diff --git "a/ray_dalio.md" "b/ray_dalio.md" new file mode 100644--- /dev/null +++ "b/ray_dalio.md" @@ -0,0 +1,16516 @@ +# How The Economic Machine Works by Ray Dalio +## Economics 101 -- "How the Economic Machine Works." +How the Economic Machine Works. In 30 Minutes. By Ray Dalio. The economy works like a simple machine. But many people don't understand it, or they don't agree on how it works, and this has led to a lot of needless economic suffering. I feel a deep sense of responsibility to share my simple, but practical economic template. Though it's unconventional, it has helped me to anticipate and to sidestep the global financial crisis. And it has worked well for me for over 30 years. Let's begin. Though the economy might seem complex, it works in a simple mechanical way. It's made up of a few simple parts, and a lot of simple transactions that are repeated over and over again, a zillion times. These transactions are above all else driven by human nature, and they create three main forces that drive the economy. Number one, productivity growth. Number two, the short-term debt cycle. And number three, the long-term debt cycle. We'll look at these three forces and how laying them on top of each other creates a good template for tracking economic movements and figuring out what's happening now. Let's start with the simplest part of the economy: transactions. An economy is simply the sum of the transactions that make it up. And a transaction is a very simple thing. You make transactions all the time. Every time you buy something, you create a transaction. + +# How The Economic Machine Works by Ray Dalio +## Economics 101 -- "How the Economic Machine Works." +Each transaction consists of a buyer exchanging money, or credit, with a seller for goods, services, or financial assets. Credit spends just like money, so adding together the money spent and the amount of credit spent, you can know the total spending. The total amount of spending drives the economy. If you divide the amount spent by the quantity sold, you get the price. And that's it. That's a transaction. It's the building block of the economic machine. All cycles and all forces in an economy are driven by transactions. So, if we can understand transactions, we can understand the whole economy. If you add up the total spending and the total quantity sold in all of the markets, you have everything you need to know to understand the economy. It's just that simple. People, businesses, banks and governments, all engage in transactions the way I just described, exchanging money and credit for goods, services and financial assets. The biggest buyer and seller is the government, which consists of two important parts: a central government that collects taxes and spends money, and a central bank, which is different from other buyers and sellers because it controls the amount of money and credit in the economy. It does this by influencing interest rates and printing new money. For these reasons, as we'll see, the central bank is an important player in the flow of credit. + +# How The Economic Machine Works by Ray Dalio +## Economics 101 -- "How the Economic Machine Works." +I want you to pay attention to credit. Credit is the most important part of the economy and probably the least understood. It's the most important part because it's the biggest and most volatile part. Just like buyers and sellers go to the market to make transactions, so do lenders and borrowers. Lenders usually want to make their money into more money, and borrowers usually want to buy something they can't afford, like a house or a car, or they want to invest in something like starting a business. Credit can help both lenders and borrowers get what they want. Borrowers promise to repay the amount they borrow, called principal, plus an additional amount, called interest. When interest rates are high, there is less borrowing because it's expensive. When interest rates are low, borrowing increases because it's cheaper. When borrowers promise to repay, and lenders believe them, credit is created. Any two people can agree to create credit out of thin air. That seems simple enough, but credit is tricky because it has different names. As soon as credit is created, it immediately turns into debt. Debt is both an asset to the lender, and a liability to the borrower. In the future, when the borrower repays the loan, plus interest, the asset and the liability disappear, and the transaction is settled. So why is credit so important? Because when a borrower receives credit, he is able to increase his spending. And remember, spending drives the economy. + +# How The Economic Machine Works by Ray Dalio +## Economics 101 -- "How the Economic Machine Works." +This is because one person's spending is another person's income. Think about it. Every dollar you spend someone else earns, and every dollar you earn someone else has spent. So when you spend more, someone else earns more. When someone's income rises, it makes lenders more willing to lend him money because now he's more worthy of credit. A creditworthy borrower has two things: the ability to repay and collateral. Having a lot of income in relation to his debt gives him the ability to repay. In the event that he can't repay, he has valuable assets to use as collateral that can be sold. This makes lenders feel comfortable lending him money. So increased income allows increased borrowing, which allows increased spending, and since one person's spending is another person's income, this leads to more increased borrowing and so on. This self-reinforcing pattern leads to economic growth and is why we have cycles. In a transaction, you have to give something in order to get something. And how much you get depends on how much you produce. Over time, we learn, and that accumulated knowledge raises our living standards. We call this productivity growth. Those who are inventive and hard-working raise their productivity and their living standards faster than those who are complacent and lazy. But that isn't necessarily true over the short run. + +# How The Economic Machine Works by Ray Dalio +## Economics 101 -- "How the Economic Machine Works." +Productivity matters most in the long run, but credit matters most in the short run. This is because productivity growth doesn't fluctuate much, so it's not a big driver of economic swings. Debt is, because it allows us to consume more than we produce when we acquire it, and it forces us to consume less than we produce when we have to pay it back. Debt swings occur in two big cycles. One takes about 5 to 8 years, and the other takes about 75 to 100 years. While most people feel the swings, they typically don't see them as cycles because they see them too up close, day by day, week by week. In this chapter, we're going to step back and look at these three big forces and how they interact to make up our experiences. As mentioned, swings around the line are not due to how much innovation or hard work there is. They are primarily due to how much credit there is. Let's for a second imagine an economy without credit. In this economy, the only way I can increase my spending is to increase my income, which requires me to be more productive and do more work. Increased productivity is the only way for growth. Since my spending is another person's income, the economy grows every time I or anyone else is more productive. If we follow the transactions and play this out, we see a progression like the productivity growth line. + +# How The Economic Machine Works by Ray Dalio +## Economics 101 -- "How the Economic Machine Works." +But because we borrow, we have cycles. This isn't due to any laws or regulations, it's due to human nature and the way that credit works. Think of borrowing as simply a way of pulling spending forward. In order to buy something you can't afford, you need to spend more than you make. To do this, you essentially need to borrow from your future self. In doing so, you create a time in the future that you need to spend less than you make in order to pay it back. It very quickly resembles a cycle. Basically, any time you borrow, you create a cycle. This is as true for an individual as it is for the economy. This is why understanding credit is so important because it sets into motion a mechanical predictable series of events that will happen in the future. This makes credit different from money. Money is what you settle transactions with. When you buy a beer from a bartender with cash, the transaction is settled immediately. But when you buy a beer with credit, it's like starting a bar tab. You're saying you promise to pay in the future. Together you and the bartender create an asset and a liability. You just created credit out of thin air. It's not until you pay the bar tab later that the asset and the liability disappear, the debt goes away and the transaction is settled. The reality is that most of what people call money is actually credit. The total amount of credit in the United States is about $50 trillion, and the total amount of money is only about $3 trillion. + +# How The Economic Machine Works by Ray Dalio +## Economics 101 -- "How the Economic Machine Works." +Remember, in an economy without credit, the only way to increase your spending is to produce more. But in an economy with credit, you can also increase your spending by borrowing. As a result, an economy with credit has more spending and allows incomes to rise faster than productivity over the short run, but not over the long run. Now don't get me wrong. Credit isn't necessarily something bad that just causes cycles. It's bad when it finances overconsumption that can't be paid back. However, it's good when it efficiently allocates resources and produces income so you can pay back the debt. For example, if you borrow money to buy a big TV, it doesn't generate income for you to pay back the debt. But if you borrow money to, say buy a tractor, and that tractor lets you harvest more crops and earn more money, then you could pay back your debt and improve your living standard. In an economy with credit, we can follow the transactions and see how credit creates growth. Let me give you an example. Suppose you earn $100,000 a year and have no debt. You are creditworthy enough to borrow $10,000, say on a credit card. So you can spend $110,000 even though you only earn $100,000. Since your spending is another person's income, someone is earning $110,000. The person earning $110,000 with no debt can borrow $11,000, so he can spend $121,000, even though he has only earned $110,000. + +# How The Economic Machine Works by Ray Dalio +## Economics 101 -- "How the Economic Machine Works." +His spending is another person's income, and by following the transactions, we can begin to see how this process works in a self-reinforcing pattern. But remember, borrowing creates cycles, and if the cycle goes up, it eventually needs to come down. This leads us into the short-term debt cycle. As economic activity increases, we see an expansion, the first phase of the short-term debt cycle. Spending continues to increase and prices start to rise. This happens because the increase in spending is fueled by credit, which can be created instantly out of thin air. When the amount of spending and incomes grow faster than the production of goods, prices rise. When prices rise, we call this inflation. The central bank doesn't want too much inflation because it causes problems. Seeing prices rise, it raises interest rates. With higher interest rates, fewer people can afford to borrow money, and the cost of existing debts rises. Think about this as the monthly payments on your credit card going up. Because people borrow less and have higher debt repayments, they have less money left over to spend. So spending slows. And since one person's spending is another person's income, incomes drop. Which makes people less creditworthy, causing borrowing to go down. Debt repayments continue to rise, which makes spending drop even further. And the cycle reverses itself. + +# How The Economic Machine Works by Ray Dalio +## Economics 101 -- "How the Economic Machine Works." +This is a recession. If the recession becomes too severe and inflation is no longer a problem, the central bank will lower interest rates to cause everything to pick up again. With low interest rates, debt repayments are reduced and borrowing and spending pick up, and we see another expansion. As you can see, the economy works like a machine. In the short-term debt cycle, spending is constrained only by the willingness of lenders and borrowers to provide and receive credit. When credit is easily available, there's an economic expansion. When credit isn't easily available, there's a recession. And note that this cycle is controlled primarily by the central bank. The short-term debt cycle typically lasts 5 to 8 years and happens over and over again for decades. But notice that the bottom and top of each cycle finish with more growth than the previous cycle, and with more debt. Why? Because people push it. They have an inclination to borrow and spend more instead of paying back debt. It's human nature. Because of this, over longer periods of time, debts rise faster than incomes, creating the long-term debt cycle. + +# How The Economic Machine Works by Ray Dalio +## Economics 101 -- "How the Economic Machine Works." +Despite people becoming more indebted, lenders even more freely extend credit. Why? Because everyone thinks things are going great. People are just focused on what's been happening lately. And what's been happening lately? Incomes have been rising, asset values are going up. The stock market roars. It pays to buy goods, services and financial assets with borrowed money. When people do a lot of that, we call it a bubble. So even though debts have been growing, incomes have been growing nearly as fast to offset them. Let's call the ratio of debt to income the debt burden. So long as incomes continue to rise, the debt burden stays manageable. At the same time, asset values soar. People borrow huge amounts of money to buy assets as investments, causing their prices to rise even higher. People feel wealthy. So even with the accumulation of lots of debt, rising incomes and asset values help borrowers remain creditworthy for a long time. But this obviously cannot continue forever. + +# How The Economic Machine Works by Ray Dalio +## Economics 101 -- "How the Economic Machine Works." +And it doesn't. Over decades, debt burdens slowly increase, creating larger and larger debt repayments. At some point, debt repayments start growing faster than incomes, forcing people to cut back on their spending. And since one person's spending is another person's income, incomes begin to go down. Which makes people less creditworthy, causing borrowing to go down. Debt repayments continue to rise, which makes spending drop even further. And the cycle reverses itself. This is the long-term debt peak. Debt burdens have simply become too big. For the United States, Europe and much of the rest of the world, this happened in 2008. It happened for the same reason it happened in Japan in 1989 and in the United States back in 1929. Now the economy begins deleveraging. In a deleveraging, people cut spending. Incomes fall. Credit disappears. + +# How The Economic Machine Works by Ray Dalio +## Economics 101 -- "How the Economic Machine Works." +Asset prices drop. Banks get squeezed. The stock market crashes. Social tensions rise and the whole thing starts to feed on itself the other way. As incomes fall and debt repayments rise, borrowers get squeezed. No longer creditworthy, credit dries up, and borrowers can no longer borrow enough money to make their debt repayments. Scrambling to fill this hole, borrowers are forced to sell assets. The rush to sell assets floods the market at the same time as spending falls. This is when the stock market collapses. The real estate market tanks and banks get into trouble. As asset prices drop, the value of the collateral borrowers can put up drops. This makes borrowers even less creditworthy. People feel poor. Credit rapidly disappears. Less spending, less income, less wealth, less credit, less borrowing, and so on. It's a vicious cycle. This appears similar to a recession, but the difference here is that interest rates can't be lowered to save the day. In a recession, lowering interest rates works to stimulate borrowing. However, in a deleveraging, lowering interest rates doesn't work because interest rates are already low and soon hit 0%. + +# How The Economic Machine Works by Ray Dalio +## Economics 101 -- "How the Economic Machine Works." +So the stimulation ends. Interest rates in the United States hit 0% during the deleveraging of the 1930s, and again in 2008. The difference between a recession and a deleveraging is that in a deleveraging, borrowers' debt burdens have simply gotten too big and can't be relieved by lowering interest rates. Lenders realize that debts have become too large to ever be fully paid back. Borrowers have lost their ability to repay and their collateral has lost value. They feel crippled by the debt. They don't even want more. Lenders stop lending, borrowers stop borrowing. Think of the economy as being not creditworthy, just like an individual. So what do you do about a deleveraging? The problem is debt burdens are too high and they must come down. There are four ways this can happen. One, people, businesses and governments cut their spending. + +# How The Economic Machine Works by Ray Dalio +## Economics 101 -- "How the Economic Machine Works." +Two, debts are reduced through defaults and restructurings. Three, wealth is redistributed from the haves to the have-nots. And finally four, the central bank prints new money. These four ways have happened in every deleveraging in modern history. Usually, spending is cut first. As we just saw, people, businesses, and even governments tighten their belts and cut their spending so that they can pay down their debt. This is often referred to as austerity. When borrowers stop taking on new debts and start paying down old debts, you might expect the debt burden to decrease. But the opposite happens. Because spending is cut, and one man's spending is another man's income, it causes incomes to fall. They fall faster than debts are repaid, and the debt burden actually gets worse. As we've seen, this cut in spending is deflationary and painful. + +# How The Economic Machine Works by Ray Dalio +## Economics 101 -- "How the Economic Machine Works." +Businesses are forced to cut costs, which means less jobs and higher unemployment. This leads to the next step. Debts must be reduced. Many borrowers find themselves unable to repay their loans. And a borrower's debts are a lender's assets. When a borrower doesn't repay the bank, people get nervous that the bank won't be able to repay them. So they rush to withdraw their money from the bank. Banks get squeezed, and people, businesses and banks default on their debts. This severe economic contraction is a depression. A big part of a depression is people discovering much of what they thought was their wealth isn't really there. Let's go back to the bar. When you bought a beer and put it on a bar tab, you promised to repay the bartender. Your promise became an asset of the bartender. But if you break your promise, if you don't pay him back, and essentially default on your bar tab, then the asset he has isn't really worth anything. It has basically disappeared. + +# How The Economic Machine Works by Ray Dalio +## Economics 101 -- "How the Economic Machine Works." +Many lenders don't want their assets to disappear and agree to debt restructuring. Debt restructuring means lenders get paid back less, or get paid back over a longer time frame, or at a lower interest rate than was first agreed. Somehow, a contract is broken in a way that reduces debt. Lenders would rather have a little of something than all of nothing. Even though debt disappears, debt restructuring causes incomes and asset values to disappear faster. So the debt burden continues to get worse. Like cutting spending, debt reduction is also painful and deflationary. All of this impacts the central government because lower incomes and less employment means the government collects fewer taxes. At the same time it needs to increase its spending because unemployment has risen. Many of the unemployed have inadequate savings and need financial support from the government. + +# How The Economic Machine Works by Ray Dalio +## Economics 101 -- "How the Economic Machine Works." +Additionally, governments create stimulus plans and increase their spending to make up for the decrease in the economy. This increases people's income, as well as the government's debt. However, it will lower the economy's total debt burden. This is what's happening when you hear about the budget deficit on the news. To fund their deficits, governments need to either raise taxes or borrow money. But with incomes falling and so many unemployed, who is the money going to come from? The rich. Since governments need more money, and since wealth is heavily concentrated in the hands of a small percentage of the people, governments naturally raise taxes on the wealthy, which facilitates a redistribution of wealth in the economy from the haves to the have-nots. The have-nots who are suffering begin to resent the wealthy haves. + +# How The Economic Machine Works by Ray Dalio +## Economics 101 -- "How the Economic Machine Works." +The wealthy haves being squeezed by the weak economy, falling asset prices, and higher taxes, begin to resent the have-nots. If the depression continues, social disorder can break out. Not only do tensions rise within countries, they can rise between countries, especially debtor and creditor countries. This situation can lead to political change that can sometimes be extreme. In the 1930s, this led to Hitler coming to power, war in Europe and depression in the United States. Pressure to do something to end the depression increases. Remember, most of what people thought was money was actually credit. So when credit disappears, people don't have enough money. People are desperate for money, and you remember who can print money. The central bank can. Having already lowered its interest rates to nearly zero, it's forced to print money. Unlike cutting spending, debt reduction and wealth redistribution, printing money is inflationary and stimulative. + +# How The Economic Machine Works by Ray Dalio +## Economics 101 -- "How the Economic Machine Works." +Inevitably, the central bank prints new money out of thin air, and uses it to buy financial assets and government bonds. It happened in the United States during the Great Depression and again in 2008 when the United States Central Bank, the Federal Reserve, printed over $2 trillion. Other central banks around the world that could, printed a lot of money too. By buying financial assets with this money, it helps drive up asset prices, which makes people more creditworthy. However, this only helps those who own financial assets. You see, the central bank can print money, but it can only buy financial assets. The central government, on the other hand, can buy goods and services and put money in the hands of the people, but it can't print money. So in order to stimulate the economy, the two must cooperate. By buying government bonds, the central bank essentially lends money to the government, allowing it to run a deficit and increase spending on goods and services through its stimulus programs and unemployment benefits. This increases people's income, as well as the government's debt. However, it will lower the economy's total debt burden. + +# How The Economic Machine Works by Ray Dalio +## Economics 101 -- "How the Economic Machine Works." +This is a very risky time. Policy makers need to balance the four ways that debt burdens come down. The deflationary ways need to balance with the inflationary ways in order to maintain stability. If balanced correctly, there can be a beautiful deleveraging. You see, a deleveraging can be ugly, or it can be beautiful. How can a deleveraging be beautiful? Even though a deleveraging is a difficult situation, handling a difficult situation in the best possible way is beautiful. A lot more beautiful than the debt-fueled unbalanced excesses of the leveraging phase. In a beautiful deleveraging: debts decline relative to income, real economic growth is positive, and inflation isn't a problem. It is achieved by having the right balance. The right balance requires a certain mix of cutting spending, reducing debt, transferring wealth, and printing money, so that economic and social stability can be maintained. If policy makers achieve the right balance, a deleveraging isn't so dramatic. Growth is slow, but debt burdens go down. It takes roughly a decade or more for debt burdens to fall and economic activity to get back to normal. Hence the term lost decade. In closing. Of course, the economy is a little bit more complicated than this template suggests. + +# How The Economic Machine Works by Ray Dalio +## Economics 101 -- "How the Economic Machine Works." +However, laying the short-term debt cycle on top of the long-term debt cycle, and then laying both of them on top of the productivity growth line, gives a reasonably good template for seeing where we've been, where we are now, and where we're probably headed. So in summary, there are three rules of thumb that I'd like you to take away from this. First, don't have debt rise faster than income, because your debt burdens will eventually crush you. Second, don't have income rise faster than productivity, because you'll eventually become uncompetitive. And third, do all that you can to raise your productivity, because in the long run, that's what matters most. This is simple advice for you, and it's simple advice for policy makers. You might be surprised, but most people, including most policy makers, don't pay enough attention to this. This template has worked for me, and I hope it will work for you. Thank you. By Ray Dalio. With animation directed by Jonathan Jarvis. Animated by Thornberg & Forester. Produced by Heather Hartnett. Music composed by Jeremy Turner. Sound by Matt Hauser, Big Foote Music. If you'd like to learn more go to: economicprinciples.org. + +# Billionaire investor Ray Dalio is worried about 'something worse than recession’ +## Ray Dalio, founder of the world’s largest hedge fund, tells Meet the Press that Trump’s economic agenda could lead to a “breaking down of the monetary order” as the president ramps up tariffs on China. +Welcome back, and joining me now is Ray Dalio, the founder of the world's largest hedge fund, Bridgewater Associates. He is also the author of the new book, How Countries Go Broke: The Big Cycle. It's out in June. Mr. Dalio, welcome to Meet the Press. Thank you. Good to be here. Just call me Ray. Okay. Well, Ray, I'll take you up on that. Thank you so much for being here. We really appreciate your perspective. As I just said, you did found the world's largest hedge fund. You have been in this field for more than 50 years. It's worth pointing out to our viewers, I think it's important to note, you consider yourself to be apolitical. And you say that the tariff problem is a symptom of a much greater problem. What do you mean by that? There's a financial problem. There's an imbalance problem. There are basically five big forces through history that drive everything. + +# Billionaire investor Ray Dalio is worried about 'something worse than recession’ +## Ray Dalio, founder of the world’s largest hedge fund, tells Meet the Press that Trump’s economic agenda could lead to a “breaking down of the monetary order” as the president ramps up tariffs on China. +First, there's the money, credit, debt, economic cycle. In which there's a building up of debt in a cyclical way that becomes too large, and we're going to have problems. We're going to have a government debt problem, maybe we can get into this. The second big force through time is the, um, internal conflict force, the left and the right. Differences in wealth and values causing a conflict that we're seeing changing our political order. So the first is changing our monetary order. The second is changing our political order internally. And then the third is the great world order. The how countries deal with each other, when there's a rising power challenging an existing power. And now we are going from multilateralism, which is largely an American world order type of thing, to a unilateral world order in which there's great conflict. And the other two factors all through history have been acts of nature, droughts, floods, and pandemics. And number four is technology, technology changing. And how they are coming together are the main forces behind this. For example, there can't be imbalances anymore in that environment. + +# Billionaire investor Ray Dalio is worried about 'something worse than recession’ +## Ray Dalio, founder of the world’s largest hedge fund, tells Meet the Press that Trump’s economic agenda could lead to a “breaking down of the monetary order” as the president ramps up tariffs on China. +Do you think that President Trump's tariffs are exacerbating what you are describing, this complicated mix of challenges that the world is facing? I think it's just a function of how well they're handled. You know, it's a reality that it's a desire to bring in tax revenue from that. It's a reality that we would like to build manufacturing and jobs here. This is a reality that's how that's done. Whether that's done in a practical way, whether that's done in a stable way, whether that's done with quality negotiations, in which that's a mutual problem, or whether it's done in a chaotic and disruptive way that produces great conflict, makes all the difference in the world. I want to ask you about something that's on a lot of people's minds, your predictions for the future, and I want to start with the R word. I know you think this is just a piece of it, of course I'm talking about a recession. Do you think it is likely that the United States will dip into a recession because of President Trump's tariffs? + +# Billionaire investor Ray Dalio is worried about 'something worse than recession’ +## Ray Dalio, founder of the world’s largest hedge fund, tells Meet the Press that Trump’s economic agenda could lead to a “breaking down of the monetary order” as the president ramps up tariffs on China. +I think that, um, right now we are at a decision-making point and very close to recession. And I'm worried about something worse than a recession if this isn't handled well. A recession is two negative quarters of GDP, and whether it goes slightly there, we always have those things. We have something that's much more profound. We have a breaking down of the monetary order. We are going to change the monetary order because we cannot spend the amounts of money, so we have that problem. And when we talk about the dollar, and we talk about tariffs, we have that. We are having profound changes in our domestic order, how ruling is existing. And we're having profound changes in the world order. Such times are very much like the 1930s. I've studied history, and this repeats over and over again. So if you take tariffs, if you take debt, if you take the rising power challenging existing power, if you take those factors and look at the factors, that those changes in the orders, the systems are very, very disruptive. How that's handled could produce something that is much worse than a recession, or it could be handled well. Let's take the debt situation. + +# Billionaire investor Ray Dalio is worried about 'something worse than recession’ +## Ray Dalio, founder of the world’s largest hedge fund, tells Meet the Press that Trump’s economic agenda could lead to a “breaking down of the monetary order” as the president ramps up tariffs on China. +Yeah. I'm sorry, go ahead. Well, very, very quickly because I want to be very specific about what you mean. You're saying worse than recession. You're saying this is reminiscent of the 1930s. We should tell our viewers, you correctly predicted the 2008 financial crisis. What is your prediction for where the country is headed right now? Right now we're at a juncture. Let's take the budget. It the budget deficit can be reduced to 3% of GDP. It's about, it will be about 7% if things are not changed. If it could be reduced to about 3% of GDP, and these trade deficits and so on are managed in the right way. This could all be managed very well. I believe that members of Congress should take the pledge, what I call the 3% pledge. That in one way or another, that they will get that budget deficit down to that number. If they don't, we're going to have a supply, demand problem for debt at the same time as we have these other problems. + +# Billionaire investor Ray Dalio is worried about 'something worse than recession’ +## Ray Dalio, founder of the world’s largest hedge fund, tells Meet the Press that Trump’s economic agenda could lead to a “breaking down of the monetary order” as the president ramps up tariffs on China. +And the results of that will be worse than a normal recession. So, and and just to follow up on that point. Worse than a recession, you're talking about the 1930s. What specifically are you warning of? To be very specific, to put it into terms people can understand. To be, to be very specific. The value, the value of money, uh, internal conflict, that is not the normal democracy as we know it, and international conflict in a way that is highly disruptive to the world economy and could even be a military conflict just as these breakdowns have occurred before. You know, we have a new order that began in 1945, a new monetary order and a new geopolitical order, and these go in cycles that can be measured, and I worry about the breakdown of that kind of an order, particularly since it doesn't need to happen because there are certain things that could be done in which this is better, a better restructuring of these debts and actions taken. So that takes me to my next question. + +# Billionaire investor Ray Dalio is worried about 'something worse than recession’ +## Ray Dalio, founder of the world’s largest hedge fund, tells Meet the Press that Trump’s economic agenda could lead to a “breaking down of the monetary order” as the president ramps up tariffs on China. +You have this book, How Countries Go Broke: The Big Cycle. What is the solution here? Well, there are a series of solutions, but let's, let's take the most important. And we have one minute. One minute. Okay. 3% of GDP, bring that deficit down. It can be done in a bipartisan way the way it was done between 1991 and '98. I explain how that could be done. Doing things together for the greater good. And then internationally, on all of these issues, to, um, use American strength, but to negotiate well, to lay out ways in which bad conflict and inefficient policies don't create great disruptions but get us through this in an orderly way. All right, Ray Dalio. Thank you so much. Your book, How Countries Go Broke: The Big Cycle. We really appreciate it. Thank you so much for being here. We really appreciate it. Thanks for watching. Stay updated about breaking news and top stories on the NBC News app or follow us on social media. + +# Principles for Dealing with the Changing World Order by Ray Dalio +Principles for Dealing with the Changing World Order. The times ahead will be radically different from those that we've experienced in our lifetimes, though similar to many times before. How do I know that? Because they always have been. Over my roughly 50 years of global macroeconomic investing, I've learned the hard way that most of the big events that surprised me, did so because they'd never happened in my lifetime. These painful surprises led me to study the last 500 years of history for similar situations, where I saw that they indeed had happened many times before, with the ups and downs of the Dutch, British, and U.S. empires. And every time they did, it was a sign of the changing world order. This study taught me valuable lessons that I'm going to pass along to you here in a distilled form. You can find the comprehensive version in my book, Principles for Dealing with the Changing World Order, Why Nations Succeed and Fail, Ray Dalio. + +# Principles for Dealing with the Changing World Order by Ray Dalio +Let me begin with a story that brought me to this point: How I Learned to Anticipate the Future by Studying the Past. In 1971, when I was a young clerk on the floor of the New York Stock Exchange, the United States ran out of money and defaulted on its debts. The U.S. ran out of money? That's right. The U.S. ran out of money. How? Well, back then, gold was the money used in transactions between countries. Paper money, like the dollar, was like checks in a checkbook, in that it had no value other than it could be exchanged for gold, which was the real money. At the time, the United States was spending a lot more money than it was earning by writing a lot more of these paper money checks than it had gold in the bank to exchange for them. As people turned these checks into the bank for gold money, the amount of gold in the U.S. started to dwindle. It soon became obvious that the U.S. couldn't keep its promises for all the existing paper money, so people holding dollars rushed to exchange them before the gold ran out. + +# Principles for Dealing with the Changing World Order by Ray Dalio +Recognizing that the U.S. was going to run out of real money, on Sunday evening, August 15th, President Nixon went on television to tell the world that the U.S. was breaking its promise to let people exchange their dollars for gold. Of course, he didn't say it that way. He said it more diplomatically, without making it clear that the United States was defaulting. The strength of a nation's currency is based on the strength of that nation's economy. And the American economy is by far the strongest in the world. Accordingly, I have directed the Secretary of the Treasury to take the action necessary to defend the dollar against the speculators. I have directed Secretary Connally to suspend temporarily the convertibility of the dollar into gold or other reserve assets, except in amounts and conditions determined to be in the interest of monetary stability and in the best interests of the United States. I watched in awe, realizing that money as we understood it was ending. What a crisis. + +# Principles for Dealing with the Changing World Order by Ray Dalio +I expected the stock market to plunge the next day, so I got on the Exchange floor early to prepare. When the opening bell rang, pandemonium broke out, but not the kind I expected. The market was up, way up, and went on to rise nearly 25%. That surprised me because I never experienced a currency devaluation before. When I dug into history, I discovered that the exact same thing happened in 1933 and had the exact same effect. Then, paper dollars were also linked to gold, which the U.S. was running out of because it was spending more paper money checks than it had gold to exchange for them. And President Roosevelt announced on the radio that he would break the country's promise to exchange dollars for gold. It was then that I issued the proclamation, providing for the National Bank Holiday, and this was the first step in the government's reconstruction of our financial and economic fabric. + +# Principles for Dealing with the Changing World Order by Ray Dalio +The second step, last Thursday, was the legislation, promptly and patriotically passed by the Congress, confirming my proclamation and broadening my powers so that it became possible in view of the requirement of time to extend the holiday and lift the ban of that holiday gradually in the days to come. This law also gave authority to the controller of the currency. In both cases, breaking the link to gold allowed the U.S. to continue spending more than it earned, simply by printing more paper dollars. Since there was an increase in the number of dollars without an increase in the country's wealth, the value of each dollar fell. As these new dollars entered the market without a corresponding increase in productivity, they went to buy lots of stocks, gold, and commodities, and hence caused their prices to rise. As I studied more history, I saw that the exact same thing happened many, many times before. + +# Principles for Dealing with the Changing World Order by Ray Dalio +I saw that since the beginning of time, when governments spent much more than they took in in taxes, and conditions got bad, they ran out of money and they needed more. So they printed more, a lot more, which made its value fall and made the prices of most everything, including stocks, gold, and commodities rise. That's when I first learned the principle that: when central banks print a lot of money, buy stocks, gold, and commodities, because their value will rise, and the value of paper money will fall. This printing of money is also what happened in 2008 to relieve the mortgage-driven debt crisis, and in 2020 to relieve the pandemic-driven economic crisis. And it almost certainly will happen in the future. So I suggest that you keep this principle in mind. These experiences gave me another principle, which is: to understand what is coming at you, you need to understand what happened before you. + +# Principles for Dealing with the Changing World Order by Ray Dalio +That principle led me to study how the Roaring Twenties bubble turned into the 1930s Depression, which gave me the lessons that allowed me to anticipate and profit from the 2007 bubble turning into the 2008 bust. All these experiences led me to develop an almost instinctual urge to look to the past for similar situations, to learn how to handle the future well. Changing Orders. Over the last few years, three big things that hadn't happened in my lifetime prompted me to do this study. First, countries didn't have enough money to pay their debts, even after lowering interest rates to zero. So their central banks began printing lots of money to do so. Second, big internal conflicts emerged due to growing gaps in wealth and values. This showed up in political populism and polarization between the left, who want to redistribute wealth, and the right, who want to defend those holding the wealth. And third, increasing external conflict between a rising great power and the leading great power, as is now happening with China and the United States. So I looked back. + +# Principles for Dealing with the Changing World Order by Ray Dalio +I saw that all these had happened together before, many times, and nearly always led to changing domestic and world orders. The last time this sequence happened was from 1930 to 1945. What exactly is an order, you might ask? It's a governing system for people dealing with each other. There are internal orders for governing within countries, typically laid out in constitutions. And there is a world order for governing between countries, typically laid out in treaties. Internal orders change at different times than world orders. The weather within or between countries, these orders typically change after wars. Civil wars within countries, international wars between countries. They happen when revolutionary new forces defeat weak old orders. For example, the U.S. internal order was laid out in the Constitution in 1789 after the American Revolution, and it is still operating today, even after the American Civil War. Russia got rid of its old order and established a new one with the Russian Revolution in 1917, which ended in 1991 with a relatively bloodless revolution. + +# Principles for Dealing with the Changing World Order by Ray Dalio +China began its current internal order in 1949 when the Chinese Communist Party won the Civil War. You get the idea. The current world order, commonly called the American World Order, formed after the Allied victory in World War II, when the U.S. emerged as the dominant world power. It was set out in agreements and treaties for how global governance and monetary systems work. In 1944, the new world monetary system was laid out in the Bretton Woods Agreement, and established the dollar as the world's leading reserve currency. A reserve currency is a currency that is commonly accepted around the world. And having one is a key factor in a country becoming the richest and most powerful empire. With a new dominant power and monetary system established, a new world order begins. These changes take place in a timeless and universal cycle that I call The Big Cycle. + +# Principles for Dealing with the Changing World Order by Ray Dalio +I'll start with a quick overview. Then give you a more complete version. And then direct you to my book if you want more. As I studied the 10 most powerful empires over the last 500 years, and the last three reserve currencies, it took me through the rise and decline of the Dutch Empire and the Guilder, the British Empire and the Pound, the rise and early decline in the United States Empire and the Dollar, and the decline and rise of the Chinese Empire and its currencies, as well as the rise and decline of the Spanish, German, French, Indian, Japanese, Russian, and Ottoman empires, along with their significant conflicts, as measured in this chart. + +# Principles for Dealing with the Changing World Order by Ray Dalio +To understand China's patterns better, I also studied the rise and fall of Chinese dynasties and their moneys back to the year 600. Because looking at all these measures at once can be confusing, I'll focus on the four most important ones: the Dutch, British, U.S., and Chinese. You'll quickly notice the pattern. Now let's simplify the form a bit. As you can see, they transpired in overlapping cycles that lasted about 250 years, with 10 to 20 year transition periods between them. Typically these transitions have been periods of great conflict, because leading powers don't decline without a fight. So, how am I measuring an empire's power? In this study, I used eight metrics. Each country's measure of total power is derived by averaging them together. They are: education, inventiveness and technology development, competitiveness in global markets, economic output, share of world trade, military strength, the power of their financial center for capital markets, and the strength of their currency as a reserve currency. Because these powers are measurable, we can see how strong each country is now, was in the past, and whether they're rising or declining. + +# Principles for Dealing with the Changing World Order by Ray Dalio +By examining the sequences from many countries, we can see how a typical cycle transpires. And because the wiggles can be confusing, we can simplify it a bit to focus on the pattern of cause-effect relationships that drive the rise and decline of a typical empire. As you can see, better education typically leads to increased innovation and technology development, and with a lag, the establishment of the currency as a reserve currency. You can also see that these forces then declined in a similar order, reinforcing each other's decline. Let's now look at the typical sequence of events going on inside a country that produces these rises and declines. In a nutshell, the Big Cycle typically begins after a major conflict, often a war, establishes the new leading power and the new world order. Because no one wants to challenge this power, a period of peace and prosperity typically follows. As people get used to this peace and prosperity, they increasingly bet on it continuing. They borrow money to do that, which eventually leads to a financial bubble. + +# Principles for Dealing with the Changing World Order by Ray Dalio +The empire's share of trade grows, and when most transactions are conducted in its currency, it becomes a reserve currency, which leads to even more borrowing. At the same time, this increased prosperity distributes wealth unevenly, so the wealth gap typically grows between the rich haves and the poor have-nots. Eventually, the financial bubble bursts, which leads to the printing of money, and increased internal conflict between the rich and the poor, which leads to some form of revolution to redistribute wealth. This can happen peacefully or as a civil war. While the empire struggles with this internal conflict, its power diminishes relative to external rival powers on the rise. When a new rising power gets strong enough to compete with the dominant power that is having domestic breakdowns, external conflicts, most typically wars, take place. Out of these internal and external wars, come new winners and losers. Then the winners get together to create the new world order, and the cycle begins again. As I looked back, I saw that these cause and effect relationships drove the cycles of rises and declines all the way back to the Roman Empire. + +# Principles for Dealing with the Changing World Order by Ray Dalio +I saw how the stories of each one of these cycles blended together with others before, during and after, in the same way as each individual story blends with others to make the epic 500-year story that is our collective history. And like human life cycles, no two are exactly the same, but most are similar. They're driven by logical cause and effect relationships that progress through stages from birth to strength and maturity, to weakness and inevitable decline. However, that's like saying a person's life cycle takes 80 years on average without recognizing that many are much shorter, and many are longer. While age can be a good indicator of future longevity, a better way is to look at health indicators. One can do that with empires and their vital signs, too. I found that by watching the indicators of power change, I was able to see what stage a country was in, which helped me to anticipate what was likely to come next. + +# Principles for Dealing with the Changing World Order by Ray Dalio +Now, I'll take you through the Big Cycle in more detail. Give me 20 minutes and I'll give you the last 500 years of history, and show you the similar patterns across the Dutch, British, U.S., and Chinese Empires. 