Principles for Dealing with the Changing World Order: Why Nations Succeed and Fail, by Ray Dalio
Overall, this was an excellent book, and I learned a lot! It prompted me to think about many topics such as capital markets, investments, the US conflict with China, domestic unrest, innovation, and technology. Broadly speaking across all metrics of wealth and power, the US is declining, whereas China is exponentially rising. What does this mean for the US economy? How does this impact my financial and career decisions? What will the future be like?
The Big Cycle
Throughout time, all of the world powers have risen and fallen in an archetypical pattern that Ray Dalio calls the Big Cycle. The United States is no different. The US, the world’s largest economic and military power, is experiencing events that the people of this generation have never experienced in their lifetimes. Therefore, our experiences seem unique, frightening, and uncertain. However, the US is following the archetypical Big Cycle, which means that by studying and understanding the Big Cycles of historical world powers, we can also make well-informed predictions about what is going to happen in the future of the US.
Ray Dalio studied the rise and decline of the last three (3) reserve currencies (the Dutch, the British, and the American) as well as the six (6) other significant world empires over the last 500 years (Germany, France, Russia, India, Japan, and China). With these studies, he created a chart that shows how the wealth and power of all the world empires has risen and fallen since 1500. The wealth and power of each empire was calculated using eight (8) metrics, shown later.
In this eye-opening chart (pg. 38), he shows that China dominated the world for several hundred years, up until about 1600, when it began to decline relative to the Netherlands. China remained strong until about 1800, when they experienced a sharp decline and the “Century of Humiliation”. Now, China’s wealth and power is rising exponentially and rapidly approaching the wealth and power of the US.
In the 1600s, the Netherlands became the world’s reserve currency, which sky-rocketed them to a position of high wealth and power. This was enabled primarily by their invention of ships and capital markets. After the Netherlands, the UK followed a similar path, in which they rose to become the world’s reserve currency in the 1800s. Most recently, the US has established the dollar as the world’s reserve currency and has become the world’s leading superpower. These events occurred after WWII. Although the wealth and power of the US far exceeds that of every other country, China’s wealth and power is increasing exponentially, and if this chart is accurate, China will soon equal and surpass the US on metrics of wealth and power.
The eight (8) determinants that inform wealth and power are:
Innovation and technology
Share of world trade
Financial center strength
Reserve currency status
There are many other determinants and dynamics that factor into an empire’s wealth and power (such as desired to keep wealth, geography, leadership, etc.), but these eight (8) are the most significant. Each of these metrics follows an archetypical rise and fall pattern during the Big Cycle. There is a rise, a peak, and a decline.
Rising education leads to increased innovation and technology, which leads to increased economic output and military strength, and then with a lag comes reserve currency status. At the peak, there is typically increased leisure, widening wealth gaps, less productivity, and increased borrowing. These things give the perception of wealth, but in terms of real wealth, the empire is actually declining, because the focus of the empire’s people has shifted from competition to indulgence. During the decline phase, debts become large, the empire chooses to print large amounts of money, additional taxes are imposed on the rich which encourages them to flee, there is internal conflict and civil war, and there exists an external superpower with similar wealth and power.
The Big Cycle is more easily understood when viewed in three (3) distinct cycles:
The Big Cycle of debt, money, credit, and capital markets
The Big Cycle of internal order/disorder
The Big Cycle of external order/disorder
The Big Cycle of Debt, Money, Credit, and Capital Markets
The primary factors that drive the world order are wealth and power, and religious ideology. For the purposes of this book, religious ideologies and influences are not discussed. Most people, and most empires, want wealth and power.
To understand wealth and power, you need to understand money, credit, and debt. Money settles claims. Debt is a promise to deliver money, which is a promise to settle claims. When lenders lend money, this creates debt. When money, credit, and debt are working correctly, these exchanges lead to productivity gains that benefit both lenders and borrowers.
The central banks are the institutions that control money and credit. When debts are too high, the central banks typically create money and credit, which devalues the reserve currency. By controlling the flow of credit and money, central banks create short-term debt cycles (approximately 7 years) and long-term debt cycles (approximately 75 years).
Currently, we are in the long-term debt cycle that began in 1944 in Bretton Woods, New Hampshire. At the Bretton Woods conference, delegates created a new monetary system following WWII. The US dollar became the world’s reserve currency, and the US dollar was linked directly to gold. The US banks were responsible for ensuring that all money could be exchanged directly for gold. In 1971, President Nixon announced that dollars were no longer linked directly to gold.
The long-term debt cycle, which lasts approximately 75 years, is summarized in the following stages:
A new monetary system is established that exchanges “hard money” (gold and silver coins), and claims can be settled immediately by exchanging gold
Banks are created to issue paper claims on the hard money. Paper claims are considered money, because they can be redeemed directly for hard money.
