Changing World Order (Ray Dalio)

Books · Investing

Introduction

Economic and political systems have had a classic cycle over the years. There are swings between peaceful periods and conflict periods, and peaceful periods are roughly 5x longer than conflict periods

The really big boom periods and really big bust periods come about once in a lifetime and surprise those that have not studied history

When Nixon took the US off the gold standard, the US$ was effectively devalued wrt “safer” physical assets and stocked jumped ⇒ this is expected when a currency is devalued

When wealth and values gaps are large and there is an economic downturn, it is likely that there will be conflict about how to divide the pie

The big cycle in a nutshell

People with wealth are those who own the means of wealth production. To maintain/increase their wealth, they work with people who have political power and who are in a symbiotic relationship with them to set and enforce the rules

Over time, this leads to a small percentage of population gaining and controlling especially large percentages of the total wealth and power, then becoming overextended, and then the country as a whole encountering bad times

This hurts the least wealthy and the least powerful the hardest, and that leads to conflicts that produce revolutions or civil wars. When these conflicts are over, a new cycle starts

đź’ˇ Embedded in swings in one direction are the reasons that lead to swings in the opposite direction

Innovations and productivity improvements do not cause big, abrupt shifts in who has wealth and power. Those come from booms, busts, revolutions, and wars.

8 determinants of wealth and power (in order of leading to lagging indicators)

  1. Education
  2. Competitiveness
  3. Innovation and technology
  4. Economic output
  5. Share of world trade
  6. Military strength
  7. Financial center strength
  8. Reserve currency status

Archetypical Cycle

Rise

  • low levels of debt
  • small wealth, values, political gaps
  • people working together for prosperity
  • good education and infrastructure
  • strong and capable leaders
  • innovation and invention with new technologies

The Top

  • high debt
  • large wealth, values, political gaps
  • declining education and infrastructure
  • class conflicts
  • struggle between countties

The Decline

  • either print money or default on debts, leads to devalue currency of raise inflation
  • populism, which leads to higher taxes on the rich, which leads to capital flight, which leads to lower total taxes and ability to nation-build

Visually, this can be represented in the following cycle

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Chapter 2: The Determinants

There are 3 big cycles that determine a country’s progress. Its economic cycle (chapter 3), its cycle of external order and disorder (chapter 6), and its cycle of internal order and disorder (chapter 5).

Within these, there are 8 key determinants of a country’s power (listed above), as well as additional determinants that include:

  • geology and natural resources
  • resource allocation efficiency
  • acts of nature
  • infrastructure and investment
  • character, civility, and determination of its people
  • governance and the rule of law
  • gaps in wealth, opportunities, and values

Chapter 3: Big cycle of money, credit, debit, and economic activity

💡 If you don’t understand how money and credit work, you can’t understand how the system works, and you don’t know what is coming at you

In the roaring 20s, the US had a massive debt bubble and wealth gap. When this bubble burst, it let to the great depression, and that led to conflicts over wealth.

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

Debt eats equity. Debts have to be paid above all else. If you have a house and can’t make mortgage payments, the house will be taken away. Creditors get paid ahead of owners.

However, central bankers can feed debt by printing money instead – especially when the political costs of eating equity and causing economic pain are high.

There isn’t a fixed amount of money in existence. Money/credit can easily be created by central bankers. When more money is created, spending power goes up. This makes prices go up.

At the same time, when debt is created, it must be paid back. As such, consumers must eventually spend less than they earn.

Because of both of these factors, credit and relative money go down over the long term when central bankers print more money.

What is debts don’t have to be paid back? This essentially happens when interest rates are 0. It’s bad for those who still hold the debts as assets – as they won’t get returns that would preserve their purchasing power.

When incomes are low compared to expenses, but debt and other liabilities (like pensions/healthcare) are very large relative to the value of assets, people can look rich even though they are in the process of going broke. “Richness” (GDP) is measured by spending – which can be unsustainably high in the short term

Having a reserve currency is great while it lasts. It gives you exceptional borrowing and spending power + power over other countries that need to trade. When countries desperately need reserve currencies to service their reserve-currency denominated debt, they can go bankrupt

💡 Money/credit ≠ wealth! Money and credit can buy wealth (goods and services). But you cannot create wealth just by producing more money and credit. To create more wealth, you must be more economically productive.

Financial economy (money/credit) and the real economy(wealth) are related, but different. One must watch out for changes in the supply and demand of both.

An increase in money doesn’t necessarily mean an increase in wealth. The intrinsic value of a thing doesn’t necessarily go up just because its price goes up. If your house is 2x more expensive just because capital is cheaper, its intrinsic value is still the same.

Money and credit are stimulative when they are given out and depressing when they have to be paid back. This is why money, credit, and economic growth are cyclical.

Short-term debt cycles last 5-10 years. Long-term debt cycles last 50-75 years. Most are familiar with the former, and most are not familiar with the latter.

Long-term debt cycles end when debts are high and when the central bank loses ability to convert money into real economic growth. I.e., when the price of financial assets increases way more than real economic activity.

