Ray Dalio is the founder and co-chief investment officer of Bridgewater Associates, the world’s largest hedge fund, which Dalio started in 1975 out of his two-bedroom apartment in New York. In his new book, “Principles for Dealing With the Changing World Order,” the famed investor offers the insights he gleaned from undertaking a comprehensive study of major empires and their markets over the the past 500 years. The excerpt below, taken from the books’ final chapter, “The Future,” explores the potential dangers ahead for the U.S. in monetary policy and the potential consequences, including armed conflict, of the growing rivalry between the U.S. and China.
“He who lives by the crystal ball is destined to eat ground glass” is a market adage I learned when I was about 14. Since I’ve personally experienced it to be true, it has affected how I look at both the future and the past. I have learned to look at the past 1) to determine what’s likely to happen and 2) to protect myself and others I am responsible for against the possibility I am wrong or missing something important.
Knowing how things have changed in the past leads me to consider the possibility that something similar might happen in the future. That is a big advantage relative to being unaware. For example, there are numerous examples in history of revolutions, wars, and acts of nature leading to violent events in which virtually all wealth is wiped out or confiscated. Knowing this, I am constantly looking for leading indicators of the same things happening again. And having leading indicators of these things, even if they aren’t perfect, puts me in a better position to protect myself than remaining blissfully unaware and unprepared for what might happen.
Being unaware of best-case scenarios can be equally bad. I remember very well how my dad and his friends failed to take advantage of the boom that followed the Great Depression and World War II, as their mindsets had been formed by those awful eras. In playing the game of life it pays to do one’s best to understand how the world works, imagine the full range of possibilities (including their risks and rewards), and know how to spread one’s bets around well.
My approach is based on my ideas about a) evolution, which causes changes over time, generally toward improvement, such as increasing productivity, b) cycles, which cause rhythmic ups and downs in the economy (like debt bubbles and busts) and bumps along the way (non-rhythmic ups and downs, like acts of nature), and c) indicators that can help us see where we are in the cycles and what might come next.
Throughout my roughly 50 years of investing, I have seen a number of well-established beliefs based on both what happened before and what seemed logical at the time be proven wrong (to choose a recent example, the belief that bond yields can’t go negative). The greatest recent disruptor of well-established beliefs was the Digital Revolution. Through these experiences and observations, I learned that identifying, understanding, and adapting to paradigm shifts is essential, even if one can’t anticipate them—though trying to anticipate them with good indicators that help is important too. Having good indicators can also help you tell when what looks like a paradigm shift is only a passing fad, which is just as important.
Trouble looming in the business cycle
The debt/money/capital market cycle is the biggest driver of the ups and downs in economies that have big implications for internal and external politics and wars, so knowing where countries are in this cycle is essential to anticipating what’s likely to come next.
Based on my readings of history, my readings of existing conditions, and my understanding of how the economic machine works, the promises that are denominated in the world’s reserve currencies, most importantly the dollar, are too large and growing too fast to be paid in hard money. In other words, the debt that is denominated in these currencies is an overhang, so money will probably be printed to service debts and debt growth and interest rates will probably be held below inflation and economic/income growth rates. This reflects the fact that the major reserve currency countries are late in their debt/money/capital market/economic cycles and that wealth will probably be increasingly redistributed from those who have a lot of it to those who don’t have enough of it in one way or another. The extent to which these things will be true will vary from country to country, though it will likely be worldwide.
For that reason, the biggest risk in the long run is the “currency value of money” risk, which most people don’t pay enough attention to.
To be clear, because the reserve currency countries that are running big deficits have their deficits and debts denominated in their own currencies, their ability to print the money to service the debts transfers the risks from them as debtors to those who are holding the debt as creditors. So, the big risk is not that those big debtors will default; it is that creditors will hold assets that will be devalued—i.e., that the returns from holding debt assets will be less than the inflation rate.I believe a great transfer of wealth from creditors to debtors (as happened in the biblical years of Jubilee, for instance) is coming for the same reasons it has always come in the past.