500 Years of Big Cycles. I'm going to describe the typical cycle by dividing it into three phases: The Rise, The Top, and The Decline. The Rise. Successful new orders that rise, both internal and external, are typically started by powerful revolutionary leaders doing four things: First, they win power by gaining more support than the opposition. Second, they consolidate power by converting, weakening, or eliminating the opposition so they don't stand in their way. Third, they establish systems and institutions that make the country work well. And fourth, they pick their successors well, or create systems that do that. Because a great empire requires many great leaders over several generations. At this stage, soon after winning the fight, there is typically a period of peace and growing prosperity because the leadership is clearly dominant and has broad support, so no one wants to fight it. During this phase, leaders within the country have to design an excellent system to raise the country's wealth and power. + +# Principles for Dealing with the Changing World Order by Ray Dalio +First and foremost, to be great, they must have strong education, which is not just teaching knowledge and skills, but also strong character, civility, and work ethic. These are typically taught in the family, schools, and religious institutions. That provides a healthy respect for rules and laws, order within society, low corruption, and enables them to unite behind a common purpose and work well together. As they do this, they increasingly shift from producing basic products to innovating and inventing new technologies. For example, the Dutch rose to defeat the Habsburg Empire and become superbly educated. They became so inventive that they came up with a quarter of all major inventions in the world, the most important of which was the invention of ships that could travel around the world to collect great riches, and the invention of capitalism, as we know it today, to finance those voyages. They, like all leading empires, enhanced their thinking by being open to the best thinking in the world. As a result, the people in the country become more productive and more competitive in world markets, which shows up in their growing economic outputs and rising shares of world trade. You can see this happening now as the U.S. and China are roughly comparable in both their economic outputs and their shares of world trade. + +# Principles for Dealing with the Changing World Order by Ray Dalio +As countries trade more globally, they must protect their trade routes and their foreign interests from attack, so they develop great military strength. If done well, this virtuous cycle leads to strong income growth, which can be used to finance investments in education, infrastructure, and research and development. They must also develop systems to incentivize and empower those that have the ability to make or take wealth. In all of these cases, the most successful empires used a capitalist approach to develop productive entrepreneurs. Even China, which is run by the Chinese Communist Party, used the form of this capitalist approach. Deng Xiaoping, when asked about this, said, "It doesn't matter if it's a white cat or a black cat, as long as it catches mice." And, "It's glorious to be rich." To do this well, they must develop their capital markets, most importantly, their lending, bond, and stock markets. That allows people to convert their savings into investments to fund invention and development, and share in the successes of those who make great things happen. + +# Principles for Dealing with the Changing World Order by Ray Dalio +The Dutch created the first publicly listed company, the Dutch East India Company, and the first stock market to fund it, which were integral parts of the system that produced massive wealth and power. As a natural consequence, the greatest empires developed the world's leading financial centers for attracting and distributing the world's capital. Amsterdam was the world's financial center when the Dutch were preeminent. London, when the British were on top. New York is now. And China is quickly developing its financial centers. Most importantly, the capitalists, the governments, and the military must work together. Not only did the Dutch work well together, they were one and the same. The Dutch East India Company was granted a trade monopoly from the government, and had its own officially sanctioned military to go out into the global markets to make and take wealth. The British followed with the British East India Company, and had a similar coordination of their government, business, and military operations. The U.S. military-industrial complex followed suit, as does the Chinese system today. This raises the risk of great international conflict, especially if the rival has built up a comparable military. + +# Principles for Dealing with the Changing World Order by Ray Dalio +Defending oneself and one's empire against rivals requires great military spending, which has to occur as domestic economic conditions are deteriorating, and the empire can least afford it. Still, these estimates aren't precise, and the cycle can be extended if those in charge pay attention to their vital signs and improve them. For example, knowing that a person is 60 years old, how fit they are, whether they smoke or not, and a few other basic vital signs, one can estimate the person's longevity. One can do that with empires and their vital signs, too. It won't be precise, but it will be broadly indicative, and give clear direction on steps to take to increase longevity. It's most often the case that a nation's greatest war is with itself, over whether or not it can make the hard decisions needed to sustain success. As for what we need to do, it comes down to just two things: earn more than we spend, and treat each other well. All other things I mentioned - strong education, inventiveness, being competitive, and all the rest - are just ways of getting at these two things. + +# Principles for Dealing with the Changing World Order by Ray Dalio +It's easy to measure if we're doing them. So like people who want to get fit, let's get on the program and improve our vitals. Let's do that individually and collectively. My goal for sharing this picture of how the world works and a few principles for dealing with it well, is to help you recognize where we are and the challenges we face, and to make the wise decisions needed to navigate these times well. Thank you, and may the force of evolution be with you. Principles for Dealing with the Changing World Order. Narrated by & based on the book by Ray Dalio. + +# The Changing World Order +## Introduction +### Ray Dalio +#### September 2020 +I believe that the times ahead will be radically different from the times we have experienced so far in our lifetimes, though similar to many other times in history. + +I believe this because about 18 months ago I undertook a study of the rises and declines of empires, their reserve currencies, and their markets, prompted by my seeing a number of unusual developments that hadn’t happened before in my lifetime but that I knew had occurred numerous times in history. Most importantly, I was seeing the confluence of 1) high levels of indebtedness and extremely low interest rates, which limits central banks’ powers to stimulate the economy, 2) large wealth gaps and political divisions within countries, which leads to increased social and political conflicts, and 3) a rising world power (China) challenging the overextended existing world power (the US), which causes external conflict. The most recent analogous time was the period from 1930 to 1945. This was very concerning to me. + +As I studied history, I saw that this confluence of events was typical of periods that existed as roughly 10- to 20-year transition phases between big economic and political cycles that occurred over many years (e.g., 50-100 years). These big cycles were comprised of swings between 1) happy and prosperous periods in which wealth is pursued and created productively and those with power work harmoniously to facilitate this and 2) miserable, depressing periods in which there are fights over wealth and power that disrupt harmony and productivity. These bad periods consisted of revolutions and/or wars that were like cleansing storms that got rid of weaknesses and excesses (such as too much debt) and returned the fundamentals to a sounder footing (albeit painfully). They eventually caused adaptations that made the whole stronger, though they typically changed who was on top and the prevailing world order. + +These cycles evolve over long periods, with transition periods coming along only about once in a lifetime, so they surprise us with circumstances that we’ve never encountered before. Because these circumstances are so unusual, they raise interesting questions that provide us with valuable clues as to why these things are happening and what the future will be like. For example, throughout my life, the dollar has been the world’s reserve currency, monetary policy has been an effective tool for stimulating economies, and democracy and capitalism have been widely regarded as the superior political and economic systems. What if these things didn’t exist in the future? + +The answers to this question can only be found by studying the mechanics behind similar cases in history—the 1930-45 period but also the rise and fall of the British and Dutch empires, the rise and fall of Chinese dynasties, and others—to unlock an understanding of what is happening and what is likely to happen.1 That was the purpose of this study. Then the pandemic came along, which was another one of those big events that never happened to me but happened many times before my lifetime that I needed to understand better. + +# My Approach + +While it might seem odd that an investment manager who is required to make investment decisions on short time frames would pay so much attention to long-term history, through my experiences I have learned that I need this perspective to do my job well. My biggest mistakes in my career came from missing big market moves that hadn’t happened in my lifetime but had happened many times before. These mistakes taught me that I needed to understand how economies and markets have worked throughout history and in faraway places so that I could learn the timeless and universal mechanics underlying them and develop timeless and universal principles for dealing with them well. + +To be clear, while I am describing these cycles of the past, I’m not one of those people who believe that what happened in the past will necessarily continue into the future without understanding the cause-effect mechanics that drive changes. My objective above all else is to have you join with me in looking at the cause-effect relationships and then to use that understanding to explore what might be coming at us and agree on principles to handle it in the best possible way. + +--- + +The first of these big surprises for me came in 1971 when I was 22 years old and clerking on the floor of the New York Stock Exchange as a summer job. On a Sunday night, August 15, 1971, President Nixon announced that the US would renege on its promise to allow paper dollars to be turned in for gold. This led the dollar to plummet. As I listened to Nixon speak, I realized that the US government had defaulted on a promise and that money as we knew it had ceased to exist. That couldn’t be good, I thought. So on Monday morning I walked onto the floor of the exchange expecting pandemonium as stocks took a dive. There was pandemonium all right, but not the sort I expected. Instead of falling, the stock market jumped about 4 percent. I was shocked. That is because I hadn’t experienced a currency devaluation before. In the days that followed, I dug into history and saw that there were many cases of currency devaluations that had similar effects on stock markets. By studying further, I figured out why, and I learned something valuable that would help me many times in my future. It took a few more of those painful surprises to beat into my head the realization that I needed to understand all the big economic and market moves that had happened in the last 100+ years and in all major countries. + +In other words, if some big and important event had happened in the past (like the Great Depression of the 1930s), I couldn’t say for sure that it wouldn’t happen to me, so I had to figure out how it worked and be prepared to deal with it well. Through my research I saw that there were many cases of the same type of thing happening (e.g., depressions) and that by studying them just like a doctor studies many cases of a particular type of disease, I could gain a deeper understanding of how they work. The way I work is to study as many of the important cases of a particular thing I can find and then to form a picture of a typical one, which I call an archetype. The archetype helps me see the cause-effect relationships that drive how these cases typically progress. Then I compare how the specific cases transpire relative to the archetypical one to understand what causes the differences between each case and the archetype. This process helps me refine my understanding of the cause-effect relationships to the point where I can create decision-making rules in the form of “if/then” statements—i.e., if X happens, then make Y bet. Then I watch actual events transpire relative to that template and what we are expecting. I do these things in a very systematic way with my partners at Bridgewater Associates. + +If events are on track we continue to bet on what typically comes next, and if events start to deviate we try to understand why and course correct. + +My approach is not an academic one created for scholarly purposes; it is a very practical one that I follow in order to do my job well. You see, as a global macro investor, the game I play requires me to understand what is likely to happen to economies better than the competition does. From my years of wrestling with the markets and trying to come up with principles for doing it well, I’ve learned that 1) one’s ability to anticipate and deal well with the future depends on one’s understanding of the cause-effect relationships that make things change and 2) one’s ability to understand these cause-effect relationships comes from studying how they have played out in the past. How practical this approach has been can be measured in Bridgewater’s performance track record over several decades. + +For example, I have followed this approach for debt cycles because I’ve had to navigate many of them over the last 50 years and they are the most important force driving big shifts in economies and markets. If you are interested in understanding my template for understanding big debt crises and seeing all the cases that made it up, you can get Principles for Navigating Big Debt Crises in free digital format www.economicprinciples.org or in print form for sale in bookstores or online. It was that perspective that allowed Bridgewater to navigate the 2008 financial crisis well when others struggled. I’ve studied many big, important things (e.g., depressions, hyperinflation, wars, balance of payments crises, etc.) by following this approach, usually because I was compelled to understand unusual things that appeared to be germinating around me. + + + +--- + +# This Approach Affects How I See Everything + +Having done many such studies in pursuit of timeless and universal principles, I’ve learned that most things—e.g., prosperous periods, depressions, wars, revolutions, bull markets, bear markets, etc.—happen repeatedly through time. They come about for basically the same reasons, typically in cycles, and often in cycles that are as long or longer than our lifetimes. This has helped me come to see most everything as “another one of those,” just like a biologist, upon encountering a creature in the wild, would identify what species (or “one of those”) the creature belongs to, think about how that species of thing works, and try to have and use timeless and universal principles for dealing with it effectively. + +Seeing events in this way helped shift my perspective from being caught in the blizzard of things coming at me to stepping above them to see their patterns through time. The more related things I could understand in this way, the more I could see how they influence each other—e.g., how the economic cycle works with the political one—and how they interact over longer periods of time. I also learned that when I paid attention to the details I couldn’t see the big picture and when I paid attention to the big picture I couldn’t see the details. Yet in order to understand the patterns and the cause-effect relationships behind them, I needed to see with a higher-level, bigger-picture perspective and a lower-level, detailed perspective simultaneously, looking at the interrelationships between the most important forces over long periods of time. To me it appears that most things evolve upward (improve over time) with cycles around them, like an upward-pointing corkscrew: + +For example, over time our living standards rise because we learn more, which leads to higher productivity, but we have ups and downs in the economy because we have debt cycles that drive actual economic activity up and down around that uptrend. + +I believe that the reason people typically miss the big moments of evolution coming at them in life is that we each experience only tiny pieces of what’s happening. We are like ants preoccupied with our jobs of carrying crumbs in our minuscule lifetimes instead of having a broader perspective of the big-picture patterns and cycles, the important interrelated things driving them, and where we are within the cycles and what’s likely to transpire. From gaining this perspective, I’ve come to believe that there are only a limited number of personality types going down. + +3 I approach seeing just about everything this way. For example, in building and running my business, I had to understand the realities of how people think and learn principles for dealing with these realities well, which I did using this same approach. If you are interested in what I learned about such non-economic and non-market things, I conveyed it in my book Principles: Life and Work, which is free in an app called “Principles in Action” available on the Apple App Store or is for sale in the usual bookstores. + +© 2020 Bridgewater Associates, LP + +--- + + +a limited number of paths that lead them to encounter a limited number of situations to produce only a limited number of stories that repeat over time.4 + +The only things that change are the clothes the characters are wearing and the technologies they’re using. + +# This Study & How I Came to Do It + +One study led to another that led me to do this study. More specifically: + +- Studying money and credit cycles throughout history made me aware of the long-term debt cycle (which typically lasts about 50-100 years), which led me to view what is happening now in a very different way than if I hadn’t gained that perspective. For example, before interest rates hit 0% and central banks printed money and bought financial assets in response to the 2008-09 financial crisis I had studied that happening in the 1930s, which helped us navigate that crisis well. From that research, I also saw how and why these central bank actions pushed financial asset prices and the economy up, which widened the wealth gap and led to an era of populism and conflict. We are now seeing the same forces at play in the post-2009 period. +- In 2014, I wanted to forecast economic growth rates in a number of countries because they were relevant to our investment decisions. I used the same approach of studying many cases to find the drivers of growth and come up with timeless and universal indicators for anticipating countries’ growth rates over 10-year periods. Through this process, I developed a deeper understanding of why some countries did well and others did poorly. I combined these indicators into gauges and equations that we use to produce 10-year growth estimates across the 20 largest economies. Besides being helpful to us, I saw that this study could help economic policymakers because, by seeing these timeless and universal cause-effect relationships, they could know that if they changed X, it would have Y effect in the future. I also saw how these 10-year leading economic indicators (such as the quality of education and the level of indebtedness) were worsening for the US relative to big emerging countries such as China and India. This study is called “Productivity and Structural Reform: Why Countries Succeed and Fail, and What Should Be Done So Failing Countries Succeed.” +- Soon after the Trump election in 2016 and with increases in populism in developed countries becoming more apparent, I began a study of populism. That highlighted for me how gaps in wealth and values led to deep social and political conflicts in the 1930s that are similar to those that exist now. It also showed me how and why populists of the left and populists of the right were more nationalistic, militaristic, protectionist, and confrontational—and what such approaches led to. I saw how strong the conflict between the economic/political left and right could become and the strong impact this conflict has on economies, markets, wealth, and power, which gave me a better understanding of events that were and still are transpiring. +- From doing these studies, and from observing numerous things that were happening around me, I saw that America was experiencing very large gaps in people’s economic conditions that were obscured by looking only at economic averages. So I divided the economy into quintiles—i.e., looking at the top 20% of income earners, the next 20%, and so on down to the bottom 20%—and examined the conditions of these populations individually. This resulted in two studies. In “Our Biggest Economic, Social, and Political Issue: The Two Economies—The Top 40% and the Bottom 60%,” I saw the dramatic differences in conditions between the “haves” and the “have-nots,” which helped me understand the greater polarity and populism I saw emerging. Those findings, as well as the intimate contact my wife and I were having through her philanthropic work with the reality of wealth and opportunity gaps in Connecticut communities and their schools, led to the research that became my “Why and How Capitalism Needs to Be Reformed” study. + +4. In my book Principles: Life and Work, I shared my thinking about these different ways of thinking. I won’t describe them here but will direct you there should you be interested. + + + +--- + + +At the same time, through my many years of international dealings in and research of other countries, I saw huge global economic and geopolitical shifts taking place, especially in China. I have been going to China a lot over the last 35 years and am lucky enough to have become well-acquainted with its top policy makers. This has helped me see up close how remarkable the advances in China have been and how excellent the capabilities and historical perspectives that were behind them are. These excellent capabilities and perspectives have led China to become an effective competitor with the US in production, trade, technology, geopolitics, and world capital markets. + +By the way you can read these studies for free at www.economicprinciples.org. + +So, what you are now reading came about because of my need to understand important things that are now happening that hadn’t happened in my lifetime but have happened many times before that. These things are the result of three big forces and the questions they prompt. + +# 1) THE LONG-TERM MONEY AND DEBT CYCLE + +At no point in our lifetimes have interest rates been so low or negative on so much debt as they are today. At the start of 2020, more than $10 trillion of debt was at negative interest rates and an unusually large amount of additional new debt will soon need to be sold to finance deficits. This is happening at the same time as huge pension and healthcare obligations are coming due. These circumstances raised some interesting questions for me. Naturally I wondered why anyone would want to hold debt yielding a negative interest rate and how much lower interest rates can be pushed. I also wondered what will happen to economies and markets when they can’t be pushed lower and how central banks could be stimulative when the next downturn inevitably came. Would central banks print a lot more currency, causing its value to go down? What would happen if the currency that the debt is denominated in goes down while interest rates are so low? These questions led me to ask what central banks will do if investors flee debt denominated in the world’s reserve currencies (i.e., the dollar, the euro, and the yen), which would be expected if the money that they are being paid back in is both depreciating in value and paying interest rates that are so low. + +In case you don’t know, a reserve currency is a currency that is accepted around the world for transactions and savings. The country that gets to print the world’s primary currency (now the US) is in a very privileged and powerful position, and debt that is denominated in the world’s reserve currency (i.e., US dollar-denominated debt) is the most fundamental building block for the world’s capital markets and the world’s economies. It is also the case that all reserve currencies in the past have ceased to be reserve currencies, often coming to traumatic ends for the countries that enjoyed this special privilege. So I also began to wonder whether, when, and why the dollar will decline as the world’s leading reserve currency—and how that would change the world as we know it. + +# 2) THE DOMESTIC WEALTH AND POWER CYCLE + +Wealth, values, and political gaps are now larger than at any other time during my lifetime. By studying the 1930s and other prior eras when polarity was also high, I’ve learned that which side wins out (i.e., left or right) will have very big impacts on economies and markets. So naturally I wondered what these gaps will lead to in our time. My examinations of history have taught me that, as a principle, when wealth and values gaps are large and there is an economic downturn, it is likely that there will be a lot of conflict about how to divide the pie. How will people and policy makers be with each other when the next economic downturn arrives? I am especially concerned because of the previously mentioned limitations on central banks’ abilities to cut interest adequately to stimulate the economy. In addition to these traditional tools being ineffective, printing money and buying financial assets (now called “quantitative easing”) also widen the wealth gap because buying financial assets pushes up their prices, which benefits the wealthy who hold more financial assets than the poor. + +© 2020 Bridgewater Associates, LP + + +--- + + +# 3) THE INTERNATIONAL WEALTH AND POWER CYCLE + +For the first time in my lifetime, the United States is encountering a rival power. China has become a competitive power to the United States in a number of ways and is growing at a faster rate than the US. If trends continue, it will be stronger than the United States in most of the most important ways that an empire becomes dominant. (Or at the very least, it will become a worthy competitor.) I have seen both countries up close for most of my life, and I now see how conflict is increasing fast, especially in the areas of trade, technology, geopolitics, capital, and economic/political/social ideologies. I can’t help but wonder how these conflicts, and the changes in the world order that will result from them, will transpire in the years ahead and what effects that will have on us all. + +The confluence of these three factors piques my curiosity and most draws my attention to similar periods such as the 1930-45 period and numerous others before that. More specifically, in 2008-09 like in 1929-32, there were serious debt and economic crises. In both cases, interest rates hit 0% which limited central banks’ ability to use interest rate cuts to stimulate the economy, so, in both cases, central banks printed a lot of money to buy financial assets which, in both cases, caused financial asset prices to rise and widened the wealth gap. In both periods, wide wealth and income gaps led to a high level of political polarization that took the form of greater populism and battles between ardent socialist-led populists of the left and ardent capitalist-led populists of the right. These domestic conflicts stewed while emerging powers (Germany and Japan in the 1930s) increasingly challenged the existing world power. And finally, just like today, the confluence of these factors meant that it was impossible to understand any one of them without also understanding the overlapping influences among them. + +As I studied these factors, I knew that the short-term debt cycle was getting late and I knew that a downturn would eventually come. I did not expect the global pandemic to be what brought it about, though I did know that past pandemics and other acts of nature (like droughts and floods) have sometimes been important contributors to these seismic shifts. + +To gain the perspective I needed about these factors and what their confluence might mean, I looked at the rises and declines of all the major empires and their currencies over the last 500 years, focusing most closely on the three biggest ones: the US empire and the US dollar which are most important now, the British Empire and the British pound which were most important before that, and the Dutch Empire and the Dutch guilder before that. I also focused less closely on the other six other significant, though less dominant, empires of Germany, France, Russia, Japan, China, and India. Of those six, I gave China the most attention and looked at its history back to the year 600 because 1) China was so important throughout history, it’s so important now, and it will likely be even more important in the future and 2) it provides many cases of dynasties rising and declining to look at to help me better understand the patterns and the forces behind them. In these cases, a clearer picture emerged of how other influences, most importantly technology and acts of nature, played significant roles. From examining all these cases across empires and across time, I saw that important empires typically lasted roughly 250 years, give or take 150 years, with big economic, debt, and political cycles within them lasting about 50-100 years. By studying how these rises and declines worked individually, I could see how they worked on average in an archetypical way, and then I could examine how they worked differently and why. Doing that taught me a lot. My challenge is in trying to convey it well. + +Remember That What I Don’t Know Is Much Greater Than What I Know + +In asking these questions, from the outset I felt like an ant trying to understand the universe. I had many more questions than answers, and I knew that I was delving into numerous areas that others have devoted their lives to studying. So I aggressively and humbly drew on knowledge of some remarkable scholars and practitioners, who each had in-depth perspectives on some piece of the puzzle, though none had the holistic understanding that I needed in order to adequately answer all my questions. In order to understand all the cause-effect relationships behind these cycles, I combined my triangulation with historians (who specialized in different parts of this big, complicated history) and policy makers (who had both practical experiences and historical perspectives) with an examination of statistics drawn out of ancient and contemporary archives by my excellent research team and by reading a number of superb books on history. + +© 2020 Bridgewater Associates, LP + +--- + + +While I have learned an enormous amount that I will put to good use, I recognize that what I know is still only a tiny portion of what I’d like to know in order to be confident about my outlook for the future. Still, I also know from experience that if I waited to learn enough to be satisfied with my knowledge, I’d never be able to use or convey what I have learned. So please understand that while this study will provide you with my very top-down, big-picture perspective on what I’ve learned and my very low-confidence outlook for the future, you should approach my conclusions as theories rather than facts. But please keep in mind that even with all of this, I have been wrong more times than I can remember, which is why I value diversification of my bets above all else. So, whenever I provide you with what I think, as I’m doing in this study, please realize that I’m just doing the best I can to openly convey to you my thinking. + +It’s up to you to assess for yourself what I’ve learned and do what you like with it. + +# How This Study Is Organized + +As with all my studies, I will attempt to convey what I learned in both a very short, simple way and in a much longer, more comprehensive way. To do so, I wrote this book in two parts. + +Part 1 summarizes all that I learned in one very simplified archetype of the rises and declines of empires, drawing from all my research of specific cases. In order to make the most important concepts easy to understand, I will write in the vernacular, favoring clarity over precision. As a result, some of my wording will be by and large accurate but not always precisely so. (I will also highlight key sentences in bold so that you can just read these and skip the rest to quickly get the big picture.) I will first distill my findings into an index of total power of empires, which provides an overview of the ebbs and flows of different powers, that is constituted from eight indexes of different types of power. Then I go into an explanation of these different types of power so you can understand how they work, and finally I discuss what I believe it all means for the future. + +Part 2 shows all the individual cases in greater depth, sharing the same indices for all the major empires over the last 500 years. Providing the information this way allows you to get the gist of how I believe these rises and declines work by reading Part 1 and then to choose whether or not to go into Part 2 to see these interesting cases individually, in relation to each other, and in relation to the template explained in Part 1. I suggest that you read both parts because I expect that you will find the grand story of the evolutions of these countries over the last 500 years in Part 2 fascinating. That story presents a sequential picture of the world’s evolution via the events that led the Dutch empire to rise and decline into the British empire, the British empire to rise and decline into the US empire, and the US empire to rise and enter its early decline into the rise of the Chinese empire. It also compares these three empires with those of Germany, France, Russia, Japan, China, and India. As you will see in the examinations of each of them, they all broadly followed the script, though not exactly. Additionally, I expect that you will find fascinating and invaluable the stories of the rises and declines of the Chinese dynasties since the year 600 just like I did. Studying the dynasties showed me what in China has been similar to the other rises and declines (which is most everything), helped me to see what was different (which is what makes China different from the West), and gave me an understanding of the perspectives of the Chinese leaders who all study these dynasties carefully for the lessons they provide. + +Frankly, I don’t know how I’d be able to navigate what is happening now and what will be coming at us without having studied all this history. But before we get into these fascinating individual cases, let’s delve into the archetypical case. + +© 2020 Bridgewater Associates, LP + + + +--- + +NO_CONTENT_HERE + +--- + +# Chapter 1: + +# The Big Cycles in a Tiny Nutshell + +--- + +NO_CONTENT_HERE + +--- + +Chapter 1: The Big Cycles in a Tiny Nutshell + +As explained in the Introduction, the world order is now rapidly shifting in important ways that have never happened in our lifetimes but have happened many times before in history. My objective is to show you those cases and the mechanics that drove them and, with that perspective, attempt to imagine the future. + +What follows here is an ultra-distilled description of the dynamics that I saw in studying the rises and declines of the last three reserve currency empires (the Dutch, the British, and the American) and the six other significant empires (Germany, France, Russia, India, Japan, and China) over the last 500 years, as well as all of the major Chinese dynasties back to the Tang Dynasty around the year 600. The purpose of this chapter is simply to provide an archetype to use when looking at all the cycles, most importantly the one that we are now in. In studying these past cases, I saw clear patterns that occurred for logical reasons that I briefly summarize here and cover more completely in subsequent chapters of Part 1. While the focus of this chapter and this book are on those forces that affected the big cyclical swings in wealth and power, I also saw ripple-effect patterns in all dimensions of life including culture and the arts, social mores, and more, which I will touch on in Part 2. By going back and forth between this simple archetype and the cases shown in Part 2, we will see how the individual cases fit the archetype (which is essentially just the average of those cases) and how well the archetype describes the individual cases. Doing this, I hope, will help us better understand what is happening now. + +I’m on a mission to figure out how the world works and to gain timeless universal principles for dealing with it well. It’s both a passion and a necessity for me. While the curiosities and concerns that I described earlier pulled me into doing this study, the process of conducting it gave me a much greater understanding of the really big picture on how the world works than I expected to get, and I want to share it with you. It made much clearer to me how peoples and countries succeed and fail over long swaths of time, it revealed giant cycles behind these ups and downs that I never knew existed, and, most importantly, it helped me put into perspective where we now are. + +Though the big-picture synthesis that I’m sharing in this chapter is my own, you should know that the theories I express in this book have been well-triangulated with other experts. About two years ago, when I felt that I needed to answer the questions I described in the Introduction, I decided to immerse myself in research with my research team, digging through archives, speaking with the world’s best scholars and practitioners who each had in-depth understandings of bits and pieces of the puzzle, reading relevant great books by insightful authors, and reflecting on the prior research I’ve done and the experiences that I have from investing globally for nearly 50 years. + +Because I view this as an audacious, humbling, necessary, and fascinating undertaking, I am worried about missing important things and being wrong, so my process is iterative. I do my research, write it up, show it to the world’s best scholars and practitioners to stress test it, explore potential improvements, write it up again, stress test it again, and so on, until I get to the point of diminishing returns. This study is the product of that exercise. While I can’t be sure that I have the formula for what makes the world’s greatest empires and their markets rise and fall exactly right, I’m confident that I got it by-and-large right. I also know that what I learned is essential for me putting what is happening now in perspective and for imagining how to deal with important events that have never happened in my lifetime but have happened repeatedly throughout history. + +I’m passing it along to you to take or leave as you like. + +© 2020 Bridgewater Associates, LP + +--- + +The Countries Shown in This Study Had the Most Wealth and Power + +This is a study of how wealth and power have come and gone in the leading powers of the world. To be clear, while the leading powers covered in this study were the richest and most powerful, they weren’t necessarily the best-off countries for two reasons. First, while wealth and power are what most people want and will fight over most, some people and their countries don’t think that these things are the most important and wouldn’t think of fighting over them. For example, some believe that having peace and savoring life are more important than having a lot of wealth and power and wouldn’t think of fighting hard enough to gain enough of the wealth and power to make it into the group included in this study. (By the way, I think there is a lot to be said for putting peace and savoring life ahead of gaining wealth and power.) Second, this group of countries excludes what I will call the “boutique countries” (like Switzerland and Singapore) that score very high in wealth and living standards but aren’t large enough to become one of the biggest empires. + +# Throughout History Wealth Was Gained by Either Making It, Taking It from Others, or Finding It in the Ground + +Let’s start with the big-picture basics. Throughout recorded history various forms of groups of people (e.g., tribes, kingdoms, countries) have gained wealth and power by building it themselves, taking it from others, or finding it in the ground. When they gathered more wealth and power than any other group, they became the world’s leading power, which allowed them to determine the world order. When they lost that wealth and power, which they all did, the world order changed in very big ways. That changed all aspects of life in profound ways. In this chapter we will describe how throughout time the same basic forces have ebbed and flowed in basically the same sorts of ways to cause these ups and downs in empires. + +Human productivity is the most important force in causing the world’s total wealth, power, and living standards to rise over time. Productivity—i.e., the output per person, driven by learning, building, and inventiveness—has steadily improved over time because learning is gained more than lost. However, it has risen at different rates for different people, though always for the same reasons—because of the quality of people’s education, inventiveness, work ethic, and economic systems to turn ideas into output. These reasons are important for policy makers to understand in order to achieve the best possible outcomes for their countries, and for investors and companies to understand in order to determine where the best long-term investments are. + +But while significant, these learnings and productivity improvements are evolutionary, so they are not what cause big shifts in who has what wealth and power. They are caused by a number of forces, most importantly money and credit cycles. I have identified 17 important forces in total that have explained almost all of these movements throughout time, which we will delve into in a moment. These big forces generally transpire in classic cycles that are mutually reinforcing in ways that tend to create a single very big cycle of ups and downs. This big archetypical cycle governs the rising and declining of empires and influences everything about them, including their currencies and markets (which I’m especially interested in). As with the archetypical debt cycle, which I outlined in Principles for Navigating Big Debt Crises, this big cycle represents the archetypical one that we can compare others to, including the one that we are now in. I believe that we need to understand this archetypical cycle in order to put where we are in perspective and attempt to squint into the future. + +Of the 17 forces, the debt cycle, the money and credit cycle, the wealth gap cycle, and the global geopolitical cycle are most important to understand in order to put where we are in perspective. For reasons explained in this book, I believe that we are now seeing an archetypical big shift in relative wealth and power and the world order that will affect everyone in all countries in profound ways. This big wealth and power shift is not obvious because most people don’t have the patterns of history in their minds to see this one as “another one of those.” So in this first chapter, I will describe in a very brief way how I see the archetypical mechanics behind rises and declines of empires and their markets working. Then we will delve into the various factors happening in the various past cases. + +© 2020 Bridgewater Associates, LP + +--- + + +# To See the Big Picture, You Can’t Focus on the Details + +While I will attempt to paint this big sweeping picture accurately, I can’t paint it in a precise way, and, in order for you to see it and understand it, you can’t try to do so in a precise way. That is because we are looking at evolution over long time frames. To see it, you will have to let go of the details. Of course, when the details are important, which they often are, I will go from the very big, imprecise picture to a more detailed one. + +Looking at what happened in the past from this very big-picture perspective will radically alter how you see things. For example, because the span of time covered is so large, many of the most fundamental things that we take for granted and many of the terms we use to describe them did not exist over the full period of time. As a result, I will be imprecise in my wording so that I can convey the big picture without getting tripped up on what might seem to be big things but, in the scope of what we are looking at, are relative details. + +For example, I wrestled with how much I should worry about the differences between countries, kingdoms, nations, states, tribes, empires, and dynasties. Nowadays we think mostly in terms of countries. However, countries as we know them didn’t come into existence until the 17th century, after Europe’s Thirty Years’ War. In other words, before then there were no countries—generally speaking, though not always, there were kingdoms instead. In some places, kingdoms still exist and can be confused with being countries, and some places are both. Generally speaking, though not always, kingdoms are small, countries are bigger, and empires are biggest (spreading beyond the kingdom or the country). The relationships between them are often not all that clear. The British Empire was mostly a kingdom that gradually evolved into a country and then an empire that extended way beyond England’s borders, so that its leaders controlled broad areas and many non-English peoples. + +It’s also the case that each of these types of singularly controlled entities—countries, kingdoms, tribes, empires, etc.