Why US geopolitical uncertainty matters for the dollar

Donald Trump’s new brand of imperialism doesn’t sit well with the dollar. The greenback dropped against other major currencies as the US president talked about taking control of Greenland, and continued falling even after he backed down. The issue is less that geopolitical animosity can unseat the dollar as the world’s dominant currency, and more that it can erode a key benefit: financial surveillance and sanctions power.

Taken since the end of 2024, the dollar has fallen roughly 13 percent against the euro. Though often attributed to the “Liberation Day” tariffs Trump announced in April of last year, the slide began two months earlier, not long after US Vice President JD Vance signalled a retreat from Washington’s commitment to defend Europe. It suggests the market sees a link between a more US-centric foreign policy and the greenback’s global dominance: namely, if the world’s police force retreats, perhaps international use of its currency does too. A more extreme version of the same idea, which was raised by a controversial Deutsche Bank research note during the Greenland crisis, is that Europe would dump some of its $14 trillion of US financial assets.

Replacing the dollar on a grand scale seems far-fetched, though. Even if the US were matched in GDP by China or the euro zone, its financial openness, legal protections and issuance of Treasuries as a single safe asset — unlike Europe’s fragmented sovereign bond market — would still leave the dollar without challengers. Despite some recent moves by foreign central banks to diversify, 57 percent of global official reserves are in dollars. Liabilities matter even more: 49 percent of cross‑border loans and 46 percent of international bonds use the greenback. The dollar appears in 89 percent of foreign‑exchange trades and, for the average country, on 62 percent of export invoices.

Most of these figures, which come from the Bank for International Settlements and the International Monetary Fund, have been stable since at least 1999. It gives Washington a powerful lever: because payments ultimately pass through correspondent bank accounts in New York, the US Treasury has been able to monitor flows and block transactions of North Korean entities, Venezuelan institutions and Hezbollah‑linked networks. It has also frozen assets and imposed sanctions, as against Iran in 2012 and Russia in 2022. And, because allied nations face similar exposures in their banks, they are effectively forced to cooperate. US authorities in 2014 slapped France’s BNP Paribas with a $9 billion penalty linked to violating American sanctions on Sudan, Cuba and Iran.

This echoes the work of German economist Georg Friedrich Knapp, who in 1905 argued that a state’s ability to extract taxes and fines is what gives its currency domestic value. Through sanctions, the US applies a version of this internationally, with the world’s most advanced military ensuring its ability to collect.

Defence capabilities and currency power have a close relationship. The presence of dollars and euros in other nations’ global currency reserves roughly matches US and European governments’ share of military spending since 1971, according to the SIPRI Military Expenditure Database. One explicit example of the link was the 1974 US-Saudi accord, which set the terms of economic co-operation between the two sides. It involved American military support in exchange for the Gulf state investing in Uncle Sam’s debt.

Yet for many countries, particularly in Europe, the US is no longer a reliable provider of military security. In other words, the international version of Knapp’s theory may now start working in reverse. An unpredictable and unreliable American defence guarantee gives governments in Europe and elsewhere less of an incentive, on the margin, to use greenbacks. As Canadian Prime Minister Mark Carney said in a speech at the World Economic Forum last week, great powers using “financial infrastructure as coercion” sparks a search for autonomy.

What does this mean for the United States? The risk isn’t really a loss of financial benefits, which are surprisingly elusive beyond the profit American banks get from intermediating foreign transactions. Often cited is the US’s ability to borrow cheaply from abroad, but this may just be skewed by the tax‑avoidance strategies of multinationals. 

Or take the Federal Reserve’s role as global lender of last resort. True, it shielded the US during the 2008 and 2020 crises, but it also forced the central bank to help provide dollars to foreign nations or face a domestic blowback.

Equally, the supposed negative effects of dollar dominance are overstated too. Take the so-called “exorbitant burden” created by international demand for the greenback, which according to Fed ratesetter Stephen Miran and Peking University professor Michael Pettis makes US exports uncompetitive. The 1970s, early 1990s and mid‑2000s show that a global dollar can coexist with a weak exchange rate.

Dollar dominance is a reflection of US military, financial and economic strength. None of this is entirely imperilled by Trump’s antagonising of his NATO allies. The truth is subtler. Elliot Hentov of State Street Investment Management notes that transactions can migrate to more localised networks without causing a big dent on international dollar assets and liabilities.

China is already doing this, settling bilateral trade in yuan and local currencies while keeping a big US Treasury stash. India has begun using special rupee “vostro accounts”, to pay for imports such as Russian oil. Europe half-heartedly attempted something similar between 2019 and 2023 with INSTEX, a special purpose vehicle to facilitate trade with Iran without triggering US sanctions. As Germany, Britain and France take more responsibility for their own security, there may be better efforts along those lines. By ruling only through fear, King Dollar may lose some of what turned its might into power.