Learn the stock market in 7 easy steps. Get spreadsheets & eBook with your free subscription!

Fiat Money vs. Commodity Money: A Breakdown of the Pros and Cons

“Money, it’s a crime.”

Pink Floyd

My grandparents used to say that money makes the world go around, but what do we know about the money that we use today? We currently use fiat money but also deal with commodity money as well. And then, we add Bitcoin and other types of electronic currency, and we all get confused. Fiat money versus commodity money— that is the battle that is raging today in the markets.

Money has been a part of our human history for about 3,000 years, give or take. Money has evolved from bartering to credit cards, with some elements of bartering still in existence today.

I didn’t know this but the first known currency was established in 660 B.C. by King Alyattes in Lydia, which is now part of Turkey. The first coin ever minted contained a figure of a roaring lion.

Coins evolved from metal to banknotes around 1661 A.D., and the first credit card appeared in 1946. China was the first to create paper money in around 770 B.C.

Money, in and of itself, is worthless. There is no difference, whether it is gold, paper, electronic, the value is symbolic. Money conveys the importance that we place on that currency. Money actually derives its value from the functions is allows, such as a medium of exchange, storehouses of wealth, or a unit of measurement.

Some confusion around money exists in terms of money and currency. Currency, some argue, is the physical such as coins, notes, credit cards. And money is an intangible concept that denotes our value that we place in a currency as having a value.

The recent rise of Bitcoin has brought all of these questions into focus recently. As we decide whether it is “money” or not, we need to understand the difference between fiat money and commodity money.

In today’s post, we will learn:

  • What is Commodity Money
  • What is Fiat Money
  • Pros of Commodity Money
  • Pros of Fiat Money
  • Fiat Money vs. Commodity Money

Ok, let’s dive in and learn more about fiat money versus commodity money.

What is Commodity Money?

What exactly is commodity money?

According to Wikipedia:

“Commodity money is money whose value comes from a commodity of which it is made. Commodity money consists of objects having value or use in themselves (intrinsic value) as well as their value in buying goods.

Examples of commodity money are endless:

  • Gold
  • Silver
  • Copper
  • Salt
  • Tea
  • Silk
  • Coffee
  • Alcohol
  • Cocoa beans

And the list could go on and on, think back to when you were a kid, and you used to swap toys, books, games, or baseball cards. All of that was a form of commodity money because you placed a value on that item and used it to trade with your friends.

Commodity money is no different.

Commodity money has a unique feature in that the value we derive from the commodity is based on the utility or beauty of tokens as goods. The exchange of commodity money is similar to bartering, but it is different in that a single value placed on the commodity, that is recognized by all.

A great example of commodity money and the value recognized by all from history:

“People left their surplus clothing, toilet requisites, and food there until they were sold at a fixed price in cigarettes. Only sales in cigarettes were accepted – there was no barter […] Of food, the shop carried small stocks for convenience; the capital was provided by a loan from the bulk store of Red Cross cigarettes and repaid by a small commission taken on the first transactions. Thus the cigarette attained its fullest currency status, and the market was almost completely unified.”

Commodity money is most often associated with metals, such as gold and silver.

The use of gold and silver in governments by minting coins, typically with a symbol or mark on the metal, is associated with commodity money, which serves as a guarantee based on the purity and weight of the metal, which gives the commodity value in the eyes of the people using those coins.

Money in the colonies in early America at first was strictly commodity money in the sense that it involved trading items such as furs, wampum, rice, and tobacco, for example. These items were used as money because the colonies were forbidden to create their own money, such as coins.

In the early years of the Americas, the only physical coin that found widespread use was the Spanish Dollar, which was the unofficial currency of early America from the early 1600s to 1700s. An interesting fact— to make change from the Spanish Dollar, they cut it into pieces or bits.

We are moving onto to gold, the longest-held commodity of value for humans over our entire history.