—controls its population in different ways, which further confuses things for those who seek precision. For example, in some cases empires are areas that are occupied by a dominant power while in other cases empires are areas influenced by a dominant power that controls other areas through threats and rewards. The British Empire generally occupied the countries in its empire while the American Empire has controlled more via rewards and threats—though that is not entirely true, as at the time of this writing the US has military bases in 70 countries. So, though it is clear that there is an American Empire, it is less clear exactly what is in it. Anyway, you get my point—that trying to be precise can stand in the way of conveying the biggest, most important things. So in this chapter you are going to have to bear with my sweeping imprecisions. You will also understand why I will henceforth imprecisely call these entities countries, even though not all of them were countries, technically speaking. + +Along these lines, some will argue that my comparing different countries with different systems in different times is impossible. While I can understand that perspective, I want to assure you that I will seek to explain whatever major differences exist, that the timeless and universal similarities are much greater than the differences, and that to let the differences stand in the way of seeing those similarities which provide us with the lessons of history we need, would be tragic. + +© 2020 Bridgewater Associates, LP + + + +--- + + +# Most Everything Evolves in an Uptrend with Cycles Around It + +As mentioned earlier, over long periods of time we evolve because we learn to do things better, which raises our productivity. Over the long run, that is the most important force, though over the short run, the swings around this upward trend are most important. This is conveyed in the chart below, which shows the estimated output (i.e., estimated real GDP) per person over the last 500 years. As shown from this top-down, big-picture perspective, output per person appears to be steadily improving, though very slowly in the early years and faster after around 1800, when the slope becomes much steeper, reflecting the faster productivity gains. This shift from slower productivity gains to faster productivity gains was primarily due to the improvements in broad learning and the conversion of that learning into productivity. That was brought about by a number of factors going as far back as the invention of the printing press in Europe in the mid-15th century (it had been used in China substantially earlier), which increased the knowledge and education available to many more people, contributing to the European Renaissance, the Scientific Revolution, the Enlightenment, and the first Industrial Revolution in Britain. + +That broader-based learning also shifted wealth and power away from 1) an agriculture-based economy in which land ownership was the principal source of power, and the monarchies, nobles, and church worked together to maintain their grip on it, toward 2) an industrial-based economy in which inventive capitalists created and owned the means of production of industrial goods and worked together with those in government to maintain the system that allowed them to have the wealth and power. In other words, since the Industrial Revolution, which brought about that change, we have been operating in a system in which wealth and power have primarily come more from the combination of education, inventiveness, and capitalism, with those who run governments working with those who control most of the wealth and education. While in the first half of the 20th century there were deviations away from capitalism toward communism (which in the years between 1950 and 1990 showed that it didn’t work in the forms that have been tried) and socialism (which is essentially a hybrid wealth and opportunity distribution system that people can debate the merit of), the formula for success has been a system in which educated people come up with innovations, receive funding through capital markets, and own the means by which their innovations are turned into the production and allocation of resources, allowing them to be rewarded by profit-making. This happens best in capitalism and the government systems that work symbiotically with it. At the same time, how this is happening continues to evolve. For example, while ages ago agricultural land and agricultural production were worth the most and that evolved into machines and what they produced being worth the most, digital things that have no apparent physical existence (data and information processing) are evolving to become worth the most. That will create a fight over who obtains the data and how they use it to have wealth and power. (We will delve into that in the chapter that deals with learning and improving to raise productivity.) The main point I’m trying to get across is that the greatest power that produces these uptrends in living standards is humanity’s ability to adapt and improve—so much so that movements around that uptrend caused by everything else don’t even show up when one looks at what’s happening from the higher level in order to gain a bigger-picture perspective. + +At the same time, like all such systems, capitalism has failed to do that job well enough to achieve the goals of producing equal opportunity and maximum productivity through broad-based human capital development (for more on that see “Why and How Capitalism Needs to Be Reformed”). But, to reiterate the main point: from the top-down, big-picture level shown in the below chart, things pretty much keep getting better because people keep getting smarter and keep conveying that smartness into more and better output. + +© 2020 Bridgewater Associates, LP + + +--- + + +# Global RGDP per Capita (2017 USD, ln) + +11.0 +10.5 +10.0 +9.5 +9.0 +8.5 +8.0 +7.5 +7.0 + +1500 1550 1600 1650 1700 1750 1800 1850 1900 1950 2000 + +Underneath this relatively smooth upward trajectory of learning and productivity are turbulent historical periods, including booms, busts, revolutions, and wars. History shows us that almost all of these turbulent times are due to money and credit collapses, big wealth gaps, fighting over wealth and power (i.e., revolutions and wars), and severe acts of nature (like droughts, floods, and epidemics). It also shows that how bad these periods get depends almost exclusively on how strong the countries are to endure them. For example, those with large savings, low debts, and a strong reserve currency can withstand economic and credit collapses better than those that don’t have much savings, have a lot of debt, and don’t have a strong reserve currency. Likewise those with strong and capable leadership and civil populations can be managed better than those that don’t have these, and those that are more inventive will adapt better than those that are less inventive. As you will read in the cases in Part 2, these factors are measurable timeless and universal truths. + +Because these turbulent times are small in relation to the evolutionary uptrend of humanity’s capacity to adapt and invent, they barely show up in the previous chart, appearing only as relatively minor wiggles. Yet these wiggles seem very big to us because we are so small and short-lived. Take the 1930-45 depression and war period, for example. The levels of the US stock market and global economic activity are shown in the chart below. As you can see, the economy fell by about 10%, and the stock market fell by about 85% and then began to recover. + +# Global RGDP per Capita (2017 USD, ln) vs USA Equities Cumulative Return + +| 8.80 | | 160 | +| ---- | ---------- | --- | +| 8.75 | | 140 | +| 8.70 | \~12% fall | 120 | +| 8.65 | | 100 | +| 8.60 | | 80 | +| 8.55 | \~10% fall | 60 | +| 8.50 | | 40 | + +1929 1931 1933 1935 1937 1939 1941 1943 1945 + +© 2020 Bridgewater Associates, LP + +--- + + +# Money and Credit Cycles + +This is part of the classic money and credit cycle that has happened for as long as there has been recorded history and that I will explain in the money and credit cycles chapter. More specifically, a credit collapse that happened because there was too much debt so the central government had to spend a lot of money it didn’t have and make it easier for debtors to pay their debt. To do that, the central bank had to print money and liberally provide credit—like they are doing now. When credit collapsed, spending collapsed with it so they had to print money. In that case the debt bust was the natural extension of the Roaring ‘20s boom that became a debt-financed bubble that popped in 1929. Almost all debt busts, including the one we are now in, come about for basically the same reason of extrapolating the uptrend forward and over-borrowing to bet heavily on things going up and being hurt when they go down. + +Back then, the popping of the bubble and the resulting economic bust were the biggest influences on the 1930-45 period’s internal and external fight for wealth and power. Then, like now and like in most other cases, there were large wealth gaps, which when heightened by debt/economic collapses led to revolutionary changes in social and economic programs and big wealth transfers that were manifest in different systems in different places. Clashes and wars developed over which of these systems was best and as different people and countries fought to get their share. The popular systems that were fought over included communism (which supported dividing most wealth pretty much equally), fascism (which was autocratic state-controlled capitalism), and socialized democracy (which redistributed a lot of wealth while maintaining democracy and a more free-market capitalism—though often in a more autocratic form during the war years). There are always arguments or fights between those who want to make big redistributions of wealth and those who don’t. In the US in the 1930s, Mother Nature also gave us a painful drought. + +Looking over the whole of the cases I examined, I’d say that past economic and market declines each lasted about three years until they were reversed through a big restructuring process that included restructuring of the debt and the monetary and credit system, fiscal policies of taxation and spending, and changes in political power. The quicker the printing of money to fill the debt holes, the quicker the closing of the deflationary depression and the sooner the worrying about the value of money begins. In the 1930s US case, the stock market and the economy bottomed the day that newly elected President Roosevelt announced that he would default on the government’s promise to let people turn in their money for gold, and that the government would create enough money and credit so that people could get their money out of banks and others could get money and credit to buy things and invest. As shown in the previous chart, that created a big improvement but not a full recovery. Then came the war, which resulted from fighting over wealth and power as the emerging powers of Germany and Japan challenged the existing leading world powers of Great Britain, France, and eventually the US (which was dragged into the war). The war period raised economic output of things that were used in war, but it would be a misnomer to call the war years a “productive period”—even though when measured in output per person, it was—because there was so much destruction. At the end of the war, global GDP per capita had fallen by about 12%, much of which was driven by declines in the economies of countries that lost the war. The stress test that these years represented wiped out a lot, made clear who the winners and losers were, and led to a new beginning and a new world order in 1945. Classically that was followed by a lengthy period of peace and prosperity that became overextended so that all countries are now, 75 years later, being stress tested again. + +Most cycles in history happened for basically the same reasons. For example, the 1907-19 period began with the Panic of 1907, which, like the 1929-32 money and credit crisis following the Roaring ‘20s, was the result of boom periods (the Gilded Age in the US, the Belle Époque in continental Europe, and the Victorian era in Great Britain) becoming debt-financed bubbles that led to economic and market declines. These declines also happened when there were large wealth gaps that led to big wealth redistributions and a world war. The wealth redistributions, like those in the 1930-45 period, came about through large increases in taxes and government spending, big deficits, and big changes in monetary policies that monetized the deficits. Then Mother Nature brought about a pandemic (the Spanish flu) that intensified the stress test and the resulting restructuring process. This stress test and global economic and geopolitical restructuring led to a new world order in 1919, which was expressed in the Treaty of Versailles. That ushered in the 1920s debt-financed boom, which led to the 1930-45 period and the same things happening again. + +© 2020 Bridgewater Associates, LP + + +--- + + +Basically these periods of destruction/reconstruction cleaned out the weak, made clear who the powerful were, and established revolutionary new approaches to doing things that set the stage for periods of reconstruction and prosperity that became overextended as debt bubbles with large wealth gaps and led to debt busts that produced new stress tests and destruction/reconstruction periods, which eventually again led to the strong gaining relative to the weak, and so on. + +What are these destruction/reconstruction periods like for the people who experience them? Since you haven’t been through one of these and the stories about them are very scary, the prospect of being in one is very scary to most people. It is true that these destruction/reconstruction periods have produced tremendous human suffering both financially and, more importantly, in lost or damaged human lives. Like the coronavirus experience, what each of these destruction/reconstruction periods has meant and will mean for each person depends on each person’s own experiences, with the broader deep destruction periods damaging the most people. While the consequences are worse for some people, virtually no one escapes the damage. Still, history has shown us that typically the majority of people stay employed in the depressions, are unharmed in the shooting wars, and survive the natural disasters. + +Some people who struggled through them have even described these very difficult times as bringing about important, good things like drawing people closer together, building strength of character, learning to appreciate the basics, etc. For example, Tom Brokaw called the people who went through these times “the Greatest Generation” because of the strength of character it gave them. My parents and aunts and uncles who went through the Great Depression and World War II, as well as others of their era whom I’ve spoken to in other countries who went through their own versions of this destruction period, saw it that way too. Keep in mind that economic destruction periods and war periods typically don’t last very long—they tend to last roughly two or three years. And the lengths and severities of natural disasters (like droughts, floods, and epidemics) vary, though they typically lessen in painfulness as adaptations are made. One rarely gets all three of these types of big crises—i.e., 1) economic, 2) revolution and/or war, and 3) natural disaster—at the same time. + +My point is that while these periods can be depressing and lead to a lot of human suffering, we should never, especially in the worst of times, lose sight of the fact that humanity’s power to adapt and quickly get to new, higher levels of well-being is much greater than all the bad stuff that can be thrown at us. For that reason, I believe that it is smart to believe and invest in humanity’s adaptability and inventiveness. So, while I am pretty sure that in the coming years both you and the world order will experience big challenges and changes, I believe that humanity will become smarter and stronger in very practical ways that will lead us to overcome these challenging times and go on to new and higher levels of prosperity. + +Now let’s look at the cycles of rises and declines in the wealth and power of the major countries over the last 500 years. + +© 2020 Bridgewater Associates, LP + + + +--- + +# The Shifts in Wealth and Power That Occurred Between Countries + +While the first chart of rising productivity shared previously was for the whole world (to the best of our ability to measure it), it doesn’t show the shifts in wealth and power that occurred between countries. The chart below shows you the relative wealth and power of the 11 leading empires over the last 500 years. Each one of these indices of wealth and power is a composite of eight different measures that I will explain shortly. Though these indices aren’t perfect because all data through time isn’t perfect, they do an excellent job of painting the big picture. + +As you can see, nearly all of these empires saw periods of ascendancy followed by periods of decline. The thicker lines represent the four most important empires: the Dutch, British, American, and Chinese. These empires held the last three reserve currencies—the US now, the British before it, and the Dutch before that. China is included because it has risen to be the second-most powerful empire/country and because it was so consistently powerful in most years prior to around 1850. To very briefly summarize what the chart shows: + +- China was dominant for centuries (consistently outcompeting Europe in goods trade), though it entered a steep decline starting in the 1800s. +- The Netherlands, a relatively small country, became one of the world’s great empires in the 1600s. +- The UK followed a very similar path, peaking in the 1800s. +- Finally, the US rose to become the world’s superpower over the last 150 years, though particularly during and after WWII, and is now in relative decline while China is catching up once again. + +# Rough Estimates of Relative Standing of Great Empires + +| Major Wars | United States | China | United Kingdom | Netherlands | Spain | Germany | France | India | Japan | Russia | Ottoman Empire | +| ---------- | ------------- | ----- | -------------- | ----------- | ----- | ------- | ------ | ----- | ----- | ------ | -------------- | + +1.0 + +0.8 Empires + +0.6 Max + +0.4 Relative Level = (1 + +0.2 + +0.0 + +1500 1550 1600 1650 1700 1750 1800 1850 1900 1950 2000 + +These indices were made up of a number of different statistics, some of which were directly comparable and some of which were broadly analogous or broadly indicative. In some cases, a data series that stopped at a certain point had to be spliced with a series that continued back in time. Additionally, the lines shown on the chart are 30-year moving averages of these indices, shifted so that there is no lag. I chose to use the smoothed series because the volatility of the unsmoothed series was too great to allow one to see the big movements. Going forward, I will use these very smoothed versions when looking at the very long term and much less smoothed or unsmoothed versions when looking at these developments up close, because the most important developments were best captured this way. + +© 2020 Bridgewater Associates, LP + + + +--- + + +Now let’s look at the same chart that extends the data all the way back to the year 600. I focused on the one above (which covers just the last 500 years) rather than the one below (which covers the last 1,400 years) because it includes the empires I focused on most intently on and is simpler, though with 11 countries, 12 major wars, and over 500 years, it can hardly be called simple. Still, the one below is more extensive and worth glancing at. I left out the shading of the war periods to lessen the confusion. As shown, in the pre-1500 period, China was almost always the most powerful, though the Middle Eastern caliphates, the French, the Mongols, the Spanish, and the Ottomans were also in the picture. + +# Rough Estimates of Relative Standing of Great Empires + +| United States | China | United Kingdom | Netherlands | +| ------------------------- | ----- | -------------- | -------------- | +| Mongol Empire | Spain | Germany | France | +| India | Japan | Russia | Ottoman Empire | +| Middle Eastern Caliphates | | | | + +1.0 + +0.8 Empires + +Max) + +0.6 Other + +(1=All-Time to Relative Level + +0.4 + +0.2 + +0.0 + +0600 0700 0800 0900 1000 1100 1200 1300 1400 1500 1600 1700 1800 1900 2000 + +© 2020 Bridgewater Associates, LP + +--- + +# Our Measures of Wealth and Power + +The single measure of wealth and power that I showed you for each country in the prior charts is made up as a roughly equal average of eight measures of strength. They are: 1) education, 2) competitiveness, 3) technology, 4) economic output, 5) share of world trade, 6) military strength, 7) financial center strength, and 8) reserve currency. While there are more measures of and influences on power that we will explore later, let’s begin by focusing on these key eight. + +The chart below shows the average of each of these measures of strength, with most of the weight on the most recent three reserve countries (i.e., the US, the UK, and the Dutch).⁶ + +| Education | Innovation and Technology | Competitiveness | Military | Trade | Output | Financial Center | Reserve Status | +| --------------------------------------------------------------------------- | ------------------------- | --------------- | -------- | ----- | ------ | ---------------- | -------------- | +| ![Chart showing the average of measures of strength](chart_placeholder.png) | | | | | | | | + +The lines on the chart do a pretty good job of telling the story of why and how the rises and declines took place. Using these and referring to some additional factors that we will delve deeper into later, I will describe that cycle in a nutshell. But before I start, it’s worth noting that all of these measures of strength rose and declined over the arc of the empire. That’s because these strengths and weaknesses are mutually reinforcing—i.e., strengths and weaknesses in education, competitiveness, economic output, share of world trade, etc., contribute to the others being strong or weak, for logical reasons. For example, it makes sense that better-educated people would produce societies that are more innovative, competitive, and productive. I call this cyclical interrelated move up and down “the Big Cycle.” + +Take note of the order that these items move up and down in the chart because it is broadly indicative of the processes that lead to the rising and declining of empires. For example, quality of education has been the long-leading strength of rises and declines in these measures of power, and the long-lagging strength has been the reserve currency. That is because strong education leads to strengths in most areas, including the creation of the world’s most common currency. That common currency, just like the world’s common language, tends to stay around because the habit of usage lasts longer than the strengths that made it so commonly used. + +6. We show where key indicators were relative to their history by averaging them across the cases. The chart is shown such that a value of “1” represents the peak in that indicator relative to history and “0” represents the trough. The timeline is shown in years with “0” representing roughly when the country was at its peak (i.e., when the average across gauges was at its peak). In the rest of this section, we walk through each of the stages of the archetype in more detail. While the charts show the countries that produced global reserve currencies, we’ll also heavily reference China, which was a dominant empire for centuries, though it never established a reserve currency. + +--- + +The Big Cycle + +Broadly speaking, we can look at these rises and declines as happening in three phases: 1) the ascent phase, which is characterized by the gaining of competitive advantages; 2) the top phase, which is characterized by sustaining the strength but eventually sowing the seeds for the loss of the competitive advantages that were behind the ascent; and 3) the decline phase, which is characterized by self-reinforcing declines in all of these strengths. + +In a nutshell, the ascent phase comes about when there is… + +- strong enough and capable enough leadership to provide the essential ingredients for success, which include… +- strong education. By strong education I don’t just mean teaching knowledge and skills; I also mean teaching… +- strong character, civility, and a strong work ethic, which are typically taught in the family as well as in school. These lead to improved civility that is reflected in factors such as… +- low corruption and high respect for rules, such as rule of law. +- People being able to work well together, united behind a common view of how they should be together and a common purpose, is also important. When people have knowledge, skills, good character, and the civility to behave and work well together, and there is… +- a good system for allocating resources, which is significantly improved by… +- being open to the best global thinking, the country has the most important ingredients in order to succeed. That lead to them gaining… +- greater competitiveness in the global market, which brings in revenues that are greater than expenses, which leads them to have… +- strong income growth, which allows them to make… +- increased investments to improve their infrastructures, education systems, and research and development, which leads them to have… +- higher productivity (more valuable output per hour worked). Increasing productivity is what increases wealth and productive capabilities. When they achieve higher productivity levels, they can become productive inventors of… +- new technologies. These new technologies are valuable for both commerce and the military. As these countries become more competitive in these ways, naturally they gain… +- a significant share of world trade, which requires them to have… +- a strong military to protect their trade routes and to influence those who are important to it outside its borders. +- In becoming economically pre-eminent they develop the world’s leading… +- financial centers for attracting and distributing capital. (For example, Amsterdam was the world’s financial center when the Dutch empire was pre-eminent, London was it when the British empire was on top, and New York is now it because the US is on top, but China is beginning to develop its own financial center in Shanghai.) In expanding their trade globally, these growing empires bring their… +- strong equity, currency, and credit markets. Naturally those dominant in trade and capital flows have their currency used much more as the preferred global medium of exchange and the preferred storehold of wealth, which leads to their currency becoming a reserve currency. That is how the Dutch guilder became the world’s reserve currency when the Dutch Empire was pre-eminent, the British pound became the world’s reserve currency when the British Empire was pre-eminent, and the US dollar became the world’s reserve currency in 1944 when the US was about to win World War II and was clearly pre-eminent economically, financially, and militarily. Having one’s currency be a reserve currency naturally gives that country greater borrowing and purchasing power. As shown in the most recent chart, gaining and losing of reserve currency status happens with a significant lag to the other fundamentals. + +It is through the mutually reinforcing and unwavering improvements in these things that countries rise and sustain their powers. Those who build empires allocate resources well by coordinating their economic, political, and military forces into a profitable economic/political/military system. For example, the Dutch created the Dutch East India Company, the British created the British East India Company, the US created the military-industrial complex, and China has Chinese state capitalism. Such economic, political, and military coordination has proved essential for all empires to profitably expand. + +© 2020 Bridgewater Associates, LP + +--- + + +# In a nutshell + +The top phase typically occurs because within the successes behind the ascent lie the seeds of decline. More specifically, as a rule: + +- Prosperous periods lead to people earning more, which naturally leads them to become more expensive, which naturally makes them less competitive relative to those in countries where people are willing to work for less. +- Those who are most successful typically have their ways of being more successful copied by emerging competitors, which also contributes to the leading power becoming less competitive. For example, British shipbuilders, who had less expensive workers than Dutch shipbuilders, hired Dutch shipbuilding architects to design ships that were built more cost-effectively than the Dutch ships. Because it takes less time and money to copy than invent, all else being equal, emerging empires tend to gain on mature empires through copying. +- Those who become richer naturally tend to work less hard, engage in more leisurely and less productive activities, and at the extreme, become decadent and unproductive. That is especially true as generations change from those who had to be strong and work hard to achieve success to those who inherited wealth—these younger generations tend to be less strong/battle-hardened, which makes them more vulnerable to challenges. Over time people in the prosperous society tend to want and need more luxuries and more leisure and tend to get weaker and more overextended in order to get them, which makes them more vulnerable. +- The currencies of countries that are richest and most powerful become the world’s reserve currencies, which gives them the “exorbitant privilege” of being able to borrow more money, which gets them deeper into debt. This boosts the leading empire’s spending power over the short term and weakens it over the longer run. In other words, when borrowing and spending are strong, the leading empire appears strong while its finances are in fact being weakened. That borrowing typically sustains its power beyond its fundamentals by financing both domestic over-consumption and the military and wars that are required to maintain its empire. This over-borrowing can go on for quite a while and even be self-reinforcing, because it strengthens the reserve currency, which raises the returns of foreign lenders who lend in it. When the richest get into debt by borrowing from the poorest, it is a very early sign of a relative wealth shift. For example, in the 1980s, when the US had a per capita income that was 40 times that of China’s, it started borrowing from Chinese who wanted to save in US dollars because the dollar was the world’s reserve currency. This was an early sign of that dynamic beginning. Similarly, the British borrowed a lot of money from its much poorer colonies, particularly during WWII, and the Dutch did the same before their top, which contributed to the reversals in their currencies and economies when the willingness to hold their currency and debt suddenly fell. The United States has certainly done a lot of borrowing and monetization of its debt, though this hasn’t yet caused a reduced demand for the US currency and debt. +- The leading country extends the empire to the point that the empire has become uneconomical to support and defend. As the costs of maintaining it become greater than the revenue it brings in, the unprofitability of the empire further weakens the leading country financially. That is certainly the case for the US. +- Economic success naturally leads to larger wealth gaps because those who produce a lot of wealth disproportionately benefit. Those with wealth and power (e.g., those who benefit commercially and those who run the government) naturally work in mutually supportive ways to maintain the existing system that benefits them while other segments of the population lag, until the split becomes so large that it is perceived as intolerably unfair. This is an issue in the US. + +© 2020 Bridgewater Associates, LP + +19 + + + +--- + + +# The Decline Phase + +The decline phase typically happens as the excesses of the top phase are reversed in a mutually reinforcing set of declines, and because a competitive power gains relative strength in the previously described areas. + +- When debts become very large, when the central banks lose their ability to stimulate debt and economic growth, and when there is an economic downturn, that leads to debt and economic problems and to more printing of money, which eventually devalues it. +- When wealth and values gaps get large and there is a lot of economic stress (wherever that stress comes from), there are high probabilities of greater conflict between the rich and the poor, at first gradually and then increasingly intensely. That combination of circumstances typically leads to increased political extremism—i.e., populism of both the left (i.e., those who seek to redistribute the wealth, such as socialists and communists) and the right (i.e., those who seek to maintain the wealth in the hands of the rich, such as the capitalists). That happens in both democratically and autocratically run countries. For example, in the 1930s, increasingly extreme populists of the left became communist and those from the right became fascist. Populists tend to be more autocratic, more inclined to fight, and more inclined to respect power than law. +- When the rich fear that their money will be taken away and/or that they will be treated with hostility, that leads them to move their money and themselves to places, assets, and/or currencies that they feel are safer. If allowed to continue, these movements reduce the tax and spending revenue in the locations experiencing these conflicts, which leads in turn to a classic self-reinforcing hollowing-out process in the places that money is leaving. That’s because less tax money worsens conditions, which raises tensions and taxes, causing still more emigration of the rich and even worse conditions, and so on. For example, we are now seeing some of that happening via the rich leaving higher-tax states where there is financial stress and large wealth gaps. When it gets bad enough, governments no longer allow that to happen—i.e., they outlaw the flows of money out of the places that are losing them and to the places, assets, and/or currencies that are getting them, which causes further panic by those seeking to protect themselves. +- When these sorts of disruptive conditions exist, they undermine productivity; that shrinks the economic pie and causes more conflict about how to divide the shrinking resources well, which leads to even more internal conflict that increasingly leads to fighting between the populist leaders from both sides who want to take control to bring about order. That is when democracy is most challenged by autocracy. This is why in the 1920s and 1930s Germany, Japan, Italy, and Spain (and a number of smaller countries) all turned away from democracy to autocratic leadership, and the major democracies (the US, the UK, and France) became more autocratic. It is widely believed that, during periods of chaos, more centralized and autocratic decision making is preferable to less centralized and more democratic, debate-based decision making, so this movement is not without merit when there is unruly, violent crowd fighting. +- When a country gains enough economic, geopolitical, and military power that it can challenge the existing dominant power, there are many areas of potential conflict between these rival world powers. Since there is no system for peacefully adjudicating such disputes, these conflicts are typically resolved through tests of power. +- When a leading country’s costs of maintaining its empire abroad become greater than the revenue that the empire brings in, that economically weakens the country. When that happens at the same time that other countries are emerging as rival powers, the leading power feels compelled to defend its interests. This is especially threatening to the leading country both economically and militarily, because greater military spending is required to maintain the empire, which comes when worsening domestic economic conditions are making it more difficult for leaders to tax and more necessary for them to spend on domestic supports. Seeing this dilemma, enemy countries are more inclined to mount a challenge. Then the leading power is faced with the difficult economic and military choice of fighting or retreating. +- When other exogenous shocks, such as acts of nature (e.g., plagues, droughts, or floods), occur during times of vulnerabilities such as those mentioned above, they increase the risk of a self-reinforcing downward spiral. +- When the leadership of the country is too weak to provide what the country needs to be successful at its stage in the cycle, that is also a problem. Of course, because each leader is responsible for leading during only a tiny portion of the cycle, they have to deal with, and can’t change, the condition of the country that they inherit. This means that destiny, more than the leader, is in control. + +© 2020 Bridgewater Associates, LP + + + +--- + + +I threw a lot at you fast in the last few paragraphs in which I tried to briefly describe the major cause-effect relationship, so you might want to read them again slowly so you can see if that sequence makes sense to you. In Part 2, we will get into a number of specific cases in greater depth and you will see the patterns of these cycles emerge, albeit not in a precise way. The fact that they occur and the reasons for them occurring are less disputable than the exact timing of their occurrences. + +To summarize, around the upward trend of productivity gains that produce rising wealth and better living standards, there are cycles that produce 1) prosperous periods of building, in which the country is fundamentally strong because there are a) relatively low levels of indebtedness, b) relatively small wealth, values, and political gaps, c) people working effectively together to produce prosperity, d) good education and infrastructure, e) strong and capable leadership, and f) a peaceful world order that is guided by one or more dominant world powers. These are the prosperous and enjoyable periods. When they are taken to excess, which they always are, the excesses lead to 2) depressing periods of destruction and restructuring, in which the country’s fundamental weaknesses of a) high levels of indebtedness, b) large wealth, values, and political gaps, c) different factions of people unable to work well together, d) poor education and poor infrastructure, and e) the struggle to maintain an overextended empire under the challenge of emerging powerful rivals lead to a painful period of fighting, destruction, and then a restructuring that establishes a new order, setting the stage for a new period of building. + +Looked at even more simply, the items shown below are the main forces that drive the rises and declines of countries. For any country, the more items it has on the left, the more it is likely to ascend; the more items it has on the right, the more it is likely to decline. Those that make it to the top acquire the characteristics on the left (which causes them to ascend), but with time they move to the right, which makes them more prone to decline, while new competitive countries acquire the characteristics to the left until they are stronger, at which time the shift occurs. + +| Strong Leadership Capabilities | Weak | +| ------------------------------------------ | --------------- | +| High Education Levels | Low | +| Strong Character/Determination | Weak | +| Strong Rule of Law | Weak | +| Low Corruption | High | +| High Resource Allocation Efficiency | Low | +| A Openness to Global Thinking | Little | +| High Productivity/Output Growth | Low | +| Inexpensive Cost Competitiveness | Expensive | +| Favorable Trade and Capital Flows | Unfavorable | +| High Infrastructure & Investment | Low | +| Low Indebtedness | High | +| High Military Strength | Low | +| Small Gaps in Wealth, Opportunity & Values | Large | +| Low Internal Conflict (Social & Political) | High | +| Advantageous Geography | Disadvantageous | +| Stabilizing Acts of Nature | Disruptive | + +© 2020 Bridgewater Associates, LP + + + +--- + + +That, in a nutshell, is what my research has shown makes the cycles of rising and declining empires occur. Now, for the fun of it you might want to go through a little exercise of ticking off where each of those measures is for each country you’re interested in. Rank each country on a 1-10 scale for each attribute, beginning with 10 on the far left and 1 on the far right. If you add these all these rankings up, the higher the number, the greater the probability of the country rising on a relative basis. The lower the number, the more likely it will fall. Take a moment to calculate where the United States is, where China is, where Italy is, where Brazil is, and so on. Later in this report we will do exactly this in a systematic way for each of the largest 20 countries using key performance indicators that I will show you. + +Because all of these factors, both ascending and descending, tend to be mutually reinforcing, it is not a coincidence that large wealth gaps, debt crises, revolutions, wars, and changes in the world order have tended to come as a perfect storm. The big cycles of an empire’s rise and decline look like those in the chart below. The bad periods of destruction and restructuring via depression, revolution, and war, which largely tear down the old system and set the stage for the emergence of a new system, typically take about 10 to 20 years, though variations in the range can be much larger. They are depicted by the shaded areas in the chart. They are followed by more extended periods of peace and prosperity in which smart people work harmoniously together and no country wants to fight the world power because it’s too strong. These peaceful periods last for about 40 to 80 years, though variations in the range can be much larger. Within these cycles are smaller cycles like the short-term debt/business cycle that last about 7 to 10 years. + +# Reserve Arcs (Conceptual Example) + +| | 100 | 80 | 60 | 40 | 20 | 0 | | +| - | -------- | ------ | -------------- | ------- | --- | --- | --- | +| | Relative | Likely | revolution/war | periods | | | | +| | 0 | 20 | 40 | 60 | 80 | 100 | | +| | Time | 120 | 140 | 160 | 180 | 200 | 220 | + +For example, when the Dutch Empire gave way to the British Empire and when the British Empire gave way to the US Empire, most or all of the following things happened. + +- End of the Old, Beginning of the New (e.g., Dutch to British) +- Debt restructuring and debt crisis +- Internal revolution (peaceful or violent) that leads to large transfer of wealth from the “haves” to the “have nots” +- External war +- Big currency breakdown +- New domestic and world order + +- End of the Old, Beginning of the New (e.g., British to US) +- Debt restructuring and debt crisis +- Internal revolution (peaceful or violent) that leads to large transfer of wealth from the “haves” to the “have nots” +- External war +- Big currency breakdown +- New domestic and world order + +© 2020 Bridgewater Associates, LP + + + +--- + +# Where We Are Now + +As previously explained, the last major period of destroying and restructuring happened in 1930-45, which led to the new period of building and the new world order that began in 1945 with the creation a new global monetary system (built in 1944 in Bretton Woods, New Hampshire) and a new American-dominated system of world governance (located the United Nations in New York and the World Bank and the International Monetary Fund in Washington, DC). The new American world order was the natural consequence of the US being the richest country (it then had 80% of the world’s gold stock and gold was then money), the dominant economic power (it then accounted for about half of world production), and the strongest military power (it then had a monopoly on nuclear weapons and the strongest conventional forces). + +It is now 75 years later, and we are classically near the end of a long-term debt cycle when there are large debts and classic monetary policies don’t work well for the world’s reserve currency central banks. This is happening as we are simultaneously in a deep economic and debt contraction that is producing income and balance sheet holes for people, companies, nonprofit organizations, and governments, while politically fragmented central governments are trying to fill in these holes by giving out a lot of money that they are borrowing. Central banks are helping them do that by monetizing government debt. All this is happening at the same time that there are big wealth and values gaps and there is a rising world power that is competing with the leading world power in trade, technology development, capital markets, and geopolitics. And on top of all this, we have a pandemic to contend with. + +At the same time, we have great human capital and thinking technologies that can help us see how to best deal with these challenges and do the inevitable restructurings well. If we can all deal with each other well, we will certainly get past this difficult time and move on to a new prosperous period that will be quite different. + +In the next chapters of Part 1, I will more closely look into the histories and mechanics of the most important of the 17 drivers and will conclude by attempting to squint into the future. + +I will try to pass along pieces of this study to you about once a week until we reach the point of diminishing returns. + +© 2020 Bridgewater Associates, LP + +23 + +--- + +# Chapter 2: + +# The Big Cycle of Money, Credit, Debt, and Economic Activity + +--- + +NO_CONTENT_HERE + +--- + +Chapter 2: The Big Cycle of Money, Credit, Debt, and Economic Activity + +Because what most people and their countries want the most is wealth and power, and because money and credit are the biggest single influence on how wealth and power rise and decline, if you don’t understand how money and credit work, you can’t understand the biggest driver of politics within and between countries so you can’t understand how the world order works. And if you don’t understand how the world order works, you can’t understand what’s coming at you. + +For example, if you don’t understand how the Roaring ’20s led to a debt bubble and a big wealth gap, and how the bursting of that debt bubble led to the 1930-33 depression, and how the depression and wealth gap led to conflicts over wealth all around the world, you can’t understand the forces that led to Franklin D. Roosevelt being elected president. You also wouldn’t understand why, soon after his inauguration in 1933, he announced a new plan in which the central government and the Federal Reserve would together provide a lot of money and credit, a change that was similar to things happening in other countries at the same time and similar to what is happening now. Without understanding money and credit, you wouldn’t understand why these things changed the world order nor would you understand what happened next (i.e., the war, how it was won and lost, and why the new world order was created as it was in 1945), and you won’t be able to understand what is happening now or imagine the future. However, by seeing many of these cases and understanding the mechanics behind them, you will be able to better understand what is happening now and what is likely to happen in the future. + +In doing this study, I spoke with several of the world’s most renowned historians and political practitioners, including current and former heads of state, foreign ministers, finance ministers, and central bankers. In our explorations of how the world really works, it was clear that we each brought different pieces of the puzzle that made the picture much clearer when we put them together. We agreed that the two most essential understandings to have are of 1) how money, credit, and economics work and 2) how domestic and international politics work. Several told me that the understanding conveyed in this chapter has been the biggest missing piece in their quest to understand the lessons of history and I explained to them how their perspectives helped me better understand the political dynamic that affects economic policy choices. This chapter is focused on the money, credit, and economic piece. + +# The Timeless and Universal Fundamentals of Money and Credit + +All entities—people, companies, nonprofit organizations, and governments—deal with the same basic financial realities, and always have. They have money that comes in (i.e., revenue) and money that goes out (i.e., expenses) which, when netted, makes up their net income. These flows are measured in numbers that can be shown in their income statements. If one brings in more than one spends, one has a profit that causes one’s savings to go up. If one’s spending is more than one’s earnings, one’s savings goes down or one has to make up the difference by borrowing it or taking it from someone else. The assets and liabilities (i.e., debts) that one has can be shown in one’s balance sheet. Whether one writes these numbers out or not, every country, company, nonprofit organization, and person has them. The relationships between each entity’s income, expenses, and savings when combined to be the relationships between all entities’ incomes, expenses, and savings transpire in a dynamic way to be the biggest driver of changes in the world order. So, if you can take your understanding of your own income, expenses, and savings, imagine how that applies to others, and put them together, you will see how the whole thing works. + +In brief, if one spends more than one takes in one has to get the money from somewhere, and if one takes in more than one spends one has to put the money one gains somewhere. If one is short of money one can get the money by either drawing down one’s saving, borrowing the money, or taking it from someone else. If one has more money than one uses it will either be added to one’s savings as an investment or given to someone else. What one’s savings looks like—i.e., the assets and the liabilities—shows up in one’s balance sheet. If one has many more assets than liabilities (i.e., a large net worth), one can spend above one’s income by selling assets until the money runs out, at which point one has to slash one’s expenses. If one doesn’t have much more in + +© 2020 Bridgewater Associates, LP + +--- + + +assets than one has in liabilities and one’s income falls beneath the amount one needs to pay out to cover the total of one’s operating expenses and one’s debt-service expenses, one will have to cut one’s expenses or will default/restructure one’s debts. Since one person’s spending is another person’s income, that cutting of expenses will hurt not just the entity that is having to cut those expenses but it will hurt the ones who depend on that spending to earn income. Similarly, since one’s debts are another’s assets, that defaulting on debts reduces other entities’ assets, which requires them to cut their spending. This dynamic produces a self-reinforcing downward debt and economic contraction that becomes a political issue as people argue over how to divide the shrunken pie. As a principle, debt eats equity. What I mean by that is that for most systems, when the rules of the game are followed, debts have to be paid above all else so that when one has “equity” ownership—e.g., in one’s investment portfolio or in one’s house—and one can’t service the debt, the asset will be sold or taken away. In other words, the creditor will get paid ahead of the owner of the asset. As a result, when one’s income is less than one’s expenses and one’s assets are less than one’s liabilities (i.e., debts), one is on the way to having one’s assets sold and going broke. + +However, unlike what most people intuitively think, there isn’t a fixed amount of money and credit in existence. Money and credit can easily be created by governments. Their creating it is liked because it gives people, companies, nonprofit organizations, and governments more spending power. Their taking the credit and spending it on goods, services, and investment assets makes most everything go up in price which most people like. The problem is that it creates a lot of debt and paying it back is difficult and painful. That is why money, credit, debt, and economic activity are inherently cyclical. In the credit creation phase, demand for goods, services, and investment assets and the production of them is strong, and in the debt paying back phase it is weak. + +But what if the debts never had to be paid back? Then there would be no debt squeeze and no painful paying back period. But that would be terrible for those that lent to them because they’d lose their money, right? Let’s think about that for a moment to see if we can find a way around that problem. Since government (i.e., the central government and the central bank combined) has the abilities to both make and borrow money, why couldn’t the central bank lend money at an interest rate of about 0% to the central government (to distribute as it likes) and also lend to others at low rates and allow those debtors to never pay it back. Normally debtors have to pay the original amount borrowed (principal) plus interest in installments over a period of time. But what if the interest rate was 0% and the central bank that lent the money kept rolling over the debt so that the debtor never had to pay it back? That would be the equivalent of giving the debtors the money but it wouldn’t look that way because the debt would still be accounted for as an asset that the central bank owns so the central bank can still say it is performing its normal lending functions. Central banks could do that. In fact that is what is now happening. + +To understand what is now happening and will happen financially to you, to other individuals, to companies, to nonprofit organizations, to governments, and to whole economies, it is important to watch how their income statements and balance sheets are doing and to imagine what will likely happen. Take a moment to think about how this is happening to you and your own financial situation. How much income do you have and will you have in the future relative to your expenses? How much savings do you have, and what’s that savings in? Now play things out. If your income fell or disappeared, how long would your savings last? How much risk do you have in the value of the investments in your savings? If your savings fell in value by half how would you be financially? Can you easily sell your assets to get cash to pay your expenses or service your debts? What are your other sources of money, from the government or from elsewhere? These are the most important calculations you can make to assure your economic well-being. Now look at others—other people, businesses, nonprofit organizations, and governments—realizing that the same is true for them. Now see how we are interconnected and what changes in conditions might mean for you and others who might affect you. Since the economy is nothing more than all these entities operating in this way, if you can visualize this well it will help you understand what is happening and what is likely to happen. + +As for what is happening now, the biggest problem that we collectively now have is that for many people, companies, nonprofit organizations, and governments the incomes are low in relation to the expenses, and the debts and other liabilities (such as those for pension, healthcare, and insurance) are very large relative to the value of their assets. It may not seem that way—in fact it often seems the opposite—because there are many + + + +--- + + +people, companies, nonprofit