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

by Ray Dalio

In 1919, the victors—the US, Britain, France, Japan, and Italy—met at the Paris Peace Conference to lay out the new world order in the Treaty of Versailles.

Those debt burdens contributed to an inflationary depression in Germany from 1920 to 1923. Elsewhere, much of the world entered a decade of peace and prosperity, the Roaring ’20s. As is typical, the debts and the wealth gaps that were built up burst in 1929, causing the Great Depression. These two big boom and bust cycles came unusually close together, though they followed the classic stages.

The Great Depression coupled with the large wealth gaps led to a rise in populism and extremism in nearly every major country. In some countries—e.g., the US and the UK—this led to big redistributions of wealth and political power while capitalism and democracy were maintained. In others, particularly those with weaker economies (Germany, Japan, Italy, Spain), populist dictators seized control and sought to expand their empires. Classically, before all-out wars begin, there is typically about a decade of economic, technological, geopolitical, and capital skirmishing.

THE DECLINE The Allied victory in 1945 produced a tremendous shift of wealth and power, with the US emerging as the world’s dominant empire just as the British had after the Napoleonic Wars.

It took another 20 years for the British pound to fully lose its status as an international reserve currency.

The most important geopolitical elements of the post-war order were: The US was the dominant power, which made it the de facto global police force.

The United Nations was established to resolve global disputes.

The most important financial elements of the new world order consisted of: The Bretton Woods monetary system, which established the dollar as the world’s reserve currency. The IMF and the World Bank, designed to support the new global financial system. New York as the new global financial center. From the European perspective, the key aspect of the new world order was the shift from a balance of power in which the preeminent European powers were on top to a world in which they were exhausted and overshadowed by new superpowers that dwarfed any one European state (especially as their colonies gained independence).

THE BIG CYCLE RISE AND DECLINE OF THE UNITED STATES AND THE DOLLAR This chapter covers the Big Cycle rise of the US beginning in the 19th century, its gradual surpassing of the UK as the world’s most powerful empire, and its recent decline. As the story of the US as the world’s leading empire is still unfolding and is highly relevant to the world today, I will be going through its Big Cycle in more detail than I did for the Dutch and British, especially as it relates to the dollar’s status as a global reserve currency and the economic and monetary policy forces that have impacted it.

After the US Civil War came the Second Industrial Revolution, which was one of those classic times in which the peaceful pursuit of wealth and prosperity created great gains in incomes, technologies, and wealth in England, continental Europe, and the United States. In the US, these gains were financed through a system of free-market capitalism that, as is classic, produced both lots of wealth and big wealth gaps.

The US went through many boom/bust cycles, in which classically a flurry of debt-financed investments (into land, railroads, etc.) became overextended, leading to credit losses and a credit crunch. As a result, banking system panics were extremely common.

Like London, New York was well-established as a trading center long before it became a global financial center, a development that didn’t occur until after the turn of the 20th century.

the second half of the 19th century was a boom period of peace and prosperity that has been called “the Second Industrial Revolution,” “the Gilded Age,” and “the Robber Barron Era” because it was the period in which capitalism and innovation flourished, wealth gaps widened enormously, decadence was apparent, and resentment built.

Following the standard script, the winning powers—in this case the US, Britain, France, Japan, and Italy—met after the war to set out the new world order. That meeting, called the Paris Peace Conference, took place in early 1919, lasted for six months, and led to the Treaty of Versailles.

The important thing to remember here is that the Allied victory in 1945 produced the next shift in the world order. It was a tremendous shift of wealth and power. On a relative basis the US came out the big winner because the US sold and lent a lot before and during the war, basically all of the fighting took place off of US territory so the US wasn’t physically damaged, and US deaths were comparatively low in relation to those of most other major countries.

While there was relatively good cooperation between the US and Russia immediately after the war, it didn’t take long for the two greatest powers with opposing ideologies to enter a “cold” war.

Because spending on the military takes government money away from spending on social programs, and because military technologies go hand in hand with private sector technologies, the biggest military risk for the leading powers is that they lose the economic and technology wars.

Americans are impulsive and tactical; they fight for what they want in the present. Most Chinese are strategic; they plan for how they can get what they want in the future.

Chinese history and philosophy, most importantly Confucian/Taoist/legalist/Marxist philosophies, have a much bigger influence on Chinese thinking than American history and its Judeo-Christian/European philosophical roots have on American thinking.

The planning horizon that Chinese leaders concern themselves with is well over a century because that’s at least how long a good dynasty lasts. They understand that the typical arc of development has different multidecade phases in it, which they plan for.

America is run from the bottom up (e.g., democracy) and optimized for the individual; China is run from the top down and optimized for the collective.