What does that mean for the dollar (most importantly) and the other more minor reserve currencies? Will they decline and others replace them? Most probably they will decline analogously to past reserve currency declines: slowly for a long time and then very quickly.
As we saw in those cases, the pace of reserve currency decline significantly lags the pace of the declines in other measures of strength. Reserve currencies tend to live on long after their fundamentals cease to justify their prominence because they become deeply entrenched in the ways things are done and there is a strong inclination to keep them. Then they abruptly plunge when it becomes clear that the fundamentals behind the currency make holding debt in it a bad deal.
The fall happens fast because the currency’s rate of decline outpaces the interest rate paid to the holders of the debt; the net losses lead to selling, which causes more losses, so the spiral becomes self-reinforcing. The Dutch guilder and the British pound both plunged in this way due to geopolitical crises/defeats happening when they had large debts. Those events made it clear to creditors that their fundamentals were weaker than they had assumed and the interest rate couldn’t compensate for the decline.
While I have very good indicators to identify this kind of decline happening as it happens, and some pretty good leading indicators that indicate when it will happen in the short term, my long-term leading indicators are only so-so for timing purposes. That is because they are financial and based on supply and demand. It is pretty easy to assess the financial conditions of countries in the same ways that one assesses the financial conditions of people and companies (by checking whether they are running surpluses or deficits and have more assets than liabilities, and finding out if their debts are in their own or foreign currencies and who is funding them and why). Because these are all long-term drivers, it is also pretty easy to see which countries and currencies are vulnerable. But anticipating exactly when the big fall will happen is difficult.
While the U.S.’s debt burdens are high, its debt is denominated in dollars, the world’s leading reserve currency, so it has the ability to print money to service its debts. This reduces its risk of default but increases its devaluation risk. If the U.S. lost its reserve currency status, it would be in serious financial trouble. Russia and Germany rank strongest on the debt burden gauge because they are the least indebted. Russia has no reserve currency status, and Germany has a fair amount because it uses the Euro, now the second most important reserve currency. China is in the middle of the rankings on the debt burden gauge because its debts are moderately high, mostly in its own currency, and mostly held by the Chinese. Its reserve currency status is emerging.
The internal order and disorder cycle
Luo Guanzhong’s classic book “Romance of the Three Kingdoms” begins: “The empire long divided must unite and long united must divide. Thus it has ever been.” That has been true of China and most other places, and it is likely to continue, so it’s a good principle. Here’s another key principle: Peace is profitable and war is costly.
That holds both within countries and between them. When parties cooperate and compete well, and don’t waste resources on fighting, productivity and living standards rise. When they fight, they waste resources (sometimes including lives), they destroy more than they produce, and living standards fall. It is for this reason that the degree of conflict within a country is such an important indicator.
All internal orders, even those that are not democratic, have rules about how decisions are made and how power is gained and shared. Because one can usually see how well these governance rules are respected or ignored, it is pretty easy to see when an internal order is being threatened by an emerging civil war. For example, when close elections are adjudicated and the losers respect the decisions, it is clear that the order is respected. When power is fought over and grabbed, that clearly signals the significant risk of a revolutionary change with all its attendant disorder.
There have been signs of that happening in the U.S., with some people contesting the validity of elections and expressing a willingness to fight for their aims. This bears watching.
There is also an exceptional amount of polarization in the U.S. right now, as reflected in the stats. Survey data about the sentiments of the voters paints a picture of polarization and intransigence. For example, in a 2019 Pew survey 55% of Republicans and 47% of Democrats viewed the other as more immoral than other Americans, and 61% of Republicans and 54% of Democrats said that those of the other party don’t share their values. Another study reported that 80 % of Democrats think that the Republican Party has been taken over by racists and 82% of Republicans think that the Democratic Party has been taken over by socialists.
