Liquidity, Debt Denomination, and Currency Dominance

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 argue that a liquidity-based theory is necessary 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 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 committed to the largest pool of liquid assets in the same denomination. Once a dominant currency emerges, the government hosting the currency endogenously invests more in the liquidity of its financial markets, leading to further entrenchment of that equilibrium. Our theory explains the historical experiences of the Dutch florin, the British pound sterling, the US dollar, and the transitions between them. We rationalize the current dollar-dominant international financial architecture and provide predictions about the potential rise of the Chinese renminbi.