organizations, and governments that look rich even while they are in the process of going broke. They look rich because they spend a lot, have plenty of assets, and even have plenty of cash. However, if you look carefully you will be able to identify those who look rich but are in financial trouble because they have incomes that are below their expenses and/or liabilities that are greater than their assets so, if you project out what will likely happen to their finances, you will see that they will have to cut their expenses and sell their assets in painful ways that will leave them broke. We each need to do those projections of what the future will look like for our own finances, for others who are relevant to us, and for the world economy. + +If anything I said is confusing to you, I urge you to think about it until you get it. So, pencil out what your financial safety margin looks like (how long will you be financially OK if the worst scenario happens—like you lose your job and your investment assets fall to be only half as much to account for possible price falls, taxes, and inflation). Then do that calculation for others, add them up, and then you will have a good picture of the state of the world. I’ve done that with the help of my partners at Bridgewater and find it invaluable in imagining what is likely to happen. You can read more of my perspective on this in “The Big Picture.” In a nutshell, the liabilities are enormous relative to the net incomes and the asset values that are required to meet those obligations. + +In summary, those basic financial realities work for all people, companies, nonprofit organizations, and governments in the same way they work for you and me, with one big, important exception. All countries can create money and credit out of thin air to give to people to spend or to lend it out. By producing money and giving it to debtors in need, central banks can prevent the debt crisis dynamic that I just explained. For that reason I will modify the prior principle to say debt eats equity, money feeds the hunger of debt, and central banks can produce money. So, it should not be surprising that governments print money when there are debt crises that are causing debt to eat more equity and causing more economic pain that is politically acceptable. + +However, not all money that governments print is of equal value. + +The monies (i.e., currencies) that are widely accepted around the world are called reserve currencies. At this time the world’s dominant reserve currency is the US dollar, which is created by the US central bank, which is the Federal Reserve; it accounts for about 55% of all international transactions. A much less important currency is the euro, which is produced by the Eurozone countries’ central bank, the European Central Bank; it accounts for about 25% of all international transactions. The Japanese yen, the Chinese renminbi, and the British pound all are relatively small reserve currencies now, though the renminbi is growing quickly in importance. + +Having a reserve currency is great while it lasts because it gives the country exceptional borrowing and spending power but also sows the seeds of it ceasing to be a reserve currency, which is a terrible loss. That is because having a reserve currency allows the country to borrow a lot more than it could otherwise borrow which leads it to have too much debt that can’t be paid back which requires its central bank to create a lot of money and credit which devalues the currency so nobody wants to hold the reserve currency as a storehold of wealth. Countries that have reserve currencies can produce a lot of money and credit/debt denominated in them, especially when there is a shortage of them such as now. That is what the Fed is now doing. In contrast countries that don’t have reserve currencies are especially prone to finding themselves in need of these reserve currencies (e.g., dollars) when a) they have a lot of debt that is owed in the reserve currencies that they can’t print (e.g., dollars), b) they don’t have much savings in those reserve currencies, and c) their ability to earn the currencies they need falls off. When countries that don’t have reserve currencies desperately need reserve currencies to pay their debts that are denominated in reserve currencies and to buy things from sellers who want them to pay in reserve currencies, their inability to get enough reserve currencies to meet those needs can bankrupt them. That is where things now stand for a number of countries. It is also where things stand for local governments and states and for many of us. For example a number of states, local governments, companies, nonprofit organizations, and people have suffered income losses and don’t have much savings relative to their losses. They will have to cut their expenses or get money and credit some other way. Others will get money or very cheap credit that may never have to be paid back from the government. The government, and not the free market, will determine who gets what. + +© 2020 Bridgewater Associates, LP 26 + +--- + + +At the time of this writing the income levels of a number of people, companies, nonprofit organizations, and governments have plunged to be below their expense levels by amounts that are large in relation to their net worths so they will be forced either to slash their expenses, which is painful to do now, or to risk running out of their savings and having to default on their debts. Governments that have the power to do so are creating money and credit to give to many but not all of them to help ease the debt burdens and help finance the expenses that are denominated in their own currencies. This configuration of circumstances has happened throughout history and has been handled in the same way so it’s easy to see how this machine works. That is what I want to make sure that I convey in this chapter. + +Let’s start with the real basics and build from there. + +# What is money? + +Money is a medium of exchange that can also be used as a storehold of wealth. + +By medium of exchange, I mean that it can be given to someone to buy things. Basically people produce things in order to exchange them with people who have other things that they want. Because carrying around non-money objects in the hope of exchanging them for what one wants (i.e., barter) is inefficient, virtually every society that has ever existed has invented money (also known as currency) to be something portable that everyone agrees is of value so it can be exchanged for what we want. + +By a storehold of wealth, I mean a vehicle for storing buying power between acquiring it and spending it. While people can store their wealth in assets that they expect will retain their value or appreciate (such as gold, gems, paintings, real estate, stocks, and bonds), one of the most logical things to store it in has been the money that one will use later. But they actually don’t hold the currency because they believe that they can hold something a bit better and always exchange the thing they’re holding to get the currency to buy the things they want to buy. That is where credit and debt come into the picture. + +When lenders lend, they assume that the money they will receive back will buy more goods and services than if they just held onto the money. If done well, the borrowers used the money productively and earned a profit so that they can pay the lenders back and keep some extra money. When the loan is outstanding it is an asset for the lender (e.g., a bond) and a liability (debt) for the borrower. When the money is paid back, the assets and liabilities disappear, and the exchange is good for both the borrowers and lenders. They essentially split the profits that come from doing this productive lending. It is also good for the whole society, which benefits from the productivity gains that result from this.7 + +So, it’s important to realize that 1) most money and credit (especially the fiat money that now exists) has no intrinsic value, 2) it is just journal entries in an accounting system that can easily be changed, 3) the purpose of that system is to help to allocate resources efficiently so that productivity can grow, rewarding both lenders and borrowers, and 4) that system periodically breaks down. As a result, since the beginning of time, all currencies have either been destroyed or devalued. When currencies are destroyed or devalued that shifts wealth in a big way that sends big reverberations through the economy and markets. + +More specifically, rather than working perfectly the money and credit system swings the supplies, demands, and values of money in cycles that in the upswings produce joyful abundance and in the downswings produce painful restructurings. Let’s now get into how these cycles work building from the fundamentals up to where we now are. + +7. While borrowers are typically willing to pay interest, which is what gives lenders the incentive to lend it out, nowadays there are some debt assets that have negative interest rates, which is a weird story that we will explore later. + +© 2020 Bridgewater Associates, LP 27 + + +--- + +The Fundamentals + +While money and credit are associated with wealth, they aren’t wealth. Because money and credit can buy wealth (i.e., goods and services) the amount of money and credit one has and the amount of wealth one has look pretty much the same. But one cannot create more wealth simply by creating more money and credit. To create more wealth, one has to be more productive. The relationship between the creation of money and credit and the creation of wealth (actual goods and services) is often confused yet it is the biggest driver of economic cycles, so let’s look at this relationship more closely. + +There is typically a mutually reinforcing relationship between a) the creation of money and credit and b) the amount of goods, services, and investment assets that are produced so it’s easy to get them confused. Think of it this way. There is both a real economy and a financial economy. Though they are related, they are different. Each has their own supply and demand factors that drive them. For example, in the real economy, when the level of goods and services demanded is strong and rising and the capacity to produce those things demanded is limited, the real economy’s capacity to grow is limited and, if demand keeps rising faster than the capacity to produce, inflation rises. In that example inflation rises because of what is happening in the real economy. Knowing that, central banks normally tighten money and credit at such times to slow the demand. That is an example of something that is happening in the financial economy affecting what’s happening in the real economy. During normal times, which is through most of the long-term debt cycle, central banks turn on and turn off credit, which raises and lowers demand and production. Because they do that imperfectly we have the short-term debt cycles, which we also call overheated economies and recessions. + +In the financial economy, normally money and credit are created by central banks and flow into financial assets, which produces lending that finances people’s borrowing and spending with the private credit system allocating that money and credit. How financial assets are produced by the government through fiscal and monetary policy has a huge effect on who gets the money and credit and the buying power that goes along with it, which also determines what it’s spent on. For example you now see governments atypically giving money, credit, and buying power to those they want to get it to rather than it being allocated by the marketplace, so you are seeing capitalism as we know it being suspended. + +Then of course there is the value of money and credit to consider. It is based on its own supply and demand. For example, when a lot of it is created relative to the demand for it, declines in its value will occur. Where it flows to is important in determining what happens. For example, when the money and credit that central banks are creating no longer go into lending that fuels increases in economic demand and instead go into other currencies and inflation-hedge assets, it fails to stimulate economic activity and instead causes the value of the currency to decline and the value of inflation-hedge assets to rise. At such times high inflation can occur because the supply of money and credit has increased relative to the demand for it, which we call monetary inflation. That can happen at the same time as there is weak demand for goods and services and the selling of assets so that the real economy is experiencing deflation. That is how inflationary depressions come about. For these reasons to understand what is likely to happen financially and economically one has to watch movements in the supplies and demands of both the real economy and the financial economy. + +Similarly confused is the relationship between the prices of things and the value of things. Because they tend to go together they can be confused as being the same thing. They tend to go together because when people have more money and credit they are more inclined to spend more and can spend more. In other words, if you give people more money and credit they will feel richer and spend more on goods and services. To the extent that spending increases economic production and raises the prices of goods, services, and financial assets, it can be said to increase wealth, because the people who own those assets become “richer” when measured by the way we account for wealth. However, that increase in wealth is more an illusion than a reality for two reasons: 1) the increased credit that pushes prices and production up has to be paid back, which, all things being equal, will have the opposite effect when it has to be paid back and 2) the intrinsic value of things doesn’t increase just because their prices go up. Think about it this way: if you own a house and the government creates a lot of money and credit and the price of your house goes up you will still own the same house—i.e., your actual wealth hasn’t increased; just your calculated wealth has increased. Similarly, if the government creates a lot of money and credit that is used to buy goods, services, and investment assets (e.g., stocks, bonds, and real estate) which go up in value. + +© 2020 Bridgewater Associates, LP + +--- + + +price, the amount of calculated wealth goes up but the amount of actual wealth hasn’t gone up because you own the exact same thing as you did before it was considered worth more. In other words, using market values of what one owns to measure one’s wealth gives an illusion of changes in wealth that doesn’t really exist. As far as how the economic machine works, the big thing is that money and credit is stimulative when it’s given out and depressing when it has to be paid back. That’s what normally makes money, credit, and economic growth so cyclical. + +The people who control money and credit (i.e., central banks) vary the costs and availability of money and credit to control markets and the economy as a whole. When the economy is growing too quickly and they want to slow it down, they make less money and credit available, causing both to become more expensive. This encourages people to lend rather than to borrow and spend. When there is too little growth and central bankers want to stimulate the economy, they make money and credit cheap and plentiful, which encourages people to borrow and invest and/or spend. These variations in the cost and availability of money and credit also cause the prices and quantities of goods, services, and investment assets to rise and fall. But banks can only control the economy within their capacities to produce money and credit growth, and their capacities to do that are limited. + +Think of the central bank as having a bottle of stimulant that they can inject into the economy as needed with the amount of stimulant in the bottle being limited. When the markets and the economy sag they give them shots of the money and credit stimulant to pick them up, and when they’re too hot they give them less stimulant. These moves lead to cyclical rises and declines in the amounts and prices of money and credit, and of goods, services, and financial assets. These moves typically come in the form of short-term debt cycles and long-term debt cycles. The short-term cycles of ups and downs typically last about eight years, give or take a few. The timing is determined by the amount of time it takes the stimulant to raise demand to the point that it reaches the limits of the real economy’s capacity to produce. Most people have seen enough of these short-term debt cycles to know what they are like—so much so that they mistakenly think that they will go on working this way forever. They’re most popularly called “the business cycle,” though I call them “the short-term debt cycle” to distinguish them from “the long-term debt cycle.” Over long periods of time these short-term debt cycles add up to long-term debt cycles that typically last about 50 to 75 years. Because they come along about once in a lifetime most people aren’t aware of them; as a result they typically take people by surprise, which hurts a lot of people. The last big long-term debt cycle, which is the one that we are now in, was designed in 1944 in Bretton Woods, New Hampshire, and was put in place in 1945 when World War II ended and we began the dollar/US-dominated world order. + +These long-term debt cycles start when debts are low after previously existing excess debts have been restructured in a way so that central banks have a lot of stimulant in the bottle, and they end when debts are high and central banks don’t have much stimulant left in the bottle. More specifically, the ability of central banks to be stimulative ends when the central bank loses its ability to produce money and credit growth that pass through the economic system to produce real economic growth. That lost ability of central bankers typically takes place when debt levels are high, interest rates can’t be adequately lowered, and the creation of money and credit increases financial asset prices more than it increases actual economic activity. At such times those who are holding the debt (which is someone else’s promise to give them currency) typically want to exchange the currency debt they are holding for other storeholds of wealth. When it is widely perceived that the money and the debt assets that are promises to receive money are not good storeholds of wealth, the long-term debt cycle is at its end, and a restructuring of the monetary system has to occur. In other words the long-term debt cycle runs from 1) low debt and debt burdens (which gives those who control money and credit growth plenty of capacity to create debt and with it to create buying power for borrowers and a high likelihood that the lender who is holding debt assets will get repaid with good real returns) to 2) high debt and debt burdens with little capacity to create buying power for borrowers and a low likelihood that the lender will be repaid with good returns. At the end of the long-term debt cycle there is essentially no more stimulant in the bottle (i.e., no more ability of central bankers to extend the debt cycle) so there needs to be a debt restructuring or debt devaluation to reduce the debt. + +8. By the way, please understand that these rough estimates of cycle times are just rough estimates, and to know where we are in these cycles we need to look more at the conditions than the amount of time. + +© 2020 Bridgewater Associates, LP + + +--- + + +burdens and start this cycle over again. Throughout history central governments and central banks have created money and credit which weakened their own currencies and raised their levels of monetary inflation to offset the deflation that comes from the deflationary credit and economic contractions. + +Since these cycles are big deals and have happened virtually everywhere for as long as there has been recorded history, we need to understand them and have timeless and universal principles for dealing with them well. However, these long-term debt cycles take about a lifetime to transpire, unlike the short-term debt cycles that we all experience a number of times in our lifetimes so most people understand better. When it comes to the long-term debt cycle most people, including most economists, don’t recognize or acknowledge its existence because, to see a number of them in order to understand the mechanics of how they work, one has to look at them operating in a number of countries over many hundreds of years in order to get a good sample size. In Part 2 of this study we will look at all of the most important cycles with reference to the timeless and universal mechanics of why money and credit have worked and failed to work as mediums of exchange and storeholds of wealth. In this chapter, we will look at how they archetypically work. + +I will start with the basics of the long-term debt cycle from way back when and bring you up to the present, giving you a classic template. To repeat, while I’m saying that this is a classic template I’m not saying that all cases transpire exactly like this, though I am saying that almost all follow this pattern closely. + +# The Long-Term Debt Cycle + +# Let’s start with the basics. + +1. It Begins with No or Low Debt and “Hard Money” + +When societies first invented money they used all sorts of things, like grain and beads. But mostly they used things that had intrinsic value, like gold, silver, and copper. Let’s call that “hard money.” + +Gold and silver (and sometimes copper and other metals like nickel) were the preferred forms of money because 1) they had intrinsic value and 2) they could easily be shaped and sized to be portable so they could easily be exchanged. Having intrinsic value (i.e., being useful in and of themselves) was important because no trust—or credit—was required to carry out an exchange with them. Any transaction could be settled on the spot, even if the buyer and seller were strangers or enemies. There is an old saying that “gold is the only financial asset that isn’t someone else’s liability.” That is because it has widely accepted intrinsic value, unlike debt assets or other assets that require an enforceable contract or a law to ensure the other side will deliver on its promise to deliver whatever it promised to deliver (which when it’s just “paper” currency that can easily be printed isn’t much of a promise). On the other hand, if during such a period of lack of trust and enforceability one receives gold coins from a buyer, that doesn’t have a credit component to it—i.e., you could melt them down and still receive almost the same amount of value because of its intrinsic value—so the transaction can happen without the same sort of risks and lingering promises that need to be kept. When countries were at war and there was not trust in the intentions or abilities to pay, they could still pay in gold. So gold (and to a lesser extent silver) could be used as both a safe medium of exchange and a safe storehold of wealth. + +Then Come Claims on “Hard Money” (aka, “Notes” or “Paper Money”) + +Because carrying a lot of metal money around was risky and inconvenient, credible parties (which came to be known as banks, though they initially included all sorts of institutions that people trusted, such as temples in China) arose that would put the money in a safe place and issue paper claims on it. Soon people treated these paper “claims on money” as if they were money themselves. After all, they were as good as money because they could be redeemed for tangible money. This type of currency system is called a linked currency system because the value of the currency is linked to the value of something, typically a “hard money” such as gold. + +© 2020 Bridgewater Associates, LP + + + +--- + + +# 3) Then Comes Increased Debt + +At first there is the same number of claims on the “hard money” as there is hard money in the bank. However, the holders of the paper claims and the banks discover the wonders of credit and debt. They can lend these paper claims to the bank in exchange for an interest payment so they get interest. The banks that borrow it from them like it because they lend the money to others who pay a higher interest rate so the banks make a profit. And those who borrow the money from the bank like it because it gives them buying power that they didn’t have. And the whole society likes it because it leads asset prices and production to rise. Since everyone is happy with how things are going they do a lot of it. More lending and borrowing happens over and over again many times, there is a boom, and the quantity of the claims on the money (i.e., debt assets) rises relative to the amount of actual goods and services there are to buy. Trouble approaches either when there isn’t enough income to survive one’s debts or when the amount of the claims (i.e., debt assets) that people are holding in the expectation that they can sell them to get money to buy goods and services increases faster than the amount of goods and services by an amount that makes the conversion from that debt asset (e.g., that bond) implausible. These two problems tend to come together. + +Concerning the first of these problems, think of debt as negative earnings and a negative asset that eats up earnings (because earnings have to go to pay it) and eats up other assets (because other assets have to be sold to get the money to pay the debt). It is senior —meaning it gets paid before any other type of asset—so when incomes and the values of one’s assets fall, there is a need to cut expenditures and sell off assets to raise the needed cash. When that’s not enough, there needs to be a) debt restructurings in which debts and debt burdens are reduced, which is problematic for both the debtor and the creditor because one person’s debts are another’s assets and/or the b) central bank printing money and the central government handing out money and credit to fill in the holes in incomes and balance sheets (which is what is happening now). + +Concerning the second of these problems, it occurs when holders of debt don’t believe that they are going to get adequate returns from it. Debt assets (e.g., bonds) are held by investors who believe that they are storeholds of wealth that can be sold to get money, which can be used to buy things. When the holders of debt assets try to make the conversion to real money and real goods and services and find out that they can’t, this problem surfaces. Then a “run” occurs, by which I mean that lots of holders of that debt want to make that conversion to money, goods, services, and other financial assets. The bank, regardless of whether it is a private bank or a central bank, is then faced with the choice to allow that flow of money out of the debt asset, which will raise interest rates and cause the debt and economic problems to worsen, or to “print money” and buy enough of those bonds that others are selling to prevent interest rates from rising and hopefully reverse the run out of them. Sometimes their doing that buying works temporarily, but if the ratio of a) claims on money (debt assets) to b) the amount of money there is and the quantity of goods and services there are to buy is too high, the bank is in a bind that it can’t get out of because it simply doesn’t have enough money to meet the claims so it will have to default on its claims. When that happens to a central bank it has the choice either to default or to print the money and devalue it. They inevitably devalue. When these debt restructurings and currency devaluations are big they lead to breakdowns and possibly destructions of the monetary system. Whatever the bank or the central bank does, the more debt (i.e., claims on money and claims on goods and services) there is, the more the likelihood that it will be necessary to devalue the money. + +Remember that there is always a limited amount of goods and services because the amount is constrained by the ability to produce. Also remember that in our example of paper money being claims on “hard money,” there is a limited amount of that “hard money” (e.g., the gold on deposit), while the amount of paper money (e.g., the claims on that hard money) and debt (the claims on that paper money) is constantly growing. And, as that amount of paper money claims grows relative to the amount of hard money in the bank and goods and services in the economy, the risk increases that the holders of those debt assets may not be able to redeem them for the amounts of hard money or goods and services that they expect to be able to exchange them for. + +© 2020 Bridgewater Associates, LP 31 + +--- + + +It is important to understand the difference between money and debt. Money is what settles claims—i.e., one pays one’s bills and one is done. Debt is a promise to deliver money. In watching how the machine is working it is important to watch a) the amounts of both debt and money that exist relative to the amount of hard money (e.g., gold) in the bank and b) the amounts of goods and services that exist, which can vary, remembering that debt cycles happen because most people love to expand their buying power (generally through debt) while central banks tend to want to expand the amount of money in existence because people are happier when they do that. But this can’t go on forever. And it is important to remember that the “leveraging up” phase of the money and debt cycle ends when bankers—whether private bankers or central bankers—create a lot more certificates (paper money and debt) than there is hard money in the bank to give and the inevitable day comes when more certificates are turned in than there is money to give. Let’s look at how that happens. + +# 4) Then Come Debt Crises, Defaults, and Devaluations + +History has shown that when the bank’s claims on money grow faster than the amount of money in the bank—whether the bank is a private bank or government-controlled (i.e., central bank)—eventually the demands for the money will become greater than the money the bank can provide and the bank will default on its obligations. That is what is called a bank run. One can quite literally tell when a bank run is happening and a banking crisis is imminent by watching the amounts of money in banks (whether “hard” or paper) decline and approach the point of running out due to withdrawals. + +A bank that can’t deliver enough hard money to meet the claims that are being made on it is in trouble whether it is a private or a central bank, though central banks have more options than private banks do. That’s because a private bank can’t simply print the money or change the laws to make it easier to pay their debts, while a central bank can. Private bankers must either default or get bailed out by the government when they get into trouble, while central bankers can devalue their claims (e.g., pay back 50-70%) if their debts are denominated in their national currency. If the debt is denominated in a currency that they can’t print, then they too must ultimately default. + +# 5) Then Comes Fiat Money + +Central banks want to stretch the money and credit cycle to make it last for as long as they can because that is so much better than the alternative, so, when “hard money” and “claims on hard money” become too painfully constrictive, governments typically abandon them in favor of what is called “fiat” money. No hard money is involved in fiat systems; there is just “paper money” that the central bank can “print” without restriction. As a result, there is no risk that the central bank will have its stash of “hard money” drawn down and have to default on its promises to deliver it. Rather the risk is that, freed from the constraints on the supply of tangible gold or some other “hard” asset, the people who control the printing presses (i.e., the central bankers working with the commercial bankers) will create ever more money and debt assets and liabilities in relation to the amount of goods and services being produced until a time when those who are holding the enormous amount of debt will try to turn them in for goods and services which will have the same effect as a run on a bank and result in either debt defaults or the devaluation of money. That shift from a) a system in which the debt notes are convertible to a tangible asset (e.g., gold) at a fixed rate to b) a fiat monetary system in which there is no such convertibility last happened in 1971. When that happened—on the evening of August 15, when President Nixon spoke to the nation and told the world that the dollar would no longer be tied to gold—I watched that on TV and thought, “Oh my God, the monetary system as we know it is ending,” and it was. I was clerking on the floor of the New York Stock Exchange at the time, and that Monday morning I went on the floor expecting pandemonium with stocks falling and found pandemonium with stocks rising. Because I had never seen a devaluation before I didn’t understand how they worked. Then I looked into history and found that on Sunday evening March 5, 1933, President Franklin Roosevelt gave essentially the same speech doing essentially the same thing which yielded essentially the same result over the following months (a devaluation, a big stock market rally, and big gains in the gold price), and I saw that that happened many times before in many countries, including essentially the same proclamations by the heads of state. + +© 2020 Bridgewater Associates, LP 32 + + +--- + + +# In the years leading up to 1971 + +The US government spent a lot of money on military and social programs then referred to as “guns and butter” policy, which it paid for by borrowing money that created debt. The debt was a claim on money that could be turned in for gold. The investors bought this debt as assets because they got paid interest on this government debt and because the US government promised that it would allow the holders of these notes to exchange them for the gold that was held in the gold vaults in the US. As the spending and budget deficits in the US grew the US had to issue much more debt —i.e., create many more claims on gold—even though the amount of gold in the bank didn’t go up. Naturally more investors turned in their promises to get the gold for the claims on the gold. People who were astute enough to pay attention could see that the US was running out of gold and the amount of outstanding claims on gold was much larger than the amount of gold in the bank, so they realized that if this continued the US would default. Of course the idea that the United States government, the richest and most powerful government in the world, would default on its promise to give those who had claims on gold the gold it promised to give them seemed implausible at the time. So, while most people were surprised at the announcement and the effects on the markets, those who understood the mechanics of how money and credit work were not. + +# When credit cycles reach their limit + +It is both the logical and the classic response for central governments and their central banks to create a lot of debt and print money that will be spent on goods, services, and investment assets to keep the economy moving. That is what was done during the 2008 debt crisis, when interest rates could no longer be lowered because they had already hit 0%. As explained that was also done in response to the 1929-32 debt crisis, when interest rates had been driven to 0%. This creating of the debt and money is now happening in amounts that are greater than at any time since World War II. + +# To be clear + +Central banks’ “printing money” and giving it out for spending rather than supporting spending with debt growth is not without its benefits —e.g., money spends like credit, but in practice (rather than in theory) it doesn’t have to be paid back. In other words, there is nothing wrong with having an increase in money growth instead of an increase in credit/debt growth, provided that the money is put to productive use. The main risks of printing money rather than facilitating credit growth are a) market participants will fail to carefully analyze whether the money is being put to productive use and b) it eliminates the need to have the money paid back. Both increase the chances that money will be printed too aggressively and not used productively so people will stop using it as a storehold of wealth and will shift their wealth into other things. Throughout history, when the outstanding claims on hard money (debt and money certificates) are far greater than there is hard money and goods and services, a lot of defaults or a lot of printing of money and devaluing have always happened. + +# History has shown us that + +We shouldn’t rely on governments to protect us financially. On the contrary, we should expect most governments to abuse their privileged positions as the creators and users of money and credit for the same reasons that you might do these abuses if you were in their shoes. That is because no one policy maker owns the whole cycle. Each one comes in at one or another part of it and does what is in their interest to do at that time given their circumstances at the time. + +# Because early in the debt cycle + +Governments are considered trustworthy and they need and want money as much or more than anyone else, they are typically the biggest borrowers. Later in the cycle, when successive leaders come in to run the more indebted governments the new government leaders and the new central bankers have to face the greater challenge of paying back debts when they have less stimulant in the bottle. To make matters worse, governments also have to bail out debtors whose failures would hurt the system. As a result, they tend to get themselves into big cash flow jams that are much larger than those of individuals, companies, and most other entities. + +© 2020 Bridgewater Associates, LP + +--- + + +In other words, in virtually all cases the government contributes to the accumulation of debt in its actions and by becoming a large debtor and, when the debt bubble bursts, bails itself and others out by printing money and devaluing it. The larger the debt crisis, the more that is true. While undesirable, it is understandable why this happens. When you can manufacture money and credit and pass it out to everyone to make them happy, it is very hard to resist the temptation to do so.⁹ It is a classic financial move. Throughout history, rulers have run up debts that won’t come due until long after their reign is over, leaving it to their successors to pick up the pieces. + +How do governments react when they have debt problems? They do what any practical, heavily indebted entity with promises to give money that they can print would do. Without exception, they print money and devalue it if the debt is in their own currency. When central banks print money and buy up debt that puts money into the financial system and bids up the prices of financial assets (which also widens the wealth gap because it helps those with the financial assets that are bid up relative to those who don’t have financial assets). It also puts a lot of debt in the hands of the central bank, which allows the central bank to handle the debts however they see fit. Also their printing of the money and buying the financial assets (mostly bonds) holds interest rates down, which stimulates borrowing and buying and encourages those holding these bonds to sell them and encourages the borrowing of money at low interest rates to invest it in higher-returning assets, which leads to central banks printing more money and buying more bonds and sometimes other financial assets. That typically does a good job of pushing up financial asset prices but is relatively inefficient in getting money and credit and buying power into the hands of those who need it most. That is what happened in 2008 and has happened for most of the time since until just recently. Then, when the printing of money and the central bank’s buying up of financial assets fails to get money and credit to where it needs to go, the central government—which can decide what to spend money on—borrows money from the central bank (which prints it) so it can spend it on what it needs to be spent on. In the US the Fed announced this plan on April 9, 2020. This approach of printing money to buy debt (called debt monetization) is vastly more politically palatable as a way of getting money and shifting wealth from those who have it to those who need it than imposing taxes, which leads taxed people to get angry. That is why in the end central banks always print money and devalue. + +When governments print a lot of money and buy a lot of debt so the amounts of both money and debt increase, they cheapen money and debt, which essentially taxes those who own it to make it easier for debtors and borrowers. When this happens enough that the holders of this money and debt assets realize what is happening, they seek to sell their debt assets and/or borrow money to get into debt that they can pay back with cheap money. They also often move their wealth to other storeholds of wealth like gold, certain types of stocks, and/or somewhere else (like another country that is not having these problems). At such times central banks have typically continued to print money and buy debt directly or indirectly (e.g., by having banks do the buying for them) and have outlawed the flow of money into inflation-hedge assets and alternative currencies and alternative places. + +Such periods of reflation either stimulate another money and credit expansion that finances another economic expansion (which is good for stocks) or devalue money so that it produces monetary inflation (which is good for inflation-hedge assets such as gold). Earlier in the long-term debt cycle when the amounts of outstanding debts aren’t large and when there is lots of room to stimulate by lowering interest rates (and failing that, printing money and buying financial assets), the greater the likelihood that credit growth and economic growth will be good, while later in the long-term debt cycle when the amounts of debt are large and when there isn’t much room to stimulate by lowering interest rates (or printing money and buying financial assets) the greater the likelihood that there will be a monetary inflation accompanied by economic weakness. + +9 Some central banks have made this harder by separating themselves from the direct control of politicians, but virtually every central bank has to bail out their governments at some point, so devaluations always happen. + +© 2020 Bridgewater Associates, LP + +--- + + +# Then Comes the Flight Back into Hard Money + +When taken too far, the over-printing of fiat currency leads to the selling of debt assets and the earlier-described bank “run” dynamic, which ultimately reduces the value of money and credit, which prompts people to flee out of both the currency and the debt (e.g., bonds). They need to decide what alternative storehold of wealth they will use. History teaches us that they typically turn to gold, other currencies, assets in other countries not having these problems, and stocks that retain their real value. Some people think that there needs to be an alternative reserve currency to go to, but that’s not true as the same dynamic of the breakdown of the monetary system and the running to other assets happened in cases in which there was no alternative currency to go to (e.g., in China and in the Roman Empire). The debasement of the currency leads it to devalue and have people run from it and debt denominated in it into something else. There is a whole litany of things people run to when money is devalued, including rocks (used for construction) in Germany’s Weimar Republic. + +Typically at this stage in the debt cycle there is also economic stress caused by large wealth and values gaps, which lead to higher taxes and fighting between the rich and the poor, which also makes those with wealth want to move to hard assets and other currencies and other countries. Naturally those who are governing the countries that are suffering from this flight from their debt, their currency, and their country want to stop it. So, at such times, governments make it harder to invest in assets like gold (e.g., via outlawing gold transactions and ownership), foreign currencies (via eliminating the ability to transact in them), and foreign countries (via establishing foreign exchange controls to prevent the money from leaving the country). Eventually the debt is largely wiped out, usually by making the money to pay it back plentiful and cheap, which devalues both the money and the debt. + +When this becomes extreme so that the money and credit system breaks down and debts have been devalued and/or defaulted on, necessity generally compels governments to go back to some form of hard currency to rebuild people’s faith in the value of money as a storehold of wealth so that credit growth can resume. Quite often, though not always, the government links its money to some hard money (e.g., gold or a hard reserve currency) with promises to allow holders of the new money to make that conversion to the hard money. Sometimes that hard money is another country’s. For example, over the past decades many weak-currency countries have linked their money to the US dollar or simply dollarized their economy (i.e., used the dollar as their own medium of exchange and storehold of wealth). + +To review, in the long-term debt cycle, holding debt as an asset that provides interest is typically rewarding early in the cycle when there isn’t a lot of debt outstanding, but holding debt late in the cycle when there is a lot of it outstanding and it is closer to being defaulted on or devalued is risky relative to the interest rate being given. So, holding debt (e.g., bonds) is a bit like holding a ticking time bomb that rewards you while it’s still ticking and blows you up when it goes off. And as we’ve seen, that big blowup (i.e., big default or big devaluation) happens something like once every 50 to 75 years. + +These cycles of debt and writing off debts have existed for thousands of years and in some cases have been institutionalized. For example, the Old Testament provided for a year of Jubilee every 50 years, in which debts were forgiven (Leviticus 25:8-13). Knowing that the debt cycle would happen on that schedule allowed everyone to act in a rational way in preparation for it. Helping you understand this dynamic so that you are prepared for it rather than are surprised by it is the main objective behind my writing this. + +Because most people don’t pay attention to this cycle much in relation to what they are experiencing, ironically the closer people are to the blowup the safer they tend to feel. That is because they have held the debt and enjoyed the rewards of doing that and the longer it has been from the time since the last one blew up, the more comfortable they have become as the memories of the last blowup fade—even as the risks of holding this debt rise and the rewards of holding it decline. By keeping an eye on the amount of debt that needs to be paid relative to the amount of hard money that there is to pay it, the amount of debt payments that have to be made relative to the amount of cash flow the debtors have to service the debt, and the interest rewards that one is getting for lending one’s money, one can assess the risk/reward of holding the time bomb. + +© 2020 Bridgewater Associates, LP 35 + +--- + +# The Long-Term Debt Cycle in Summary + +For thousands of years there have always been three types of monetary system: + +- Hard Money (e.g., metal coins) +- “Paper Money” claims on hard money +- Fiat Money (e.g., the US dollar today) + +Hard money is the most restrictive system because money can’t be created unless the supply of the metal or other intrinsically valuable commodity that is the money is increased. Money and credit are more easily created in the second type of system, so the ratio of the claims on hard money to the actual hard money held rises, which eventually leads to a “run” on the banks. The result is a) defaults, when the bank closes its doors and the depositors lose their hard assets and/or b) devaluations of the claims on money, which means that the depositors get back less. In the third type of system, governments can create money and credit freely, which works for as long as people continue to have confidence in the currency and fails when they don’t. + +Throughout history, countries have transitioned across these different types of systems for logical reasons. As a country needs more money and credit than it currently has, whether to deal with debts, wars, or other problems, it naturally moves from Type 1 to Type 2, or Type 2 to Type 3, so that it has more flexibility to print money. Then creating too much money and debt depreciates its value, causing people to get out of holding the debt and money as a storehold of wealth, and moving back into hard assets (like gold) and other currencies. Since this typically takes place when there is wealth conflict and sometimes a war, there is typically also a desire to get out of the country. Such countries need to re-establish confidence in the currency as a storehold of wealth before they can restore their credit markets. + +The below diagram conveys these different transitions. There are many historical examples, from the Song Dynasty to Weimar Germany, of countries making the full transition from constrained types (Type 1 and Type 2) to fiat money, then back to a constrained currency as the old fiat currency hyperinflates. + +| Type 1: Hard Money | Type 2: Claims on Hard Money (e.g., Banknotes) | Type 3: Fiat Money (e.g., USD Today) | +| --------------------------------------- | ---------------------------------------------- | --------------------------------------- | +| Maximizes Credibility, Minimizes Credit | / | Maximizes Credit, Minimizes Credibility | + +© 2020 Bridgewater Associates, LP + +36 + +--- + + +# As noted earlier this big debt cycle plays out over the long term—something like 50 to 75 years—and, at its end, is characterized by a restructuring of debts and of the monetary system. + +The abrupt parts of these restructurings—i.e., the debt and currency crisis periods—typically happen quickly, lasting only months to up to three years, depending on how long it takes the governments to exercise these moves. However, the ripple effects of them can be long-lasting. For example, these circumstances can lead to reserve currencies stopping being reserve currencies. Within each of these currency regimes there are typically two to four big debt crises—i.e., big enough to cause banking crises and debt write-downs or devaluations of 30% or more—but not big enough to break the currency system. Because I have invested in many countries for about 50 years I have experienced dozens of them. They all run the same way, which is explained in greater depth in my book *Principles for Navigating Big Debt Crises*. + +# The Monetary System That We Are in, from Its Beginning