Fiat currency explained

Taken, unedited, from a comment by Sensei at MoneyWeb: Bitcoin is not a currency

"...gold is money while fiat currencies are debt tokens or IOU’s or a promise to pay. It is not payment, it is deferred payment. The institution who originally issued the promise to pay, namely the government, changed the laws of payment (1971 the Nixon Shock) to enable them to redeem an IOU with another promise to pay.

If we take 2 steps back, it becomes clear that we are currently living in a era of paper money or “fiat currency”. This is the last phase in the cycle of money.

The cycle begins with a commodity currency and a barter system with or without debt. Wheat is exchanged for eggs and debt is redeemed – no trust needed.

The next phase in the cycle of money is metallic money( copper, silver and gold). The bag of grain is too heavy to carry around so we carry something that is light, but represents a lot of value. In that way a person can carry the value of 10 bags of wheat in his pocket. – no trust needed.

The next phase is “representative money” and this is where things gets interesting. The owner of the gold coins is afraid he might get robbed so he goes to the only guy in town who owns a safe – the goldsmith. The goldsmith issues a receipt for the gold on deposit. This receipt represents the gold and can be given to the shop-owner as payment. Here, for the first time trust is needed. The owner of the gold has to trust the goldsmith that he won’t issue more receipts than the amount of gold deposited with him.

The next phase is “Fiat money” or money by decree. After the goldsmith (banks) issued a hundred times more receipts (to themselves which they then borrowed to the king) than the amount of gold in the vault, they cannot produce the gold when the shop owner hands in the receipt in exchange for gold. Then the “king” makes a law stating that from now on forward gold in not money any longer and that the receipts will now act as money. People need to trust the bankers and the government during this phase. They have to trust that the government won’t issue more receipts or promises to pay than the amount of gold(actual money) in the vault. Only the most ignorant and naive citizens trust the government and the banks during this phase. The mere fact that the country is on a fiat currency system implies that they broke all their promises already!

Then when people wake up to the fact that the government is issuing promises to pay at such a rate that nobody accepts that promise as payment any more, the system collapses and starts afresh at phase one."