Gold As a Commodity Money

Gold has existed as a form of money, whether a commodity or fiat, for as long as humans have known about gold. It has achieved a value in our eyes that transcends all other store holders of wealth.

The biggest difference in gold versus other commodities is gold is never used up, like oil or tobacco. Once the gold is found and mined, it stays in our existence.

Think about gold and its impact on civilization; it has helped forge empires, as well as tear them down. Over time gold was given the power over any other commodity on the planet, which has never wavered.

The U.S. based its monetary system on the gold standard until the 1970s; some say that was the beginning of the end.

Proponents of the gold standard argue that this type of system helps control credit expansion, and controls the lending standards employed by banks. All because the physical supply of gold backs the extension of credit.

A word about the gold standard, a gold standard is a monetary system where the country’s money has value based on the link directly to gold. Any country that uses the gold standard buys and sells gold at a fixed price, and that price becomes the value of the country’s money.

The gold standard was the monetary system of choice for much of the world until the early 1970s when the U.S. moved away from the currency. The gold standard has a long and complicated history, not only in the U.S. but around the world and is a subject for another day.

The bottom line is commodity money is associated with establishing a value backed by a physical product that everyone assumes has a value, such as gold, silver, or tobacco. And when that commodity is used for purchasing items that become the money or currency that is accepted by all.

Examples throughout history of commodity money:

  • Roman denarii
  • Greek drachma
  • Spanish bouillon
  • Dutch Kroner

All of the above were forms of commodity money that was backed by a physical commodity that had an accepted value by all.

Let’s move onto discovering more about fiat money.

What is Fiat Money?

According to Investopedia:

Fiat money is government-issued currency that is not backed by a physical commodity, such as gold or silver, but rather by the government that issued it. The value of fiat money is derived from the relationship between supply and demand and the stability of the issuing government, rather than the worth of a commodity backing it as is the case for commodity money. Most modern paper currencies are fiat currencies, including the U.S. dollar, the euro, and other major global currencies.”

The rise of fiat currencies over the last fifty years is also tied to the creation of more credit in our system, but not historically so, which I find interesting.

Fiat money gives central banks more control over the amount and frequency of credit that is extended, because of the control it allows the banks to “print” more money.

As we discussed in our series on the Federal Reserve and how the U.S. banks, money is not “printed” per se, rather it is created out of extension of credit and debits recorded on the Central Banks’ balance sheet.

Like commodity money, fiat money has value because it is determined to have value by most concerned. In this case, it is the government that issues that fiat money, such as the U.S. government.

Unlike commodity money, fiat money cannot be redeemed. Fiat money is not linked or “pegged” to any physical reserves, such as gold.

Back in the day of the gold reserve, the money was printed out of a valuable physical commodity such as gold, silver, or paper money that could be redeemed for a set amount of the gold or silver.

Fiat money has none of those characteristics and is not pegged to any tangible value; rather, it is only as valuable as the faith the people put in the money.

Early examples of fiat money, not backed by a physical substance, were the continental currency issued during the American Revolution, the “greenbacks” of the American Civil War, and the paper mark issued in Germany after World War One.

Fiat currencies rose to prominence in the early 20th century as governments sought to insulate our economies from the booms and busts of the economic cycles. By allowing the central banks to control the printing of money, it allowed countries to avoid society crushing depressions like experienced in the early 1920s, or so the theory believes.

Ok, let’s move onto pros of commodity money

Pros of Commodity Money

Commodity money has many proponents that believe it is the best form of money and that we should move back towards that style of money.

Commodity money has several advantages over fiat money.

For example, it offers more flexibility for the money holder, has more possibility of getting rich quick, and offers more protection from inflation on the economy.

Of course, modern economists argue that commodity money has far more disadvantages than advantages, which his why fiat money is the money of choice for all developed nations.

The number one advantage of commodity money is the ability to serve more than one purpose. For example, gold can become jewelry, is used as wiring in computers. Tobacco can be smoked, rice is eaten, or alcohol is consumed.