There are more claims on the hard money than actual hard money in the bank. Banks create credit and debt, which produces economic prosperity
Banks cannot repay all of the claims on money, so they either default, or in the case of a central bank, devalue the currency by printing more money (this reduces debt burdens)
Fiat money is created. In fiat systems, the paper claims on money are no longer linked to hard money, so the central bank can print money without restriction. The US shifted to fiat system in 1971, when they abandoned their link to gold
Frequent devaluations and defaults lead investors and governments to flee to hard money (return to stage 1)
The loss of reserve currency status comes after chronic large devaluations. Increases in the supply of money and credit decrease the value of money and credit. This is bad for the people that hold money and credit, but it is good for the people who hold debt. The additional supply of money and credit (which is used to relieve debt) is good when the money and credit is used to increase productivity and company profits. On the other hand, it is damaging if people move into inflation-hedged assets and other currencies, such as gold, real estate, crypto, art, etc.
The Big Cycle of Internal Order and Disorder
The biggest things that people fight over are wealth and power, and religion and ideology.
The six (6) archetypical stages of internal order and disorder are:
New leadership and consolidated power
Resource-allocation systems and governments are established
Peace and prosperity
Excess of wealth, plus widening wealth and political gaps
Bad financial conditions and lots of conflict
Civil wars and revolutions (which leads back to stage 1)
The US is currently in stage 5, which is the downward side of the Big Cycle. On the other hand, China is located in stage 2 and rising towards the top of the Big Cycle. Stage 5 is categorized by decadence, bureaucracy, populism, extremism, and fighting. How long will the US system bend before it breaks and civil war breaks out? We appear to be on the brink of stage 6.
The Big Cycle of External Oder and Disorder
External affairs are driven primarily by raw power dynamics. Whoever has the most power is able to create the rules. Wars can come in the form of economic wars, technology wars, geopolitical wars, capital wars, and military wars. The most successful empires have only been able to maintain their power for 200-300 years.
In the past 500 years, there have been approximately 3 Big Cycles of wars:
The Thirty Years’ War
The Napoleonic Wars
The World Wars
During WWII, nearly all of the wealth was erased from countries such as Japan, Germany, China, Russia, Austria, France, and Italy. After WWII, the United States emerged as the dominant world superpower.
The Last 700 Years
c. 1350: The financial concepts of bonds, stocks, and markets were established around 1350. Up until this point, the Christian and Islam communities prohibited lending. In Judaism, lending was only permitted outside of the Jewish community. The establishment of markets created new forms of wealth. Today, most of our wealth is contained in markets.
One of the first and most successful entities to create credit was the Medici family in Florence around 1350. In the Renaissance period (1300s-1600s), Italian city-states and European countries started to think more logically than religiously, which led to flourishing art, architecture, business, and technology. The Medici family, which was a family of business folks, was one of the leaders.
The Dutch Guilder: the wealth and power of the Dutch started to climb around 1581 and peaked around 1650. The Dutch valued education, hard work, and inventiveness. Most significantly, they invented ships which enabled them to travel around the world and collect riches, and they established capital markets which created money to fund further exploration. They established the world’s first publicly listed company, the Dutch East India Trading Company, and the world’s first reserve currency, the Dutch Guilder (other than gold or silver).
The British Pound: The British started to rise in the 1600s, but they did not peak until about 1850, after the decline of the Dutch in the 1700s. The UK benefited from Enlightenment thinking, which espoused that society should be based on science and reasoning rather than inspiration received from God. Enlightenment thinking encouraged education and scientific thinking, which sparked the Industrial Revolution and many inventions, such as the steam engine, iron refining, locomotion and railways, and more. However, overextension, the World Wars, and European conflicts caused the British to decline in the 1900s.
The US Dollar: The US started its rise after being established in the 1700s, and it peaked around 1970. The US emerged as the biggest winner after WWII, and New York was established as the global financial center at this time. During the 1900s, education, military strength, and innovation flourished in the United States.
After WWII, the US peaked and experienced about 30 years of great prosperity. During this time, the value of US markets grew significantly. In August 1971, the US defaulted on its commitments to pay in gold and turned to a Type 3 fiat money system. At the end of the 1970s inflation was at 14%, short-term interest rates were at 13%, and unemployment was at 6%. During this time, gold surged and commodities kept pace with inflation. In general, during high inflation, commodities seem to be a good investment. After the 1970s, the real value of the USD has steadily decreased. It is clear that the US is now on a downward trajectory.
When financial banks print money, like they did in 2008 and during the COVID-19 pandemic, it puts money in the hands of investors, who buy financial assets, which causes financial asset prices to rise, which helps the economy but also makes the rich richer and widens the wealth gap. Money does not trickle down. Instead, these initiatives only widen the wealth gap.