until Now + +The dollar became the world’s leading reserve currency when the United States became the world’s strongest economic and military power at the end of World War II. Since then having the world’s leading reserve currency has been critical to the United States sustaining and extending its power. That is because a great power comes from being able to create money and credit in the currency that is widely accepted around the world as a medium of exchange and a storehold of wealth. As a result of having the ability to print the world’s currency the United States’ relative financial economic power is multiple times the size of its real economic power. + +At the risk of boring you by repeating some of the things I already told you, I will now review the US case and the circumstances that led to the US and the dollar putting the world in the position that we are now in. + +In brief, the new world order began after the end of World War II in 1945, with the Bretton Woods agreement having put the dollar in the position of being the world’s leading reserve currency in 1944. The US and the dollar naturally fit into that role because at the end of the war, the US had around two-thirds of the world’s gold held by governments (which was the world’s money at the time), accounted for 50% of the world’s economic production, and was the dominant military power. The new monetary system was a Type 2 (i.e., claims on hard money) monetary system, in which “paper dollar” claims on gold could be exchanged by other countries’ central banks for an ounce of gold at a price of $35/ounce. It was then illegal for individuals to own gold because government leaders didn’t want gold to compete with money and credit as a storehold of wealth. So, at the time, gold was the money in the bank and the paper dollars were like checks in a checkbook that could be turned in for the real money. At the time of the establishment of this new monetary system there was $50 of paper money in existence for each ounce of gold the US government owned, so there was nearly 100% gold backing. + +Other major countries that were US allies (e.g., the UK, France, and the Commonwealth countries) or under US control (Germany, Japan, and Italy) had US-controlled currencies that were linked to the dollar. In the years that followed, to finance its activities, the US government spent more than it took in in tax revenue so it had to borrow money, which created more dollar-denominated debt. The US Federal Reserve allowed the creation of a lot more claims on gold (i.e., dollar-denominated money and credit) than could actually be converted into gold at that $35 price. As the paper money was turned in for the hard money (gold), the quantity of gold in the US bank went down at the same time as the claims on it continued to rise. As a result, the Bretton Woods monetary system broke down on August 15, 1971 when President Nixon, like President Roosevelt on March 5, 1933, defaulted on the US’s promise to allow holders of paper dollars to turn them in for gold. Thus the dollar devalued against gold and other currencies. That is when the US and all countries went to a Type 3 fiat monetary system. If you want to read a great description of this process of figuring out how to go from the old monetary system to the new fiat one, I recommend *Changing Fortunes* by Paul Volcker, who was the leading American negotiator of how the new monetary system would work. + +This move to a fiat monetary system freed the Federal Reserve and other central banks to create a lot of dollar-denominated money and credit, which led to the inflationary 1970s, which was characterized by a flight from dollars and dollar-denominated debt to goods, services, and inflation-hedge assets such as gold. That panic out of dollar debt also led interest rates to rise and drove the gold price from the $35 that it was fixed at in 1944 and officially stayed at until 1971 to a then-peak of $670 in 1980. + +© 2020 Bridgewater Associates, LP + +--- + + +With the money and credit managed this way in the 1970s it was profitable to borrow dollars and convert them into goods and services, so many entities in many countries borrowed dollars largely through US banks to do that. As a result, dollar-denominated debt grew rapidly around the world, and US banks made a lot of money lending it to these borrowers. This lending led to the classic debt bubble part of the debt cycle. The panic out of dollars and dollar-debt assets and into inflation-hedge assets, as well as the rapid borrowing of dollars and the getting into debt, accelerated. That created the money and credit crisis of 1979-82, during which time the US dollar and dollar-denominated debt were at risk of ceasing to be an accepted storehold of wealth. Of course, the average citizen didn’t understand how this money and credit dynamic worked, but they felt it in the form of high inflation and high interest rates, so it was a huge political issue. President Carter, who like most political leaders didn’t understand the monetary mechanics very well, knew that something had to be done to stop it and appointed a strong monetary policy maker, Paul Volcker. Just about everyone who followed such things, including me, hung on his every word. He was strong enough to do the painful but right things needed to break the back of inflation. He became a hero of mine and eventually a good personal friend because of his great character and great capabilities, and I loved his wry humor too. + +To deal with that monetary inflation crisis and to break the back of inflation, Volcker tightened the supply of money, which drove interest rates to the highest level “since Jesus Christ,” according to German Chancellor Helmut Schmidt. Because the interest rate was far above the inflation rate debtors had to pay much more in debt service at the same time as their incomes and assets fell in value. That squeezed the debtors and required them to sell assets. Because of the great need for dollars, the dollar was strong. For these reasons, inflation rates fell, which allowed the Federal Reserve to lower interest rates and to ease money and credit for Americans. Of course many debtors and holders of these assets that were falling in value went broke. So in the 1980s these debtors, especially foreign debtors and more especially those in emerging countries, went through a decade-long depression and debt-restructuring period. The Federal Reserve protected the American banks by providing them with the money they needed, and the American accounting system protected them from going broke by not requiring them to account for these bad debts as losses or value these debt assets at realistic prices. This debt management and restructuring process lasted until 1991, when it was completed through the Brady Bond agreement, named after Nicholas Brady who was the US Secretary of Treasury at the time. This whole 1971-91 cycle, which affected just about everyone in the world, was the result of the US going off the gold standard. It led to the soaring of inflation and inflation-hedge assets in the 1970s, which led to the 1979-81 tightening and a lot of deflationary debt restructuring by non-American debtors, falling inflation rates, and excellent performance of bonds and other deflationary assets in the 1980s. The entire period was a forceful demonstration of the power of the US having the world’s reserve currency—and the implications for everyone around the world of how that currency was managed. + +From that 1979-81 peak in dollar-denominated inflation and dollar-denominated interest rates until now, both the inflation rates and interest rates have fallen to nearly 0%. You can clearly see that whole big cycle up and down in interest rates and inflation rates since the new dollar-denominated monetary system. + +| USA Long Rates | USA Core Inflation | USA Short Rates | USA Headline Inflation | +| -------------- | ------------------ | --------------- | ---------------------- | +| 20% | 20% | | | +| 18% | 18% | | | +| 16% | 16% | | | +| 14% | 14% | | | +| 12% | 12% | | | +| 10% | 10% | | | +| 8% | 8% | | | +| 6% | 6% | | | +| 4% | 4% | | | +| 2% | 2% | | | +| 0% | 0% | | | +| -2% | -2% | | | + +© 2020 Bridgewater Associates, LP + + + +--- + +USA Gold Price +| $2,000 | 8% | 120% | 600% | | +| ------ | ------ | ---- | ----- | ---- | +| | $1,800 | 6% | 100% | 500% | +| | $1,600 | 4% | 80% | 400% | +| | $1,400 | 2% | | | +| | $1,200 | | 60% | 300% | +| | $1,000 | 0% | 40% | 200% | +| | $800 | -2% | | | +| | $600 | -4% | 20% | 100% | +| | $400 | -6% | 0% | 0% | +| | $200 | | | | +| $0 | -8% | -20% | -100% | | + +55 65 75 85 95 05 15 + +After the 1980s debt restructurings were completed the 1990s saw a new global increase in money, credit, and debt begin again, which again produced a prosperity that led to debt-financed purchases of speculative investments that became the dot-com bubble, which burst in 2000. That led to an economic downturn in 2000-01 that spurred the Federal Reserve to ease money and credit, which pushed debt levels to new highs and created another prosperity that turned into another and bigger debt bubble in 2007, which burst in 2008, which led the Fed and other reserve currency countries’ central banks to ease again, leading to the next bubble that just recently burst. So, between the 1980s debt restructuring and 2008 there were two fairly typical debt/economic cycles. However, the credit/economic contraction of 2008 needed to be handled differently. + +Because short-term interest rates hit 0% in 2008 and that amount of interest rate decline wasn’t enough to create the money and credit expansion that was needed, central banks needed to print money and buy financial assets. Stimulating money and credit growth by lowering interest rates is the first-choice monetary policy of central banks. I call it “Monetary Policy 1.” With this approach no longer available to central banks, they turned to the second-choice monetary policy (which I call “Monetary Policy 2”), which is the printing of money and the buying of financial assets, mostly government bonds and some high-quality debt. The last time they had needed to do that because interest rates had hit 0% began in 1933 and continued through the war years. This approach is called “quantitative easing” rather than “debt monetization” because it sounds less threatening. All the world’s major reserve currency central banks did this. The paradigm that began in 2008 worked as follows. + +By printing money and buying debt, as had been done beginning in 1933, central banks kept the money and debt expansion cycle going. They did that by making those purchases, which pushed bond prices up, and providing the sellers of these bonds with cash, which led them to buy other assets. This pushed those asset prices up and, as they rose in price, drove future expected returns down. With interest rates below the expected returns of other investments and bond yields and other future expected returns falling to very low levels relative to the returns needed by investors to fund their various spending obligations, investors increasingly borrowed money to buy assets that they expected to have greater returns than their borrowing costs. In other words they followed the classic bubble process of buying financial assets with borrowed money betting that the assets they bought would have higher returns than their costs of funds. Those leveraged purchases pushed these asset prices up, drove their expected future returns down, and created a new debt bubble vulnerability that would come home to roost if the incomes produced by the assets they bought had returns that were less than their borrowing costs. With both long-term and short-term interest rates around 0% and central banks’ purchases of bonds not as effectively flowing through to stimulate economic growth and help those who needed it most, it became apparent to me that the second type of monetary policy wouldn’t work well and the third type of monetary policy—“Monetary Policy 3,” or MP3—would be needed. MP3 works by the reserve currency central governments increasing their borrowing and targeting their spending and lending to where they want it to go with the reserve currency central banks creating money and credit and buying debt (and possibly other assets, like stocks) to fund these purchases. + +© 2020 Bridgewater Associates, LP + +--- + + +Throughout all this time, inclusive of all of these swings, the amount of dollar-denominated money, credit, and debt in the world and the amounts of other non-debt liabilities (such as pensions and healthcare) continued to rise in relation to incomes, especially in the US because of the Federal Reserve’s unique ability to support this debt growth. Though I won’t explain the various ways of doing that here, they were explained in my book Principles for Navigating Big Debt Crises, which you can get online for free here. + +So, before we had the pandemic-induced downturn, the circumstances were set up for this path being the necessary one in the event of a downturn. If you want to look at relevant research pieces that look at these issues in greater depth that I did at the time, you can find them at economicprinciples.org. + +In any case, throughout this period debt and non-debt obligations (e.g., pensions and healthcare) continued to rise relative to incomes while central banks managed to keep debt service costs down (see my report “The Big Picture” for a more complete explanation of the coming “squeeze” this will cause). This pushed interest rates toward nil and made the debt long-term so that principal payments would be low. These conditions—i.e., central banks owning a lot of debt, interest rates around 0% so no interest payment would be required, and structuring debt to be paid back over the very long term so principal payments could be spread out or even possibly not paid back—meant that there was little or no limit to the capacities of central banks to create money and credit. That set of conditions set the stage for what came next. + +The coronavirus triggered economic and market downturns around the world, which created holes in incomes and balance sheets, especially for indebted entities that had incomes that suffered from the downturn. Classically, central governments and central banks had to create money and credit to get it to those entities they wanted to save that financially wouldn’t have survived without that money and credit. So, on April 9, 2020 the US central bank (the Fed) announced a massive money and credit creation program, alongside massive programs from the US central government (the president and Congress). They included all the classic MP3 techniques, including helicopter money (direct payments from the government to citizens). It was essentially the same announcement that Roosevelt made on March 5, 1933. While the virus triggered this particular financial and economic downturn, something else would have eventually triggered it, and regardless of what did, the dynamic would have been basically the same because only MP3 would have worked to reverse the downturn. The European Central Bank, the Bank of Japan, and—to a lesser extent—the People’s Bank of China made similar moves, though what matters most is what the Federal Reserve did because it is the creator of dollars, which are still the world’s dominant money and credit. + +The US dollar now accounts for about 55% of the world’s international transactions, savings, and borrowing. The Eurozone’s euro accounts for about 25%. The Japanese yen accounts for less than 10%. The Chinese renminbi accounts for about 2%. Most other currencies are not used internationally as mediums of exchange or storeholds of wealth, though they are used within countries. Those other currencies are ones that even the smart people in those countries, and virtually everyone outside those countries, won’t hold as storeholds of wealth. In contrast, the reserve currencies I mentioned are the currencies that most people around the world like to save, borrow, and transact, roughly in proportion to the percentages I just mentioned. + +Countries that have the world’s reserve currencies have amazing power—a reserve currency is probably the most important power to have, even more than military power. That is because when a country has a reserve currency it can print money and borrow money to spend as it sees fit, the way the US is doing now, while those that don’t have reserve currencies have to get the money and credit that they need (which is denominated in the world’s reserve currency) to transact and save in it. For example right now, as of this writing, those who have a lot of debt that they need to service and need more dollars to buy goods and services now that their dollar incomes have fallen are strongly demanding dollars. + +As shown in the chart in Chapter 1 that depicts eight measures of a country’s rising and declining power, the reserve currency power (which is measured by the share of transactions and savings in that currency) significantly lags the other measures of the country’s strength. That has been true for the US and the US dollar. For example, in 1944 when the US dollar was anointed as the world’s dominant reserve currency, the US had around two-thirds of the world’s gold held by governments (which was considered money at the time) and accounted for about half of + + + +--- + + +world GDP. Today the US accounts for only around 20% of world GDP but still accounts for about 60% of global reserves and about half of international transactions. So the US dollar and the dollar-based monetary and payments system still reign supreme and are outsized relative to the size of the US economy. + +As with all banks that printed reserve currencies, the Federal Reserve is now in the strong but awkward position of running its monetary policy in a way that is good for Americans but that might not be good for others around the world who are dependent on dollars. For example the US central government just recently decided that it would borrow money to give it and dollar credit to Americans and the Federal Reserve decided to buy that US government debt and a lot more other debt of Americans to help them through this financial crisis. Understandably little of that will go to foreigners. The European Central Bank will do something similar for those in the Eurozone. The Bank of Japan, which is still smaller on the world scene, will do the same thing for the Japanese, and the People’s Bank of China will do the same thing for the Chinese. A couple of other relatively small countries (like Switzerland) might be able to do something similar for their people, but most of the world won’t get the money and credit they need to fill their income and balance sheet holes the way Americans will. This dynamic of countries not being able to get the hard currency they need is like what happened in the 1982-91 period, except interest rates can’t be cut significantly this time while they could be cut very significantly in that 1982-91 period. + +At the same time, dollar-denominated debt owed by non-Americans (i.e., those in emerging markets, European countries, and China) is about $20 trillion (which is about 50% higher than what it was in 2008), with a bit less than half of that total being short-term. These dollar debtors will have to come up with dollars to service these debts and they will have to come up with more dollars to buy goods and services in world markets. So, by having the US dollar as the world’s reserve currency and having the world’s bank that produces that currency, and by having the power to put these needed dollars in the hands of Americans, the US can help Americans (and others around the world if it so chooses) more effectively than most other countries’ governments can help their own citizens. At the same time the US risks losing this privileged position by creating too much money and debt. In the appendix to this chapter we will look much more closely into how countries that had reserve currencies lost them and how devaluations of currencies work. + +# In Summary: How the Big Cycle of Money, Credit, Debt & Economic Activity Fits In with the Big Domestic and International Political Cycles to Affect the World Order + +Stepping back to look at all of this from the big-picture level, what I’m saying about the relationship between 1) the economic part (i.e., money, credit, debt, economic activity, and wealth) and 2) the political part (both within countries and between countries) of rises and declines looks like the picture shown below. Typically the big cycles start with a new world order—i.e., a new way of operating both domestically and internationally that includes a new monetary system and new political systems. The last one began in 1945. Because at such times, after the conflicts, there are dominant powers that no one wants to fight and people are tired of fighting, there is a peaceful rebuilding and increasing prosperity that is supported by a credit expansion that is sustainable. It is sustainable because income growth exceeds or keeps pace with the debt-service payments that are required to service the growing debt and because of central banks’ capacities to stimulate credit and economic growth is great. Along the way up there are short-term debt and economic cycles that we call recessions and expansions. With time investors extrapolate past gains into the future and borrow money to bet on them continuing to happen, which creates debt bubbles at the same time as the wealth gaps grow because some benefit more than others from this money-making upswing. This continues until central banks run out of their abilities to stimulate credit and economic growth effectively. As money becomes tighter the debt bubble bursts and credit contracts and with it the economy contracts. At the same time, when there is a large wealth gap, big debt problems, and an economic contraction, there is often fighting within countries and between countries over wealth and power. These typically lead to revolutions and wars that can be either peaceful or violent. At such times of debt and economic problems central governments and central banks typically create money and credit to fund their domestic and war-related financial needs. These money and credit crises, revolutions, and wars lead to restructurings of a) the debts, b) the monetary system, c) the domestic order, and d) the international order — which together I am simply calling the world order. + +© 2020 Bridgewater Associates, LP + +--- + + +Then it starts again. For example in the United States in the 1930-45 period there was a peaceful domestic revolution that produced a significant wealth redistribution that was accompanied by large government borrowings (creating a lot of government debt) that was financed by the central bank creating a lot of money and credit…and this was followed by violent external wars that were due to rising powers challenging existing world powers, with these wars financed by large government borrowings (that created a lot of government debt) that was financed by central banks creating of money and credit. + +The cycle that I am describing is conveyed in the chart below. While no cycle goes exactly this way, almost all of them by and large go that way. + +| Big Wealth Gap | | Debt Bust | | +| --------------- | ----------- | -------------------------------- | - | +| | Debt Bubble | | | +| | | Printing Money and Credit | | +| | | Revolutions and Wars | | +| | | Debt and Political Restructuring | | +| New World Order | | 4 Prosperity | | +| New World Order | | | | + +This explanation of money and credit will be followed by an appendix that will show why and how all currencies devalue and/or die, with references to the most important cases of the last 500 years. + +© 2020 Bridgewater Associates, LP 42 + + + +--- + +NO_CONTENT_HERE + +--- + +# Chapter 3: + +# The Changing Value of Money + +--- + +NO_CONTENT_HERE + +--- + +# Chapter 3: The Changing Value of Money + +This is an appendix to Chapter 2, “The Big Cycle of Money, Credit, Debt, and Economic Activity.” It is intended to look at the concepts expressed in that chapter in a more granular way and to show you how these concepts are consistent with the actual cases that are behind the concepts. While in this appendix we will get a bit more into the mechanics and specifics than we did in Chapter 2, it is written in a way that should be both palatable to most people and specific enough to satisfy the needs of skilled economists and investors. If you find that the material that you are reading is getting too wonky for your taste just stick to reading that which is in bold and you should be just fine. + +Rather than carefully examining the whole cycle (which we will do in the Part 2 examinations) we will focus exclusively on big devaluations and end of reserve currency periods because a) the dollar, euro, and yen are in the late stages of their long-term debt cycles when the debts denominated in them are high, real interest rate compensations for holding these debt assets are low, and large amounts of new debt denominated in them are being created and monetized—which is a higher-risk confluence of circumstances, and b) such big devaluations and/or the loss of reserve currency status by the leading reserve currencies would be the most disruptive economic event we could imagine. + +As previously explained, there is a real economy and there is a financial economy, which are intertwined but different. The real economy and the financial economy each has its own supply and demand dynamics. In this section we will focus more on the supply and demand dynamics of the financial economy to explore what determines the value of money. + +# Printing and Devaluing Money Is the Easiest Way out of a Debt Crisis + +While people tend to think that a currency is pretty much a permanent thing and believe that “cash” is the safe asset to hold, that’s not true because all currencies devalue or die and when they do cash and bonds (which are promises to receive currency) are devalued or wiped out. That is because printing a lot of currency and devaluing debt is the most expedient way of reducing or wiping out debt burdens. When the debt burdens are sufficiently reduced or eliminated, the credit/debt expansion cycles can begin all over again, as described in Chapter 2. + +As I explained more comprehensively in my book Principles for Navigating Big Debt Crises than I can explain here, there are four levers that policy makers can pull to bring debt and debt-service levels down relative to the income and cash-flow levels that are required to service one’s debts: + +- Austerity (spending less) +- Debt defaults and restructurings +- Transfers of money and credit from those who have more than they need to those who have less than they need (e.g., raise taxes) +- Printing money and devaluing it + +Austerity is deflationary and doesn’t last long because it’s too painful. Debt defaults and restructurings are also deflationary and painful because the debts that are wiped out or reduced in value are someone’s assets; as a result defaults and restructurings are painful for both the debtor who goes broke and has their assets taken away and for the creditor who loses the wealth arising from having to write down the debt. Transfers of money and credit from those who have more than they need to those who have less than they need (e.g., raising taxes to redistribute wealth) is politically challenging but more tolerable than the first two ways and is typically part of the resolution. In comparison to the others, printing money is the most expedient, least well-understood, and most common big way of restructuring debts. In fact it seems good rather than bad to most people because it helps to relieve debt squeezes, it’s tough to identify any harmed parties that the wealth was taken away from to provide this financial wealth (though they are the holders of money and debt assets), and in most cases it causes assets to go up in the depreciating currency that people use to measure their wealth in so that it appears that people are getting richer. + +© 2020 Bridgewater Associates, LP + +--- + + +You are seeing these things happen now in response to the announcements of the sending out of large amounts of money and credit by central governments and central banks. + +Note that you don’t hear anyone complaining about the money and credit creation; in fact you hear cries for a lot more with accusations that the government would be cheap and cruel if it didn’t provide more. There isn’t any acknowledging that the government doesn’t have this money that it is giving out, that the government is just us collectively rather than some rich entity, and that someone has to pay for this. Now imagine what it would have been like if government officials cut expenses to balance their budgets and asked people to do the same, allowing lots of defaults and debt restructurings, and/or they sought to redistribute wealth from those who have more of it to those who have less of it through taxing and redistributing the money. This money and credit producing path is much more acceptable. It’s like playing Monopoly in a way where the banker can make more money and redistribute it to everyone when too many of the players are going broke and getting angry. You can understand why in the Old Testament they called the year that it’s done “the year of Jubilee.” + +Most people don’t pay enough attention to their currency risks. Most worry about whether their assets are going up or down in value; they rarely worry about whether their currency is going up or down. Think about it. Right now how worried are you about your currency declining relative to how worried you are about how your stocks or your other assets are doing? If you are like most people, you are not nearly as aware of your currency risk and you need to be. + +So let’s explore that currency risk. + +# All Currencies Have Been Devalued or Died + +Think about holding currencies (which is the same as holding cash) in the same way as you would think about holding any other assets. How would you have done in these investments? + +Of the roughly 750 currencies that have existed since 1700, only about 20% remain, and of those that remain all have been devalued. In 1850 the world’s major currencies wouldn’t look anything like the ones today. While the dollar, pound, and Swiss franc existed back then, most others were different and have since died. In 1850 in what is now Germany, you would have used the gulden or the thaler. There was no yen, so in Japan you might have used a koban or the ryo instead. In Italy you would have used one or more of the six possible currencies. You would have used different currencies in Spain, China, and most other countries. Some were completely wiped out (in most cases they were in countries that had hyperinflation and/or lost wars and had large war debts) and replaced by entirely new currencies. Some were merged into currencies that replaced them (e.g., the individual European currencies were merged into the euro). And some remain in existence but were devalued, like the British pound and the US dollar. + +© 2020 Bridgewater Associates, LP + +--- + + +What Do They Devalue Against? + +The most important thing for currencies to devalue against is debt. That is because the goal of printing money is to reduce debt burdens. Debt is a promise to deliver money, so giving more money to those who need it lessens the debt burden. How this newly created money and credit then flow determines what happens next. Increases in the supply of money and credit both reduce the value of money and credit (which hurts holders of it) and relieve debt burdens. In cases in which the debt relief facilitates the flows of this money and credit into productivity and profits for companies, rising real stock prices (i.e., the value of stocks after adjusting for inflation) happens. When it sufficiently hurts the actual and prospective returns of “cash” and debt assets so that it drives flows out of these assets and into inflation-hedge assets and other currencies, that leads to a self-reinforcing decline in the value of money. + +At times when the central bank is faced with the choice of a) allowing real interest rates (i.e., the rate of interest minus the rate of inflation) to rise to the detriment of the economy or b) preventing real interest rates from rising by printing money and buying those cash and debt assets, they will choose the second path, which reinforces the bad returns of holding “cash” and those debt assets. The later one is in the long-term debt cycle—i.e., a) when the amounts of debt and money are impossibly large for them to be turned into real value for the amounts of goods and services they are claims on, b) when the levels of real interest rates that are low enough to save debtors from bankruptcy are below the levels that are required for creditors to hold the debt as a viable storehold of wealth, and c) when the normal central bank levers of allocating capital via interest rate changes (MP1) and/or printing money and buying high-quality debt (MP2) don’t work so that monetary policy becomes a facilitator of the political system that allocates resources in an uneconomic way—the greater the likelihood that there will be a breakdown in the currency and monetary system. + +So, there are a) systemically beneficial devaluations (though they are always costly to the holders of money and debt) and b) systemically destructive ones that damage the credit/capital allocation system but are required to wipe out the debt in order to create a new monetary order. It’s important to be able to tell the difference. In this study we will explore both types. + +To do that I will show you the value of currencies in relation to both gold and consumer price index weighted baskets of goods and services because gold has been the timeless and universal alternative currency and because money is meant to buy goods and services so its buying power is of paramount importance. I will also touch on their value in relation to other currencies/debt and in relation to stocks because they too can be storeholds of wealth. The pictures that all these measures convey are broadly similar in big currency devaluations because the currency moves are so significant that they change in relation to most things. Because many other things (real estate, art, etc.) are also alternative storeholds of wealth, we could go on and on describing how they perform in big currency devaluations but I chose not to because that would take this past the point of diminishing returns. + +# In Relation to Gold + +The chart below shows spot currency returns of the three major reserve currencies in relation to gold since 1600. While we will examine these in depth in this study, for now I would like to focus your attention on both the spot currency returns and the total returns of holding interest-earning cash in all the major currencies since 1850. + +© 2020 Bridgewater Associates, LP + +45 + + +--- + +Reserve Currencies vs Gold (Spot FX) + +# Reserve Currencies vs Gold (Spot FX) + +| NLD | GBR | USA | +| ------------------------------------------------------------------------------------------------------------------ | --- | --- | +| War of 1812 Great Depression Napoleonic Wars WWI US WWII Inflationary Civil War '70s Collapse of Bank of Amsterdam | | | + +As shown in the next two charts, devaluations typically occur as relatively abrupt declines during debt crises that are separated by periods of currency stability during periods of prosperity. I noted six such ones, which we will soon delve into. Of course there were many more devaluations of more minor currencies that we won’t get into right now. + +# Spot FX vs Gold + +| USA | GBR | DEU | FRA | ITA | JPN | CHE | ESP | NLD | CHN | +| -------------------------------- | --- | --- | --- | --- | --- | --- | --- | --- | --- | +| 0% (4) (1) (2) (3) (5) (6) -100% | | | | | | | | | | + +# FX Total Return vs Gold (ln) + +| USA | GBR | DEU | FRA | ITA | JPN | CHE | ESP | NLD | +| --------------------- | --- | --- | --- | --- | --- | --- | --- | --- | +| 10,000 1,000 100 10 1 | | | | | | | | | + +© 2020 Bridgewater Associates, LP + +--- + + +# Notable Takeaways + +- Big devaluations have tended to be more episodic than evolutionary. There were six time frames that there were really big devaluations of major currencies (though plenty more of minor currencies) over the last 170 years. +- In the 1860s the large financing needs of the Civil War prompted the US to suspend gold convertibility and print money (known as “greenbacks”) to help monetize war debts. +- After the US returned to its prior gold peg in the mid-1870s a number of other countries joined the gold standard; most currencies remained fixed against gold up until World War I. Major exceptions were Japan (which was on a silver-linked standard until the 1890s, which led its exchange rate to devalue against gold as silver prices fell during this period), and Italy and Spain, which frequently suspended convertibility to support large fiscal deficits. +- Then came World War I when warring countries ran enormous deficits that were funded by central banks’ printing and lending of money. During the war years gold was international money as international credit was lacking because trust was lacking. Then the war ended, and a new monetary order was created with gold and the winning countries’ currencies, which were tied to it, at the center of that new monetary order. +- Still, in 1919-22 the printing of money and devaluations of several European currencies were required as an extension of the debt crises of those most indebted, especially those that lost World War I. As shown this led to the total extinction of the German mark and German mark debt in the 1920-23 period and big devaluations in other countries’ currencies including the winners of the war that also had debts that had to be devalued to create a new start. +- With the debt, domestic political, and international geopolitical restructurings done, the 1920s was a boom period, which became a bubble that burst in 1929. +- In 1930-45, 1) when the debt bubble burst that required central banks to print money and devalue it, and then 2) when the war debts had to increase to fund the war that required more printing of money and more devaluations. +- At the end of the war, in 1944-45, the new monetary system that linked the dollar to gold and other currencies to the dollar was created, and the currencies and debts of Germany, Japan, Italy, and China (and a number of other countries) were quickly and totally destroyed while those of most winners of the war were slowly but still substantially depreciated. That monetary system stayed in place until the late 1960s. +- In 1968-73 (most importantly in 1971), when excessive spending and debt creation especially by the US required the breaking of the link with gold because claims on gold were being turned in for actual gold and the claims were far greater than the amount of gold that was available to redeem the claims, that led to going to a dollar-based fiat monetary system that allowed the big increase in dollar-denominated money and credit that fueled the inflation of the 1970s and led to the debt crisis of the 1980s. +- Since 2000 the value of money has fallen in relation to the value of gold due to lots of money and credit creation and because of interest rates being low in relation to inflation rates. Because the monetary system has been a free-floating monetary system there have not been the abrupt breaks that there have been in the past; there has been a more gradual and continuous devaluation in which low or in some cases negative interest rates did not provide compensation for the increasing amount of money and credit and the resulting (albeit low) inflation. + +# Closer Look at Periods + +As shown in the prior charts, the returns of holding currencies (i.e., short-term debt that collects interest) during the period from 1850 to 1913 were generally profitable relative to the returns of holding gold. During that more than 60-year debt/currency cycle period, most currencies were able to remain fixed against gold or silver and one would have collected an attractive interest rate because it was mostly a prosperous period in which both lending and borrowing worked well for those who did it. That prosperous period was what is known as the Second Industrial Revolution, when the borrowers turned the money they borrowed into earnings that allowed the debts to be paid back. While there were debt crises in that period (such as “the Panic of 1873,” “the Panic of 1893,” and “the Panic of 1907” in the US) they were not big enough to necessitate devaluations, though they were. + +© 2020 Bridgewater Associates, LP + +--- + + +turbulent. For example, the prosperity of the Second Industrial Revolution led to a debt-financed speculative boom in stocks that grew overextended, which led to a banking and brokerage crisis. In the US that led to the six-week-long Panic of 1907 at the same time the large wealth gap and other social issues (e.g., women’s suffrage) caused political tensions, capitalism was challenged, and taxes started to rise to fund the wealth redistribution process. + +In China, which was still a world away but impacted, there was the same dynamic—a stock market bubble led by rubber production stocks (which was China’s equivalent of America’s railroad stock bubbles that contributed to panics there throughout the 19th century) that burst and led to a crash in 1910, which some have described as a factor in a debt/money/economic downswing that contributed to the end of Imperial China. So, throughout that period the Type 2 monetary systems (i.e., with notes convertible into metal money) remained in place in most countries and holders of notes got paid good interest rates without having their currencies devalued. The big exceptions were the US devaluation to finance the Civil War debts in the 1860s, the frequent devaluations of Spain’s currency due to its continued weakening as a global power, and the sharp devaluations in Japan’s currency due to its remaining on a silver-linked standard until the 1890s (and silver prices falling relative to gold prices in this period). + +# Spot FX vs Gold (1850-1913) + +| | USA | | GBR | DEU | FRA | ITA | JPN | CHE | ESP | NLD | +| ----------------------------------------------- | ------------ | --------------- | --- | --- | ---- | --- | --- | --- | --- | --- | +| | | Broad stability | | | | | | | | | +| | | | | | 10% | | | | | | +| | | | | | 0% | | | | | | +| Fiscal crisis in Spain | | | | | | | | | | | +| | | | | | -10% | | | | | | +| | | | | | -20% | | | | | | +| | | | | | -30% | | | | | | +| | US Civil War | | | | | | | | | | +| Falling silver prices producing JPN devaluation | | | | | | | | | | | +| | | | | | -40% | | | | | | +| | | | | | -50% | | | | | | +| | | | | | -60% | | | | | | +| | | | | | -70% | | | | | | + +1850 1855 1860 1865 1870 1875 1880 1885 1890 1895 1900 1905 1910 + +World War I began in 1914 and countries borrowed a lot to fund it, which led to the late debt cycle breakdowns and devaluations that came when war debts had to be wiped out, effectively destroying the monetary systems of those who lost the war. The Paris Peace Conference that ended the war in 1918 attempted to institute a new international order around the League of Nations, but the efforts at cooperation were unable to avoid debt crises and monetary instability due to huge war indemnities placed on the defeated powers (such as Germany in the Treaty of Versailles), as well as large war debts owed by the victorious Allies to each other (particularly to the US). As shown in the chart below, that led to a complete wipeout of the value of money and credit in Germany, which led to the world’s most iconic hyperinflation in the Weimar Republic. As you will read briefly when we cover Germany’s rise and decline in Part 2 (and as you can read much more completely in my detailed examination of the Weimar Republic in Principles for Navigating Big Debt Crises) this case was the direct result of Germany having these enormous war-related debts and indemnities that had to be disposed of. The Spanish flu also occurred during the period, beginning in 1918 and ending in 1920. Coming out of the war, all currencies except the US dollar, the Japanese currency, and the Chinese currency devalued because they had to monetize some of their war debts and because not to devalue with the countries that devalued would have hurt their competitiveness in world markets. As shown in the chart below, China’s silver-based currency rallied sharply relative to gold (and gold-linked currencies) near the end of the war as prices rose and then mechanically devalued as silver prices fell sharply amid the post-war deflation in the US. That was then followed by an extended and productive period of economic prosperity, particularly in the US, that was known as the Roaring ’20s, which like all such periods, led to big debt and asset bubbles and a large wealth gap that sowed the seeds for the turbulence that lay ahead. + +© 2020 Bridgewater Associates, LP 48 + +--- + +Spot FX vs Gold (1913-30) +| USA | GBR | DEU | FRA | ITA | JPN | CHE | ESP | NLD | CHN | +| --- | --- | --- | --- | --- | --- | --- | --- | --- | --- | +| | | | | | | | | | | + +Post-WWI devaluations and German hyperinflation + +1913 1915 1917 1919 1921 1923 1925 1927 1929 + +Next, in the 1930s you see different versions of the same thing happening in all countries—i.e., in the 1930-33 period there was a global debt crisis that led to economic contractions that led to the printing of money and competitive devaluations in virtually all countries, which eroded the value of money moving into World War II. The conflicts over wealth within countries and between countries led to greater conflicts within and between countries. All the warring countries built up war debts while the US gained a lot of wealth (gold) in the war. Then, after the war, the value of money and debt was completely wiped out for the losers of the war (i.e., Germany, Japan, and Italy), as well as for China, and was severely devalued for Great Britain and France even though they were the supposed winners of the war. I should note that during war years money and credit are not commonly accepted between countries because there is a justifiable wariness about whether they will get paid back in currency that has value. During wars gold, or in some cases silver or barter, is the coin of the realm. At such times prices and capital flows are typically controlled so it is even difficult to say what the real prices of many things are. After the war was the prosperity period that we won’t examine other than to say that within it was excessive borrowing that sowed the seeds of the next big devaluation, which happened in 1968-73. + +Spot FX vs Gold (1930-50) +| USA | GBR | DEU | FRA | ITA | JPN | CHE | ESP | NLD | CHN | +| --- | --- | --- | --- | --- | --- | --- | --- | --- | --- | +| | | | | | | | | | | + +1930 1932 1934 1936 1938 1940 1942 1944 1946 1948 1950 + +By the mid-1950s, before that devaluation, the dollar and the Swiss franc were the only currencies worth even half of their 1850s value. As shown below, the downward pressure in currencies and upward pressure in gold started in 1968 and was made official on August 15, 1971, when President Nixon ended the Bretton Woods monetary system, leaving the Type 2 monetary system in which the dollar was backed by gold, and going to a fiat monetary system. + +© 2020 Bridgewater Associates, LP + +--- + + +# Spot FX vs Gold (1965-77) + +| USA | GBR | DEU | FRA | ITA | JPN | CHE | ESP | NLD | CHN | +| -------------------- | --- | --- | --- | --- | --- | --- | --- | --- | --- | +| 20% | | | | | | | | | | +| 0% | | | | | | | | | | +| -20% | | | | | | | | | | +| -40% | | | | | | | | | | +| End of Bretton Woods | | | | | | | | | | +| -60% | | | | | | | | | | +| -80% | | | | | | | | | | +| -100% | | | | | | | | | | +| 1966 | | | | | | | | | | +| 1968 | | | | | | | | | | +| 1970 | | | | | | | | | | +| 1972 | | | | | | | | | | +| 1974 | | | | | | | | | | +| 1976 | | | | | | | | | | + +# Spot FX vs Gold (1998-Present) + +| USA | | | GBR | | | DEU | | FRA | | ITA | JPN | CHE | ESP | NLD | CHN | +| --- | -- | -- | --- | -- | ---- | --- | -- | --- | -- | --- | ----- | --- | --- | --- | --- | +| | | | | | 50% | | | | | | | | | | | +| | | | | | | | | | | | 6% | | | | | +| | | | | | | | | | | | 0% | | | | | +| | | | | | -50% | | | | | | | | | | | +| | | | | | | | | | | | -100% | | | | | +| 98 | 02 | 06 | 10 | 14 | 18 | 98 | 02 | 06 | 10 | 14 | 18 | | | | | + +# In summary the basic picture is that: + +- The average annual return of holding interest-earning cash currency since 1850 was 1.2%, which was a bit lower than the average real return of holding gold, which was 1.3%, though there were huge differences in their returns at various periods of time and in various countries. +- In about half of the countries since 1850 you would have received a positive real return for holding bills, in half a negative real return, and in cases like Germany you would have been totally wiped out twice. +- Most of the real return from holding interest-earning cash currency came in the periods when most countries were on gold standards that they adhered to because they were in prosperous periods (e.g., in the Second Industrial Revolution and in the post-1945 boom when debt levels and debt-service burdens were relatively low and income growth was nearly equal to debt growth) until near the end of that long cycle. +- The real (i.e., inflation-adjusted) return for bills since 1912 (the modern fiat era) has been -0.2%. The real return of gold during this era has been 2.2%. During this period you would only have made a positive real return holding interest-earning cash currency in about half of the countries, and you would have lost meaningfully in the rest (losing over 2% a year in France, Italy, and Japan, and losing over 15% a year in Germany due to the hyperinflation). + +© 2020 Bridgewater Associates, LP + +50 + + + +--- + + +Currencies of Major Economies in 1850 & Returns to Present + +# Real Returns (vs. CPI), Ann. + +# 1850-Present + +| Country | Continuous | | Continuous | | Continuous | | +| -------------- | ---------- | ---- | ---------- | ----- | ---------- | ---- | +| | Gov Bill | Gold | Gov Bill | Gold | Gov Bill | Gold | +| United Kingdom | 1.4% | 0.6% | 3.1% | -0.1% | 0.5% | 1.1% | +| United States | 1.6% | 0.2% | 3.7% | -1.0% | 0.4% | 0.9% | +| Germany | -11.9% | 2.8% | 2.9% | -1.0% | -17.0% | 4.2% | +| France | -0.7% | 0.6% | 2.6% | -0.4% | -2.6% | 1.1% | +| Italy | -0.6% | 0.2% | 4.7% | -0.5% | -2.6% | 0.5% | +| Japan | -0.7% | 0.9% | 4.9% | 0.3% | -2.2% | 1.1% | +| Switzerland | 1.5% | 0.0% | 3.4% | -0.6% | 0.5% | 0.3% | +| Spain | 1.5% | 1.0% | 4.5% | 0.0% | 0.3% | 1.4% | +| Netherlands | 1.4% | 0.5% | 3.3% | 0.0% | 0.3% | 0.7% | +| China | -- | 3.3% | -- | -- | -- | 3.3% | +| Average | 1.2% | 1.3% | 3.6% | -0.3% | -0.2% | 2.2% | + +Note: Data for CHE is since 1851; data for DEU, ESP, and ITA is since 1870; data