The Chinese fought to stop those sales, which led to the First Opium War, in which the technologically superior British Navy defeated the Chinese in 1839–42, leading Britain to impose a treaty that gave the British Hong Kong and opened up a number of Chinese ports, most notably Shanghai, to traders from Britain (as well as other powers in subsequent treaties), which eventually led to the loss of large parts of northern China to Russia and Japan and the loss of what we now call Taiwan to Japan.

Marx’s most important theory/system is called “dialectical materialism.” “Dialectical” refers to how opposites interact to produce change, and “materialism” means that everything has a material (i.e., physical) existence that interacts with other things in a mechanical way. In a nutshell, dialectical materialism is a system for producing change by observing and influencing the “contradictions” of “opposites” that produce “struggles” that, when resolved, produce progress. Marx meant it to apply to everything. The conflict and struggle between the classes that is manifest in the conflict between capitalism and communism is just one of many such examples.

The Rise from 1949 until Now Though it’s a bit of an oversimplification, we can think of China’s evolution from 1949 until now as occurring in three phases: 1. The Mao phase, from 1949 to 1976. 2. The Deng and Deng’s successors phase, from 1978 to 2012 when Xi Jinping came to power. 3. The Xi Jinping phase from 2012 until now. Each phase moved China along the arc of its long-term development, building on its earlier accomplishments. In brief, events transpired as follows:

At the end of World War II, Korea was divided at the 38th parallel, with the Russians controlling the north and the Americans the south. In June 1950, North Korea invaded South Korea. The Chinese stayed out of the fighting initially, as they were preoccupied with their own challenges and didn’t want to be drawn into a war. In conjunction with the United Nations, the United States responded by bringing its forces into the fighting, taking the war into North Korea, which borders China. The Chinese viewed this as a threat, especially since US General Douglas MacArthur made it clear that he would attack China. Though the Soviets and the Chinese had a pact to support each other, Stalin didn’t want to go war with the United States so he didn’t provide China with the military support it expected. Though the Chinese were ill-prepared for war against the much greater (and nuclear-armed) American power, the Chinese entered the war, pushing the American and UN troops back to the previously established border. This was Mao’s first great challenge, and it is considered a great victory by the Chinese.

In 1979, he established full diplomatic relations with the US. Early on, Deng set out a 70-year plan to a) double incomes and ensure that the population would have enough food and clothing by the end of the 1980s, b) quadruple GDP per capita by the end of the 20th century (which was achieved in 1995, five years ahead of schedule), and c) increase per capita GDP to the levels of medium-level developed countries by 2050 (on the 100th anniversary of the PRC). He made it clear that China would achieve those goals by having a “socialist market economy,” which he also referred to as “socialism with Chinese characteristics.”

Regaining territories it lost during its Century of Humiliation was also a very important long-term goal. In 1984, after a lot of haggling with the UK, it was agreed that Hong Kong would return to Chinese sovereignty in 1997, with a “one country, two systems” approach. Then in 1986, China reached an agreement with Portugal to obtain Macau’s return to Chinese sovereignty in 1999.

Then, a shock happened that led everyone to question just about everything. In 1989, a movement to democratize China grew into the demonstrations that led to the crackdown known as the Tiananmen Square incident. The leadership was split on how to handle the movement. Deng made the defining choice, which was to sideline the liberal forces and go ahead with the conservatives’ crackdown. Most Chinese people I spoke with at the time were worried that China would slip back into its old Mao/Gang-of-Four-type ways.

Over the next decade, the economy continued its strong growth, and relations and trade with the West became better than ever. Globalization, which helped China immensely, can be said to have begun in 1995 with the formation of the World Trade Organization (the epoch effectively ended with the election of Donald Trump in 2016).

During this period of globalization, a symbiotic relationship developed between China and the US in which the Chinese manufactured consumer goods in an extremely cost-effective way and loaned the US money to buy them. It was a hell of a “buy now, pay later” deal for the Americans, and the Chinese liked it because they built their savings in the world’s reserve currency.

As a result of the “Third Taiwan Strait Crisis,” the Chinese significantly built up their military capabilities in the region. I point this out to convey a) how important Taiwan’s reunification with China is and b) how risky the situation was 25 years ago, when China was not nearly as strong militarily as it is now. In short, I would worry a lot if we were to see a “Fourth Taiwan Strait Crisis.”

From the start of his reforms in 1978 until his death in 1997, the Chinese economy grew at an average rate of 10 percent a year, sextupling in size while experiencing an average inflation rate of just 8 percent.

Phase Three: The Emergence of US-China Conflicts and the End of Globalization (2008–Present) As is classic, periods of prosperity financed by debt growth lead to debt bubbles and large wealth gaps.

