Throughout history, powerful nations have used economic leverage to bend others to their will. Florence’s Medici banking dynasty shaped Renaissance politics with its financial dominance, and imperial Britain used trade dominance to bind its empire together and wield power across the globe. Today, the United States freezes access to financial markets or urges its allies to impose export controls on essential technologies, and China threatens restrictions on rare earths to expand its influence. These are examples of geoeconomics, or the use of financial and trade relationships to achieve geopolitical and economic goals.
With the recent surge in great-power competition and increasing use of tariffs, sanctions, and export controls, understanding geoeconomics has become essential for policymakers navigating an increasingly volatile world. The use of geoeconomic power can increase cooperation and prosperity, but it can also cause fragmentation and disintegration. It is important to understand both its potential and its drawbacks.
The academic study of geoeconomics dates most prominently to 1945, when economist Albert Hirschman published National Power and the Structure of Foreign Trade. In it, he examines how Nazi Germany had structured its economy to maximize leverage over its neighbors during the interwar period. He rejected the naive view that because trade is voluntary and mutually beneficial, it is geopolitically harmless. Benefits can be mutual, Hirschman argues, without being symmetrical. And asymmetry is how power builds.
Since Hirschman’s time, economists have left the study of global power dynamics largely to political scientists and historians, who have led the development of this area of research. Though almost every economics student encounters the Herfindahl-Hirschman Index, few know it was invented to measure the economic power of nations, not firms. Perhaps there was a sense that the postwar world order made such concerns obsolete.
Now, in the wake of increasing competition between great powers, geoeconomics has become impossible to ignore, and economists have new tools at their disposal, including network analysis and modern macro, trade, and game theory. Our own research agenda aims to provide an economic modeling framework for geoeconomics. The goal is not only theoretical clarity on the sources and channels of power but also the ability to bring models to the data and discipline policy counterfactuals.
Geoeconomic power
How do countries build geoeconomic power? Suppose Country A supplies intermediate goods to Country B. It could threaten to withhold those goods if Country B does not comply with its demand. If the intermediate goods are sufficiently important, and if it is sufficiently difficult to source them elsewhere, such that Country B would be better off acquiescing to Country A’s demand than dealing with the realization of its threat, then Country B would comply.
Threats to withhold only one input can work; however, threats are more powerful when the imposing country controls multiple economic relationships. A country that controls many related inputs, such as intermediate goods and foreign capital, exerts greater power, because it can inflict greater losses on the target country. That is why countries such as the United States and China are often referred to as hegemons. A hegemon uses these joint threats to exert power over firms and governments in its network and ask them to take costly actions. These actions can take the form of monetary transfers, changes in markups on prices, and surcharges on loans but also policy actions such as trade restrictions (for example, tariffs and quotas) or political concessions.
Consider how China has structured its Belt and Road Initiative. Beijing provides developing economies with package deals that combine loans, infrastructure projects, and access to manufactured goods. If a borrowing country defaults, it risks losing all these relationships simultaneously. This bundling increases China’s geoeconomic power. In exchange, Beijing might demand political concessions, such as closer alignment over key geopolitical issues.
Adding to the power of hegemons is their ability to sway countries outside their network, reshaping the world equilibrium to consolidate more power. For example, when the United States put pressure on European governments and firms to stop using Huawei’s 5G technology, so-called network effects amplified the impact. Because the value of a telecommunications network increases the more widely it is adopted, getting some countries to reject Huawei made the technology less attractive for others, including countries the US could not directly pressure.
Choke points and dependencies
Inputs are called choke points, or critical dependencies, if the hegemon controls a dominant market share of the input in the targeted economy and it is difficult to find alternatives to the hegemon’s inputs. For example, the US and its allies control an overwhelming share of global financial services, upward of 80 to 90 percent in many countries. Payment systems, settlement infrastructure, and dollar-denominated lending are basic inputs in a functioning economy. The lack of viable alternatives to the US financial infrastructure gives the country considerable geoeconomic power. Recently, it has wielded this power by imposing comprehensive financial sanctions on Iran and Russia, putting pressure on HSBC to disclose transactions linked to Huawei, and cutting Russian banks’ access to the SWIFT messaging system for international financial transactions.
However, there is a catch. The relationship between control over a sector and geoeconomic power is not linear; rather, power increases disproportionately as a hegemon approaches complete control. The difference between controlling 95 percent and 85 percent of an input is disproportionately large. At 95 percent, a target economy has almost no viable alternatives and must accept whatever terms the hegemon demands. At 85 percent, there is enough of an alternative to give the target meaningful options, and the hegemon’s leverage dissipates rapidly.
US policymakers often take comfort in the fact that the dollar remains dominant and Chinese alternatives to the Western financial system remain marginal. By standard metrics, China accounts for a small fraction of global financial services. The argument goes that even if China provided 10 percent of world basic financial services, that would pale in comparison to US dominance.
This reasoning is correct about market shares but wrong about power. There is a difference between macroeconomic relevance and geoeconomic relevance. For a medium-sized economy, the existence of an alternative provider with even a 10 percent market share is enough to withstand much of the coercion that a dominant power can exert. A disproportionate part of the losses to US power would come from a Chinese alternative going from 1 percent to 10 percent, with further Chinese market gains causing progressively less power dilution for the US.
Russia’s preparation for Western sanctions illustrates this dynamic. After its invasion of Crimea in 2014, Russia moved to reduce its dependence on the US-led coalition, further developing its domestic payment system and connecting to China-based systems. Consequently, the US-led coalition’s financial power over Russia greatly diminished. This preparation helps explain the somewhat muted effect of the sweeping financial sanctions imposed after 2022: Russia had already built enough of an alternative to blunt the weapon’s edge.
China and India are following Russia’s example and building alternative payment and settlement systems. Granted, these are unlikely to replace the dollar-centric architecture. However, the question is not whether an alternative system can rival the dollar across all its uses, but whether it can be viable enough to significantly diminish US influence at the margin. Emerging markets aren’t alone. Euro area countries are pushing forward a digital currency in the hope of gaining greater monetary sovereignty and reducing dependence on the US financial infrastructure.