for JPN is since 1882; data for CHN is since 1926 (excluding 1948-50). Average return is un-rebalanced and doesn’t include China. + +# Real Return of Gold vs CPI (ln) + +USA, GBR, DEU, FRA, ITA, JPN, CHE, ESP, NLD, CHN + +10,000 + +1,000 + +100 + +10 + +1850 1860 1870 1880 1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010 2020 + +© 2020 Bridgewater Associates, LP + + +--- + +The Value of Currencies in Relation to Goods and Services + +Thus far we have looked at the market values of currencies in relation to the market value of gold. That raises the question about how much of this picture is because we are looking at the value of currencies relative to gold and whether that is an appropriate gauge. The next chart shows the value of interest-rate-earning cash currency in terms of the CPI baskets of goods and services in these currencies, so it shows changes in buying power. As shown the two world wars were very bad, and since then there have been ups and downs. In about half of the currencies interest-rate-earning cash provided a return that was above the rate of inflation, in the other half it provided bad real returns, and in all cases, there were big and roughly 10-year-long swings around these averages. In other words, 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. + +# Real Return of Bills (vs CPI) + +| USA | GBR | DEU | FRA | ITA | JPN | CHE | ESP | NLD | +| ---------------------------------------------------- | --- | --- | --- | --- | --- | --- | --- | --- | +| ![Real Return of Bills Chart](chart_placeholder.png) | | | | | | | | | + +1850 1860 1870 1880 1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010 2020 2030 + +# The Patterns of Countries Devaluing and Losing Their Reserve Currency Status + +Currencies devaluing and currencies losing their reserve currency position aren’t necessarily the same things though they are caused by the same things (debt crises) and a currency losing its reserve currency status comes from chronic and large devaluations. As previously explained, when central banks increase the supply of money and credit it reduces the value of money and credit. This is bad for holders of money and credit but a relief to debt burdens. When this debt relief allows money and credit to flow into productivity and profits for companies, real stock prices rise. But it can also damage the actual and prospective returns of “cash” and debt assets enough to drive people out of those assets and into inflation-hedge assets and other currencies. This leaves the central bank faced with the choice of either allowing real interest rates to rise to the detriment of the economy or preventing rates from rising by printing money and buying those cash and debt assets. Inevitably, they will follow the second path, which reinforces the bad returns of holding “cash” and those debt assets. As explained earlier, when it’s late in the long-term debt cycle, there is a greater likelihood that there will be a breakdown in the currency and monetary system, and the important thing is to tell the difference between systemically beneficial devaluations and systemically destructive ones. + +# What do these devaluations have in common? + +- In the major cases we looked at, all of the economies experienced a classic “run” dynamic, as there were more claims on the central banks than there was hard currency available to satisfy the claims on that money, which was typically gold, though it was US dollars for the UK reserve currency decline because at that time the British pound was linked to the US dollar. +- Net central bank reserves start falling prior to the actual devaluation, in some cases starting years ahead of the devaluation. It’s also worth noting that in several cases countries suspended convertibility ahead. + +© 2020 Bridgewater Associates, LP + +--- + + +of the actual devaluation of the exchange rate, such as with the UK in 1947 ahead of the 1949 devaluation, or for the US in 1971. + +- The run on the currency and the devaluations typically came alongside significant debt problems, often related to wartime spending (the Fourth Anglo-Dutch War for the Dutch, the world wars for the UK, Vietnam for the US under Bretton Woods), which put pressure on the central bank to print. The worst situations were when countries lost their wars; that typically led to the total collapse and restructuring of their currencies and their economies. However, winners of wars that ended up with debts that were much larger than their assets and reduced competitiveness (e.g., Great Britain) also lost their reserve currency status, though more gradually. +- Typically central banks respond initially by not increasing the supply of money so that when their currency and debt are being sold they let short-term rates rise to forestall the devaluation, but that is too economically painful, so they quickly capitulate and devalue. Then, after the devaluation, they typically cut rates. +- After devaluation, the outcomes diverge significantly across the cases, with a key variable being how much economic and military power the country retained at the time of the devaluation, which impacted how willing savers were to continue holding their money there. +- More specifically for the major reserve currencies: + +As this appendix is getting long, I have decided to cut it here and to follow in a few days with the rest, which consists of brief explanations of the decline phases of the Dutch guilder and British pound and their empires. + +© 2020 Bridgewater Associates, LP 53 + + + +--- + +NO_CONTENT_HERE + +--- + +# Chapter 4: + +# The Last 500 Years Part 1: + +# The Big Cycles of the Dutch and British Empires and Their Currencies + +--- + +NO_CONTENT_HERE + +--- + +Chapter 4: The Last 500 Years Part 1: The Big Cycles of the Dutch and British Empires and Their Currencies + +In Chapter 1 (“The Big Picture in a Tiny Nutshell”), I looked at the archetypical rises and declines of empires and their reserve currencies and the various types of powers that they gained and lost, and in Chapter 2 (“The Big Cycle of Money, Credit, Debt, and Economic Activity”) and its appendix (“The Changing Value of Money”) I reviewed the big money, credit, and debt cycles. In this chapter, I will review the rises and declines of the Dutch, British, and American empires and their reserve currencies and will touch on the rise of the Chinese empire. + +While the evolution of empires and currencies is one continuous story that started before there was recorded history, in this chapter I am going to pick up the story around the year 1600. My objective is simply to put where we are in perspective of history and bring us up to date. I will begin by very briefly reviewing what the Big Cycle looks like and then scan through the last 500 years to show these Big Cycles playing out before examining more closely the declines of the Dutch and British empires and their reserve currencies. Then I will show how the decline of the British empire and the pound evolved into the rise of the US empire and US dollar and I will take a glimpse at the emergence of the Chinese empire and the Chinese renminbi. + +That will bring us up to the present and prepare us to try to think about what will come next. + +# The Big Cycle of the Life of an Empire + +Just as there is a human life cycle that typically lasts about 80 years (give or take) and no two are exactly the same but most are similar, there is an analogous empire life cycle that has its own typical patterns. For example, for most of us, during the first phase of life we are under our parents’ guidance and learn in school until we are about 18-24, at which point we enter the second phase. In this phase we work, become parents, and take care of others who are trying to be successful. We do this until we are about 55-65, at which time we enter the third phase when we become free of obligations and eventually die. It is pretty easy to tell what phases people are in because of obvious markers, and it is sensible for them to know what stages they are in and to behave appropriately in dealing with themselves and with others based on that. The same thing is true for countries. + +The major phases are shown on this chart. It’s the ultra-simplified archetypical Big Cycle that I shared in the last chapter. + +| The Typical Big Cycle Behind Empires' Rises and Declines | | +| -------------------------------------------------------- | ------------------------------- | +| Debt Bubble and Big Wealth Gap | Debt Bust and Economic Downturn | +| Printing Money and Credit | Revolutions and Wars | +| Debt and Political Restructuring | | +| New World Order | New World Order | + +In brief, after the creation of a new set of rules establishes the new world order, there is typically a peaceful and prosperous period. As people get used to this they increasingly bet on the prosperity continuing, and they increasingly borrow money to do that, which eventually leads to a bubble. As the prosperity increases the wealth + +© 2020 Bridgewater Associates, LP + +--- + + +gap grows. Eventually the debt bubble bursts, which leads to the printing of money and credit and increased internal conflict, which leads to some sort of wealth redistribution revolution that can be peaceful or violent. Typically at that time late in the cycle the leading empire that won the last economic and geopolitical war is less powerful relative to rival powers that prospered during the prosperous period, and with the bad economic conditions and the disagreements between powers there is typically some kind of war. Out of these debt, economic, domestic, and world-order breakdowns that take the forms of revolutions and wars come new winners and losers. Then the winners get together to create the new domestic and world orders. + +That is what has repeatedly happened through time. The lines in the chart signify the relative powers of the 11 most powerful empires over the last 500 years. In the chart below you can see where the US and China are currently in their cycles. As you can see the United States is now the most powerful empire by not much, it is in relative decline, Chinese power is rapidly rising, and no other powers come close. + +| Major Wars | United States | China | United Kingdom | +| ----------- | ------------- | ------- | -------------- | +| Netherlands | Spain | Germany | France | +| India | Japan | Russia | Ottoman Empire | + +0.0 + +1500 1550 1600 1650 1700 1750 1800 1850 1900 1950 2000 + +Because that chart is a bit confusing, for simplicity the next chart shows the same lines as in that chart except for just the most powerful reserve currency empires (which are based on an average of eight different measures of power that we explained in Chapter 1 and will explore more carefully in this chapter). + +© 2020 Bridgewater Associates, LP + +--- + + +Rough Estimates of Relative Standing of Great Empires + +# Major Wars + +| | United States | China | United Kingdom | Netherlands | +| - | ------------- | ----- | -------------- | ----------- | +| | 1.0 | | | | +| | 0.8 | | | | +| | 0.6 | | | | +| | 0.4 | | | | +| | 0.2 | | | | +| | 0.0 | | | | + +1500 1550 1600 1650 1700 1750 1800 1850 1900 1950 2000 + +The next chart offers an even more simplified view. As shown, the United States and China are the only two major +powers, you can see where each of their Big Cycles is, and you can see that they are approaching comparability, +which is when the risks of wars of one type or another are greater than when the leading powers are earlier in the +cycle. To be clear, I didn’t start out trying to make an argument and then go looking for stats to support it; doing +that doesn’t work in my profession as only accuracy pays. I simply gathered stats that reflected these different +measures of strength and put them in these indices, which led to these results. I suspect that if you did that exercise +yourself picking whatever stats you’d like you’d see a similar picture, and I suspect that what I’m showing you here +rings true to you if you’re paying attention to such things. + +For those reasons I suspect that all I am doing is helping you put where we are in perspective. To reiterate, I am +not saying anything about the future. I will do that in the concluding chapter of this book. All I want to do is bring +you up to date and, in the process, make clear how these cycles have worked in the past, which will also alert you +to the markers to watch out for and help you see where in the cycles the major countries are and what is likely to +come next. + +# Reserve Empire Transitions of the Past Four Centuries + +# (Simplified Representation) + +| NLD | GBR | USA | CHN | +| --- | --- | --- | --- | +| | | | 100 | +| | | | 80 | +| | | | 60 | +| | | | 40 | +| | | | 20 | +| | | | 0 | + +© 2020 Bridgewater Associates, LP + +56 + + +--- + + +The chart below from Chapter 1 shows this play out via the eight measures of strength—education, innovation and technology, competitiveness, military, trade, output, financial center, and reserve status—that we capture in the aggregate charts. It shows the average of each of these measures of strength, with most of the weight on the most recent three reserve countries (the US, the UK, and the Dutch).¹⁰ + +# The Archetypical Rise and Decline by Factor + +| Education | Innovation and Technology | Competitiveness | Military | Trade | Output | Financial Center | Reserve Status | +| ------------------------------------------------------------ | ------------------------- | --------------- | -------- | ----- | ------ | ---------------- | -------------- | +| ![Chart showing measures of strength](chart_placeholder.png) | | | | | | | | + +As explained in Chapter 1, in brief these strengths and weaknesses are mutually reinforcing—i.e., strengths and weaknesses in education, competitiveness, economic output, share of world trade, etc., contribute to the others being strong or weak, for logical reasons—and their order is broadly indicative of the processes that lead to the rising and declining of empires. For example, quality of education has been the long-leading strength of rises and declines in these measures of power, and the long-lagging strength has been the reserve currency. That is because strong education leads to strengths in most areas, including the creation of the world’s most common currency. That common currency, just like the world’s common language, tends to stay around because the habit of usage lasts longer than the strengths that made it so commonly used. + +We will now look at the specifics more closely, starting with how these Big Cycles have played out over the last 500 years and then looking at the declines of the Dutch and British empires so you can see how these things go. + +# 1) The Last 500 Years in About 4,000 Words + +# The Rise & Decline of the Dutch Empire and the Dutch Guilder + +In the 1500-1600 period the Spanish empire was the pre-eminent economic empire in the “Western” world while the Chinese empire under the Ming Dynasty was the most powerful empire in the “Eastern” world, even more powerful than the Spanish empire (see the green dashed line and the red solid line in chart 2). The Spanish got rich by taking their ships and military power around the world, seizing control of vast areas (13% of the landmass of the earth!) and extracting valuable things from them, most importantly gold and silver which were the money of the time. As shown by the orange line in the chart of the relative standing of the great empires, the Dutch gained power as Spanish power was waning. + +¹⁰ We show where key indicators were relative to their history by averaging them across the cases. The chart is shown such that a value of “1” represents the peak in that indicator relative to history and “0” represents the trough. The timeline is shown in years with “0” representing roughly when the country was at its peak (i.e., when the average across gauges was at its peak). In the rest of this section, we walk through each of the stages of the archetype in more detail. While the charts show the countries that produced global reserve currencies, we’ll also heavily reference China, which was a dominant empire for centuries, though it never established a reserve currency. + + + +--- + + +the time Spain controlled the small area we now call Holland. When the Dutch became powerful enough in 1581, they overthrew the Spanish and went on to eclipse both the Spanish and the Chinese as the world’s richest empire from around 1625 to their collapse in 1780. The Dutch empire reached its peak around 1650 in what was called the Dutch Golden Age. This period was one of great globalization as ships that could travel around the world to gain the riches that were out there flourished, and the Dutch, with their great shipbuilding and their economic system, were ahead of others in using ships, economic rewards, and military power to build their empire. Holland (as we now call it) remained the richest power for about 100 years. How did that happen? + +- The Dutch were superbly educated people who were very inventive —in fact they came up with 25% of all major inventions in the world at their peak in the 17th century. The two most important inventions they came up with were 1) ships that were uniquely good that could take them all around the world, which, with the military skills that they acquired from all the fighting they did in Europe, allowed them to collect great riches around the world, and 2) the capitalism that fueled these endeavors. +- Not only did the Dutch follow a capitalist approach to resource allocation, they invented capitalism. By capitalism I mean public debt and equity markets. Of course production existed before, but that is not capitalism, and of course trade existed before, but that is not capitalism, and of course private ownership existed before, but that is not capitalism. By capitalism I mean the ability of large numbers of people to collectively lend money and buy ownership in money-making endeavors. The Dutch created that when they invented the first listed public company (the Dutch East India Company) and the first stock exchange in 1602 and when they built the first well-developed lending system in which debt could more easily be created. +- They also created the world’s first reserve currency. The Dutch guilder was the first “world reserve currency” other than gold and silver because it was the first empire to extend around much of the world and to have its currency so broadly accepted. Fueled by these qualities and strengths, the Dutch empire continued to rise on a relative basis until around 1700 when the British started to grow strongly. +- The numerous investment market innovations of the Dutch and their successes in producing profits attracted investors, which led to Amsterdam becoming the world’s leading financial center; the Dutch government channeled money into debt and some equity investments in various businesses, the most important of which was the Dutch East India Company. +- At this time of prosperity, other countries grew in power too. As other countries became more competitive, the Dutch empire became more costly and less competitive, and it found maintaining its empire less profitable and more challenging. Most importantly the British got stronger economically and militarily in the classic ways laid out in Chapter 1. Before they had become clear competitors they had military partnerships during most of the 80+ years leading up to the Fourth Anglo-Dutch War. That changed over time as they bumped into each other in the same markets. The Dutch and British had lots of conflicts over economic issues. For example, the English made a law that only English ships could be used to import goods into England, which hurt Dutch shipping companies that had a big business of shipping others’ goods to England, which led to the English seizing Dutch ships and expanding the British East India Company. Typically before all-out war is declared there is about a decade of these sorts of economic, technological, geopolitical, and capital wars when the conflicting powers approach comparability and test and try to intimidate each other’s powers. At the time the British came up with military inventions and built more naval strength, and they continued to gain relative economic strength. +- As shown in the chart of relative standing of empires shown above, around 1750 the British became a stronger power than the Dutch, particularly economically and militarily, both because the British (and French) became stronger and because the Dutch became weaker. As is classic the Dutch a) became more indebted, b) had a lot of internal fighting over wealth (between its states/provinces, between the rich and the poor, and between political factions)¹¹, and c) had a weakened military—so the Dutch were weak and divided, which made them vulnerable to attack. +- As is typical, the rising great power challenged the existing leading power in a war to test them both economically and militarily. The English hurt the Dutch economically by hurting their shipping business with other countries. The British attacked the Dutch. Other competing countries, most importantly + +11 A good example of this is the popularity of the Patriot movement in the Netherlands around this time: Encyclopedia Britannica, The Patriot movement, https://www.britannica.com/place/Netherlands/The-18th-century#ref414139 + +© 2020 Bridgewater Associates, LP + + +--- + + +France, took this as an opportunity to grab shipping business from the Dutch. That war, known as the Fourth Anglo-Dutch War, lasted from 1780 to 1784. The British won it handily both financially and militarily. That bankrupted the Dutch and caused Dutch debt and equities, the Dutch guilder, and the Dutch empire to collapse. In the next section we will look at that collapse up close. + +At that time, in the late 18th century, there was a lot of fighting between countries with various shifting alliances within Europe. While similar fights existed around the world as they nearly always do, the only reason I’m focusing on these fights is because I’m focusing just on the leading powers and these were the leading two. After the British defeated the Dutch, Great Britain and its allies (Austria, Prussia, and Russia) continued to fight the French led by Napoleon in the Napoleonic Wars. Finally, after around a quarter-century of frequent fighting since the start of the French Revolution, the British and its allies won in 1815. + +# The Rise & Decline of the British Empire and the British Pound + +As is typical after wars, the winning powers (most notably the UK, Russia, Austria, and Prussia) met to agree on the new world order. That meeting was called the Congress of Vienna. In it the winning powers re-engineered the debt, monetary, and geopolitical systems and created a new beginning as laid out in the Treaty of Paris. That set the stage for Great Britain’s 100-year-long “imperial century” during which Great Britain became the unrivaled world power, the British pound became the world’s dominant currency, and the world flourished. + +As is typical, following the period of war there was an extended period—in this case 100 years—of peace and prosperity because no country wanted to challenge the dominant world power and overturn the world order that was working so well. Of course during these 100 years of great prosperity there were bad economic periods along the lines of what we call recessions and which used to be called panics (e.g., the Panic of 1825 in the UK, or the Panics of 1837 and 1873 in the US) and there were military conflicts (e.g., the Crimean War between Russia on one side and the Ottoman empire with a coalition of Western European powers as allies on the other), but they were not significant enough to change the big picture of this being a very prosperous and peaceful period with the British on top. + +Like the Dutch before them, the British followed a capitalist system to incentivize and finance people to work collectively, and they combined these commercial operations with military strength to exploit global opportunities in order to become extremely wealthy and powerful. For example the British East India Company replaced the Dutch East India Company as the world’s most economically dominant company and the company’s military force became about twice the size of the British government’s standing military force. That approach made the British East India Company extremely powerful and the British people very rich and powerful. Additionally, at the same time, around 1760, the British created a whole new way of making things and becoming rich while raising people’s living standards. It was called the Industrial Revolution. It was through machine production, particularly propelled by the steam engine. So, this relatively small country of well-educated people became the world’s most powerful country by combining inventiveness, capitalism, great ships and other technologies that allowed them to go global, and a great military to create the British empire that was dominant for the next 100 years. + +Naturally London replaced Amsterdam as the world’s capital markets center and continued to innovate financial products. + +Later in that 100-year peaceful and prosperous period, from 1870 to the early 1900s the inventive and prosperous boom continued as the Second Industrial Revolution. During it human ingenuity created enormous technological advances that raised living standards and made those who developed them and owned them rich. + +This period was for Great Britain what “the Dutch Golden Age” was for the Dutch about 200 years earlier because it raised the power in all the eight key ways—via excellent education, new inventions and technologies, stronger competitiveness, higher output and trade, a stronger military and financial center, and a more widely used reserve currency. + +At this time several other countries used this period of relative peace and prosperity to get richer and stronger by colonizing enormous swaths of the world. As is typical during this phase, other countries copied Britain’s technologies and techniques and flourished themselves, producing prosperity and, with + + + +--- + + +# Wealth Gaps and Global Conflicts + +It, great wealth gaps. For example, during this period there was the invention of steel production, the development of the automobile, and the development of electricity and its applications such as for communications including Alexander Graham Bell’s telephone and Thomas Edison’s incandescent light bulb and phonograph. This is when the United States grew strongly to become a leading world power. These countries became very rich and their wealth gaps increased. That period was called “the Gilded Age” in the US, “la Belle Époque” in France, and “the Victorian Era” in England. As is typical at such times the leading power, Great Britain, became more indulgent while its relative power declined, and it started to borrow excessively. + +- As other countries became more competitive, the British empire became more costly and less profitable to maintain. Most importantly other European countries and the US got stronger economically and militarily in the classic ways laid out in Chapter 1. As shown in the chart of the standing of empires above, the US became a comparable power economically and militarily around 1900 though the UK retained stronger military power, trade, and reserve currency status, and the US continued to gain relative strength from there. +- From 1900 until 1914, as a consequence of the large wealth gaps, there became 1) greater arguments about how wealth should be divided within countries and 2) greater conflicts and comparabilities in economic and military powers that existed between European countries. As is typical at such times the international conflicts led to alliances being formed and eventually led to war. Before the war the conflicts and the alliances were built around money and power considerations. For example, typical of conflicting powers that seek to cut off their enemies’ access to money and credit, Germany under Bismarck refused to let Russia sell its bonds in Berlin, which led them to be sold in Paris, which reinforced the French-Russian alliance. The wealth gap in Russia led it to tumble into revolution in 1917 and out of the war, which is a whole other dramatic story about fighting over wealth and power that is examined in Part 2 of this book. Similar to the economically motivated shipping conflict between the British and the Dutch, Germany sank five merchant ships that were going to England in the first years of the war. That brought the United States into the war. Frankly, the complexities of the situations leading up to World War I are mind-boggling, widely debated among historians, and way beyond me. +- That war, which was really the first world war because it involved countries all around the world because the world had become global, lasted from 1914 until 1918 and cost the lives of an estimated 8.5 million soldiers and 13 million civilians. As it ended, the Spanish flu arrived, killing an estimated 20-50 million people over two years. So 1914-20 was a terrible time. + +© 2020 Bridgewater Associates, LP + + + +--- + +# The Rise of the American Empire and the US Dollar After World War I + +As is typical after wars, the winning powers—in this case the US, Britain, France, Japan, and Italy—met to set out the new world order. That meeting, called the Paris Peace Conference, took place in early 1919, lasted for six months, and concluded with the Treaty of Versailles. In that treaty the territories of the losing powers (Germany, Austria-Hungary, the Ottoman Empire, and Bulgaria) were carved up and put under the controls of the winning empires and the losing powers were put deeply into debt to the winning powers to pay back the winning countries’ war costs with these debts payable in gold. The United States was then clearly recognized as a leading power so it played a role in shaping the new world order. In fact the term “new world order” came about in reference to US President Woodrow Wilson’s vision for how countries would operate in pursuit of their collective interest through a global governance system (the League of Nations) which was a vision that quickly failed. After World War I the US chose to remain more isolationist while Britain continued to expand and oversee its global colonial empire. The monetary system in the immediate post-war period was in flux. While most countries endeavored to restore gold convertibility, currency stability against gold only came after a period of sharp devaluations and inflation. + +The large foreign debt burdens placed on Germany set the stage for 1) Germany’s post-war inflationary depression from 1920 to 1923 that wiped out the debts and was followed by Germany’s strong economic and military recovery, and 2) a decade of peace and prosperity elsewhere, which became the “Roaring ’20s.” + +During that time the United States also followed a classic capitalist approach to resource allocation and New York became a rival financial center to London, channeling debt and investments into various businesses. + +Other countries became more competitive and prosperous and increasingly challenged the leading powers. Most importantly Germany, Japan, and the US got stronger economically and militarily in the classic ways laid out in Chapter 1. However, the US was isolationist and didn’t have a big colonial empire past its borders so it was essentially out of the emerging conflict. As shown in the chart of the standing of empires above, Germany and Japan both gained in power relative to the UK during this interwar period, though the UK remained stronger. + +As is typical, the debts and the wealth gaps that were built up in the 1920s led to the debt bubbles that burst in 1929 which led to depressions, which led to the printing of money, which led to devaluations of currencies and greater internal and external conflicts over wealth and power in the 1930s. For example, in the United States and the UK, while there were redistributions of wealth and political power, capitalism and democracy were maintained, while in Germany, Japan, Italy, and Spain they were not maintained. Russia played a significant peripheral role in ways I won’t delve into. China at the time was weak, fragmented, and increasingly controlled by a rising and increasingly militaristic and nationalistic Japan. To make a long story short, the Japanese and Germans started to make territorial expansions in the early to mid-1930s, which led to wars in Europe and Asia in the late 1930s that ended in 1945. + +As is typical, before all-out wars were declared there was about a decade of economic, technological, geopolitical, and capital wars when the conflicting powers approached comparability and tested and tried to intimidate the other powers. While 1939 and 1941 are known as the official start of the wars in Europe and the Pacific, the wars really started about 10 years before that, as economic conflicts that were at first limited progressively grew into World War II. As Germany and Japan became more expansionist economic and military powers, they increasingly competed with the UK, US, and France for both resources and influence over territories. + +That brought about the second world war which, as usual, was won by the winning countries coming up with new technologies (the nuclear bomb, while the most important, was just one of the newly invented weapons). Over 20 million died directly in the military conflicts, and the total death count was still higher. So 1930-45, which was a period of depression and war, was a terrible time. + +While most people think that the ascent of the US came after World War II, it really started here and went on across both wars—and the seeds of that rise came still earlier from the self-reinforcing upswings in US education, innovation, competitiveness, and economic outcomes over the 19th century. + +--- + +# The Rise of the American Empire and the US Dollar After World War II + +• As is typical after wars, the winning powers—most importantly the US, Britain, and Russia—met to set out the new world order. While the Bretton Woods Conference, Yalta Conference, and Potsdam Conference were the most noteworthy, several other meetings occurred that shaped the new world order, which included carving up the world and redefining countries and areas of influence and establishing a new money and credit system. In this case, the world was divided into the US-controlled capitalist/democratic countries and Russia-controlled communist and autocratically controlled countries, each with their own monetary systems. Germany was split into pieces, with the United States, Great Britain, and France having control of the West and Russia having control of the East. Japan was under US control and China returned to a state of civil war, mostly about how to divide the wealth, which was between communists and capitalists (i.e., the Nationalists). Unlike after World War I when the United States chose to be relatively isolationist, after World War II the United States took the primary leadership role as it had most of the economic, geopolitical, and military responsibility. + +• The US followed a capitalist system. The new monetary system of the US-led countries had the dollar linked to gold and had most other countries’ currencies tied to the dollar. This system was followed by over 40 countries. Because the US had around two-thirds of the world’s gold then and because the US was much more powerful economically and militarily than any other country, this monetary system has worked best and carried on until now. As for the other countries that were not part of this system—most importantly Russia and those countries that were brought into the Soviet Union and the satellite countries that the Soviets controlled—they were built on a much weaker foundation that eventually broke down. Unlike after World War I, when the losing countries were burdened with large debts, countries that were under US control, including the defeated countries, received massive financial aid from the US via the Marshall Plan. At the same time the currencies and debts of the losing countries were wiped out, with those holding them losing all of their wealth in them. Great Britain was left heavily indebted from its war borrowings and faced the gradual end of the colonial era which would lead to the unraveling of its empire which was becoming uneconomic to have. + +• During this post-World War II period the United States, its allies, and the countries that were under its influence followed a classic capitalist-democratic approach to resource allocation. New York flourished as the world’s pre-eminent financial center, and a new big debt and capital markets cycle began. That produced what has thus far been a relatively peaceful and prosperous 75-year period that has brought us to today. + +• As is typical of this peaceful and prosperous part of the cycle, in the 1950-70 period there was productive debt growth and equity market development that were essential for financing innovation and development early on. That eventually led to too much debt being required to finance both war and domestic needs—what was called “guns and butter.” The Vietnam War and the “War on Poverty” occurred in the US. Other countries also became overly indebted and the British indebtedness became over-leveraged which led to a number of currency devaluations, most importantly the breakdown of the Bretton Woods monetary system (though countries like the UK and Italy had already devalued prior to that time). Then in 1971, when it was apparent that the US didn’t have enough gold in the bank to meet the claims on gold that it had put out, the US defaulted on its promise to deliver gold for paper dollars which ended the Type 2 gold-backed monetary system, and the world moved to a fiat monetary system. As is typical, this fiat monetary system initially led to a wave of great dollar money and debt creation that led to a big wave of inflation that carried until 1980-82 and led to the worst economic downturn since the Great Depression. It was followed by three other waves of debt-financed speculations, bubbles, and busts—1) the 1982 and 2000 money and credit expansion that produced a dot-com bubble that led to the 2000-01 recession, 2) the 2002-07 money and credit expansion that produced a real estate bubble that led to the 2008 Great Recession, and 3) the 2009-19 money and credit expansion that produced the investment bubble that preceded the COVID-19 downturn. Each of these cycles raised debt and non-debt obligations (e.g., for pensions and health care) to progressively higher levels and led the reserve currency central banks of the post-war allies to push interest rates to unprecedented low levels and to print unprecedented amounts of money. Also classically, the wealth, values, and political gaps + +--- + + +widened within countries, which increases internal conflicts during economic downturns. That is where we now are. + +• During this prosperous post-war period many countries became more competitive with the leading powers economically and militarily. The Soviet Union/Russia initially followed a communist resource allocation approach as did China and a number of other smaller countries. None of these countries became competitive following this approach. However, the Soviet Union did develop nuclear weapons to become militarily threatening and gradually a number of other countries followed in developing nuclear weapons. These weapons were never used because using them would produce mutually assured destruction. Because of its economic failures the Soviet Union/Russia could not afford to support a) its empire, b) its economy, and c) its military at the same time in the face of US President Ronald Reagan’s arms race spending. As a result the Soviet Union broke down in 1991 and abandoned communism. The breakdown of its money/credit/economic system was disastrous for it economically and geopolitically for most of the 1990s. In the 1980-95 period most communist countries abandoned classic communism and the world entered a very prosperous period of globalization and free-market capitalism. + +• In China, Mao Zedong’s death in 1976 led Deng Xiaoping to a shift in economic policies to include capitalist elements including private ownership of large businesses, the development of debt and equities markets, great technological and commercial innovations, and even the flourishing of billionaire capitalists—all, however, under the strict control of the Communist Party. As a result of this shift and the simultaneous shift in the world to greater amounts of globalism China grew much stronger in most ways. For example, since I started visiting China in 1984, the education of its population has improved dramatically, the real per capita income has multiplied by 24, and it has become the largest country in the world in trade (exceeding the US share of world trade), a rival technology leader, the holder of the greatest foreign reserves assets in the world by a factor of over two, the largest lender/investor in the emerging world, the second most powerful military power, and a geopolitical rival of the United States. And it is growing in power at a significantly faster pace than the United States and other “developed countries.” + +• At the same time, we are in a period of great inventiveness due to advanced information/data management and artificial intelligence supplementing human intelligence with the Americans and Chinese leading the way. As shown at the outset of Chapter 1, human adaptability and inventiveness has proven to be the greatest force in solving problems and creating advances. Also, because the world is richer and more skilled than ever before, there is a tremendous capacity to make the world better for more people than ever if people can work together to make the whole pie as big as possible and to divide it well. That brings us to where we now are. + +As you can see, all three of these rises and declines followed the classic script laid out in Chapter 1 and summarized in the charts at the beginning of this chapter, though each had its own particular turns and twists. + +Now let’s look at these cases, especially the declines, more closely. + +© 2020 Bridgewater Associates, LP 63 + + + +--- + +A Closer Look at the Rises and Declines of the Leading Empires Over the Last 500 Years + +# The Dutch Empire and the Dutch Guilder + +Before we get to the collapse of the Dutch empire and the Dutch guilder let’s take a quick look at the whole arc of its rise and decline. While I previously showed you the aggregated power index for the Dutch empire, the chart below shows the eight powers that make it up from the ascent around 1575 to the decline around 1780. In it, you can see the story behind the rise and decline. + +| The Netherlands: Indexes of Major Drivers of Power | | +| -------------------------------------------------- | ---------------- | +| Major Wars | Education | +| Innovation and Technology | Competitiveness | +| Military | Trade | +| Output | Financial Center | +| Reserve Status | | + +After declaring independence in 1581, the Dutch fought off the Spanish and built a global trading empire that became responsible for over a third of global trade largely via the first mega-corporation, the Dutch East India Company. As shown in the chart above, with a strong educational background the Dutch innovated in a number of areas. They produced roughly 25% of global inventions in the early 17th century, most importantly in shipbuilding, which led to a great improvement in Dutch competitiveness and its share of world trade. Propelled by these ships and the capitalism that provided the money to fuel these expeditions, the Dutch became the largest traders in the world, accounting for about one-third of world trade. As the ships traveled around the world, the Dutch built a strong military to defend them and their trade routes. + +As a result of this success they got rich. Income per capita rose to over twice that of most other major European powers. They invested more in education. Literacy rates became double the world average. They created an empire spanning from the New World to Asia, and they formed the first major stock exchange with Amsterdam becoming the world’s most important financial center. The Dutch guilder became the first global reserve currency, accounting for over a third of all international transactions. For these reasons over the course of the late 1500s and 1600s, the Dutch became a global economic and cultural power. They did all of this with a population of only 1-2 million people. Below is a brief summary of the wars they had to fight to build and hold onto their empire. As shown, they were all about money and power. + +13 Rough estimate based on internal calculations + +14 Rough estimate based on internal calculations + +15 Rough estimate based on internal calculations + +16 In this piece, when talking about “the guilder,” we generally refer to guilder bank notes, which were used at the Bank of Amsterdam, rather than the physical coin (also called “guilder”). + +© 2020 Bridgewater Associates, LP + +--- + + +# Eighty Years’ War (1566-1648) + +This was a revolt by the Netherlands against Spain (one of the strongest empires of that era), which eventually led to Dutch independence. The Protestant Dutch wanted to free themselves from the Catholic rule of Spain and eventually managed to become de facto independent. Between 1609 and 1621, the two nations had a ceasefire. Eventually, the Dutch were recognized by Spain as independent in the Peace of Munster, which was signed together with the Treaty of Westphalia, ending both the Eighty Years’ War as well as the Thirty Years’ War.17 + +# First Anglo-Dutch War (1652-1654) + +This was a trade war. More specifically, in order to protect its economic position in North America and damage the Dutch trade that the English were competing with, the English Parliament passed the first of the Navigation Acts in 1651 that mandated that all goods from its American colonies must be carried by English ships, which set off hostilities between the two countries.18 + +# The Dutch-Swedish War (1657–1660) + +This war centered around the Dutch wanting to maintain low tolls on the highly profitable Baltic trade routes. This was threatened when Sweden declared war on Denmark, a Dutch ally. The Dutch defeated the Swedes and maintained the favorable trade arrangement.19 + +# The Second Anglo-Dutch War (1665–1667) + +England and the Netherlands fought again over another trade dispute, which again ended with a Dutch victory.20 + +# The Franco-Dutch War (1672-1678) and the Third Anglo-Dutch War (1672-1674) + +This was also a fight over trade. It was between France and England on one side and the Dutch (called the United Provinces), the Holy Roman Empire, and Spain on the other.21 The Dutch largely stopped French plans to conquer the Netherlands and forced France to reduce some of its tariffs against Dutch trade,22 but the war was more expensive than previous conflicts, which increased their debts and hurt the Dutch financially. + +# The Fourth Anglo-Dutch War (1780-1784) + +This was fought between the Dutch and the rapidly strengthening British, partially in retaliation for Dutch support of the US in the American Revolution. The war ended in significant defeat for the Dutch, and the costs of the fighting and eventual peace helped usher in the end of the guilder as a reserve currency.23 + +# The chart below shows the Dutch power index with the key war periods noted. + +| | Major Wars | Netherlands | Key Events | | +| ------------------ | ---------------------------------------------------------------------- | ----------- | ------------------------------------- | -------------------------------------------------------------------- | +| The Dutch | | | 0.8 | (A) Formation of the Dutch Republic (seceded from Spain) | +| defeat the British | (B) Dutch East India Co, Bank of Amsterdam, and Stock Exchange founded | | | | +| | (C) | 0.7 | (C) First and Second Anglo-Dutch Wars | | +| | | (D) | 0.6 | (D) Seven Years' War and Shadow Banking Crisis of 1763 | +| | | (E) | 0.5 | (E) Fourth Anglo-Dutch War, run on the Bank of Amsterdam | +| | | (F) | 0.4 | (F) Dutch East India Co nationalized, downfall of the Dutch Republic | +| | | | 0.3 | | +| | | | 0.2 | | +| | | | 0.1 | | +| | | | 0.0 | | + +1500 1550 1600 1650 1700 1750 1800 1850 1900 1950 2000 + +17 Encyclopedia Britannica, Eighty Years’ War, https://www.britannica.com/event/Eighty-Years-War + +18 Encyclopedia Britannica, The Anglo-Dutch Wars, https://www.britannica.com/event/Anglo-Dutch-Wars + +19 Israel, Dutch Primacy in World Trade, 1585-1740, 219 + +20 Encyclopedia Britannica, The Anglo-Dutch Wars, https://www.britannica.com/event/Anglo-Dutch-Wars + +21 Encyclopedia Britannica, The Dutch War, https://www.britannica.com/event/Dutch-War + +22 Israel, The Dutch Republic: Its Rise, Greatness, and Fall 1477-1806, 824-825 + +23 Encyclopedia Britannica, The Anglo-Dutch Wars, https://www.britannica.com/event/Anglo-Dutch-Wars + +© 2020 Bridgewater Associates, LP 65 + + +--- + + +As shown, the seeds of Dutch decline were sown in the latter part of the 17th century as they started to lose their competitiveness and became overextended globally trying to support an empire that had become more costly than profitable. Increased debt-service payments squeezed them while their worsening competitiveness hurt their income from trade. Earnings from business abroad also fell. Wealthy Dutch savers moved their cash abroad both to get out of Dutch investments and into British investments, which were more attractive due to strong earnings growth and higher yields.24 While debt burdens had grown through most of the 1700s,25 the Dutch guilder remained widely accepted around the world as a reserve currency so it held up solely because of the functionality of and faith in it.26 (As explained earlier, reserve currency status classically lags the decline of other key drivers of the rise and fall of empires.) As shown by the black line in the first chart above (designating the extent the currency is used as a reserve currency) the guilder remained widely used as a global reserve currency after the Dutch empire started to decline, up until the Fourth Anglo-Dutch War, which began in 1780 and ended in 1784.27 + +The simmering conflict between the rising British and the declining Dutch had escalated after the Dutch traded arms with the colonies during the American Revolution.28 In retaliation the English delivered a massive blow to the Dutch in the Caribbean and ended up controlling Dutch territory in the East and West Indies.29 The war required heavy expenditure by the Dutch to rebuild their dilapidated navy: the Dutch East India Company lost half its ships30 and access to its key trade routes while heavily borrowing from the Bank of Amsterdam to stay alive. And the war forced the Dutch to accumulate large debts beyond these.31 + +The main reason the Dutch lost the war was that they let their navy become much weaker than Britain’s because of disinvestment into military capacity in order to spend on domestic indulgences.32 In other words, they tried to finance both guns and butter with their reserve currency, didn’t have enough buying power to support the guns despite their great ability to borrow due to their having the leading reserve currency, and became financially and militarily defeated by the British who were stronger in both respects. + +Most importantly, this war destroyed the profitability and balance sheet of the Dutch East India Company.33 While it was already in decline due to its reduced competitiveness, it ran into a liquidity crisis after a collapse in trade caused by British blockades on the Dutch coast and in the Dutch East Indies.34 As shown below, it suffered heavy losses during the Fourth Anglo-Dutch War and began borrowing aggressively from the Bank of Amsterdam because it was too systemically important for the Dutch government. + +24 There was a general rise in foreign investment by the Dutch during this period. Investments in UK assets offered high real returns. Examples include Dutch purchases of stocks in the British East India Company, and the City of London selling term annuities (bonds) to Dutch investors. For a further description, see Hart, Jonker, and van Zanden, A Financial History of the Netherlands, 56-58. + +25 Hart, Jonker, and van Zanden, A Financial History of the Netherlands, 20-21 + +26 Quinn & Roberds, “Death of a Reserve Currency,” 13 + +27 Encyclopedia Britannica, The Anglo-Dutch Wars, https://www.britannica.com/event/Anglo-Dutch-Wars + +28 Encyclopedia Britannica, The Anglo-Dutch Wars, https://www.britannica.com/event/Anglo-Dutch-Wars + +29 Encyclopedia Britannica, The Anglo-Dutch Wars, https://www.britannica.com/event/Anglo-Dutch-Wars + +30 de Vries & van der Woude, The First Modern Economy, 455 + +31 de Vries & van der Woude, The First Modern Economy, 126 + +32 de Vries & van der Woude, The First Modern Economy, 685-686 + +33 de Vries & van der Woude, The First Modern Economy, 455 + +34 de Vries & van der Woude, The First Modern Economy, 455-456 & https://www.britannica.com/event/Anglo-Dutch-Wars + + + +--- + + +# Dutch East India Company Balance Sheet (%GDP) + +| Assets | Debt | Equity | +| ------ | ---- | ------ | +| 30% | | | +| 25% | | | +| 20% | | | +| 15% | | | +| 10% | | | +| 5% | | | +| 0% | | | +| -5% | | | +| -10% | | | + +As shown in the chart below the Dutch East India Company, which was essentially the Dutch economy and military wrapped into a company, started to make losses in 1780, which became enormous during the Fourth Anglo-Dutch War. + +# Dutch East India Company Profit & Loss (Guilder, Mln) + +10 +5 +0 +-5 +-10 +-15 + +As deposit holders at the Bank of Amsterdam realized the bank was “lending” freshly printed guilders to save the Dutch East India Company, there was a run on the Bank of Amsterdam. As investors pulled back and borrowing needs increased, gold was preferred to paper money, those with paper money exchanged it for gold at the Bank of Amsterdam, and it became clear that there wouldn’t be enough gold. The run on the bank and the run on the guilder accelerated throughout the war, as it became increasingly apparent that the Dutch would lose and depositors could anticipate that the bank would print more money and have to devalue the guilder. Guilders were backed by precious metals, but as the supply of guilders rose and investors could see what was happening they turned their guilders in for gold and silver so the ratio of claims on gold and silver rose, which caused more of the same until the Bank of Amsterdam was wiped out of its precious metal holdings. The supply of guilders continued to soar while demand for them fell. + +35 This chart only shows the financial results from the Dutch East India Company reported “in patria,” e.g., the Netherlands. It does not include the part of the revenue and debt from its operations in Asia but does include its revenues from goods it retrieved in Asia and sold in Europe. + +36 Quinn & Roberds, “Death of a Reserve Currency,” 17 + +37 “Guilder” in this case refers to devaluing bank deposits in guilder from the Bank of Amsterdam, not physical coin. For details on the run, see Quinn & Roberds, “Death of a Reserve Currency,” 16. + +© 2020 Bridgewater Associates, LP + + + +--- + + +# Bank of Amsterdam Holdings (%GDP) + +# Gold and Silver + +7% +6% +5% +4% +3% +2% +1% +0% + +As deposit holders exchange their guilder for gold and silver, the Bank of Amsterdam loses its holdings in precious metals. + +1700 1725 1750 1775 1800 + +The Bank of Amsterdam had no choice since the company was too important to allow to fail both because of its significance to the economy and its outstanding debt in the Dutch financial system, so the Bank of Amsterdam began “lending” large sums of newly printed guilders to the company. During the war, policy makers also used the bank to lend to the government. 