Finance Seminar

The international monetary system of the last four centuries has experienced the rise, persistence, and fall of specific currencies as the dominant unit of denomination in global debt contracts. We provide a liquidity-based theory to explain this pattern. Firms issue debt that can be extinguished by trading their revenues for financial assets of the same denomination. When asset markets differ in their liquidity, as modeled via endogenous search frictions, firms optimally choose to denominate their debt in the unit of the asset that is most liquid. Equilibria with a single dominant currency emerge from a positive feedback cycle whereby issuing in the more liquid denomination endogenously raises the benefits of that denomination. This feedback mechanism has historically been seeded by governments that created the largest pool of liquid assets in the same denomination. Once dominance is established, a country's costs of investing in the ability to create liquid assets, such as by increasing fiscal capacity, are lower while the incentives to do so are higher, thereby entrenching dominance. We explain the historical experiences of the Dutch florin, the British pound sterling, the US dollar, and the transitions between them. Our theory highlights normative features of liquidity provision in the international monetary system through the lens of the Bretton Woods arrangement, and we discuss the implications of modern policy tools such as central bank swap lines. We rationalize the current dollar-dominant international financial architecture and provide predictions about the potential rise of the Chinese renminbi.

with Antonio Coppola and Arvind Krishnamurthy