Fiat Currency a Brief Explanation
One very important aspect to understand when investing, is the competitors of the asset you are investing in. Modern day government currency is the largest competitor of cryptocurrencies. Government issued currency is no longer backed by precious metals like gold and silver and is known as “fiat currency”. Two things that give fiat value are as follows, 1: the network effect that was established while the currency was interchangeable for precious metals and 2: the ability to pay your taxes with that specific currency.
This type of monetary system has been tried many times in history and always ends in the same result, currency debasement and eventually hyper inflation. There are many reasons for why this happens, governments tend to spend more than they take in and use the printing press as a tool to combat their debts. Increasing the money supply has a negative effect on the value of that currency, by increasing the supply without simultaneously increasing the demand the real value of the currency will fall. (see graph below).
The current system is managed by central banks all around the world, the United States central bank is known as the Federal Reserve. These central banks do not actually print the money (the treasury handles the physical money creation) but instead selects the interest rates at which the federal reserve will lend new money out to banks (also known as the federal funds rate). Lower interest rates will lead to higher inflation as more and more new money will enter the economy since lending is cheaper. Higher interest rates will result in slower money creation since lending would be more expensive. Since the great recession of 2008 the federal funds rate has been at all time lows in an attempt to grow the economy through an expansion of credit (see graph on following page).
Credit expansion may work to alleviate short run troubles but is merely kicking the can down the road to avoid the necessary economic restructuring that was needed in the 2008 financial crisis. Credit expansion must eventually result in credit contraction otherwise an economic phenomenon will occur called a “flight to assets” in which people flee out of their native currency and into real assets causing serious inflation troubles as the demand curve would also begin to shift to the left, dropping real value even further down (see chart below).
During a credit contraction many businesses that were started during the expansion must close their doors because they can no longer afford the higher interest rates, this will often lead to a domino effect that can send shockwaves through an economy as unnaturally low interest rates are now rising and many can no longer afford the interest on their debts. Balancing interest rates with time and attempting to find equilibrium is virtually impossible for any centralized authority. Before the issuance of fiat currency in America depressions tended to occur more often but were relatively short lived and not as disastrous to the economy.