38 The chart below shows this explosion of loans on the bank’s balance sheet through the Fourth Anglo-Dutch War (note: there was about 20 million bank guilder outstanding at the start of the war).39 + +# Bank of Amsterdam Loans Outstanding (Guilder, Mln) + +| Gov | City Chamber | Dutch East India Company | +| --- | ------------ | ------------------------ | +| 14 | | | +| 12 | | | +| 10 | | | +| 8 | | | +| 6 | | | +| 4 | | | +| 2 | | | +| 0 | | | + +1775 1780 1785 1790 40 + +Interest rates rose and the Bank of Amsterdam had to devalue, undermining the credibility of the guilder as a storehold of value. Over the years, and at this moment of crisis, the bank had created many more “paper money” claims on the hard money in the bank than could be met so that led to a classic run on the Bank of Amsterdam, which led to the collapse of the Dutch guilder.42 It also led to the British pound clearly replacing the Dutch guilder as the leading reserve currency. + +38 Quinn & Roberds, “Death of a Reserve Currency,” 17-18 + +39 Quinn & Roberds, “Death of a Reserve Currency,” 16 + +40 Quinn & Roberds, “Death of a Reserve Currency,” 34 + +41 Quinn & Roberds, “Death of a Reserve Currency,” 15-16 + +The Bank of Amsterdam was ahead its time and used ledgers instead of real “paper money.” See Quinn & Roberds, “The Bank of Amsterdam Through the Lens of Monetary Competition,” 2 + +© 2020 Bridgewater Associates, LP + + +--- + + +# What happened to the Dutch was classic + +as described in both Chapter 1’s very brief summary of why empires rise and fall and in Chapter 2’s description of how money, credit, and debt work. As for the money, credit, and debt cycle, the Bank of Amsterdam started with a Type 1 monetary system that morphed into a Type 2 monetary system. It started with just coins that led to the bank having a 1:1 backing of paper money by metal, so the bank provided a more convenient form of hard money. The claims on money were then allowed to rise relative to the hard money to increasingly become a Type 2 monetary system, in which paper money seems to acquire a value itself as well as a claim on hard money (coins), though the money wasn’t fully backed. This transition usually happens at times of financial stress and military conflict. And it is risky because the transition decreases trust in the currency and adds to the risk of a bank-run-like dynamic. While we won’t go deeply into the specifics of the war, the steps taken by policy makers during the period led to the loss of Dutch financial power so are worth describing because they are so archetypical when there is a clear shift in power and the losing country has a bad income statement and balance sheet. This period was like that and ended with the guilder supplanted by the pound as the world’s reserve currency and London succeeding Amsterdam as the world’s financial center. + +# Deposits of the Bank of Amsterdam + +(i.e., holdings of short-term debt) of the Bank of Amsterdam, which had been a reliable storehold of wealth for nearly two centuries, began to trade at large discounts to guilder coins (which were made of gold and silver).43 The bank used its holdings of other countries’ debt (i.e., its currency reserves) to buy its currency on the open market to support the value of deposits, but it lacked adequate foreign currency reserves to support the guilder.44 Accounts backed by coin held at the bank plummeted from 17 million guilder in March 1780 to only 300,000 in January 1783 as owners of these gold and silver coins wanted to get them rather than continue to hold the promises of the Bank of Amsterdam to deliver them.45 + +# The running out of money by the Bank of Amsterdam + +marked the end of the Dutch empire and the guilder as a reserve currency. In 1791 the bank was taken over by the City of Amsterdam, and in 1795 the French revolutionary government overthrew the Dutch Republic, establishing a client state in its place.46 After being nationalized in 1796, rendering its stock worthless, the Dutch East India Company’s charter expired in 1799.48 + +# The following charts show the exchange rates + +between the guilder and the pound/gold; as it became clear that the bank no longer had any credibility and that the currency was no longer a good storehold of wealth, investors fled to other assets and currency.49 + +43 Quinn & Roberds, “Death of a Reserve Currency,” 19, 26 + +44 Quinn & Roberds, “Death of a Reserve Currency,” 19-20 + +45 Quinn & Roberds, “Death of a Reserve Currency,” 16 + +46 Quinn & Roberds, “Death of a Reserve Currency,” 24 + +47 de Vries & van der Woude, The First Modern Economy, 685-686 + +48 Encyclopedia Britannica, The Dutch East India Company, https://www.britannica.com/topic/Dutch-East-India-Company; also see de Vries & van der Woude, The First Modern Economy, 463-464 + +49 Historical data suggests that by 1795, bank deposits were trading at a -25% discount to actual coin. Quinn & Roberds, “Death of a Reserve Currency,” 26. + + + +--- + + +Dutch Guilder + +# (A) Guilder stable through vs Gold + +# vs GBP + +most of the decline era + +| | | 1.10 | (B) Fourth Anglo-Dutch | | | +| ---- | ---- | ---- | ---------------------------------------------------------------------------------------------- | ---- | ----------------------------------------------------------------------------------------------------- | +| | | 1.05 | War leads to money printing and initial pressure on the guilder (run on the Bank of Amsterdam) | | | +| | | | (A) | 1.00 | | +| | | | (B) | 0.95 | (C) Short period of stabilization as investors seek safe havens at the start of the French Revolution | +| | | | (C) | 0.90 | | +| | | 0.85 | | | | +| | | 0.80 | (D) The French overthrow the Dutch, accounts at the bank basically wiped out | | | +| | | 0.75 | | | | +| | | 0.70 | | | | +| 1775 | 1780 | 1785 | 1790 | 1795 | 1800 | + +# Zooming Out (Dutch Guilder) + +# vs Gold vs Silver vs GBP + +| | 1.6 | | 100% | | +| ------------------------ | ---- | -------------------------------------------------------------------------------------------------------------------------- | ---- | ---- | +| | 1.4 | | 80% | | +| | 1.2 | | | | +| | 1.0 | | 60% | | +| Stable during Golden Age | 0.8 | After the Fourth Anglo-Dutch War there was a sharp decline in the ratio of precious metal to deposits (as depositors fled) | 40% | | +| | 0.6 | | 20% | | +| | 0.4 | | | | +| | 0.2 | | 0% | | +| 1600 | 1650 | 1700 | 1750 | 1800 | + +The chart below shows the returns of holding the Dutch East India Company for investors starting in various years. As with most bubble companies, it originally did great, with great fundamentals, which attracted more investors even as its fundamentals started to weaken, but it increasingly got into debt, until the failed fundamentals and excessive debt burdens broke the company. + +Note: To fully represent the likely economics of a deposit holder at the Bank of Amsterdam, we assumed depositors each received their pro-rated share of precious metal still in the bank’s vaults when it was closed (that was roughly 20% of the fully backed amount, thus the approximately 80% total devaluation). + +© 2020 Bridgewater Associates, LP + + +--- + + +# Dutch EIC Total Returns by Year of Initial Investment + +(50yr Intervals, ln) + +Returns for Dutch East India Company stockholders went from incredible to devastating + +| | 10,000 | | | | | | | | 1,000 | +| ---- | ------ | ---- | ---- | ---- | ---- | ---- | ---- | ---- | ----- | +| | 100 | | | | | | | | 10 | +| 1600 | 1625 | 1650 | 1675 | 1700 | 1725 | 1750 | 1775 | 1800 | | + +As is typical, with the decline in power of the leading empire and the rise in power of the new empire, the returns of investment assets in the declining empire fell relative to the returns of investing in the rising empire. For example, as shown below, the returns on investments in the British East India Company far exceeded those in the Dutch East India Company, and the returns of investing in Dutch government bonds were terrible relative to the returns of investing in English government bonds. This was reflective of virtually all investments in these two countries. + +# Total Equity Returns (Indexed) + +# Government Bond Yields + +| Dutch East India Company | British East India Company | +| ------------------------ | -------------------------- | +| | 9% | +| | 8% | +| 1,000 | 7% | +| | 6% | +| | 5% | +| 100 | 4% | +| | 3% | +| | 2% | +| 10 | 1% | + +| | Holland Bond Prices (Term Annuities) | +| ------------------------------------------------------------------- | ------------------------------------ | +| | 1.0 | +| Start of various wars in 1672 | 0.8 | +| Rebounds after the wars end, but falls with the Glorious Revolution | 0.6 | +| Series of military losses against the French | 0.4 | +| Fourth Anglo-Dutch War and conquest by France | 0.2 | +| | 0.0 | + +1600 1625 1650 1675 1700 1725 1750 1775 1800 + +51 Gelderblom & Jonker, “Exploring the Market for Government Bonds in the Dutch Republic (1600-1800),” 16 + +© 2020 Bridgewater Associates, LP + +71 + + + +--- + +The British Empire and the British Pound + +Before we get to the collapse of the British empire and the British pound, let’s take a quick look at the whole arc of its rise and decline. While I previously showed you the aggregated power index for the British empire, the chart below shows the eight powers that make it up. It shows these from the ascent around 1700 to the decline in the early 1900s. In it, you can see the story behind the rise and decline. + +# United Kingdom: Index of Major Drivers of Power + +| Major Wars | Education | Innovation and Technology | Competitiveness | Military | Trade | History | +| --------------------------------------------------------------------------------------------- | --------- | ------------------------- | --------------- | -------- | ----- | ------- | +| ![Chart showing the index of major drivers of power from 1550 to 2000](chart_placeholder.png) | | | | | | | + +The British empire’s rise began before 1600, with steadily strengthening competitiveness, education, and innovation/technology—the classic leading factors for a power’s rise. As shown and previously described, in the late 1700s the British military power became pre-eminent and it beat its leading economic competitor and the leading reserve currency empire of its day in the Fourth Anglo-Dutch War. It also successfully fought other European rivals like France in a number of conflicts that culminated in the Napoleonic Wars in the early 1800s. + +Then it became extremely rich by being the dominant economic power. At its peak in the 19th century, the UK’s 2.5% of the world’s population produced 20% of the world’s income, and the UK controlled over 40% of global exports. This economic strength grew in tandem with a strong military, which, along with the privately driven conquests of the British East India Company, drove the creation of a global empire upon which “the sun never set,” controlling over 20% of the world’s land mass and 25% of the global population prior to the outbreak of World War I. With a lag, as is classic, its capital—London—emerged as the global financial center and its currency—the pound—emerged as the leading global reserve currency. As is typical, its reserve status remained well after other measures of power started declining in the late 19th century and as powerful rivals like the US and Germany rose. + +As shown in the chart above, almost all of the British empire’s relative powers began to slip as competitors emerged around 1900. At the same time wealth gaps were large and internal conflicts over wealth were emerging. + +As you know, despite winning both World War I and World War II the British were left with large debts, a huge empire that was more costly than profitable, numerous rivals that were more competitive, and a population that had big wealth gaps which led to big political gaps. + +As I previously summarized what happened in the 1914 to post-World War II period, I will skip ahead to the end of World War II in 1945 and the start of the new world order that we are now in. I will be focusing on how the pound lost its reserve currency status. + +© 2020 Bridgewater Associates, LP 72 + +--- + + + +Although the US had overtaken the UK militarily, economically, politically, and financially long before the end of World War II, it took more than 20 years after the war for the British pound to fully lose its status as an international reserve currency. Just like the world’s most widely spoken language becomes so deeply woven into the fabric of international dealings that it is difficult to replace, the same is true of the world’s most widely used reserve currency. In the case of the British pound, other countries’ central banks continued to hold a sizable share of their reserves in pounds through the 1950s, and about half of all international trade was denominated in sterling in 1960. Still, the pound began to lose its status right at the end of the war because smart folks could see the UK’s increased debt load, its low net reserves, and the great contrast with the United States’ financial condition (which emerged from the war as the world’s pre-eminent creditor and with a very strong balance sheet). + +The decline in the British pound was a chronic affair that happened through several significant devaluations over many years. After efforts at making the pound convertible failed in 1946-47, the pound devalued by 30% against the dollar in 1949. Though this worked in the short term, over the next two decades the declining competitiveness of the British led to repeated balance of payments strains that culminated with central banks actively selling sterling reserves to accumulate dollar reserves following the devaluation of 1967. Around this time the deutschmark began to re-emerge and took the pound’s place as the second-most widely held reserve currency. The charts below paint the picture. + +| GBP Share of Global Reserves (ex-Gold, Est) | GBP Share of Global Debt (Est) | GBP Share of Global Transactions (Est) | +| ------------------------------------------- | ------------------------------ | -------------------------------------- | +| WWII | 100% | 60% | +| | 80% | 50% | +| | 60% | 40% | +| | 40% | 30% | +| | 30% | 20% | +| | 20% | 10% | +| | 10% | 0% | +| | 0% | 0% | + +| USD/GBP (Inv) | GBR FX vs Gold (£/oz, Inv) | +| --------------------------------------------------------------------------------------- | -------------------------- | +| 0.15 | 2 | +| Second devaluation (1967): UK gives up defending the peg | 4 | +| 0.20 | 6 | +| 0.25 | 8 | +| First devaluation (1946-49): Convertibility crisis when the UK removes capital controls | 10 | +| 0.30 | 12 | +| 0.35 | 14 | +| 0.40 | 16 | +| 0.45 | 20 | + +On the following pages we will cover in greater detail the specific stages of this decline, firstly with the convertibility crisis of 1947 and the 1949 devaluation, secondly with the gradual evolution of the pound’s status relative to the dollar through the 1950s and early 1960s, and thirdly with the balance of payments crisis of 1967 and subsequent devaluation. We will focus in on the currency crises. + +© 2020 Bridgewater Associates, LP + +73 + + + +--- + +# The Pound’s Suspended Convertibility in 1946 and Its Devaluation in 1949 + +The 1940s are frequently referred to as “crisis years”52 for sterling. The war required the UK to borrow immensely from its allies and colonies,53 and those obligations were required to be held in sterling. These war debts financed about a third of the war effort. When the war ended, the UK could not meet its debt obligations without the great pain of raising taxes or cutting government spending, so it necessarily mandated that its debt assets (i.e., its bonds) could not be proactively sold by its former colonies. + +As such, the UK emerged from World War II with strict controls on foreign exchange. The Bank of England’s approval was required to convert pounds into dollars, whether to buy US goods or purchase US financial assets (i.e., current and capital account convertibility was suspended). To ensure the pound would function as an international reserve currency in the post-war era, and to prepare the global economy for a transition to the Bretton Woods monetary system, convertibility would have to be restored. However, because the US dollar was now the international currency of choice, the global economy was experiencing a severe shortage of dollars at the time. Virtually all Sterling Area countries (the UK and the Commonwealth countries) relied on inflows from selling goods and services and from attracting investments in dollars to get the dollars they needed while they were forced to hold their sterling-denominated bonds. The UK experienced acute balance of payments problems due to its poor external competitiveness, a domestic fuel crisis, and large war debts undermining faith in the pound as a storehold of wealth. As a result, the first effort to restore convertibility in 1947 failed completely, and it was soon followed by a large devaluation (of 30%) in 1949, to restore some competitiveness.54 + +Coming into the period, there were concerns that too quick a return to convertibility would result in a run on the pound, as savers and traders shifted to holding and transacting in dollars all at once. However, the US was anxious for the UK to restore convertibility as soon as possible as restrictions on convertibility were reducing US export profits and reducing liquidity in the global economy.55 The Bank of England was also eager to remove capital controls in order to restore the pound’s role as a global trading currency, increase financial sector revenues in London, and encourage international investors to continue saving in sterling56 (a number of governments of European creditors, including Sweden, Switzerland, and Belgium, were having increasing conflicts with the UK over the lack of convertibility).57 An agreement was reached after the war, under which the UK would reintroduce convertibility swiftly, and the US would provide the UK with a loan of $3.75 billion58 (about 10% of UK GDP). While the loan offered some buffer against a potential run on the pound, it did not change the underlying imbalances in the global economy. + +When partial convertibility was introduced in July 1947, the pound came under considerable selling pressure. As the UK and US governments were against devaluation (as memories of the competitive devaluations in the 1930s were fresh on everyone’s minds),59 the UK and other Sterling Area countries turned to austerity and reserve sales to maintain the peg to the dollar. Restrictions were imposed on the import of “luxury goods” from the US, defense expenditure was slashed, dollar and gold reserves were drawn down, and agreements were made between sterling economies not to diversify their reserve holdings to the dollar.60 Prime Minister Clement Attlee gave a dramatic speech on August 6, 1947, calling for the spirit of wartime sacrifices to be made once again in order to defend the pound: + +“In 1940 we were delivered from mortal peril by the courage, skill, and self-sacrifice of a few. Today we are engaged in another battle for Britain. This battle cannot be won by the few. It demands a united + +52 For example, see Catherine Schenk, The Decline of Sterling: Managing the Retreat of an International Currency, 1945–1992, 37 (hereafter referred to as Schenk, Decline of Sterling) + +53 See Schenk, Decline of Sterling, 39 + +54 For an overview of the convertibility crisis and devaluation, see Schenk, Decline of Sterling, 68-80; Alec Cairncross & Barry Eichengreen, Sterling in Decline: The Devaluations of 1931, 1949, and 1967, 102-147 (hereafter referred to as Cairncross & Eichengreen, Sterling in Decline). + +55 Schenk, Decline of Sterling, 44 + +56 Schenk, Decline of Sterling, 31 + +57 Alex Cairncross, Years of Recovery: British Economic Policy 1945-51, 124-126 + +58 Schenk, Decline of Sterling, 63 + +59 Schenk, Decline of Sterling, 48 + +60 Schenk, Decline of Sterling, 62 + +--- + +effort by the whole nation. I am confident that this united effort will be forthcoming and that we shall again conquer.”61 + +Immediately following the speech, the run on the pound accelerated. Over the next five days, the UK had to spend down $175 million of reserves to defend the peg.62 By the end of August, convertibility was suspended, much to the anger of the US and other international investors who had bought up sterling assets in the lead-up to convertibility hoping that they would soon be able to convert those holdings to dollars. The governor of the National Bank of Belgium even threatened to stop transacting in sterling, requiring a diplomatic intervention.63 + +The devaluation came two years later, as policy makers in both the UK and the US realized that the pound couldn’t return to convertibility at the current rate. UK exports were not competitive enough in global markets to earn the foreign exchange needed to support the pound, reserves were dwindling, and the US was unwilling to continue shoring up the pound with low interest rate loans. An agreement was reached to devalue the pound versus the dollar in order to boost UK competitiveness, help create a two-way currency market, and speed up a return to convertibility.64 In September 1949, the pound was devalued by 30% versus the dollar. Competitiveness returned, the current account improved, and by the mid-to-late 1950s, full convertibility was restored.65 The charts below paint the picture. + +| USD/GBP (Inv) | GBR Real FX vs TWI | +| ------------- | ------------------ | +| 0.15 | 25% | +| 0.20 | 20% | +| 0.25 | 15% | +| 0.30 | 10% | +| 0.35 | 5% | +| 0.40 | 0% | +| 0.45 | -5% | +| | -10% | +| | -15% | +| | -20% | +| | -25% | + +GBR Current Account (%GDP) +15% +10% +5% +0% +-5% +-10% +-15% + +1930 1940 1950 1960 + +61 As quoted in Schenk, Decline of Sterling, 62-63 + +62 Ibid + +63 Schenk, Decline of Sterling, 66-67 + +64 For more detail, see Cairncross & Eichengreen, Sterling in Decline, 139-155 + +65 See also Cairncross & Eichengreen, Sterling in Decline, 151-155 for a discussion of other contributing factors + +© 2020 Bridgewater Associates, LP + +--- + + +The currency move, which devalued sterling debt, did not lead to a panic out of sterling debt as much as one might have expected especially in light of how bad the fundamentals for sterling debt remained. That is because a very large share of UK assets was held by the US government, which was willing to take the valuation hit in order to restore convertibility, and by Sterling Area economies, such as India and Australia, whose currencies were pegged to the pound for political reasons. These Commonwealth economies, for geopolitical reasons, supported the UK’s decision and followed by devaluing their own currencies versus the dollar, which lessened the visibility of the loss of wealth from the devaluation. Still, the immediate post-war experience made it clear to knowledgeable observers that the pound was vulnerable to more weakness and would not be able to enjoy the same international role it had prior to World War II. + +# 2) The Failed International Efforts to Support the Pound in the 1950s and 1960s and the Devaluation of 1967 + +Though the devaluation helped in the short term, over the next two decades, the pound would face recurring balance of payments strains. These strains were very concerning to international policy makers who feared that a collapse in the value of sterling or a rapid shift away from the pound to the dollar in reserve holdings could prove highly detrimental to the new Bretton Woods monetary system (particularly given the backdrop of the Cold War and concerns around communism). As a result, numerous arrangements were made to try to shore up the pound and preserve its role as a source of international liquidity. These included the Bilateral Concerté (1961-64), in which major developed world central banks gave support to countries via the Bank of International Settlements, including multiple loans to the UK and the BIS Group Arrangement 1 (1966-71), which provided swaps to the UK to offset future pressure from potential falls in sterling reserve holdings. + +In addition to these wider efforts, the UK’s status as the head of the Sterling Area let it mandate that all trade within the Sterling Area would continue to be denominated in pounds and all their currencies would be pegged to sterling. As these economies had to maintain a peg to the pound, they continued to accumulate FX reserves in sterling well after other economies had stopped doing so (e.g., Australia kept 90% of its reserves in sterling as late as 1965). Foreign loans issued in the UK during the period were also almost exclusively to the Sterling Area. The result of all this is that for the 1950s and early 1960s, the UK is best understood as a regional economic power and sterling as a regional reserve currency. Yet all these measures didn’t fix the problem that the UK owed too much money and was uncompetitive, so it didn’t earn enough money to both pay its debts and pay for what it needed to import. Rearrangements were essentially futile stop-gap measures designed to hold back the changing tide. They helped keep the pound stable between 1949 and 1967. Still, sterling needed to be devalued again in 1967. + +By the mid-1960s, the average share of central bank reserves held in pounds had fallen to around 20%, while international trade was overwhelmingly denominated in dollars (about half). However, many emerging markets and Sterling Area countries continued to hold about 50% of their reserves in pounds and continued to denominate much of their trade with each other and the UK in sterling. This effectively ended following a series of runs on the pound in the 1960s. As in many other balance of payments crises, policy makers used a variety of means to try to maintain the currency peg to the dollar, including spending down reserves, raising rates, and using capital controls. In the end they were unsuccessful, and after the UK devalued by 14% versus the dollar in 1967, even Sterling Area countries were unwilling to hold their reserves in pounds, unless the UK guaranteed their underlying value in dollars. + +Throughout the 1960s, the UK was forced to defend the peg to the dollar by selling about half of its FX reserve holdings and keeping rates higher than the rest of the developed world —even though the UK economy was underperforming. In both 1961 and 1964, the pound came under intense selling pressure, and the peg was only maintained by a sharp rise in rates, a rapid acceleration in reserve sales, and the extension of short-term credits from the US and the Bank of International Settlements. By 1966, attempts to defend the peg were being described. + +66 Schenk, Decline of Sterling, 39, 46; for further description, see https://eh.net/encyclopedia/the-sterling-area/ + +67 For further description of these and other coordinated policies, see Catherine Schenk, “The Retirement of Sterling as a Reserve Currency After 1945: Lessons for the US Dollar?” + +68 John Singleton & Catherine Schenk, “The Shift from Sterling to the Dollar, 1965–76: Evidence from Australia and New Zealand,” 1162 + +69 For more detail on the dynamics of the Sterling Area, see Catherine Schenk, Britain and the Sterling Area, 1994 + + + +--- + + +by prominent British policy makers as “a sort of British Dien Bien Phu.” 70 When the pound came under extreme selling pressure again in 1967 (following rising rates in the developed world, recessions in major UK export markets, and heightened conflict in the Middle East),71 British policy makers decided to devalue sterling by 14% against the dollar. + +| GBR Current Account (%GDP) | GBR Gold Reserves (oz, MM) | GBR Short Rates (Diff to USA) | +| ---------------------------- | -------------------------- | ----------------------------- | +| Deterioration of the current | 3% | 90 | +| account, connected to | 2% | 80 | +| EUR recession | 1% | 70 | +| | 0% | 60 | +| | -1% | 50 | +| | -2% | 40 | +| | -3% | 30 | +| | | 20 | +| | | 10 | +| | | 0 | +| | | -1% | + +| GBR Real FX vs TWI | USD/GBP (Inv) | +| ------------------ | ------------- | +| 10% | 0.25 | +| 8% | | +| 6% | 0.30 | +| 4% | | +| 2% | 0.35 | +| 0% | | +| -2% | | +| -4% | 0.40 | +| -6% | | +| -8% | | +| -10% | 0.45 | + +70 As quoted by Schenk, Decline of Sterling, 156 + +71 Schenk, Decline of Sterling, 174 + + + +--- + + +After the devaluation little faith remained in the pound as the second-best reserve currency after the dollar. For the first time since the end of World War II, international central banks began actively selling their sterling reserves (as opposed to simply accumulating fewer pounds in new reserve holdings) and instead began buying dollars, deutschmarks, and yen. As you can see in the chart below on the left, the average share of sterling in central bank reserve holdings collapsed within two years of the devaluation. At the same time the UK was still able to convince Sterling Area countries not to diversify away from the pound. In the Sterling Agreement of 1968, Sterling Area members agreed to maintain a floor on their pound reserve holdings, as long as 90% of the dollar value of these holdings was guaranteed by the British government. So although the share of pound reserves in these Sterling Agreement countries like Australia and New Zealand remained high, this was only because these reserves had their value guaranteed by the British in dollars. So all countries that continued to hold a high share of their reserves in pounds after 1968 were holding de facto dollars with the British bearing the risk of a further sterling devaluation.72 + +# Average Share of Pounds in Central Bank Reserves (% Total) + +| All Countries | Central banks begin selling their sterling reserves following the devaluation. The share of the pound collapses. | | | | | | +| ------------- | ---------------------------------------------------------------------------------------------------------------- | ---------------------------------------------------------------------------------------------------------------------------------------------- | ---- | ---- | --- | --- | +| 1968 | 1969 | 1970 | 1971 | 1972 | | | +| | Sterling Agreement Countries | Sterling Agreement countries promise to continue holding pounds, but only if 90% of their dollar value is guaranteed by the British government | | | | | +| 1968 | 1969 | 1970 | 1971 | 1972 | | | +| | | 70% | 60% | 50% | 40% | 30% | +| | 20% | 10% | 0% | | | | + +By this time the dollar was having its own set of balance of payments and currency problems, but that is for the next installment of this series when I turn to the United States and China. + +For fuller coverage of this, see Schenk, Decline of Sterling, 273-31572 + +Data from Schenk, “The Retirement of Sterling as a Reserve Currency After 1945: Lessons for the US Dollar?,” 2573 + +© 2020 Bridgewater Associates, LP + +78 + + + +--- + +NO_CONTENT_HERE + +--- + +# Chapter 5: + +# The Last 500 Years Part 2: + +# The Big Cycle of the United States and the Dollar + +--- + +NO_CONTENT_HERE + +--- + +Chapter 5: The Last 500 Years Part 2: The Big Cycle of the United States and the Dollar + +To remind you, I did this study so that I could understand how we got to where we are and how to deal with the situations we are facing, but I am no great historian. I’m just a guy with a compulsion to understand how these things work and to bet on what will happen, who has access to great research assistants, fabulous data, incredibly informed experts, lots of insightful written research, and my own experiences. I’m using all of this to try to figure out what’s true and what to do about it. I am not ideological. I am mechanical. I look at reality as a perpetual-motion machine with cause/effect relationships driving developments through time. I am sharing this information with you to take or leave as you like and to have you point out any inaccuracies you think might exist as we try to figure out together what’s true and what to do about it. + +This chapter is a continuation of the last chapter in which we started to look at each of the leading reserve currency empires over the last 500 years, starting with the Dutch and British empires. We first saw the Dutch and then the British rise to become the richest and most powerful reserve currency empire and then decline into relative insignificance in cycles that were driven by timeless and universal cause/effect relationships. We ended with the British Empire declining in the first half of the 20th century. That brought us up to World War II, after which the British Empire was replaced by the US Empire. In this chapter we will examine the US and in the next we will examine China—now the two leading world powers—to see how they are progressing along the path of the archetypical cycle. That will complete our examination of the rises and declines of the leading empires over the last 500 years. We will then make one more quick review of the past before trying to squint into the future. + +As we move closer to the present, I will increasingly shift from describing each country’s story individually to weaving the most relevant countries’ stories together chronologically so you can better see the interactions, and I will do it in greater detail. I will start in 1930 and bring the story up to the present for both the US and China, and then I will focus more closely on US-China interactions, which are the most important ones today. While telling the story this way will make it a bit more complicated, it will help you see how what is happening now is similar to what happened in the past because the most important forces and cause/effect relationships behind them are essentially the same. As we delve into the particulars of the last 90 years, it is easy to lose sight of the big arcs, most importantly the three big cycles—i.e., the long-term debt/monetary cycle, the wealth and political gap cycle, and the global geopolitical cycle—as well as the eight major types of power and the 17 major drivers behind them. I will try to keep it simple, emphasizing just the most important developments in just the most influential countries, but if you find that the story starts getting more complicated than you’d like, remember that you can just read the text in bold in order to get the main points without complication. + +World affairs and history are complicated because there is a lot going on both within and between relevant countries. Understanding just the most important relevant issues of just the most important countries is challenging because one has to see all of these perspectives accurately and simultaneously. All countries are living out their own stories that transpire on a daily basis, and these stories are woven together to make up the world story. But typically, at any one time, there are only a few leading countries and a limited number of major themes that make up the major story of the changing world order. Since the end of World War I, the most relevant stories have been those of Great Britain, the United States, Germany, Japan, the Soviet Union, and China. I’m not saying that these are the only countries that matter because that isn’t true. But I am saying that the story of the changing world order since World War I can be pretty well told by understanding the main developments within and between these countries. In this chapter I will attempt to briefly tell the stories of these countries and their most important interactions. This is the highlights version of the more complete version of the stories that I will pass to you in Part 2 of this book. + +© 2020 Bridgewater Associates, LP + +--- + + +In telling these stories I will try to convey them without bias. I believe that to accurately understand both history and what is happening now, I need to see things through the relevant parties’ eyes, including those of enemies. While there are of course allies and enemies and it is tempting to demonize the enemies, most people and countries are simply pursuing their own interests in the ways they believe are best for them, so I find it productive to try to see things through their eyes and counterproductive to demonize them. If you hear me say things that sound sympathetic to former or existing enemies—like “Hitler built a strong economy before going to war”—please know that it is because I am seeking accuracy and need to be truthful rather than politically correct in conveying my thinking. While I might be wrong and we might not agree, that’s all OK with me as long as I am describing the picture as accurately as I can. + +Before I begin recounting the story of the United States I’d like to remind you of the archetypical Big Cycle that I described earlier so you can keep it in mind as you read about how events transpired up to the present. Though a super-oversimplification of the whole thing, in a nutshell it appears to me that the archetypical Big Cycle transpires as follows. + +# The Typical Big Cycle Behind Empires' Rises and Declines + +| | Debt Bubble and | Debt Bust and Economic Downturn | | | +| -------------------------------- | --------------- | ------------------------------- | - | -------------- | +| | Big Wealth Gap | | | | +| Peace, Prosperity, | | | | Printing Money | +| and Productive | | | | and Credit | +| | Debt Growth | Revolutions and Wars | | | +| Debt and Political Restructuring | | | | | +| | New | New | | | +| | World Order | World Order | | | + +A new world order typically begins after radical changes in how things work within countries (i.e., via some form of revolution) and between countries (typically some form of war). They change in big ways who has wealth and power and the approaches used to get wealth and power. For example in 1945, when the latest world order began, the US and its capitalist and democratic allies squared off against the communist and autocratic approaches of the Soviet Union and its allies. As we saw from studying the Dutch and British empires, capitalism was key to these countries’ successes but also contributed to their failures. It was successful because the pursuit of profit motivated people, and the competitive process of allocating capital and profit making directed resources relatively efficiently to what people wanted enough to pay for. In this system those who allocated efficiently profited, which led to them gaining more resources, while those who couldn’t allocate well died economically. + +At the same time, this system of increasing wealth produced widening wealth and opportunity gaps, as well as decadence in the form of people working less and increasingly living on borrowed money. As the wealth and opportunity gaps grew, that produced increasingly widespread views that the system wasn’t fair. When the debt problems and other factors led to bad economic times at the same time as the wealth and values gaps were large, that produced a lot of internal conflict that led to large, revolutionary changes in who had wealth and power and the processes for getting them. Sometimes these big changes were made peacefully, and sometimes they were made violently. When the leading countries suffered from these internal challenges at the same time as rival countries had become strong enough to challenge them, the risks of external wars increased. When these seismic shifts in how wealth and power are distributed occur within countries (i.e., via revolutions) or between countries (typically through wars, though sometimes peacefully), the old world order breaks down and a new world order begins, and the process starts all over again. + +© 2020 Bridgewater Associates, LP + +--- + + +# To refresh your memory, the chart below shows the relative powers of the leading countries as measured in indices that measure eight different types of power—education, competitiveness, innovation/technology, trade, economic output, military, financial center status, and reserve currency status. + +In examining each country’s rise and decline I look at each of the eight measures and convey the highlights of their stories while diving into key moments to understand how they transpired in a more granular way. We will now do that with the United States and China, which as you can see in this chart are currently the leading powers. + +| Major Wars | United States | China | United Kingdom | +| ----------- | ------------- | ------- | -------------- | +| Netherlands | Spain | Germany | France | +| India | Japan | Russia | Ottoman Empire | + +Empires + +1.0 + +0.8 + +0.6 + +0.4 + +0.2 + +0.0 + +1500 1550 1600 1650 1700 1750 1800 1850 1900 1950 2000 + +# The US Empire and the US Dollar + +While this section primarily focuses on the story of the US since it overtook the British Empire as the dominant global power during the world wars, we will first take a quick look at the whole arc of its rise and its somewhat recent relative decline. The chart below shows the eight types of power that make up our overall measure of power. + +In it you can see the story behind the US’s rise and decline since 1700. We start in 1700 because that was just before the emergence of the United States. While the area now occupied by the United States was of course inhabited by native people for thousands of years, the history of the United States as a nation begins with the colonists, who revolted against the colonial power of Great Britain to gain independence in 1776. + +In the chart you can see the seeds of the US’s rise going back to the early 1800s, starting with rising strengths in education and then in innovation/technology and competitiveness. These powers and world circumstances allowed the US to create massive productivity growth during the Second Industrial Revolution, which was from around 1870 to the beginning of World War I and then beyond it. + +These increased strengths were reflected in the US’s increasing shares of global economic output and world trade, as well as growing its financial strength, exemplified in New York becoming the world’s leading financial center, continuing leadership in innovations, and great usage of its financial products. + +You can see that these measures of the United States’ powers relative to its own history reached their peaks in the 1950s immediately after the Allies won World War II. At that time, the gap between the US and the rest of the world was at its greatest and the US dollar and the US world order became dominant. + +Though the United States was clearly the dominant power in the post-World War II period, the Soviet Empire was a rival, though it was never nearly as strong overall. The Soviets and their communist satellite states vied against the much stronger US and US allies and satellite states until Soviet power began to fade under the weight of its growing inefficiency around 1980 and then collapsed in 1989-91. That is about when China began to rise to become a comparable rival power to the US where it is today. + +© 2020 Bridgewater Associates, LP 81 + +--- + + +United States + +# Major Wars + +# Education + +# Innovation and Technology + +# Competitiveness + +# Military + +# Trade + +# History + +# Output + +# Financial Center + +# Reserve Status + +| 1.0 | Own | max) | +| --------- | -------- | ---- | +| 0.8 to | Relative | = | +| 0.6 | (1 | | +| 0.4 Level | | | +| 0.2 | | | +| 0.0 | | | + +1700 1750 1800 1850 1900 1950 2000 + +As you can see, while the United States’ relative strengths of education, competitiveness, trade, and production have declined significantly and steadily over the last 100 years (to now be around the 50-60th percentile versus other leading powers), its relative strength in innovation and technology, reserve currency status, financial center power, and military have remained at or near the top. At the same time, as we will see when we delve into China’s picture, China has gained on the US in all these areas, has become comparable in many ways, and is advancing considerably faster than the US. + +Let’s now drop down from the 40,000-foot level to the 20,000-foot level and pick up our story in 1930 so we can see how the United States evolved to become the dominant world power. While we focus predominantly on the US story, the linkages between economic conditions and political conditions within the United States and between the United States and other countries—most importantly with the UK, Germany, and Japan in the 1930s, with the Soviet Union and Japan from around 1950 until 1990, and with China from around 1980 until now—must be understood because economics and geopolitics within and between countries were and always are intertwined. + +# 1930 to 1939/41: The Economic War + +As a principle: + +Before there is a shooting war there is usually an economic war. + +And: + +Severe economic downturns with large wealth gaps, large debts, and ineffective monetary policies make a combustible combination that typically leads to significant conflicts and revolutionary changes within countries. + +And: + +During periods of great conflict there is a strong tendency to move to more autocratic leadership to bring order to the chaos. + +In 1929 the Roaring ’20s bubble burst and the global depression followed. It led to virtually all countries having significant internal conflicts over wealth that led them to turn to more populist, autocratic, nationalistic, and militaristic leaders and policies. These moves were either to the right or to the left and occurred in varying degrees. The extremities of these degrees varied by country, according to their circumstances and the lengths and depths of their democratic or autocratic traditions. In Germany, Japan, Italy, and Spain, their extremely bad circumstances and their less well-established democratic traditions led to extreme internal conflicts and a turn. + +© 2020 Bridgewater Associates, LP 82 + + +--- + + +to populist-autocratic leaders of the right (i.e., fascists), just as at different points in time the leaders of the Soviet Union and China, which also endured extreme circumstances and had no experience with democracy, became populist, autocratic leaders of the left (i.e., communists). The US and the UK had less severe conditions and much stronger democratic traditions, so they became more populist and autocratic than they were, but not nearly as extreme as other