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

by Ray Dalio

When countries desperately need reserve currencies to service their reserve currency-denominated debts, and to buy things from sellers who only accept reserve currencies, they can go bankrupt.

I distinguish them from the long-term debt cycle, which typically plays out over 50 to 75 years (and so contains about six to 10 short-term debt cycles).4 Because the crises that occur as these long-term debt cycles play out happen only once in a lifetime, most people don’t expect them.

The long-term debt cycle that is now in the late-cycle phase was designed in 1944 in Bretton Woods, New Hampshire, and began in 1945, when World War II ended and the dollar/US-dominated world order began.

when the central bank loses its ability to produce money and credit growth that passes through the economic system to produce real economic growth. Throughout history, central governments and central banks have created money and credit, which weakened their own currencies and raised their levels of monetary inflation to offset the deflation that comes from deflationary credit and economic contractions. This typically happens when debt levels are high, interest rates can’t be adequately lowered, and the creation of money and credit increases financial asset prices more than it increases actual economic activity. At such times those who are holding the debt (which is someone else’s promise to give them currency) typically want to exchange the debt they are holding for other storeholds of wealth. Once it is widely perceived that money and debt assets are no longer good storeholds of wealth, the long-term debt cycle is at its end, and a restructuring of the monetary system has to occur.

THE LONG-TERM DEBT CYCLE The long-term debt cycle transpires in six stages: Stage 1: It begins with a) little or no debt and b) money being “hard.”

Stage 2: Then come claims on hard money (i.e., notes or paper money).

Soon people treat these paper “claims on money” as if they are money itself.

Stage 3: Then comes increased debt. At first there are the same number of claims on the “hard money” as there is hard money in the bank. Then the holders of paper claims and the banks discover the wonders of credit and debt.

Trouble approaches when there isn’t enough income to service one’s debts, or when the amount of claims people are holding in the expectation that they can sell them to get money to buy goods and services increases faster than the amount of goods and services by an amount that makes the conversion from that debt asset (e.g., a bond) impossible. These two problems tend to come together.

Stage 4: Then debt crises, defaults, and devaluations come, which leads to the printing of money and the breaking of the link to hard money.

Private banks must either default or get bailed out by the government when they get into trouble, while central banks can devalue their claims (e.g., pay back 50–70 percent) if their debts are denominated in their national currency. If the debt is denominated in a currency that they can’t print, then they too must ultimately default.

Stage 5: Then comes fiat money, which eventually leads to the debasement of money.

When credit cycles reach their limit, it is the logical and classic response for central governments and their central banks to create a lot of debt and print money that will be spent on goods, services, and investment assets in order to keep the economy moving.

we shouldn’t rely on governments to protect us financially.

When one can manufacture money and credit and pass them out to everyone to make them happy, it is very hard to resist the temptation to do so.

Throughout history, rulers have run up debts that won’t come due until long after their own reigns are over, leaving it to their successors to pay the bill.

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.

there are four levers that policy makers can pull to bring debt and debt-service levels down relative to the income and cash flow levels required to service debts: 1. Austerity (spending less) 2. Debt defaults and restructurings 3. Transfers of money and credit from those who have more than they need to those who have less than they need (e.g., raising taxes) 4. Printing money and devaluing it

Big devaluations are abrupt and episodic rather than evolutionary.

What do these devaluations have in common? All the economies in the major cases that we examine in depth in Part II experienced a classic “run” dynamic, in which there were more claims on the central bank than there was hard currency available to satisfy them.

Net central bank reserves start falling prior to the actual devaluation, in some cases years ahead.

The run on the currency and the devaluations typically occur alongside significant debt problems

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 other things, most importantly ideology and religion.

A timeless and universal principle to keep in mind during this stage is that to be successful the system has to produce prosperity for most people, especially the large middle class. As Aristotle conveyed in Politics: “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.”

The leaders who are best during this stage are typically very different from those who succeeded in Stages 6 and 1. I call them “civil engineers.” 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 most extraordinary leaders are those who took their countries through Stages 6, 1, and 2—i.e., through the civil war/revolution, through the consolidation of power, and through the building of the institutions and systems that worked fabulously for a long time after them—and did it at scale.