The external order and disorder cycle
Based on what we have been seeing, the United States and China are clearly in four types of war (trade/economic war, technology war, capital war, and geopolitical war)—not intensely, but they are intensifying. They are not yet in the fifth type of war (military war). We can see from previous cases in history, in particular the 1930–1945 period, that these four types of wars precede military wars by about five to 10 years. Though the risks of military war seem relatively low, they are increasing.
Looking back over the last 500 years, one can see that military wars between major empires started on average about once every 10 years, give or take a couple of years, and it has been about 75 years since the last really big one (World War II). Since 1500, major powers have been at war a little bit more than half the time. From that perspective, the odds of a big military war in the next 10 years are about 50/50, but of course that’s simple minded. Let’s look at the picture a bit more carefully.
History shows that wars are terribly costly in lives and money, and the capacity to inflict harm has advanced exponentially since nuclear weapons were developed and used in World War II. I am unable to imagine what the next military war would look like. I have also seen that those who are most informed on both sides are not fully informed because a lot is unknown and because military wars always transpire in unexpected ways. For those reasons, it is impossible to confidently say who the winners and losers in the next big war would be. We also know from logic and from studying history that the losers of really big wars are completely wiped out and the winners lose too, as they suffer severe consequences and end up with big debts. In a word, it is devastating.
Students of history know that the doctrine of mutually assured destruction prevented the U.S. and the USSR from entering a hot war before the Soviet empire fell, mostly due to the failure to grow its other strengths in the face of big military spending. China is roughly comparable in power to the United States in the most important ways, and it is on its way to becoming more powerful in many ways. China won’t be as easy to defeat in any of the five types of war as the USSR was, and the USSR wasn’t easy to defeat. That means the wars are likely to intensify and increasingly favor China, especially if the U.S. doesn’t turn around the other fundamental underpinnings of strength that are highlighted in this chapter. However, it seems like it will be a long time before China can win a war without having the war lead to its own destruction as well.
So, in summary, my computer and I working together now believe that because for the foreseeable future China and the U.S. will be powerful enough to inflict unacceptable harm on each other the prospect of mutually assured destruction should prevent military war, though there almost certainly will be dangerous skirmishes. I expect this to be true unless some unexpected technological breakthrough, like dramatic advances in quantum computing, gives one of these powers such an asymmetrical advantage that mutually assured destruction would cease to exist. Also, though of less importance, an impediment to fighting is the interlinked well-being of Americans and the Chinese in this highly interconnected world.
However, as time passes the risks increase. If the U.S. continues to decline and China continues to rise, what matters most is whether or not each can do so gracefully. The big risk is that when existential irreconcilable differences exist and there is no mutually agreed-upon party or process to adjudicate the conflict, there is a good chance that there will be a fight. As explained in the last chapter, the main seemingly irreconcilable difference between the U.S. and China is over Taiwan, so I am watching developments there very closely. Taiwan is a one-of-a-kind interest that China would fight for because of its belief that “there is but one China and Taiwan is part of China.” It is doubtful that the U.S. would consider it worth a major fight to defend, though it might. This seems to me to be the only possible trigger for a military war between the two greatest powers in the next 10 years.
I think the odds favor intensifying trade/economic wars, technology wars, capital wars, and geopolitical wars as China becomes even more competitive and increasingly goes global in these areas.As Graham Allison explained in his excellent book, “Destined for War,” in the past 500 years, when two nearly equal powers experienced irreconcilable differences, there were military wars in 12 out of 16 cases, and big military buildups were associated with major wars in 80–90% percent of cases. I balance those historical insights with the logic of mutually assured destruction, which lowers the odds of war. On net, I would conclude that the probability of a big war in the next 10 years is 35%, give or take, which is essentially a wild guess. In any case, it’s a dangerously high risk.
