. All monies that exist today are issued by central banks that hold gold in reserve, or central banks that hold in reserve currencies issued by central banks that hold gold.”
Jim Rickards makes a similar argument:
“It is generally believed that President Nixon closed the gold window on August 15, 1971, and the United States has been off the gold standard ever since. And two generations of students have since been rigorously conditioned by policy makers and professors to believe that gold has no role in the international monetary system. The truth is, gold has never gone away. The power elites stopped talking about it and publicly ignored it, yet they held on to it. If gold is so worthless, why does the United States have more than eight thousand tons? Why do Germany and the IMF keep approximately three thousand tons each? Why is China acquiring thousands of tons through stealth and Russia acquiring more than one hundred tons a year? Why is there such a scramble for gold if it has no role in the system? It’s highly convenient for central bankers to convince people that money is unconnected to gold because that empowers them to print all the money they want. Everyone from Ben Bernanke to Alan Greenspan and others have disparaged gold, saying it plays no part in the system. Along with the power to control money comes the power to control behavior and politics. Still, gold is the foundation, the real underpinning, of the international monetary system.”
The Limitations Of Fiat Currency
The first is the loss of purchasing power due to the inflation of the money supply. As the money supply grows, each unit of fiat currency is worth less and less.
Therefore, if you save in fiat currency over a long period of time, the purchasing power of your savings will be eroded.
The second problem is the risk that it will catastrophically lose value and therefore functionality if the people lose faith in it.
While this has not occurred yet in the post 1971 modern fiat system, it has occurred plenty of times with fiat money systems of the past.
If the value of fiat currency is eroded to the point where nobody wants to hold it, they will dump it in favour of hard assets, causing it to lose value even further in an inflationary or hyperinflationary spiral.
The destruction of a fiat currency can have devastating short term effects on a nation and an economy.
Fiat currency is backed by confidence in the government and the central bank.
Its value comes from its status as legal tender, as well as the degree to which the central bank is successful at maintaining its stability.
While not directly convertible into gold, the existence of gold on the balance sheets of the world’s major central banks, in particular the United States Federal Reserve, gives confidence and credibility to the fiat currency system.
Ammous, Saifedean. The Fiat Standard. Saif House, 2021.
Rickards, James. The New Case for Gold. London: Penguin Business, 2019.