Cryptocurrencies like bitcoin, ethereum and dogecoin are in the headlines these days. But most of us still rely on fiat currencies — government-controlled currencies — for our day-to-day buying, spending, and saving needs. So you may be wondering about the differences between digital currencies and traditional government-backed currencies like the dollar and euro. Even more, many central banks are looking at creating their own digital currencies, which may add further complexity to the currency landscape. Here’s a deeper look at government digital currency vs cryptocurrency and how they may both play a role in the future of money.
What Is a Digital Currency?
A digital currency is any type of currency that exists in a completely digital format. This includes cryptocurrencies (explained below) and government-backed digital currencies.
You probably carry paper dollars (or euros or whatever) in your wallet. And you manage your money through your bank’s online banking system. But you can’t physically hold a digital currency. You use them only online.
Digital currencies offer much more flexibility than traditional government currencies. For example, you can send a digital currency to anyone in the world with a compatible digital wallet with near-instant speeds and low costs. Compare that to the high fees of a bank wire transfer, the time delay of an electronic funds transfer or the costs and requirements of a money transfer service.
Today, most digital currencies use blockchain technology. The blockchain tracks every currency unit on a public ledger. Public blockchains prevent fraud, counterfeiting and other common problems traditional money has. Of course, using a digital currency requires a bit more tech-savvy than using traditional money. But in an increasingly electronic world, digital currencies may take over as the main form of money in the future.
A digital currency platform supports a cryptocurrency like bitcoin or a government-backed currency like the dollar. But as of now these platforms are primarily used for cryptocurrencies outside of government management.
What’s a National (Fiat) Currency?
The term “fiat currency” refers to a national currency like the dollar, euro, peso, or yen. Central banks closely watch these currencies. These banks include the Federal Reserve Bank and European Central Bank. They ensure the money supply is managed to meet the nation’s economic goals.
In the U.S., the Federal Reserve and Congress work together to make decisions regarding government borrowing, lending and spending. All of these impact the dollar’s value compared to other currencies. This economic and currency management strategy is designed to maintain steady economic growth without sparking too much inflation.
Many government currencies — including the U.S. dollar — started on a gold standard. Every dollar was worth a specific amount of gold. But modern currencies are backed only by the government itself. In the U.S., fiat money moved away from the gold standard in 1934. The dollar is now backed by the “full faith and credit” of the U.S. government.
What Are Cryptocurrencies?
Cryptocurrencies are the most popular type of digital currency today. Cryptocurrencies are blockchain-based currencies available to anyone in the world. Unlike government-backed fiat currencies, the value of cryptocurrencies comes from the trust of their user communities.
Proponents of cryptocurrencies like the semi-anonymous nature of digital currencies. And they like that the currency is free from the control of governments. But critics argue that cryptocurrencies are not backed by anything or anyone and have little if any, value. And they could become worth nothing in an instant with strong government action.
The blockchain technology behind cryptocurrencies ensures that every new “coin” (the term for a unit of cryptocurrency) is unique and can’t be replicated. It’s possible to track the history and ownership of every coin from inception to the present and look at the public holdings of any digital wallet participating on the network. This gives users trust in the network and enables cryptocurrencies to function. But the technology behind crypto isn’t limited to nontraditional currencies. Fiat money can use blockchain as well.
Government Digital Currency vs. Cryptocurrency: What Are the Main Differences?
We’ll likely start to see governments issue their own digital currencies using technologies similar to Bitcoin’s. For example, while bitcoin is a legal tender in El Salvador, most countries looking at cryptocurrencies are interested in issuing their own digital money tied to their own national currency.
China is running one of the most ambitious digital money experiments, with billions of dollars in digital yuan transactions already taking place, and it’s not alone in digital currency ambitions. Government digital currencies come with the safety and security of a fiat currency and the convenience and adaptability of cryptocurrencies. That could be a win-win for everyone involved in the modern financial system.
Who Controls and Manages Currency?
Governments and central banks closely manage and control their fiat currencies. When currencies are managed well — as has historically been the case in the U.S. — inflation remains relatively low while economic prosperity remains high. This isn’t always the case, however.
In the past, Venezuela, Hungary, Zimbabwe, and Yugoslavia saw their currencies lose half their value in a single month. I bought a stack of 10 100-trillion Zimbabwe dollars on eBay a few years ago. And that makes me a Zimbabwe quadrillionaire. But that much money was worth only about enough to buy a loaf of bread. And the situation with the Zimbabwe dollar became so dire that the country now uses foreign currencies for daily business.
Governments are clearly not perfect at managing money in all situations, which is a major focus of cryptocurrency advocates. Crypto fans point out that cryptocurrency is open for all to examine. An international community — not a government — determines its value. And crypto fans see this as a benefit. The most popular cryptocurrencies have mechanisms to prevent hyperinflation, which isn’t the case with fiat currencies.
How Is the Value/Price of the Currency Determined?
Open currency markets determine international currency values. Log into any foreign currency exchange website or bank website to get an instant view of the rate you can use to exchange dollars into pounds, euros, yuan, rubles and other world currencies.
- A combination of economic conditions and government actions drives the price movements. Strong economies typically lead to stable currencies. But poorly performing economies see their currency values fall relative to stronger currencies.
- And one-time actions like Brexit or issuing new currency often lead to immediate negative results for the fiat currency.
- Some countries, including China, closely manage their currencies. Other governments take a more laissez-faire approach to currency management.
- But cryptocurrency values are completely driven by an open market. The value of bitcoin, dogecoin and other currencies is tied to that currency’s latest transaction. Supply and demand drive prices up and down in these relatively new currency markets.
Is There a Limit to the Amount of Currency Available?
Each currency, government, and crypto has different rules and regulations around creating new currency. Governments usually avoid printing new currency too quickly, as this could lead to rapid inflation or even hyperinflation. Of course, governments have a legal right to issue new currency at any time. But well-managed governments avoid adding too much to the money supply to avoid high inflation rates.
Cryptocurrencies use different rules around issuing new currency. Some currencies maintain a strictly fixed supply and will never add new coins. Others allow new coins to be created through mining and other mechanisms. If you invest in cryptocurrency, it’s important to know if your currency has a fixed supply or can add new coins and how they are added.
What’s the Future of Money?
Cryptocurrencies appear to be a big part of the future of money, but fiat currencies are not going anywhere soon. As the money landscape evolves, we will likely see many governments add digital versions of their currencies to complement existing monetary systems. Before we know it, you may be using crypto-dollars for online purchases and when sending money to family and friends. That’s a monetary future I’m excited to see.