Fiat currency, the government-issued money not backed by a physical commodity, has been the cornerstone of modern economies. However, its value and effectiveness as an investment is negligible due to the fact that it devalues over time due to multiple factors, especially fiscal and monetary policy decisions.
The Evolution of Fiat Money
Fiat’s history is a journey from tangible value to trust-based systems. Before fiat currency, most money was backed by physical commodities like gold or silver. Fiat, however, derives its value from government decree. Indeed, the word "fiat" is a Latin term that translates to “let it be done” or, in a general sense, a decree or arbitrary decision by someone in power.
One of the ways policymakers manage money in advanced economies is by changing the ratios of “base” and “broad” money supplies. Back in the day, base money was solely gold, whereas broad money encompassed bank deposits, banknotes, and gold, representing claims on the precious metal.
With the transition from gold to treasuries and mortgage-backed securities as the monetary base in the 1970s, the contemporary definition of a dollar emerged as a direct liability of the central bank, accessible to the public as banknotes or to banks as reserves. Now gold was out of use, policy makers could more easily expand the monetary base to support growth of the broad money supply, contributing to inflation and the debasement of currency over time.
The banking system's evolution, particularly the shift to fractional reserve banking, where banks create deposits through lending, resulted in a significant amount of claims on dollars far exceeding the base money supply. This was partly the cause of the 2008 financial crisis where the monetary base had to be expanded to prevent the collapse of broad money. This expansion, seen as a bailout, shifted leverage from the private to the public sector, also contributing to price inflation and currency debasement over time.
There were inherent inequities in the bailout mechanisms deployed in 2008 where large corporations received more immediate and substantial support compared to small businesses. Many governments had to enact austerity measures to manage the economic shocks and recession that resulted from the crisis, leading to anger and resentment from the wider population. And out of this financial brouhaha, Bitcoin was invented, and one of its main properties is that it is a type of “money” outside the control of the state.
The Rise of Bitcoin
Bitcoin’s inventor, the anonymous coder known as Satoshi Nakamoto, made this clear when he designed the first Bitcoin block — the so-called “Genesis Block” — to contain a hidden message. The message contained a headline from the London Times, which read: “The Times 03/Jan/2009 Chancellor on brink of second bailout for banks.”
While some argue that the inclusion was just a way of proving the block was not mined before the date on the newspaper, the more compelling thought is that the message speaks to the reason Nakamoto created Bitcoin: as an answer to the wanton printing of money, which exacerbates inflation disproportionately harming the most vulnerable members of society.
He or she created Bitcoin to have a hard-capped supply and use the proof-of-work method of cryptography, which means it’s extremely difficult for any centralized actor to control the network or issue more bitcoins. This is because Bitcoin only works with complete consensus between all users, any change to the protocol would require the vast majority of Bitcoin users to force a minority to change the network. Even if this were to happen, it would be strange indeed for such a cabal to make changes that would compromise their own money.
Furthermore, due to the capped supply, bitcoin mirrors the properties of commodities like gold. If you chart the value of bitcoin against any fiat currency over time, it has crushed it. Not only that, bitcoin has also appreciated against gold, real estate, and the Nasdaq.
Enter Ethereum
Ethereum is currently the second largest cryptocurrency by market cap and has an even more novel approach to the impact of inflation — an idea the Ethereum community refers to as “ultrasound money.” Since the completion of Ethereum’s move to a proof-of-stake consensus model in 2022, a small amount of Ether (ETH) is burned every time someone makes a transaction. This means that a tiny amount of ETH is sent to an address from which it can never return (spooky, I know).
This means that, for the most part, ETH is deflationary. So while other assets, even Bitcoin, slowly increase their supply over time, ETH’s supply is reducing and, the more people use and transact on the network, the faster and harder the burn. We still haven’t seen this burn mechanism play out in a bull-market scenario, where on-chain transaction spike and demand for ETH is skyrocketing, the results will be interesting to say the least.
Conclusion
While fiat currency remains a staple of global economies, its future is increasingly being questioned. The ongoing impact of inflation and the rise of crypto present both challenges to the traditional order and opportunities for those often left out of the financial system. In a world where fiat currencies devalue over time, scarce assets can act as a hedge against this phenomena, with Bitcoin witnessing the greatest rise because it’s a new asset with room to grow.
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