The era of peace, prosperity, and globalization began to wane, giving way to an era of conflicts between the rich and the poor within countries and between the rising country (China) and the dominant world power (the US).

Over the years, the Xi administration has aggressively pursued policies to reform and open up its markets and its economy; manage its debt growth; more flexibly manage its currency; support entrepreneurship and market-oriented decision making, especially in industries that China wants to be world leaders in; establish sensible regulations run by well-developed regulatory organizations; build its capabilities in the technologies and industries of the future; broaden the economic benefits extended to the people and regions that were lagging the most; and control pollution and environmental degradation.

To understand their circumstances and perspectives, I suggest that you not view what they are doing through stereotypes (e.g., of “what communists do”) and accept that they are trying, and will continue to try, to juggle these two seemingly inconsistent things. In their view capitalism is a way of raising the living standards of most people and is not meant to serve capitalists. Whether one thinks this approach is good or bad, their results have been extremely impressive so we should not expect the Chinese to abandon it for an American or Western approach. Rather, we should study it to see what we can learn from it, the same way that the Chinese have studied and learned from the West. After all, what we have is a competition of approaches that we need to understand in order to play this competitive game well. As far as foreign policy is concerned, China has become stronger and more forceful while the United States has become more confrontational. More specifically, from 2012 until the time of my writing China’s strengths have grown, which has become increasingly apparent and more openly shown (e.g., the Made in China 2025 plan trumpets its plans to dominate certain industries that the United States currently controls). This has sparked a strong reaction in the US, which became most evident after the election of Donald Trump in 2016.

As far as China’s internal politics are concerned, in 2018 Xi a) consolidated power around himself and his supporters (called “the core” leadership), b) amended the Chinese constitution to make it clear that the Chinese Communist Party has control over everything, c) eliminated term limits for the president and vice president, d) created supervisory commissions to ensure that government officials are operating consistently with the party’s wishes, and e) enshrined Xi’s perspective, called “Xi Jinping Thought,” into the constitution. As of this writing, big political changes, increased controls, and wider distribution of wealth are all underway.

Looking back over the last four decades, China’s shift from isolation to opening up and from hard-core communism to “market reforms” and capitalism have had a greater impact on the economies of China, the US, and the rest of the world than anything else.

In conclusion, this modern era for China has led to some of the most rapid improvements in basic living conditions in history as well as an obvious climb in the factors that create powerful empires. In all respects, China is now a major and expanding power. Next we will turn to the US-China relationship in light of where it is now and what matters most to Americans and the Chinese.

US-CHINA RELATIONS AND WARS

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Because the US and China are now rival powers in a number of domains, they are in “conflicts” or “wars” in these domains,

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As I see it, destiny and the Big Cycle manifestations of it have put these two countries and their leaders in the positions they are now in. They led the United States to go through its mutually reinforcing Big Cycle successes, which led to excesses that led to weakening in a number of areas. Similarly they led China to go through its Big Cycle declines, which led to intolerably bad conditions that led to revolutionary changes and to the mutually reinforcing upswings that China is now in. So, the United States appears to be in decline and China appears to be on the rise for the all the classic reasons.

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example, it is because of the United States’ great global successes that the US dollar became the world’s dominant reserve currency, which allowed Americans to borrow excessively from the rest of the world (including from China), which put the US in the tenuous position of owing other countries (including China) a lot of money which has put those other countries in the tenuous position of holding the debt of an overly indebted country that is rapidly increasing and monetizing its debt and that pays significantly negative real interest rates to those holding its debt.

History has shown that all countries’ success depends on sustaining the strengthening forces without producing the excesses that lead to countries’ declines. The really successful countries have been able to do that in a big way for 200–300 years. No country has been able to do it forever.

History has taught us that there are five major types of wars: 1) trade/economic wars, 2) technology wars, 3) geopolitical wars, 4) capital wars, and 5) military wars. To these I would add 6) culture wars and 7) the war with ourselves.

We see these wars transpiring in varying degrees now. They should not be mistaken for individual conflicts but rather recognized as interrelated conflicts that are extensions of one bigger evolving conflict. In watching them transpire we need to observe and try to understand each side’s strategic goals—e.g.,

When things are going well it is easy to keep the moral high ground. However, when the fighting gets tough, it becomes easier to justify doing that which was previously considered immoral (though rather than calling it immoral it is called moral).

I believe that we have pretty much seen the best trade agreement that we are going to see and that the risks of this war worsening are greater than the likelihood that they will lessen, and that we won’t see any treaty or tariff changes anytime soon from the Biden administration.

Classically, the most dangerous part of the trade/economic war comes when countries cut others off from essential imports.

moves to cut off essential imports from either side would signal a major escalation that could lead to a much worse conflict.