We should not rely on government to protect us financially. When one can manufacture money and pass it around to make everyone happy, it is difficult to resist the temptation to do so.

central bankers always end up printing more money and devaluating their currency

This taxes those who own debt. Holders of money and debt assets seek to sell their debt assets and/or borrow money to get into debt that can be paid with cheap money. They also move money into better storeholds, like gold or more stable countries.

When this happens, central bankers try to outlaw capital flight.

All currencies eventually devalue or die. When they do, cash and bonds are devalued or wiped out. Devalued debt is the most expedient way of reducing or wiping out debt burdens.

There are 3 types of monetary systems:

  1. Hard money (metal coins). Here, you cannot create more money unless supply of metal increases
  2. Paper money (claims on hard money). Here, it’s easier to create credit by increasing the ratio of claims on hard money to currency. This also makes these systems vulnerable to bank runs.
  3. Fiat money. Governments can create money freely, but only as long as people continue having faith in the currency

Countries often go from 1 → 2 → 3 → 1 in long debt cycles

Chapter 4: The Changing Value of Money

Of the 750 currencies that have existed since 1700, only about 20% remain. All of them have been devalued.

When currencies devalue, if debt relief facilitates the flow of money/credit into productivity and profits for companies, real stock prices rise.

But if creation of this money sufficiently hurts the return of assets (for example, via inflation), it drives flows out of those assets and into inflation hedge assets like gold, commodities, inflation-indexed bonds, and other currencies.

When currencies devalue, all of them have a “run” dynamic. There are more claims on the central bank than there is currency to satisfy them. Net central bank reserves start falling before devaluation.

Typically, central banks response by letting short-term interest rates rise. But that is economically painful. So they increase the money supply instead.

Chapter 5: Big Cycle of internal order

đź’ˇ When debt growth outpaces the growth of future cashflows to service debt, bubbles are created

The cycle of internal order goes something like this:

  1. New order starts and new leadership consolidates power
  2. Resource allocation systems and government bureaucracies are built and refined
  3. If 2 is done well, it leads to peace and prosperity
  4. Peace and prosperity often lead to great excesses in spending and debt, along with a widening of wealth and political gaps. This is both due to decadence (spending on more frivolous things) and bureaucracy (much less efficient spending)
  5. 4 can leads to bad financial conditions and intense conflict. This is due to a) country and people being in bad financial shape, b) large income, wealth, and values gaps within a country, and c) a severe negative economic shock
  6. 5 can lead to civil wears and revolution, at which point the cycle starts again

When a new order starts, it often involves power consolidation and purges once power is acquired. In order for these to be accepted by the public, your resource allocation systems must produce prosperity for most people (specially the large middle class).

Chapter 6: Big cycle of external order and disorder

International relations are driven by raw power dynamics. Power prevails, and wealth/power among equals is rarely given up without a fight

International order follows the rule of the jungle more than it follows international law.

There are 5 kinds of conflicts between counties:

  1. Trade/economic wars. These involve tariffs, import/export restrictions, and other ways of inflicting economic damage
  2. Technology wars. Which technologies are shared and which are held as protected aspects of national security?
  3. Geopolitical wars. Territory/alliance disputes that are resolved through negotiations and explicit or implicit commitments. Not fighting.
  4. Capital wars. Financial tools (like sanctions) and limiting foreign access to capital markets
  5. Military wars. Actual deployment of forces to fight

All out wars occur when existential issues are at stake and cannot be resolved by technological or economic means.

During periods of severe economic distress and large wealth gaps, there are typically revolutionary large distributions of wealth. These can be peaceful (large tax increases) or violent (forced asset confiscation)

Before a shooting war, there is always an economic war

In war, the ability to withstand pain is far more important than the ability to inflict pain

Chapter 7: Investing in light of the big cycle

All markets are primarily driven by just 4 determinants - growth, inflation, risk premiums, and discount rates.

Dalio’s goal is to put investments together in a portfolio that is well diversified and tactically tilted based on what is happening/will happen to world (given the 3 drivers)

Wealth has gone from “real” wealth (gold, property, mines) to financial wealth (promises to create more wealth in the future) ⇒ the more these promises are made by everyone, the greater the risk that they can’t be kept

If everyone tried to convert financial wealth to real wealth right now, it literally could not happen – bonds and stocks are too sizable relative to what they could buy

3 biggest risk for investors:

  • portfolio returns are less than spending needs
  • portfolio faces risk of ruin
  • large share of wealth is taken away (eg, through high taxes)

These can be difficult to predict. People assume that World War I would have been easy to predict. But before war, there had been 50 years of almost no conflict between major powers. We also had the greatest innovation and productivity growth ever. Globalization was higher than ever. Going into 1900, things looked great! Except that wealth gaps and resentments were increasing and debts had become large.

Financial assets are a share of all assets are very cyclical.

When investments go up because of lower interest rates and more money in the system, that makes them seem more attractive at the same time as interest rates and then future expected returns of financial assets are going down.