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

by Ray Dalio

While the loan is outstanding, it is an asset for the lender (e.g., a bond) and a liability (i.e., debt) for the borrower.

It’s important to realize that most money and credit (especially the government-issued money that now exists) have no intrinsic value. They are just journal entries in an accounting system that can easily be changed. The purpose of that system is to help allocate resources efficiently so that productivity can grow, rewarding both lenders and borrowers, but the system periodically breaks down

When the level of goods and services demanded is strong and rising and there is not enough capacity to produce the things demanded, the real economy’s capacity to grow is limited. If demand keeps rising faster than the capacity to produce, prices go up and inflation rises.

By raising and lowering supplies of money and credit, central banks are able to raise and lower the demand and production of financial assets, goods, and services. But they’re unable to do this perfectly, so we have the short-term debt cycle, which we experience as alternating periods of growth and recession.

Where the money and credit flow is important to determining what happens. For example, when they no longer go into lending that fuels increases in economic demand and instead go into other currencies and inflation-hedge assets, they fail to stimulate economic activity and instead cause the value of the currency to decline and the value of inflation-hedge assets to rise. At such times high inflation can occur because the supply of money and credit has increased relative to the demand for it, which we call “monetary inflation.”

we have to watch movements in the supplies and demands of both the real economy and the financial economy to understand what is likely to happen financially and economically.

For example, how financial assets are produced by the government through fiscal and monetary policy has a huge effect on who gets the buying power that goes along with them, which also determines what the buying power is spent on. Normally money and credit are created by central banks and flow into financial assets, which the private credit system uses to finance people’s borrowing and spending. But in moments of crisis, governments can choose where to direct money, credit, and buying power rather than it being allocated by the marketplace, and capitalism as we know it is suspended. This is what happened worldwide in response to the COVID-19 pandemic.

To the extent that spending increases economic production and raises the prices of goods, services, and financial assets, it can be said to increase wealth because the people who already own those assets become “richer” when measured by the way we account for wealth. However, that increase in wealth is more an illusion than a reality for two reasons: 1) the increased credit that pushes prices and production up has to be paid back, which, all things being equal, will have the opposite effect when the bill comes due and 2) the intrinsic value of a thing doesn’t increase just because its price goes up.

As far as understanding how the economic machine works, the important thing to understand is that money and credit are stimulative when they’re given out and depressing when they have to be paid back. That’s what normally makes money, credit, and economic growth so cyclical.

Most people have seen enough of these short-term debt cycles—popularly known as “the business cycle”—to know what they are like, to such an extent that they mistakenly think they will go on working this way forever.

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. As a result they typically take people by surprise and do a lot of harm.

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 debt burdens from the last cycle were largely wiped out by restructuring and debt monetization, and because

of the consequences of these, particularly inflation, there is a return to hard money like gold and silver (and sometimes copper and other metals like nickel) or sometimes a link to a hard currency. For example, after the destruction of debt and money in Germany’s Weimar Republic money became backed by gold-denominated assets and land and pegged to the dollar, and after its destruction in Argentina in the late 1980s money became linked to the dollar.

At this stage, money being “hard” is important because no trust—or credit—is required...

When countries are at war and there is no trust in their intentions or abilities to pay, they can still pay in gold. So gold (and, to a lesser extent, silver) can be used as both a safe medium of exchange and a safe storehold of wealth.

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

b) the central bank printing money paired with the central government handing out money and credit to fill in the holes in incomes and balance sheets (which is what is happening now).

When this is done well, I call it a “beautiful deleveraging,” which I describe more completely in my book Principles for Navigating Big Debt Crises.

A bank that can’t deliver enough hard money to meet the claims being made on it is in trouble whether it is a private bank or a central bank, though central banks have more options than private banks. That’s because a private bank can’t print the money or change the laws to make it easier to pay their debts, while some central banks can. 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.

As the spending and budget deficits grew, the US had to issue much more debt—i.e., create many more claims on gold—even though the amount of gold in the bank didn’t increase. Investors who were astute enough to notice could see that the amount of outstanding claims on gold was much larger than the amount of gold in the bank.

History has shown that 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.5 It is a classic financial move. 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.

When this happens to the point that the holders of money and debt assets realize what is going on, they seek to sell their debt assets and/or borrow money to get into debt they can pay back with cheap money. They also often move their wealth into better storeholds, such as gold and certain types of stocks, or to another country not having these problems.

