It’s just not gold.

Fiat money is a form of money where the currency is not backed by any commodity. It is to be accepted as payment by fiat (order) of the government. We call this ‘legal tender‘. The US Dollar is fiat money, as is the Euro, the Yen and, in fact, most modern currencies.

In the past, most money was backed by commodities. Usually, silver and gold. But this has not been the case for a long time. The last time western money was backed by gold and silver was between 1944 and 1971. After the second world war, the United States and the allied nations agreed on what is called the Bretton Woods system. In this system, the national banks of the participating countries tied their currencies to gold and kept physical gold in reserve. Commercial banks (but not consumers) were able to exchange bank notes for gold. However, this system came to an end in 1971 when the United States unilaterally terminated convertibility of the US dollar to gold.

Today, our money is not backed by anything. It’s just worthless paper. Right?

Actually I don’t agree. Our money is not backed by gold. True. But that does not mean it has no backing at all. But before I can explain, first a little refresher on how money is created.

Money is created by banks to fund loans. When the loans are payed off, the money is destroyed again.

When you go to a bank for a loan, the bank does not transfer money it already had sitting in an account somewhere to your account. No. Instead, it creates money ‘out of thin air’ and deposits it onto your account. Some people refuse to believe this and get angered by the very idea. But it is, in fact, true. Banks create the money they loan us. It was not there before we loaned it.

So, fiat money means it’s money because the government says so. And it’s created out of thin air when we get a loan at a bank. Ok. So surely then it is plain to see that the money is in fact not backed by anything? No. Hold your horses. You are forgetting one very important detail. When we get a loan from a bank, the bank does not just give us the money…

We need to sign a contract first. And what does that contract say? It says that we will repay the money in x monthly terms so we will have payed it back before date y, paying a certain amount of interest on it, etc. That contract is actually a big deal! If you ever find yourself in the situation where you are unable to fulfill your legal obligations under such a contract, you will quickly find out just how big a deal. The bank will confiscate your house or car or whatever was the collateral for the loan. And in many cases, if the collateral does not fully cover the loan, you will end up with a debt you might be paying for for a very long time. But the contract is in fact also a very big deal to the bank itself.

Without the contract, the bank is not allowed to create the money it loans you. That contract is the backing for that money! In our system, there are always two parties needed to create money. The bank, which is the only one allowed to create money, and the party taking the loan, signing the contract that is backing the money. The bank is not allowed to create money by itself! Which explains how even banks can go bankrupt.

If you have a loan, you are backing a tiny fraction of the nation’s money supply. Every day you go to work to earn the money needed to pay off your mortgage, car loan, etc. you are creating the production needed to give that money its value. When you signed that contract, you essentially pledged to work your ass off in the future, to earn the money to pay back the loan. And every single dollar or euro in existence is backed in some way by such contracts. So every single dollar or euro is backed by a contract that essentially represents future work, future production. Simply said, a dollar or euro represents a tiny fraction of the future production of the United States or Europe.

Critics of the current monetary system like to say that our money is ‘worthless’, ‘not backed by anything’, ‘hot air’ etc. But, while I share many of their criticisms, this I do not agree with. As we’ve seen, money is only created when someone (or some company, government) signs a legally binding contract stipulating how and when it should be payed back. This means that the collective of people, companies and governments that together inhabit the country, are also collectively backing the currency.