The Chinese have a very long history, which has seen many dynasties rise and fall, and has been influenced heavily by Neo-Confucian philosophy. Today, China is the next leading world superpower behind the US. China and the US have comparable powers in trade, economic output, and innovation and technology. However, China is weaker militarily (except in the Pacific, where they are stronger than the US) and weaker financially.
Between 600 and now, China has had 6 great empires:
People’s Republic of China (RPC)
The Qing Dynasty (1644-1912) was very strong, but was ultimately humiliated by the European powers. During this time, China was so large and powerful that they saw themselves as self-sufficient, and they refused to trade with the European powers. Therefore, the Europeans introduced opium to China, which caused the Chinese to get addicted to opium. Once addicted, the Chinese were willing to trade for it. This led to China’s “Century of Humiliation”, which began in the 1800s, and sparked the Opium Wars, which caused China’s rapid decline. During the Opium Wars, the British defeated the Chinese.
Since the end of the World Wars, China has been steadily rebuilding and accumulating wealth and power. They have announced goals to significantly increase income and GDP, and thus far they have been successful at achieving these goals. China wants to be a world leader.
Education in the US, according to Dalio’s metrics, is diminishing, whereas education metrics in China are rising. Ray Dalio actually sent his son to be educated in China during Elementary school, because he believed it was higher quality than the US education system.
The Chinese are influenced most significantly by Confucian, legalist, and Marxist philosophies, whereas the US is based primarily on Judeo-Christian, European philosophies. This difference leads to a significant different between how the US and China approach things. In general, the Chinese are more legalistic and hierarchical, with a greater focus on the collective and the family, whereas Americans are more individualistic and rules-adverse. The Chinese govern with a top-down approach, whereas the Americans use a bottom-up approach. The Chinese are more likely to ask questions, whereas the Americans are more likely to tell you what they think.
The Future (China, Innovation, and Investments)
Ray Dalio believes that the Chinese will continue to meet their national goals and increase their wealth. The trend shows that China will soon surpass the US on measures of wealth and power. When this happens, conflicts and wars will cause the US to rapidly decline. Things to watch that can potentially ignite a war:
Military conflict over the sovereignty of Taiwan
China stealing intellectual property and technology from the US (which is already happening)
If China cuts off essential imports to the US, this would also spark a trade/economic war
If the US cuts off China from essential technologies, this would spark a technology war
The biggest risk of external war for the United States and China is with regards to sovereignty in Taiwan. Other areas to watch for war are India, Russia, North Korea, South Korea, Afghanistan, and Pakistan.
The US is at risk of losing its reserve currency status. However, there is not a good alternative currency at this point. The Chinese Renminbi is the only alternative reserve currency that holds potential. Benefits of the Renminbi are that china’s share of world trade is growing, the Renminbi doesn’t have a 0% interest rate and negative real interest rate, and the currency is not printing and monetizing debt. Nevertheless, China has large domestic debt, and the Renminbi is not used heavily in the world economy.
Ray Dalio explains that there are very large risks in holding interest-earning cash currency as a storehold of wealth, especially late in debt cycles (pg 145). This implies that it is best to invest in inflation-hedged assets such as gold, commodities, and real estate.
The most significant determinant regarding a country’s condition is that country’s innovation and inventiveness. As historically shown, a country that is smaller in population but excels in innovation, will dominate much larger countries. This was true with the Dutch and British. The future is anything but certain, but whoever wins the technology war, through innovation, is mostly likely going to be the winner.
The world is poised to make many new innovative breakthroughs in areas of biochemistry, medicine, AI, machine learning, and quantum computing. A wise investor will expose himself to these areas and be positioned so that when a breakthrough occurs, he will reap the rewards. Ray Dalio is excited for the future of investing and being able to bet on new technologies.
In markets, and in life, to be successful, always bet on the upside that comes from productivity improvements, but don’t be so aggressive that bumps along the way will knock you out. Ray Dalio believes that we will continue to see bad times and downturns. Historically, this has always been true, and there is no indication that there will not be bad times in the future. Therefore, we need to learn how to protect ourselves from these bad times.
Specifically, there is roughly a 5% chance of civil war within the United States in the next 5 years. In the next 10 years, there is roughly a 10% chance of civil war. This is a dangerously high risk, and it must be protected against.
Another threat that we face is rising global temperatures. How will these temperatures affect acts of nature? And how will innovation address this challenge?
It is also interesting to note that everything is influenced by the people in leadership positions. The course of history is repeatedly changed by a relatively number of few people in key positions. In each generation, roughly a few hundred people make all the difference. Therefore, to make a difference in the future, it is important to study and learn from the impactful figures of the past. Similarly, surround yourself with the smartest people now so that you can be influenced by their thinking and improve your own positions in life.