At such times central banks have typically continued to print money and buy debt directly or indirectly (e.g., by having banks do the buying for them) while outlawing the flow of money into inflation-hedge assets, alternative currencies, and alternative places.

All currencies devalue or die, and when they do, cash and bonds

As I explained

Compared to the others, printing money is the most expedient, least well-understood, and most common big way of restructuring debts.

It’s tough to identify any harmed parties that the wealth was taken away from to provide this financial wealth (though they are the holders of money and debt assets).

In most cases it causes assets to go up in the depreciating currency that people measure their wealth in, so it appears that people are getting richer.

History teaches us that people typically turn to gold, silver, stocks that maintain their real value, and currencies and assets in other countries not having these problems.

Some people think that there has to be an alternative reserve currency to go to for this flight to happen, but that’s not true as the same dynamic of the breakdown of the monetary system and the running to other assets has happened in cases in which there was no alternative currency (e.g., in dynastic China and during the Roman Empire). There are a lot of things people run to when money is devalued, including rocks (used for construction) in Germany’s Weimar Republic.

So governments make it harder to invest in assets like gold (by outlawing gold transactions and ownership, for example), foreign currencies (via eliminating the ability to transact in them), and foreign countries (by establishing foreign exchange controls to prevent money from leaving the country).

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. So, holding debt is a bit like holding a ticking time bomb that rewards you while it is still ticking and blows you up when it stops. And as we’ve seen, that big blowup (i.e., big default or big devaluation) happens something like once every 50 to 75 years.

For example, the Old Testament describes a year of Jubilee every 50 years, in which debts were forgiven. Knowing that the debt cycle would happen on that schedule allowed everyone to act in a rational way to prepare for it.

Most people worry about whether their assets are going up or down; they rarely pay much attention to the value of their currency.

In cases in which debt relief facilitates the flow of this money and credit into productivity and profits for companies, real stock prices (i.e., the value of stocks after adjusting for inflation) rise.

When the creation of money sufficiently hurts the actual and prospective returns of cash and debt assets, it drives flows out of those assets and into inflation-hedge assets like gold, commodities, inflation-indexed bonds, and other currencies (including digital). This leads to a self-reinforcing decline in the value of money.

At times when the central bank faces the choice between all...

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 pat...

There are systemically beneficial devaluations (though they are always costly to holders of money and debt), and there are systemically destructive ones that damage the credit/capital allocation system but are needed to wipe out debt in order to create a new monetary order. It’s important to be able to tell the difference.

In 1968–73 (most importantly in 1971), excessive spending and debt creation (especially by the US) required breaking the dollar’s link to gold because the claims on gold that were being turned in were far greater than the amount of gold available to redeem them.

Since 2000, the value of money has fallen in relation to the value of gold due to money and credit creation and because interest rates have been low in relation to inflation rates. Because the monetary system has been free-floating, it hasn’t experienced the abrupt breaks it did in the past; the devaluation has been more gradual and continuous.

The returns from holding currencies (in short-term debt that collects interest) were generally profitable between 1850 and 1913 relative to the returns from holding gold.

With the exception of the US, virtually every country devalued its currency because they had to monetize some of their war debts. Had they not done so, they wouldn’t have been able to compete in world markets with the countries that did.

That period of war and devaluation that established the new world order in 1918 was followed by an extended and productive period of economic prosperity, particularly in the US, known as the Roaring ’20s. Like all such periods, it led to big debt and asset bubbles and large wealth gaps.

That led to high inflation and low real interest rates, which led to the big appreciation in the real gold price until 1980–81, when interest rates were raised significantly above the inflation rate, leading currencies to strengthen and gold to fall until 2000.

Interest rates raising significantly past inflation rate meant that bonds become more lucrative and a hedge against inflation. Thus, people moved money from gold to bonds.

As previously explained, increasing the supply of money and credit reduces the value of money and credit. This is bad for holders of money and credit but a relief to debtors. When this debt relief allows money and credit to flow into productivity and profits for companies, real stock prices rise. But it can also damage the actual and prospective returns of cash and debt assets enough to drive people out of them and into inflation-hedge assets and other currencies. The central bank then prints money and buys cash and debt assets, which reinforces the bad returns of holding them. The later in the long-term debt cycle this happens, the greater the likelihood that there will be a breakdown in the currency and monetary system. Policy makers and investors must be able to tell the difference between systemically beneficial devaluations and systemically destructive ones.