Stage 3: When There Is Peace and Prosperity I also call this phase “mid-prosperity.” It is the sweet spot of the internal order cycle. It is when people have an abundance of opportunity to be productive, are excited about it, work well together, produce a lot, get rich, and are admired for being successful.

This is the time for the “inspirational visionary” who can a) imagine and convey an exciting picture of a future that never existed before, b) actually build that future out, and then c) use the prosperity earned to broaden the inclusiveness of it and to invest in the future. They do this while d) maintaining sound finances and e) pursuing excellent international relations, so that they protect or expand their empires without any financially or socially debilitating wars.

During this stage the developments to pay attention to that reflect the big risks that naturally develop and undermine the self-sustaining good results are the widenings of the opportunity, income, wealth, and values gaps accompanied by bad and unfair conditions for the majority, luxurious and unfairly privileged positions for the elites, declining productivity, and bad finances in which excess debts are created.

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.

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.

But when the haves realize that they will be taxed to pay for debt service and to reduce the deficits, they typically leave, causing the hollowing-out process.

History shows that raising taxes and cutting spending when there are large wealth gaps and bad economic conditions, more than anything else, has been a leading indicator of civil wars or revolutions of some type.

Averages don’t matter as much as the number of people who are suffering and their power.

To have peace and prosperity, a society must have productivity that benefits most people.

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.

History shows that lending and spending on items that produce broad-based productivity gains and returns on investment that exceed the borrowing costs result in living standards rising with debts being paid off, so these are good policies.

What a society spends money on matters. When it spends on investment items that yield productivity and income gains, it makes for a better future than when it spends on consumption items that don’t raise productivity and income.

While early in the internal order cycle bureaucracy is low, it is high late in the cycle, which makes sensible and needed decision making more difficult.

Out of disorder and discontent come leaders who have strong personalities, are anti-elitist, and claim to fight for the common man. They are called populists. 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.

Watch populism and polarization as markers. The more that populism and polarization exist, the further along a nation is in Stage 5, and the closer it is to civil war and revolution. In Stage 5, moderates become the minority. In Stage 6, they cease to exist.

during times of increased hardship and conflict there is an increased inclination to look at people in stereotypical ways as members of one or more classes and to look at these classes as either being enemies or allies.

A classic marker in Stage 5 that increases in Stage 6 is the demonization of those in other classes, which typically produces one or more scapegoat classes who are commonly believed to be the source of the problems. This leads to a drive to exclude, imprison, or destroy them, which happens in Stage 6.

Not knowing what is true because of distortions in the media and propaganda increases as people become more polarized, emotional, and politically motivated. In Stage 5, those who are fighting typically work with those in the media to manipulate people’s emotions to gain support and to destroy the opposition.

It is well-recognized this is happening at the time of this writing. The perceived truth in media, both traditional and social, is lower than at any other time in our lifetimes. For example, a 2019 Gallup poll found that only 13 percent of Americans surveyed have “a great deal” of trust in the media and only 41 percent of those surveyed have either a “fair” or “great deal” of trust in the media. That compares with 72 percent who trusted the media in 1976.

When the causes that people are passionately behind are more important to them than the system for making decisions, the system is in jeopardy. Rules and laws work only when they are crystal clear and most people value working within them enough that they are willing to compromise in order to make them work well.

When winning becomes the only thing that matters, unethical fighting becomes progressively more forceful in self-reinforcing ways. When everyone has causes that they are fighting for and no one can agree on anything, the system is on the brink of civil war/revolution.

when in doubt, get out—if you don’t want to be in a civil war or a war, you should get out while the getting is good.

Crossing the line from Stage 5 (when there are very bad financial conditions and intense internal and external conflict exist) to Stage 6 (when there is civil war) occurs when the system for resolving disagreements goes from working to not working.

When one is in Stage 5 (like the US is now), the biggest question is how much the system will bend before it breaks.