Principles for Dealing with the Changing World Order: Why Nations Succeed and Fail

by Ray Dalio

The marketplace is incredibly efficient at weeding out bad ideas and pricing good ones. In this way the concepts of innovation and commercialism go hand in hand. They capture whether people in a society value new knowledge and the creation of new things, and whether incentives are aligned to encourage them to seek a profit by commercializing them.

Innovation + Commercial Spirit + Thriving Capital Markets = Great Productivity Gains = Increases in Wealth and Power

for most of the 13th through 19th centuries, the prominent internal order all around the world consisted of the ruling classes or elites being 1) the monarchy, which ruled in conjunction with 2) the nobility, which controlled the means of production (at the time that capital was agricultural land), and/or 3) the military. Workers were viewed as part of the means of production and had essentially no say in how the order was run.

In all countries throughout time (though in varying degrees) people find themselves within “classes” either because they choose to be with people like them or because others stereotype them as part of certain groups.

people tend to cluster in these classes, and when times are good early in the cycle there is more harmony among these classes and when things are bad there is more fighting among them.

Capitalists (i.e., those of the right) and socialists (i.e., those of the left) don’t just have different self-interests—they have different deep-seated ideological beliefs that they are willing to fight for.

In my opinion, the greatest challenge for policy makers is to engineer a capitalist economic system that raises productivity and living standards without worsening inequities and instabilities.

allies who have very different vested interests unite in opposing the common enemy—as the saying goes, “the enemy of my enemy is my friend.” This dynamic naturally leads to the different sides having roughly equal amounts of power and splits within themselves. Sometimes the differences within the parties are so great that some segments want to destroy the other segments in order to gain control of their party. This alliance- and enemy-forming dynamic happens at all different levels of relationships, from the most important international alliances that define the most important elements of the world order down to the most important alliances within countries that define the internal orders, down to those within states, within cities, within organizations, and among individuals.

Big fights typically happen when both sides have roughly equal powers and existential differences exist between them.

Remember, there is always a limited amount of goods and services because the amount is constrained by the economy’s ability to produce.

The shift from a system in which the debt notes are convertible to a tangible asset (e.g., gold and silver) at a fixed rate to a fiat monetary system in which there is no such convertibility last happened in the US on the evening of August 15, 1971.

Earlier in the long-term debt cycle, when the amount of outstanding debt isn’t large and there is a lot of room to stimulate by lowering interest rates (and failing that, printing money and buying financial assets), there is a strong likelihood that credit growth and economic growth will be good. Later in the long-term debt cycle, when the amount of debt is large and there isn’t much room to stimulate, there is a much greater likelihood of monetary inflation accompanied by economic weakness.

While people tend to believe that a currency is pretty much a permanent thing and that “cash” is the safest asset to hold, that’s not true. All currencies devalue or die, and when they do, cash and bonds (which are promises to receive currency) are devalued or wiped out. That is because printing a lot of currency and devaluing debt is the most expedient way of reducing or wiping out debt burdens. When debt burdens are sufficiently reduced or eliminated, the credit/debt expansion cycles can begin again,

The money and credit producing path is much more acceptable politically than either of those options. It’s as if you changed the rules of Monopoly to allow the banker to make more money and redistribute it whenever too many players are going broke and getting angry.

Quite often, though not always, the government links its money to gold or a hard reserve currency with a promise to allow holders of that new money to convert it to the hard money. Sometimes that hard money is another country’s.

To review, holding debt as an asset that provides interest is typically rewarding early in the long-term debt cycle when there isn’t a lot of debt outstanding, but holding debt late in the cycle, when there is a lot of debt outstanding and it is closer to being defaulted on or devalued, is risky relative to the interest rate being given.

there is a real economy and there is a financial economy, and the two are closely entwined but different. Each has its own supply-and-demand dynamics.

Most people worry about whether their assets are going up or down; they rarely pay much attention to the value of their currency. Think about it. How worried are you about your currency declining? And how worried are you about how your stocks or your other assets are doing? If you are like most people, you are not nearly as aware of your currency risk as you need to be. So, let’s explore currency risks.

