What backs money? (Fiat money vs. crypto)

When you're paid for your work in forints, euros or dollars, you rarely stop to think: what actually gives this money its value? Why is a number on your bank account screen, or a paper banknote, worth as much as a used car or a month's groceries?

Once you understand this, you'll see the whole world of money differently. You'll also understand why more and more people see Bitcoin and cryptocurrencies as an alternative to traditional, state-issued money.

What backs traditional (fiat) money?

The official currencies we use today are called fiat money (the Latin word means “let it be done”).

In the past, in the gold-standard world: real physical gold sat in vaults behind banknotes. You could walk into the bank at any time and exchange your paper money for precious metal. The value of money was tangible.

Today, in a world of trust and compulsion: this link ended decades ago (the dollar's peg to gold was abolished in 1971). Behind today's forint or dollar there is no gold, silver or land.

So what gives it value? Essentially two things:

State compulsion: the law requires you to pay your taxes in this money, and shops must accept it as a means of payment.

Shared trust: people believe their money will be worth roughly the same in the shops tomorrow as it is today.

The system's great weakness: central banks can create new money in almost unlimited quantities. In times of crisis or heavy government spending they do exactly that, so the purchasing power of your money keeps falling over the long term. This is called inflation. Nobody touches your account, yet year after year you can buy less with the same amount of money, because the amount of money in circulation keeps growing.

The illusion of cash: most of your money is just a number

There is a lesser-known fact that shows even more clearly how much the system depends on trust: the vast majority of money doesn't physically exist at all.

In developed countries, only about 10% of the money in circulation is cash (banknotes and coins). The remaining roughly 90% is deposit money, in other words digital numbers in banks' records. In some countries, such as the United Kingdom, this share is as high as 97%. In Hungary the share of cash is somewhat higher than the European average, but here too the overwhelming majority of money exists only digitally.

The reason is that banks keep only a small part of their depositors' money in cash. They lend out the rest, and by lending they themselves create new deposit money.

What does this mean in practice? If a large share of people wanted to withdraw their savings in cash at the same time, the banks simply couldn't pay everyone out. There aren't that many banknotes in the world. This is called a bank run, and it is typically followed by restrictions:

In Cyprus in 2013, the banks closed for days, and even afterwards cash withdrawals were strictly limited.

In Greece in 2015, ATM withdrawals were capped at 60 euros per person per day.

So the money in your bank account is really the bank's promise to pay you. That promise only works as long as not everyone tries to collect on it at once.

What backs Bitcoin and cryptocurrencies?

Bitcoin and modern cryptocurrencies rest on entirely different foundations. They don't have physical gold in a vault behind them either. Their value comes from factors that no government or bank can change with the stroke of a pen: mathematics, limited supply and trust in the network.

Scarcity set in stone: the 21 million cap

Unlike fiat money, Bitcoin's rules cannot be rewritten by any government, president or central bank. The code fixes in advance that there can never be more than 21 million Bitcoin. No politician can “print” another ten million overnight. This unchangeable scarcity is one of the main sources of its value.

The incorruptible network: the security of the blockchain

Behind Bitcoin there isn't a single institution, but a network of tens of thousands of computers spread around the world. Transactions that have already been recorded are practically impossible to forge. If you hold your coins in your own wallet, nobody can freeze or cut into your assets at the push of a button. Here, the backing is the predictable set of rules itself, which anyone can verify.

There's an answer to the cash question too: Bitcoin has no “bank run”. If you hold it in your own wallet, there is no intermediary that holds only a fraction of your money. All the coins really are yours, and you can access them at any time.

Real global demand

A painting or gold isn't valuable because you can eat it, but because people recognise it as valuable. In the same way, Bitcoin is backed by the voluntary decisions of millions of people worldwide. More and more individuals and companies – including several of the world's largest asset managers – see it as a possible protection against state currencies that keep losing value.

Comparison

The essentials in brief

The purchasing power of traditional money falls year after year, because others decide on money creation behind your back. On top of that, most of the amount in your bank account is just a promise that couldn't be honoured for everyone at once.

Bitcoin and the blockchain, by contrast, put a mathematically fixed, transparent system in your hands, where nobody can increase the supply.

That's why Bitcoin is called the digital gold of the modern age: in today's uncertain financial world, it is one of the ways of preserving value that rests on the most predictable rules.