The next 10 years
While this book is about the really big cycles, I’d like to focus now on the dynamics within these cycles that will be most important over the next 10 years. There are cycles within cycles within cycles, with the little ones adding up to the bigger ones, plus there are non-cyclical bumps that all together determine what happens.
The short-term debt/money/economic cycle consists of alternating periods of central banks stimulating the economy by creating money and credit, and then attempting to slowing it down by reducing the flow of them. They never get this precisely right, which is what produces the excesses that lead to bubbles, busts, and the cycle beginning again. Sometimes other negative events happen around the same time as a downturn—Sept. 11, 2001, was such a case.
This cycle typically takes about eight years, give or take a few, though the timing is less the result of how long it’s been since the last one and more the result of the underlying economic drivers themselves. Most importantly, the amount of slack in the economy, the amounts and types of financial bubbles, the amount of central bank tightening, and the markets’ and economies’ sensitivity to tightening all matter.
The last cycle began in April 2020 with largest dose of fiscal and monetary stimulation ever. The one before that began in 2008, which was also a giant dose though much less big. The ones before that began in 2001, 1990, 1982, 1980, 1974, 1970, 1960, etc. With the amounts of stimulation injected into this recent downturn being so enormous (especially in the U.S.), with the slack in the major economies being relatively limited (especially in the U.S.), with the signs of bubbles now being moderate to strong, and with the interest rate sensitivity of markets and the economy being high, my guess is that the next downturn will come sooner than is typical. I’d estimate in about four years from the publication of this book, give or take a couple of years (which is about five-and-a-half years from the bottom).
Don’t bet on what I just said happening because that configuration is not precise. I will need to monitor the factors I just mentioned, especially the rate of rebound in inflation and how quick and strong central bank tightening will be in order to home in on the precise timing. Also, I would expect any downturn to be promptly followed by a quick reversal of central bank policies toward the next big round of stimulation. That makes me less worried about the impact of the downturn and more worried about the excess money printing and the loss of value of money (particularly cash and debt in dollars, euros, and yen). Of course what happens in this economic cycle will be affected by what happens with the other cycles and the bumps along the way, just as this cycle will affect the other cycles.
Four decision-making rules to remember
Whatever success I’ve had has been more due to my knowing how to deal with what I don’t know than anything I know. Betting on the future is betting on probabilities and nothing is certain, not even the probabilities. That’s just the way it is. In a nutshell, here’s what I try to do:
Know all the possibilities, think about the worst-case scenarios, and then find ways to eliminate the intolerable ones. Identifying and eliminating the intolerable worst-case scenarios comes first. That’s because the most important thing in playing the game (of life or the markets) is to not get knocked out of it. I learned that from a big mistake I made in 1982, which nearly broke me. After that painful loss I calculated what my basic needs would cost and worked toward having enough money stashed away so my worst-case scenario would be tolerable.
Diversify. In addition to making sure I’ve covered all the worst-case scenarios I can think of, I try to cover those I can’t think of by diversifying well. I learned the math of it and I’m drawn to it instinctively. Essentially, if I have a bunch of bets that are attractive but unrelated, I can reduce my risks by up to 80% without reducing my upside at all. While this sounds like an investment strategy, it’s actually an old and well-established good life strategy that I apply to that I apply to investments as well. There is a Chinese saying that “a smart rabbit has three burrows,” meaning three places to go to in case any one of them becomes dangerous. This principle has saved many people’s lives when things got bad, and it’s one of my most important principles.
Put deferred gratification ahead of immediate gratification so you will be better off in the future.
Triangulate among the smartest people possible. I tag along with the smartest people I can find, so I can stress test my thinking and learn from them.
It is through these principles that I got so much upside with relatively little downside, albeit with bumps along the way. That’s why I recommend them to you. Though as always, you should feel free to take them or leave them as you like.
From “Principles for Dealing with the Changing World Order” by Ray Dalio. Copyright © 2021 by Ray Dalio. Reprinted by permission of Avid Reader Press, an Imprint of Simon & Schuster, Inc.
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