The holder of commodity money has several advantages; it can used or spent.

Pros of Fiat Money

The first country to use fiat currency, was China around 1000 AD, and as recently as 1971, when Richard Nixon took the U.S. off the gold standard.

Currently, most developed nations use a form of fiat money as their mode of payment. For fiat currencies to be successful, the nations must control both counterfeiting and management of monetary supply.

By far, the most important feature of fiat currency is the stability it offers, unlike commodity monies such as gold, silver, and copper. As mentioned earlier, the rise of fiat currencies came about as countries attempted to smooth out the business cycles and avoid the busts of credit cycles.

Unlike commodity monies, fiat currencies allow the central banks to print or hold money as they see fit to help control the money supply, inflation, interest rates, and liquidity.

A great example of the use of fiat monies and the ability to control interest rates, money supply, and liquidity was the central bank’s response to the Great Recession in 2008. The ability to control those aspects of the money helped lessen the blow to both the U.S. and global economies.

Fiat Money Vs. Commodity Money

Ok, time for the grudge match. Not really, but here are the pros and cons of commodity money versus fiat money.

Commodity Money vs. Fiat Money:

  • Lower inflation – because commodity money is based on a physical product, i.e., gold, it is less prone to inflation from devaluation of the money. Gold is fairly finite money, and the government cannot create more whenever they want to, thus lessening inflation. There are many examples throughout history of a devaluation of money due to hyperinflation such as Germany in the 1930s, Zimbabwe in 2016, and Argentina more recently. Fiat monies control inflation by controlling the interest rates and by creating more or less money in the system. But that creation of more money can lead to devaluing of that money over time.
  • Intrinsic Value – commodity monies have an intrinsic value based on their physical properties such as gold, oil, and silver. Where fiat money is only as valuable as the faith in the people that give it its value, gold, for example, has an utility to it; it can be made into other valuables like jewelry where a dollar bill has no other use, other than to be spent.
  • Perishability – commodity monies can devalue over time, such as oil, barley, or olive oil. They have a shelf life, and once they extend past that shelf life, they devalue. Fiat money has no shelf life, other than the degrading of the real money as it is used through the system.
  • Slower Growth – fiat monies promote faster economic growth, and because of the nature of the ability to manipulated quicker, they can provide liquidity to stimulate faster economic growth. Commodity monies take longer to grow, thus leading to slower expansion.
  • Value Tied to Government – one of the cons of fiat money is that the money will only have value for as long as the people believe and accept that it has value. It is only backed the full faith of the government, no physical asset. Gold, for example, has an intrinsic value that almost every one of the face of the Earth recognizes.

Fiat money is the monetary system of today, but it is not set in stone. Any sort of changes in the value of the faith in our monetary system could send us back to commodity money, or the rise of a different currency such as Bitcoin.

Final Thoughts

The Covid-19 pandemic has exposed the flaws in our current fiat monetary system by forcing the Federal Reserve to open its piggy bank and pour out all the money it can to keep the country and economy afloat.

Many critics of the Fed believe it has gone too far by creating so much money and flooding the system with that much liquidity. Are they right or wrong, only time will tell.

The increase in the creation of money and the impacts of that creation has led to an increased interest in cryptocurrencies as an alternative to fiat currencies. But Bitcoin has some of the same strengths and weaknesses of both commodity money and fiat money. It is both only as valuable as people believe it is, and it has a finite value, such as a commodity. The next question remains, will Bitcoin become the currency of the future, hard to say.

But for the immediate future, fiat currency is what we have to play with, and likely into the future of our children as well.

That is going to wrap up our conversation for today.

As always, thank you for taking the time to read this post. I hope you find something of value on your investing journey.

If I can be of any further assistance, please don’t hesitate to reach out.

Until next time, take care and be safe out there,

Dave