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

by Ray Dalio

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.

Many who held reserves in pounds continued to do so because of political pressures, and their assets significantly underperformed US assets during the same time.

In the case of the US, there were two big abrupt devaluations (in 1933 and 1971) and more gradual devaluations against gold since 2000, but they haven’t cost the US its reserve currency status.

Embedded in this chart are the rises and falls of major empires (particularly the Dutch and the British empires and the Ming and Qing dynasties), numerous wars, and numerous booms and busts, all of which are called out. These events don’t show up at the global level because they diversify each other and because they are small relative to the big trends, even though they are huge from the perspective of the people living through them.

During this stage the leaders who do best are “consolidators of power.” They typically have qualities similar to those who did best in the revolution in the prior stage—as they are strong, smart fighters who are willing and able to win at all costs. But in this stage they have to be much more politically astute because the enemies are much less apparent.

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

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.

Caesar Augustus (who became the first emperor of Rome in 27 BCE and began roughly 200 years of relative peace and prosperity, in which Rome became the world’s largest empire);

Successful entrepreneurs, inventors, and adventurers produce new ideas and take their societies to new places and become the heroes who others aspire to be like because of how they come up with revolutionary new ideas, make people’s lives better, and are rewarded for it.

Debt growth fuels productivity and in turn real income growth, which makes debts easy to service and provides excess profits that make equity returns excellent. Incomes exceed expenses and savings exceed liabilities with the savings financing investment in the future.

For example, the moon shot project exemplified the shared mission. The whole country cheered and was brought closer together when the lunar landing happened.

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.

They mistakenly believe that investments that have gone up a lot are good rather than expensive so they borrow money to buy them, which drives up their prices, which reinforces this bubble process. That is because as their assets go up in value their net worth and spending-to-income level rise, which increases their borrowing capacity, which supports the leveraging-up process, and so the spiral goes until the bubbles burst.

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.

However, these leaders are few and far between because fighting the ebullience of the masses is very unpopular. In almost all cases, after becoming rich, the country (and its leaders) become decadent, overspend, borrow to finance excess consumption, and lose competitiveness.

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.

That confluence typically brings about disorder, conflict, and sometimes civil wars. The economic shock can come about for many reasons, including financial bubbles that burst, acts of nature (such as pandemics, droughts, and floods), and wars. It creates a financial stress test.

The financial conditions (as measured by incomes relative to expenses and assets relative to liabilities) that exist at the time of th...

From studying 50-plus civil wars and revolutions, it became clear that the single most reliable leading indicator of civil war or revolution is bankrupt government finances combined with big wealth gaps.

A classic marker of being in Stage 5 and a leading indicator of the loss of borrowing and spending power, which is one of the triggers for going into Stage 6, is that the government has large deficits that are creating more debt to be sold than buyers other than the government’s own central bank are willing to buy. That leading indicator is turned on when governments that can’t print money have to raise taxes and cut spending, or when those that can print money print a lot of it and buy a lot of government debt. To be more specific, when the government runs out of money (by running a big deficit, having large debts, and not having access to adequate credit), it has limited options. It can either raise taxes and cut spending a lot or print a lot of money, which depreciates its value. Those governments that have the option to print money always do so because that is the much less painful path, but it leads investors to run out of the money and debt that is being printed. Those governments that can’t print money have to raise taxes and cut spending, which drives those with money to run out of the country (or state or city) because paying more taxes and losing services is intolerable. If these entities that can’t print money have large wealth gaps among their constituents, these moves typically lead to some form of civil war/revolution.

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.

What does history show as the path that bankrupt governments can follow to raise productivity that benefits most people? It shows that restructuring and/or devaluing enough of the previously created debt and non-debt obligations helps a lot. That is classic in Stages 5 and 6. Once the restructuring or devaluation reduces the debt burdens, which is typically painful at the time, the reduced debt burdens allow for a rebuilding.

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.

In fact, improvements in education and infrastructure, even those financed by debt, were essential ingredients behind the rises of virtually all empires, and declines in the quality of these investments were almost always ingredients behind empires’ declines. If done well, these interventions can more than counterbalance the classic toxic mix.