At times when the central bank faces the choice between allowing real interest rates (i.e., the rate of interest minus the rate of inflation) to rise to the detriment of the economy (and the anger of most of the public) or preventing real interest rates from rising by printing money and buying those cash and debt assets, they will choose the second path.

During World War I, warring countries ran enormous deficits that were funded by central banks’ printing and lending of money. Gold served as money in foreign transactions, as international trust (and hence credit) was lacking. When the war ended, a new monetary order was created with gold and the winning countries’ currencies, which were tied to gold.

On August 15, 1971, President Nixon ended the Bretton Woods monetary system, devaluing the dollar and leaving the monetary system in which the dollar was backed by gold and instituting a fiat monetary system.

The real return for bills since 1912 (the modern fiat era) has been -0.1 percent. The real return of gold during this era has been 1.6 percent. You would only have made a positive real return holding interest-earning cash currency in about half of the countries during this era, and you would have lost meaningfully in the rest (over 2 percent a year in France, Italy, and Japan, and over 18 percent a year in Germany, due to the hyperinflation).

From 1850 to 1971, gold returned (through its appreciation) an amount that roughly equaled the amount of money lost to inflation on average, though there were big variations around that average both across countries (e.g., Germany seeing large gold outperformance, while countries with only limited devaluations, like the US, saw gold prices not keep up with inflation) and across time (e.g., the 1930s currency devaluations and the World War II-era devaluations of money that were part of the formation of the Bretton Woods monetary system in 1944).

history has shown that there are very large risks in holding interest-earning cash currency as a storehold of wealth, especially late in debt cycles.

Net central bank reserves start falling prior to the actual devaluation, in some cases years ahead. It’s also worth noting that in several cases countries suspended convertibility before the actual devaluation of the exchange rate. The UK did this in 1947 and ahead of the 1949 devaluation, and the US did it in 1971.

The worst situations are when countries lose wars; that typically leads to the total collapse and restructuring of their currencies and their economies. However, winners of wars that end up with debts much larger than their assets and reduced competitiveness (e.g., the UK after the World Wars) also lose their reserve currency status, though more gradually.

Outcomes diverge significantly across the cases, with a key variable being how much economic and military power the country retains at the time of the devaluation. The more it has, the more willing savers are to continue holding their money there.

Typically, a country loses its reserve currency status when there is an already established loss of economic and political primacy to a rising rival, which creates a vulnerability (e.g., the Netherlands falling behind the UK, or the UK falling behind the US), and there are large and growing debts monetized by the central bank printing money and buying government debt. This leads to a weakening of the currency in a self-reinforcing run that can’t be stopped because the fiscal and balance of payments deficits are too great for any cutbacks to close.

How people are with each other is the primary driver of the outcomes they get. Within countries there are systems or “orders” for governing how people are supposed to behave with each other. These systems and the actual behaviors of people operating within them produce consequences.

Through my research, I saw how changes in internal orders (i.e., countries’ systems for governing internally) and changes in the world order (i.e., the systems determining power between countries) happen continuously and everywhere in similar and increasingly interconnected ways that flow together as one all-encompassing story from the beginning of recorded time up to this moment.

Seeing many interlinking cases evolve together helped me to discover the patterns that govern them and to imagine the future based on what I’ve learned.

I saw how the constant struggle for wealth and power produced continuously evolving internal systems/orders and external systems/orders and saw how these internal and external orders affect each other—with the whole thing (i.e., the world order) working like a perpetual-motion machine that evolves ...

The biggest thing affecting most people in most countries through time is how people struggle to make, take, and distribute wealth and power, though they also struggle over othe...

I saw why the swings between productive order and destructive disorder typically evolved in cycles driven by logical cause/effect relationships and how they happened in all countries for mostly the same reasons.

I am saying that it is important to watch the markers in order to understand both what is happening and the full range of possibilities for the period ahead. In this chapter, I explore those markers by drawing on the lessons from analogous historical cases.

Like evolution in general, the evolution of internal orders occurs in a cyclical way in which one stage typically leads to the next through a progression of stages that repeat and, in the process, evolve to higher levels of development.

