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

by Ray Dalio

The drive to tinker and invent, to discover, to improve from prior failures—this is how people learn and find new and better ways of creating things of value. In a market-based system, the most powerful way to drive innovation is to bring new ideas to market and to commercialize and profit from them. The marketplace is incredibly efficient at weeding out bad ideas and pricing good ones.

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

As Aristotle said a long time ago: “The poor and the rich quarrel with one another, and whichever side gets the better, instead of establishing a just or popular government, regards political supremacy as the prize of victory.”

Throughout time and in all countries the people who have the wealth are the people who own the means of wealth production and, in order to maintain it, they work with the people who have the power to set and enforce the rules.

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.

One timeless and universal truth that I saw go back as far as I studied history, since before Confucius who lived around 500 BCE, is that those societies that draw on the widest range of people and give them responsibilities based on their merits rather than privileges are the most sustainably successful because 1) they find the best talent to do their jobs well, 2) they have diversity of perspectives, and 3) they are perceived as the fairest, which fosters social stability.

I’ve had exposure to all kinds of economic systems all over the world and have seen why the ability to make money, save it, and put it into capital (i.e., capitalism) is an effective motivator of people and allocator of resources that raises people’s living standards. But capitalism is also a source of wealth and opportunity gaps that are unfair, can be counterproductive, are highly cyclical, and can be destabilizing. 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.

All entities—people, companies, nonprofit organizations, and governments—deal with the same basic financial realities, and always have.

The way entities collectively handle their finances as reflected in their income statements and balance sheets is the biggest driver of changes in internal and world orders.

As a principle, debt eats equity. What I mean by that is that debts have to be paid above all else.

debt eats equity but central banks can feed debt by printing money instead.

Having a reserve currency is great while it lasts because it gives a country exceptional borrowing and spending power and significant power over who else in the world gets the money and credit needed to buy and sell internationally.

The loss of its reserve currency status is a terrible thing because having a reserve currency is one of the greatest powers a country can have because it gives the country enormous buying power and geopolitical power.

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.

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.

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.

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.

THE SIX STAGES OF THE INTERNAL CYCLE Internal orders typically (though not always) change through a relatively standard sequence of stages, like the progression of a disease.

Stage 1, when the new order begins and the new leadership consolidates power, which leads to… … Stage 2, when the resource-allocation systems and government bureaucracies are built and refined, which if done well leads to… … Stage 3, when there is peace and prosperity, which leads to… … Stage 4, when there are great excesses in spending and debt and the widening of wealth and political gaps, which leads to… … Stage 5, when there are very bad financial conditions and intense conflict, which leads to… … Stage 6, when there are civil wars/revolutions, which leads to… … Stage 1, which leads to Stage 2, etc., with the whole cycle happening over again.

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.

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.

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.

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.

Populism and Extremism 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.

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.

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.

+ The Loss of Truth in the Public Domain 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.

Rule-Following Fades and Raw Fighting Begins 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.

People dying in the fighting is the marker that almost certainly signifies the progression to the next and more violent civil war stage, which will continue until the winners and losers are clearly determined.

That brings me to my next principle: 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.

This is typically late in Stage 5. History has shown that when things get bad, the doors typically close for people who want to leave. The same is true for investments and money as countries introduce ...

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. In other words, it happens when the system is broken beyond...

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

The biggest risk to democracies is that they produce such fragmented and antagonistic decision making that they can be ineffective, which leads to bad results, which leads to revolutions led by populist autocrats who represent large segments of the population who want to have a strong, capable leader get control of the chaos and make the country work well for them.

Civil wars and revolutions inevitably take place to radically change the internal order. They include total restructurings of wealth and political power that include complete restructurings of debt and financial ownership and political decision making.

Almost all civil wars have had some foreign powers participating in attempt to influence the outcome to their benefit. The beginnings of civil wars and revolutions aren’t clear when they are happening, though they are obvious when one is deeply in the middle of them.

There are five major kinds of fights between countries: trade/economic wars, technology wars, capital wars, geopolitical wars, and military wars.

1. Trade/economic wars: Conflicts over tariffs, import/export restrictions, and other ways of damaging a rival economically 2. Technology wars: Conflicts over which technologies are shared and which are held as protected aspects of national security 3. Geopolitical wars: Conflicts over territory and alliances that are resolved through negotiations and explicit or implicit commitments, not fighting 4. Capital wars: Conflicts imposed through financial tools such as sanctions (e.g., cutting off money and credit by punishing institutions and governments that offer it) and limiting foreign access to capital markets 5. Military wars: Conflicts that involve actual shooting and the deployment of military forces

When countries are weak, opposing countries take advantage of their weaknesses to obtain gains.

In war one’s ability to withstand pain is even more important than one’s ability to inflict pain.

All markets are primarily driven by just four determinants: growth, inflation, risk premiums, and discount rates.

My goal is to put these building blocks together in a portfolio that is well-diversified and tactically tilted based on what is happening or is going to happen in the world that is affecting these four drivers.