That is the complete internal order cycle. But of course the cycle repeats, with new leaders replacing the old ones and the whole cycle beginning again. How quickly a nation is able to rebuild and achieve new heights of prosperity depends on 1) how severe the civil war/revolution that ended the prior cycle was and 2) how competent the leaders of the new cycle are at establishing the things required for success.

After the new leaders have torn down the old order and consolidated power, or overlapping with that time, the new leaders have to start building a new system to better allocate resources. This is the stage when system and institution building are of paramount importance. What is required is designing and creating a system (order) that leads to people rowing in the same direction in pursuit of similar goals, with respect for rules and laws, and putting together an effective resource-allocation system that leads to rapidly improving productivity that benefits most people.

to be successful the system has to produce prosperity for most people, especially the large middle class.

“Those states are likely to be well-administered in which the middle class is large, and stronger if possible than both the other classes… where the middle class is large, there are least likely to be factions and dissensions… For when there is no middle class, and the poor are excessive in number, troubles arise, and the state soon comes to an end.”

While they need to be smart, and ideally they are still strong and inspirational, above all else they need to be able to design and build the system that is productive for most people, or they need to have people working for them who can do that. The different qualities of leaders that are required to succeed in the revolutionary Stages 6 and 1 and those that are required in this rebuilding administrative Stage 2 are exemplified by Winston Churchill and Mao being great “inspirational generals” and lousy “civil engineers.” Examples of great leaders at this stage include Konrad Adenauer in Germany, Lee Kuan Yew in Singapore, and Deng Xiaoping in China, who came to power after wars and built systems that produced prosperity well beyond their lifetimes.

This sequence of rebuilding happens all the time in varying degrees depending on the amount of change that is warranted. In some cases it comes after brutal revolutions when there needs to be a rebuilding of nearly everything, and in other cases it comes when the institutions and systems that are there just need to be modified to suit the new leader.

During this phase, the archetypical best leader is the “well-grounded, disciplined leader” who understands and conveys sound fundamental behaviors that yield productivity and sound finances and creates restraints when the crowd wants to overdo things. These leaders are the ones who lead the country to continue to reinvest a significant amount of their earnings and their time into being productive when they become richer.

The classic toxic mix of forces that brings about big internal conflicts consists of 1) the country and the people in the country (or state or city) being in bad financial shape (e.g., having big debt and non-debt obligations), 2) large income, wealth, and values gaps within that entity, and 3) a severe negative economic shock.

When the financial problems occur, they typically first hit the private sector and then the public sector. Because governments will never let the private sector’s financial problems sink the entire system, it is the government’s financial condition that matters most. When the government runs out of buying power, there is a collapse. But on the way to a collapse there is a lot of fighting for money and political power.

Those places (cities, states, and countries) that have the largest wealth gaps, the largest debts, and the worst declines in incomes are most likely to have the greatest conflicts.

Averages don’t matter as much as the number of people who are suffering and their power. Those who favor policies that are good for the whole—e.g., free trade, globalization, advances in technology that replace people—without thinking about what happens if the whole is not divided in a way that benefits most people are missing the fact that the whole is at risk.

An essential ingredient for success is that the debt and money that are created are used to produce productivity gains and favorable returns on investment, rather than just being given away without yielding productivity and income gains. If it is given away without yielding these gains, the money will be devalued to the point that it won’t leave the government or anyone else with much buying power.

Populism is a political and social phenomenon that appeals to ordinary people who feel that their concerns are not being addressed by the elites. It typically develops when there are wealth and opportunity gaps, perceived cultural threats from those with different values both inside and outside the country, and “establishment elites” in positions of power who are not working effectively for most people. Populists come into power when these conditions create anger among ordinary people who want those with political power to be fighters for them. Populists can be of the right or of the left, are much more extreme than moderates, and tend to appeal to the emotions of ordinary people.

More recently, in the United States, the election of Donald Trump in 2016 was a move to populism of the right while the popularity of Bernie Sanders, Elizabeth Warren, and Alexandria Ocasio-Cortez reflects the popularity of populism of the left.