nations. + +In addition to these economically motivated conflicts within countries and the political shifts that arose from them, all of these countries faced increased external economic conflicts as they fought for greater shares of a shrinking economic pie. Because power rather than law rules international relations, there was a sequence of intensifying tests of power that led to war and then to peace and the new world order in 1945. + +To help to convey the picture in the 1930s, I will quickly run through some geopolitical highlights of what happened from 1930 until the official start of the war in Europe in 1939 and the bombing of Pearl Harbor in 1941. Then I will quickly move through the war and come to 1945 when the new world order began. I will then look at where this world order has brought us up until now. While these stories are interesting in and of themselves, they are most important to understand because of the lessons they provide for thinking about what is now happening and what’s ahead. + +Because the United States and China are now in an economic war that could conceivably evolve into a shooting war, and I’ve never experienced an economic war, I studied a number of past ones to learn what they are like. That taught me a bit about economic warfare, helped me better understand what is happening now, and made me aware of possibilities that I hadn’t previously considered. Comparisons between the 1930s leading to World War II and today, especially with regard to economic sanctions, are especially interesting and helpful in considering what might be ahead. For that reason, I delve into the story of this period in a bit more detail than you might care to read. If you find that to be the case, just read the bold for the highlights. + +The economic wars started about 10 years before the hot wars. The Great Depression brought economic suffering to virtually all nations, which led to fighting over wealth within and between countries that led to the hot wars that began a decade later. + +In 1929 gold (and to a lesser extent silver) was money, and paper money represented a promise to deliver it (there was a Type 2 monetary system in the world, as explained in Chapter 2). In the Roaring ’20s a lot of debt (promises to deliver paper money that was convertible to gold) was created to buy speculative assets (particularly stocks). When the Federal Reserve tightened monetary policy in 1929 to curtail the speculation, the bubble burst and the global Great Depression began. + +The debt problems in the US were ruinous for American banks, which curtailed their lending around the world, hurting international borrowers. At the same time the depression created weak demand, which led to the collapse in US imports and other countries’ sales to the US. As their incomes weakened their demand fell and more credit problems occurred in a self-reinforcing downward economic spiral. At the same time the US turned protectionist to safeguard jobs, so it raised tariffs (via the passage of the Smoot-Hawley Tariff Act) in 1930, which further depressed economic conditions in other countries. + +Turning protectionist and raising tariffs to protect domestic businesses and jobs during periods of economic bad times is common. It leads to reduced efficiency because production does not occur where it can be done most efficiently, and it typically contributes to greater global economic weakness as raising tariffs usually leads to tariff wars that typically cause the country that raised tariffs to lose exports too. It does however benefit those entities protected by the tariffs and can create political support for the leader who is imposing the tariffs. + +When the Great Depression began, Germany, Japan, the Soviet Union, and China were already suffering. Germany struggled under the burdens of its World War I debt and the occupation of the Rhineland by foreign forces. Japan suffered a classic big debt crisis in 1927 that was followed by a severe depression in 1930-31 and then a classic massive currency devaluation, fiscal stimulation, and debt monetization that pretty much wiped out financial wealth in Japan. The Soviet Union suffered from its 1917-22 revolution and the civil war, a lost war to Germany, a costly war with Poland, a famine in 1921, and political purges and economic hardships through the + + + +--- + + +# 1930s + +China suffered from civil war, poverty, and a famine in 1928-30. So when things worsened in 1930, bad conditions became desperate conditions in these countries, which set in motion the economic and eventually military conflicts that followed. + +To make matters worse droughts in the US and in the Soviet Union soon followed. The drought/famine in the Soviet Union, in combination with extreme government policies, was so severe that it caused millions of deaths. Harmful acts of nature (e.g., droughts, floods, and plagues) have often caused periods of great economic hardship that when combined with other adverse conditions have led to periods of great conflict. Over the next several years in Russia internal political fighting and fears of Nazi Germany led to purges of hundreds of thousands of people who were accused of spying and shot without trials. + +While Germany had previously been saddled with tremendous reparation debts following World War I, in 1929 it was beginning to emerge from under the yoke of these via the Young Plan, which provided for considerable debt relief and the departure of foreign troops from Germany by 1930. However, the global depression hit Germany hard, leading to 25% unemployment, massive bankruptcies, and extensive poverty. As is typical, a battle between populists of the left (communists) and populists of the right (fascists) emerged. Adolf Hitler, the leading populist-fascist, tapped into the mood of national humiliation to build a nationalist furor, casting as the enemy the World-War-I-ending Treaty of Versailles and the countries that imposed it. He created a nationalist program of 25 points that gave something to everyone and rallied support around it. In response to internal fighting and a desire to restore order, Hitler was appointed chancellor in January 1933, drawing large support for his Nazi Party from industrialists who feared the communists. Two months later, the Nazi Party won the most support and the most seats. + +In the United States in 1932 there was the presidential election that led to the election of Franklin D. Roosevelt, who many considered a populist of the left. Promptly after his inauguration, in March/April 1933, he defaulted on the promise to convert paper dollars into gold, provided money to all banks so depositors at those banks could get their money, ordered all gold in denominations of more than $100 to be turned in for paper money at a rate of $20.67 per ounce, and devalued the dollar in relation to other currencies. There were also big fiscal spending programs that led to large budget deficits and large debts that the Federal Reserve bought with money that it printed. + +As a principle: Deflationary depressions are debt crises caused by there not being enough money in the hands of debtors to service their debts. They inevitably lead to the printing of money, debt restructurings, and government spending programs that increase the supply of, and reduce the value of, money and credit. The only question is how long it takes for government officials to make this move. + +In the case of the Great Depression, it took from the October 1929 peak to Roosevelt’s March 1933 action to make the move. From that point until the end of 1936—the year the Federal Reserve tightened monetary policy and caused the recession of 1937-38—the stock market returned over 200%, and the economy grew at an average real rate of about 9%! + +As a principle: During periods of severe economic distress and large wealth gaps, there are typically revolutionarily large redistributions of wealth. When done peacefully these are achieved through large tax increases on the rich and big increases in the supply of money that devalue debtors’ claims, and when done violently they are achieved by forced asset confiscations. + +© 2020 Bridgewater Associates, LP 84 + +--- + + +# In Roosevelt’s first 100 days in office + +he created a number of big government spending programs that were paid for by big tax increases and big budget deficits financed by debt that the Federal Reserve monetized. He provided jobs programs, unemployment insurance, Social Security supports, and labor- and union-friendly programs. After his 1935 tax bill, then popularly called the “Soak the Rich Tax,” the top marginal income tax rate for individuals rose to 75% (versus as low as 25% in 1930). By 1941, the top personal tax rate was 81%, and the top corporate tax rate was 31%, having started at 12% in 1930. He also imposed a number of other taxes. Despite all of these taxes and the pickup in the economy that helped to raise tax revenue, budget deficits increased from around 1% of GDP to about 4% of GDP because the spending increases were so large. Specific developments through the Great Depression are explained more completely in Chapter 2: “The Big Cycle of Money, Credit, Debt, and Economic Activity” or in great detail in Part 2 of my book Principles for Navigating Big Debt Crises. + +# Meanwhile in Germany + +Hitler continued to pursue nationalist policies, refusing to pay reparation debts to creditor countries. He also stepped out of the League of Nations and took autocratic control of the country in 1934. By holding the roles of both chancellor and president, he became Germany’s supreme leader. In democracies there are always some laws that allow countries’ leaders to grab special powers. Hitler seized them all. He invoked “Article 48” to put an end to many civil rights and suppress political opposition from the communists and forced the passage of the “Enabling Act,” which allowed him to pass laws without the approval of the parliament and the president. He pursued the autocratic advancement of the “Aryan race” and was ruthless against any opposition—e.g., he took control of or censored newspapers and broadcasting companies, created a secret police force (the Gestapo) to find and fight all opposition, deprived Jews of all rights of citizenship, and took control of the Protestant Church’s finances and arrested church officials who opposed him. Declaring the Aryan race superior, he prohibited non-Aryans from serving in government. + +# Hitler also took that same autocratic/fascist approach + +to building the economy, coupled with big fiscal and monetary stimulation programs. To create a strong economy for Aryan Germans, Hitler quickly privatized state-owned businesses and encouraged corporate investment that was paid for by borrowing. He acted strongly in support of raising their living standards. For example, he set up Volkswagen to make cars affordable and accessible to most people, and he directed the building of the Autobahn. He financed this substantially increased government spending by forcing banks to buy government bonds. The debts that were produced were paid back by the earnings of companies and the central bank (the Reichsbank) monetizing debt. These policies by and large worked well. This is another good example of how borrowing in one’s own currency and increasing one’s own debt and deficits can be highly productive if the money borrowed is put into investments that raise productivity that produces more than enough cash flow to service the debt and, even if it doesn’t cover 100% of the debt service, it can be very cost-effective in achieving the economic goals of the country. + +# As for the economic effects of these policies + +when Hitler came to power in 1933 the unemployment rate was 25%. By 1938 it was nil. Per capita income between his coming to power and five years later in 1938 increased by 22% and real growth averaged over 8% per year between 1934 and 1938. Consistent with the rise in the growth, as shown in the below charts, German equities rallied nearly 70% in a steady trend between 1933 and 1938 until the onset of the hot war. + +| DEU Equity Returns | DEU Per Capita Income (2017 USD) | +| ----------------------------- | -------------------------------- | +| (Local FX, Cumulative Excess) | 80% | +| Equities rose nearly | 70% | +| between 1933 and | 60% | +| 1938, after Hitler took | 50% | +| power in January 1933 | 40% | +| | 30% | +| | 20% | +| | 10% | +| | 0% | +| | -10% | +| | -20% | + +© 2020 Bridgewater Associates, LP + +--- + + +Also in 1935 he began to build the military, making military service required and increasing Germany’s military spending much faster than any other country because the German economy needed more resources to fuel itself and needed to get these from other countries so it built and used its military power to help get them. One could argue that getting them militarily was more cost-effective than trying to produce goods to trade with others to earn income to buy what was needed. + +Like Germany, Japan was also hit exceptionally hard by the depression and became more autocratic in response to it. Japan was especially vulnerable to the depression because, as an island nation without adequate natural resources, it relied on exports for income to import necessities. When its exports fell by around 50% between 1929 and 1931, it was economically devastated. In 1931, the depression in Japan was so severe that the country went broke—i.e., it was forced to draw down its gold reserves, abandon the gold standard, and float its currency, which depreciated it so greatly that Japan ran out of buying power. These terrible conditions and large wealth gaps led to fighting between the left and the right. In 1932 that led to a massive upsurge in right-wing nationalism and militarism to forcefully restore order and bring back economic stability. To that end, Japan’s military took control and pursued military options to get Japan the resources it needed by taking them away from other countries. Japan invaded Manchuria in 1931 and later expanded through China and Asia to obtain natural resources (e.g., oil, iron, coal, and rubber) and human resources (i.e., slave labor). As in the German case, it could be argued that this path of military aggression to get needed resources was the best path for the Japanese because relying on classic trading and economic practices wouldn’t have gotten them what they needed. + +Shifting to more autocratic, populist, and nationalist leaders and policies during times of extreme economic stress is typical, as people want strong leadership to bring order to the chaos and to deal strongly with the outside enemy. In 1934, there was severe famine in parts of Japan, causing even more political turbulence and reinforcing the right-wing, militaristic, nationalistic, and expansionistic movement. + +In the years that followed, this movement in Japan, like that in Germany, became increasingly strong with its top-down fascist command economy, building a military-industrial complex with the military mobilized to protect its existing bases in East Asia and northern China and its expansion into other territories. As was also the case in Germany, during this time, while most Japanese companies remained outside government ownership, their production was controlled by the government. + +# What is fascism, and why was it adopted in countries like Germany and Japan? + +Consider the following three big choices that one has to make in order to choose a country’s approach to governance: a) bottom-up (democratic) or top-down (autocratic) decision-making, b) capitalist or communist (with socialist in the middle) ownership of production, and c) individualistic (which treats the well-being of the individual with paramount importance) or collectivist (which treats the well-being of the whole with paramount importance). Pick the one from each category that you believe works best for your nation’s values and ambitions and you have your preferred approach. Fascism is autocratic, capitalist, and collectivist. Fascists believed that top-down autocratic leadership, in which the government directs the production of privately held companies in a way that individual gratification is subordinated to national success, is the best way to make the country and its people wealthier and more powerful. The United States and Great Britain believed that the democratic, capitalist, and individualistic mix was better, while the Soviet Union believed that the autocratic, communist, and collectivist mix was best. + +In pursuing its capitalist approach, in 1936-37, the Federal Reserve tightened money and credit to fight inflation and slow an overheating economy, which caused the fragile US economy to go into recession and other major economies to weaken with it, further raising tensions within and between countries. Meanwhile in Europe, the conflict in Spain between the populists of the left (the communists) and the populists of the right (the fascists) flared up into the brutal Spanish Civil War. Franco of the right, with the support of Hitler, purged all left-wing organizations in Spain. In November 1937, Hitler held a secret meeting with his top officials to announce his plans for German expansion in Europe to gain resources and bring together the Aryan race. Hitler then put his plans for expansion into action, first annexing Austria and then seizing a part of Czechoslovakia that contained oil resources. Europe and the US watched warily, not wanting to get drawn into another war so soon after the + + + +--- + + +# Devastation of World War I + +Then on September 1, 1939, Germany invaded Poland. That is when England and France declared war on Germany, which is why that is the date that marks the beginning of World War II in Europe. + +In the Pacific in 1937 Japan spread its occupation of China, brutally taking control of Shanghai and Nanking, killing an estimated 200,000 Chinese civilians and disarmed combatants in the capture of Nanking alone. While the US remained isolationist, it did provide China’s Chiang Kai-shek government with fighter planes and pilots to fight the Japanese, thus putting a toe in the war, and conflicts between the US and Japan began to flare when a Japanese soldier struck the US consul in Nanking and Japanese fighter planes sank a US gunship anchored nearby. + +The US remained reluctant to enter the wars in Europe and Asia. In fact, in November 1940, Roosevelt was re-elected for a third term by promising to keep the US out of the war, even though the US was already taking action to protect its interests, especially in the Pacific. Still the US began using economic supports for countries it sympathized with and economic sanctions against those it did not—e.g., earlier in 1940, US Secretary of War Henry Stimson initiated aggressive economic sanctions against Japan, culminating in the Export Control Act of 1940. In mid-1940 the US moved the US Pacific Fleet to Hawaii. In October, the US ramped up the embargo, restricting “all iron and steel to destinations other than Britain and nations of the Western Hemisphere.” The plan was to cut off the resources needed by Japan in order to strangle them into submission and force a retreat from most of the areas they had taken over. + +While in March 1941 the US still wanted to avoid the war, Congress passed the Lend-Lease Act, which allowed it to lend or lease war supplies to nations that it deemed to be acting in ways that were “vital to the defense of the United States,” which included Great Britain, the Soviet Union, and China. This was good for the US both geopolitically and economically because the US made a lot of money selling weapons, food, and other items to countries that the US favored in the war. These soon-to-be allied countries were having problems producing them while waging war, and they (most significantly Great Britain) ran out of money (i.e., gold) so the US decided to be more supportive and postpone payment until after the war (and in some cases avoiding payment entirely). The Lend-Lease policy, although not an outright declaration of war, ended the United States’ neutrality. + +As a principle, when countries are weak, opposing countries take advantage of their weaknesses to obtain gains. At the time, European Allied countries (France, Netherlands, Great Britain) had colonies in Asia and were overstretched fighting the war in Europe so they were unable to defend these colonies from Japanese takeovers. Beginning in September 1940, to obtain more resources and take advantage of the European preoccupation with the war on their own continent, Japan invaded several colonies in Southeast Asia, starting with French Indochina. In 1941, Japan extended its reach by seizing oil reserves in the Dutch East Indies to add the “Southern Resource Zone” to its “Greater East Asia Co-Prosperity Sphere.” The Southern Resource Zone was a collection of mostly European colonies in Southeast Asia whose conquest would afford Japan access to key natural resources (most importantly oil, rubber, and rice). The Greater East Asia Co-Prosperity Sphere was a bloc of Asian countries controlled by Japan. The German and Japanese fascist governments were on a roll. + +At the same time this Japanese territorial expansion was a threat to the US’s own Pacific ambitions and continued to heighten tensions with Japan. In July and August 1941 Roosevelt responded by ordering the freezing of all Japanese assets in the United States, closing Japan’s ability to ship through the Panama Canal, and embargoing all oil and gas exports to Japan. This cut off three-fourths of its trade and 80% of its oil. Japan calculated that it would be out of oil in two years. This put Japan in the position of having to choose between backing down and attacking the US. + +As with all wars the unknowns about what will happen in a war are far greater than the knowns a) because rival powers go into wars only when their powers are roughly comparable (because otherwise it would be stupidly suicidal for the obviously weaker power to go to war) and b) because there are way too many possible actions and reactions to anticipate. The only thing that is known at the outset of war is that it will probably be extremely painful and possibly. + +74 As quoted in Harry Elmer Barnes, Perpetual War for Perpetual Peace: A Critical Examination of the Foreign Policy of Franklin Delano Roosevelt And Its Aftermath, 1953. + + + +--- + + +ruinous. As a result, smart leaders typically only go into hot wars if there is no choice because the other side pushes them into the position of either fighting or losing by backing down. That is how World War II began. + +On December 7 and 8, 1941, Japan launched coordinated attacks on US military forces in the Philippines and at Pearl Harbor. That marked the beginning of World War II in the Pacific which brought the US into the war in Europe too. + +While Japan didn’t have a widely recognized plan to win the war, it appears that those Japanese leaders who were optimistic planned to destroy the US Pacific Fleet and believed that the US would lose because it was fighting a war on two fronts (Europe and Asia) and because its individualistic/capitalist political system was inferior to Japan’s and Germany’s authoritarian, fascist systems and their command military-industrial complexes. They also believed that they had the greater willingness to endure pain and die for their country, which is a big driver of which side wins. + +Before going on to describe the hot war known as World War II I want to reiterate the most common economic warfare techniques. They have been and still are: + +1. Asset Freezes/Seizures: Preventing an enemy/rival from using or selling foreign assets they rely on. These measures can range from asset freezes for targeted groups in a country (e.g., the current US sanctions of the Iranian Revolutionary Guard or the initial US asset freeze against Japan in World War II) to more severe measures like unilateral debt repudiation or outright seizures of a country’s assets (some top US policy makers are now talking about not paying our debts to China). +2. Blocking Capital Market Access: Preventing a country from accessing their own or another country’s capital markets (e.g., in 1887 Germany banned the purchase of Russian securities and debt to impede Russia’s military buildup, the US now issuing threats of doing this to China). +3. Embargoes/Blockades: Blocking trade in goods and/or services either in one’s own country, or in some cases with neutral third parties, for the purpose of weakening the targeted country or preventing it from getting essential items (e.g., the US oil embargo of Japan and cutting off its ability to ship through the Panama Canal) or blocking exports from the targeted country to other countries thus cutting off their income (e.g., France’s blockade of the UK in the Napoleonic Wars). + +If you’re interested in seeing some of the specifics and variations that have taken place in these from 1600 until now, they are set out in a table in Appendix I. + +# 1939/41 to 1945: The Hot War + +In 1940, after the war began in Europe and prior to the US entering, Germany, like Japan, looked unstoppable; it captured Denmark, Norway, the Netherlands, Belgium, Luxembourg, and France, and formed a stronger alliance with Japan and Italy, who had common enemies and were ideologically aligned. By seizing territory rapidly, Hitler’s army was able to conserve oil and gain resources quickly (e.g., it gained access to oil by annexing Romania). Its roll seemed unstoppable. Its thirst for, and acquisition of, natural resources remained a major driver of the Nazi war machine pushing its campaigns into Russia and the Middle East. The war with the communist Soviet power was inevitable as Germany’s conquests in Western Europe put these two big and ideologically opposed powers on a collision course. The only question was when. While the Soviet Union and Germany had signed a non-aggression pact to postpone it, the Soviet Union invaded several Eastern European states, including the Baltic states, and took control of them. Germany invaded Russia in June 1941, which put Germany in an extremely costly war for both the Western European and Russian/Soviet sides. + +When the US entered the European and Pacific wars after the attack on Pearl Harbor, classic wartime economic policies were put in place in most countries by leaders who became more autocratic and whose autocratic approaches were broadly supported by their populations in opposition to the evil enemy. + + + +--- + + + +Just as it is worth noting what classic economic war techniques are, it is worth noting what classic wartime economic policies within countries are. Classic wartime economic policies include government controls on just about everything as the country shifts resources from profit making to war making—e.g., the government determines + +- a) what items are allowed to be produced, +- b) what items can be bought and sold in what amounts (rationing), +- c) what items can be imported and exported, +- d) prices, wages, and profits, +- e) access to one’s own financial assets, and +- f) the ability to move one’s money out of the country. + +Because wars are expensive classically + +- g) the government issues lots of debt that is monetized, +- h) relies on non-credit money such as gold for international transactions because its credit is not accepted, +- i) governs more autocratically, +- j) imposes various types of economic sanctions on enemies including cutting off their access to capital, and +- k) experiences enemies imposing these sanctions on them. + +The table below shows the economic controls that were put in place during the war years in each of the major countries. + +| Allies | Production Rationing | Price/Wage Controls | Import or Export Controls | Takeover of Central Bank | +| -------------- | -------------------- | ------------------- | ------------------------- | ------------------------ | +| United States | Yes | Yes | Yes | Yes | +| United Kingdom | Yes | Yes | Yes | Partial | +| Axis | Production Rationing | Price/Wage Controls | Import or Export Controls | Takeover of Central Bank | +| Germany | Yes | Yes | Yes | Yes | +| Japan | Yes | Yes | Yes | Yes | + +The market movements during the hot war years were heavily affected by both government controls and how countries did in battles as the odds of wins and losses changed. The table below shows the controls over markets and capital flows that were put in place by country during the war years. + +| Allies | Market Closures | Asset Price Controls | Ownership Restrictions | FX Controls | Top Marginal Tax Rate | Limits on New Corp. Issuance | Limits on Profits | +| -------------- | --------------- | -------------------- | ---------------------- | ----------- | --------------------- | ---------------------------- | ----------------- | +| United States | No | Yes | Yes | Yes | 94% | - | Yes | +| United Kingdom | Yes | Yes | Yes | Yes | 98% | Yes | Yes | +| Axis | Market Closures | Asset Price Controls | Ownership Restrictions | FX Controls | Top Marginal Tax Rate | Limits on New Corp. Issuance | Limits on Profits | +| Germany | Yes | Yes | Yes | Yes | 60% | Yes | Yes | +| Japan | Yes | Yes | Yes | Yes | 74% | Yes | Yes | + +Stock market closings in a number of countries were common, leaving investors in stocks stuck without access to their capital. If you want to see these closures and how they transpired to understand the range of possibilities and the cause/effect relationships behind them, you can see a list of them in Appendix II. + +Because losing wars typically leads to a total wipeout of wealth and power, movements of those stock markets that remained open in the war years were largely driven by how countries did in key battles as these results shifted the probability of victory or defeat for each side. For example, German equities outperformed at the beginning of WWII as Germany captured territory and established military dominance while they underperformed after Allied powers like the US and UK turned the tide of the war. After the 1942 Battle of Midway, Allied equities rallied almost continuously until the end of the war, while Axis equities were flat or down. As shown, both the German and Japanese stock markets were closed for the end of the war, didn’t reopen for around five years, and were virtually wiped out, while US stocks were extremely strong. + +© 2020 Bridgewater Associates, LP 89 + +--- + + +Equity Return Index (USD) + +# Equities in Germany + +In contrast both US and UK equities performed well as the Axis powers dominated from 1939 to 1942, rallied almost continuously after the 1942 Battle of Midway until the end of the war... + +| USA | GBR | DEU | JPN | +| --- | --- | --- | --- | +| 3.0 | | | | +| 2.5 | | | | +| 2.0 | | | | +| 1.5 | | | | +| 1.0 | | | | +| 0.5 | | | | +| 0.0 | | | | + +1939 1940 1941 1942 1943 1944 1945 1946 1947 1948 1949 1950 + +As a principle: Protecting one’s wealth in times of war is difficult, as normal economic activities are curtailed, traditionally safe investments are not safe, capital mobility is limited, and high taxes are imposed when people and countries are fighting for their survival. During difficult times of conflict protecting the wealth of those who have wealth is not a priority relative to redistributing wealth to get it to where it is needed most. + +That was the case in those war years. + +While we won’t cover the actual battles and war moves, the headline is that the Allied victory in 1945 produced a tremendous shift of wealth and power. + +World War II was an extremely costly war in lives and money. The numbers are gigantic and extremely imprecise. An estimated 40-75 million people were killed as a result of it, which was 3% of the world’s population, which made it the deadliest war yet. More than half of these losses were Russian (around 25 million) and Chinese (around 20 million). Germany lost around 7 million people—just over half were military deaths and the rest were German civilian deaths, mostly from the Holocaust (and millions more non-Germans were also victims). Britain and the United States each lost around 400,000. The financial cost of the war was both enormous and inestimable, according to most experts, but, based on my research, was in the vicinity of $4-7 trillion in current dollars. What we do know is that on a relative basis the US came out a 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. + +In Part 2 of this chapter, we will explore the new world order starting with the US as the dominant power and tell the story that brings us right up to this moment. Then we will turn to China. + +© 2020 Bridgewater Associates, LP 90 + + +--- + +# Appendix I: Some Historical Cases of Capital Wars + +| Country | Capital War | Imposing Country | Targeted Country | Was Hot War? | Fin. Asset Blocking | Freezing/Seizure | Financial Access | Blockades/Embargoes of Key Trade | +| ------------ | ------------------------- | ---------------- | --------------------- | ------------ | ------------------- | ---------------- | ---------------- | -------------------------------- | +| 2014-Present | Venezuela | USA | Venezuela | No | - | Moderate | Moderate | Moderate | +| 2014-Present | Russia | USA | RUS | Not Directly | - | Targeted | Moderate | Moderate | +| 1986-Present | Syria | USA | Syria | Yes | No | Moderate | Severe | Severe | +| 1980-2003 | Iraq Wars | USA, UN | Iraq | Yes | Yes | Moderate | Severe | Severe | +| 1979-Present | Iran | USA | Iran | No | - | Moderate | Severe | Severe | +| 1973-1974 | OAPEC Oil Embargo | OAPEC | Dev World | No | - | No | No | Severe | +| 1960-1989 | Cuba | USA | Cuba | No | - | Severe | Severe | Severe | +| 1956 | Suez Crisis | USA | GBR | Yes | No | No | Severe | No | +| 1954-1974 | Vietnam | USA | N. Vietnam | Yes | Yes | Severe | Severe | Severe | +| 1950-Present | North Korea | USA | N. Korea | Yes | No | Moderate | Severe | Severe | +| 1948-1991 | Cold War | USA | USSR | No | - | No | Severe | Severe | +| 1940, 43 | WWII | USA, GBR | Neutrals | Not Directly | - | Moderate | No | Moderate | +| 1939 | WWII | USA | USSR | Not Directly | - | No | No | Moderate | +| 1939-45 | WWII | DEU | GBR, USA | Yes | Yes | Severe | -\* | Severe | +| 1939-45 | WWII | GBR | DEU, JPN, ITA | Yes | Yes | Severe | Severe | Severe | +| 1938-1945 | WWII | USA | DEU, JPN | Yes | Yes | Severe | Severe | Severe | +| 1936, 41, 44 | WWII | USA | ESP | No | - | Moderate | No | Moderate | +| 1935, 40-45 | WWII | USA | ITA | Yes | Yes | Severe | Severe | Severe | +| 1914-1918 | WWI | DEU | GBR, FRA, USA | Yes | No | Severe | -\* | Severe | +| 1914-1918 | WWI | USA | DEU | Yes | No | Severe | -\* | Severe | +| 1914-1918 | WWI | FRA | DEU | Yes | No | Severe | -\* | Severe | +| 1914-1918 | WWI | GBR | DEU | Yes | No | Severe | Severe | Severe | +| 1861-1865 | US Civil War | USA (South) | USA (North), GBR, FRA | Yes | No | Ineffective | -\*\* | Moderate | +| 1861-1865 | US Civil War | USA (North) | USA (South) | Yes | No | Severe | -\*\* | Severe | +| 1807-1815 | War of 1812 | GBR | USA, FRA | Yes | Yes | -\*\* | -\*\* | Severe | +| 1807-1815 | War of 1812 | USA | GBR, FRA | Yes | Yes | -\*\* | -\*\* | Moderate | +| 1806-1815 | War of 1812 | FRA | USA, GBR | Yes | - | -\*\* | -\*\* | Severe | +| 1803-1815 | Napoleonic Wars | GBR | FRA | Yes | No | -\*\* | -\*\* | Severe | +| 1803-1815 | Napoleonic Wars | FRA | GBR | Yes | No | -\*\* | -\*\* | Severe | +| 1781-1784 | Fourth Anglo-Dutch War | GBR | NLD | Yes | No | -\*\* | -\*\* | Severe | +| 1775-1783 | Revolutionary War | GBR | USA | Yes | No | -\*\* | -\*\* | Severe | +| 1756-1763 | Seven Years' War | GBR | FRA | Yes | Yes | -\*\* | -\*\* | Severe | +| 1672-1674 | Third Anglo-Dutch War | FRA, GBR | NLD | Yes | No | -\*\* | -\*\* | Ineffective | +| 1672-1678 | Franco-Dutch War | FRA, GBR | NLD | Yes | No | -\*\* | -\*\* | Ineffective | +| 1665-1667 | Second Anglo-Dutch War | NLD | GBR | Yes | Yes | -\*\* | -\*\* | Moderate | +| 1655-1660 | Dutch-Swedish War | SWE | NLD | Yes | Yes | -\*\* | -\*\* | Moderate | +| 1651-1654 | First Anglo-Dutch War | GBR | USA, NLD | Yes | Yes | -\*\* | -\*\* | Moderate | +| 1645-1669 | Cretan War | ITA | OTT | Yes | Yes | -\*\* | -\*\* | Severe | +| 1618-1648 | Thirty Years' War | NLD | ESP | Yes | No | -\*\* | -\*\* | Moderate | +| 1602-1654 | Dutch-Port. Colonial Wars | NLD | POR | Yes | No | -\*\* | -\*\* | Severe | + +* Markets were broadly closed for significant periods of the war. + +**Evidence for financial asset seizures and restrictions were limited for pre-20th century conflicts, though many of these conflicts focused upon controlling territories that were valuable sources of revenue (e.g., colonies, trading posts). + +© 2020 Bridgewater Associates, LP + +91 + +--- + +Appendix II: Cases of Market Closures in the World Wars + +The table below provides a list of all the key countries that closed their markets during WWII to give you an idea of how these things go. + +| Reason | Country | Break Date | Return Date | Length (Months) | Action Pre Stop (1 Year Prior) | Action Upon Re-Opening | +| ------------------------ | ----------- | ---------- | ----------- | --------------- | ------------------------------ | --------------------------------------------- | +| WWII - Annexed by DEU | Austria | Apr-1938 | Dec-1946 | 104 | -18.0% | 94.0% | +| WWII - Invaded by DEU | Czech. | Oct-1938 | Jan-1940 | 15 | -20.5% | 1.5%, closes again in '43 | +| WWII - Invaded by DEU | Poland | Jul-1939 | --- | --- | -16.9% | Didn't re-open until 1991 | +| WWII - Invasion by USSR | Finland | Dec-1939 | Mar-1940 | 3 | -19.2% | -10.1% | +| WWII - Invaded by DEU | Denmark | Apr-1940 | Jun-1940 | 2 | -32.8% | -8.4% | +| WWII - Invaded by DEU | Norway | Apr-1940 | Jun-1940 | 2 | -27.4% | -15.4% | +| WWII - Invaded by DEU | Belgium | May-1940 | Dec-1940 | 7 | -26.7% | 85%, closes again in '44 | +| WWII - Invaded by DEU | Netherlands | May-1940 | Sep-1940 | 4 | -23.0% | 10.5% | +| WWII - Mobilization | Switzerland | May-1940 | Jul-1940 | 2 | -19.0% | -20.7% | +| WWII - Invaded by DEU | France | Jun-1940 | Apr-1941 | 10 | -12.2% | 82.4% | +| WWII | Japan | Jun-1944 | Apr-1949 | 58 | -21.1% | -94.9% | +| WWII | Hungary | Jul-1944 | Aug-1946 | 25 | -49.1% | Brief re-opening before being dissolved again | +| WWII - Invaded by Allies | Germany | Aug-1944 | Jan-1950 | 65 | -1.3% | -83.4% | + +Sources: Jorion and Goetzmann “Global Stock Markets in Twentieth Century” (1999) + +© 2020 Bridgewater Associates, LP 92 + +--- + +The Big Cycle of the United States and the Dollar, Part 2 + +# The New World Order from 1945 until Now + +As is typical after wars, World War II’s winning powers—most importantly the US, Britain, and the Soviet Union (then called “the Big Three”)—led meetings to create the new world order, which included carving up the world into geographic areas of control and establishing new money and credit systems. While France, China, and a couple of other countries were technically aligned with these winning countries, they were lesser players. And with Germany, Japan, and Italy defeated and broken by the war, they were neither leading nor independent powers; they were subordinate to and aligned with the US. Britain, which was essentially bankrupt, was also aligned with the US. The Soviet Union was the leading rival power that was not aligned with the US, so it formed its own camp with its own allies. While there was relatively good cooperation between the two camps immediately after the war, it didn’t take long for the world to become divided between the US-led capitalist/democratic camp and the Soviet-controlled communist/autocratic camp, each with its own monetary/economic systems, though there were a small number of less significant countries that were non-aligned. + +# Rough Estimates of Relative Standing of Great Empires + +| United States | China | United Kingdom | Russia | +| ------------- | ----- | -------------- | ------ | +| Empires | | | | +| Max | | | | +| Other | | | | +| All-Time | | | | +| Relative | | | | +| Level | | | | +| 0.0 | | | | +| 0.2 | | | | +| 0.4 | | | | +| 0.6 | | | | +| 0.8 | | | | +| 1.0 | | | | + +1940 1950 1960 1970 1980 1990 2000 2010 2020 + +We will now delve into this story more closely. + +© 2020 Bridgewater Associates, LP 93 + +--- + +# The Post-War Geopolitical and Military System + +The three major powers and others got together in different conferences—the Yalta Conference, the Potsdam Conference, and the Bretton Woods Conference were the most notable—and carved up the world with US-controlled capitalist/democratic countries on one side and Soviet-controlled communist/autocratic countries on the other, with each bloc having its own monetary systems. Germany was split into pieces, with the United States, Great Britain, and France having control of West Germany and Russia controlling East Germany. Japan was under US control, and China returned to a state of civil war between communists and the capitalists (i.e., the Nationalists). Unlike after World War I when the United States chose to be relatively isolationist, after World War II the United States took the primary leadership role in the world as it had most of the economic, geopolitical, and military power. + +Geographically the US-led Western world extended east from the US through Western Europe into Germany, which was split into West Germany (which was controlled by the US and its allies) and East Germany along a line of division that became known as the Iron Curtain. East of that line, going through Eastern Europe and the Soviet Union to Korea was Soviet-controlled. Korea, like Germany, was split with the Soviets controlling the north and the Americans controlling the south. China, which was essentially left weak and in civil war, got back Shanghai and other previously held areas within the mainland but was left without Hong Kong (though with an agreement from 1898 to get large portions of it back after 99 years) and Formosa (now Taiwan). China had an initially cooperative relationship with the Soviet Union that didn’t last long. In the other direction, going west of the US into the Pacific, the US-controlled areas extended all the way to the southern half of Korea. The British Empire’s areas of control or influence remained largely the same right at the end of the war, except for some minor additions. As for geopolitical institutions, the United Nations was created in 1945, and it was located in the US (New York), reflecting the US being the leading world power. + +Ideologically, the US-led world was capitalist and democratic while the Soviet-led world was communist and autocratic. The US-led monetary system for the US-led countries linked the dollar to gold and most other countries’ currencies were tied to the dollar. This system was followed by over 40 countries. Because the US had around two-thirds of the world’s gold then and because the US was much more powerful economically and militarily than any other country, this monetary system has worked best and carried on until now. The Soviet Union and those countries that were brought into the Soviet Union’s bloc were much less rich and were built on a much weaker foundation. + +The split was clear from the outset. President Truman summarized it outlining what is now referred to as the “Truman Doctrine” in a March 1947 speech: + +“At the present moment in world history nearly every nation must choose between alternative ways of life. The choice is too often not a free one. One way of life is based upon the will of the majority, and is distinguished by free institutions, representative government, free elections, guarantees of individual liberty, freedom of speech and religion, and freedom from political oppression. The second way of life is based upon the will of a minority forcibly imposed upon the majority. It relies upon terror and oppression, a controlled press and radio, fixed elections, and the suppression of personal freedoms. I believe that it must be the policy of the United States to support free peoples who are resisting attempted subjugation by armed minorities or by outside pressures.” + +Governance between countries is very different from governance within countries. That is because within countries there are laws and standards of behavior that govern, whereas between countries raw power matters most, and laws, rules, and even mutually agreed treaties and organizations for arbitration such as the League of Nations, the United Nations, and the World Trade Organization don’t matter much. Operating internationally is like operating in a jungle in which there is survival of the fittest and most anything goes. That is what makes having a strong military so important. + +75 https://avalon.law.yale.edu/20th_century/trudoc.asp + +--- + + +# Military Alliances and Nuclear Weapons + +Military alliances were built along the same ideological and geopolitical lines. In 1949 a military alliance of 12 countries (with more joining later) that were in the US camp formed the North Atlantic Treaty Organization (NATO), and in 1954 the Southeast Asia Treaty Organization was established among the US, UK, Australia, France, New Zealand, the Philippines, Thailand, and Pakistan to prevent the spread of communism in Southeast Asia. In 1955, a military alliance of seven countries that were in the Soviet camp formed the Warsaw Pact. + +As shown in the chart below the Americans and Soviets invested massively in building up their nuclear weapons and a number of other countries followed. These weapons were never used because of the deterrence of mutually assured destruction. Still there were a couple of times it came close (e.g., Cuban Missile Crisis of 1962). + +Today, in varying amounts and degrees of capabilities, 11 countries have nuclear weapons or are on the brink of having them. Having nuclear weapons obviously gives one a big negotiating chip in the world power game so it’s understandable why some countries would want to have them and other countries would not want other countries to have them. Of course, in addition to building nuclear capabilities, various new other weapons systems were created, and though there were no nuclear wars, there were a number of wars to counter communism and other geopolitical US adversaries, most notably the Korean War in the 1950s, the Vietnam War in the 1960s, the two Gulf Wars in 1990 and 2003, and the War in Afghanistan from 2001 until now. These were costly in terms of money, lives, and public support for the United States. Were they worth it? That’s for others to decide. For the Soviet Union, which had a much smaller and weaker economy than the US, spending enough to compete with the US militarily and to maintain its empire was bankrupting. + +| Nuclear Weapons Stockpile (# Warheads, ln) | USA | GBR | CHN | IND | RUS | FRA | +| ------------------------------------------ | ------ | --- | --- | --- | --- | --- | +| 1945 | 100000 | | | | | | +| 1965 | 10000 | | | | | | +| 1985 | 1000 | | | | | | +| 2005 | 100 | | | | | | +| | 10 | | | | | | +| | 1 | | | | | | + +Of course military power consists of a lot more than nuclear weapons and a lot has changed since the Cold War. Where do things now stand? While I’m no military expert, I get to speak to some who have led me to believe that, while the US remains the strongest military power overall, it is not dominant in all parts of the world in all ways, and military challenges to it are rising. I’m told that there is a significant chance that the US would lose wars against China and Russia in their geographic areas of strength—or at least would be unacceptably harmed—and would also be unacceptably harmed by some second-tier powers. This is not the good ol’ days early after the beginning of the post-1945 world order in which the US was clearly the sole dominant military power that could not be threatened by others. While there are a number of high-risk scenarios, the most worrying one is a forceful move by China to bring Taiwan under its control. + +What would the next military conflict look like? It seems clear that new war technologies would be deployed so the war of the future will be very different from the last war in the same ways more recent wars were fought with different technologies than the ones before them. Classically the country that wins wars outspends, out-invests, and outlasts the opposition. 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 risk for the leading powers is that they lose the economic and technology races over time. + +© 2020 Bridgewater Associates, LP + +--- + +# The Post-War Monetary and Economic Systems + +Money and transactions between countries were and still are very different from money and transactions within countries. That is because within countries governments get to control the key aspects of money and transactions (such as what money is used, how much of it there is, what it costs, who handles it and how, etc.), whereas in transactions between countries the key aspects of money and transactions have to be mutually agreed-on. For example, within a country the government can mandate that only the paper money that it prints is acceptable, whereas between countries only the money that those who are transacting agree is acceptable will be acceptable. That is why gold and reserve currencies have been so important in transactions between countries while people within countries typically exchange this paper with others in the country, oblivious to the fact that that money is not much valued outside the country. + +Within countries individuals were not allowed to own or transact in gold 76 because governments wanted to be able to control the supply and value of people’s money and the distributions of people’s wealth. People’s abilities to own gold could threaten the system because gold is an alternative money that is not controlled by the government that people could use instead of the government’s money. So (to simplify a bit) within countries people or companies would use the government-controlled paper money and when they wanted to buy something from another country they would typically exchange their own paper currency for the sellers’ paper currency with the help of their central bank and the central bank would settle up with the other central bank in gold. Or, if they were American, they would typically pay in dollars and the seller would turn that money in to its country’s central bank for its local currency and that central bank would turn its surplus of dollars in for gold, so gold would leave the US central bank reserve account and go into the other central bank account. As a result, a central bank’s gold reserve savings would go down if a country spent more than it earned and would go up if a country earned more than it spent. + +As for the particular new post-war monetary and economic systems, there was one for the US-led camp and one for the Soviet-led camp, though there were also some non-aligned countries that had their own non-aligned currencies that were not widely accepted. Those countries in the US camp—which consisted of 44 countries—gathered in Bretton Woods, New Hampshire, in 1944 to make a monetary system that put the dollar and gold at the center of it. The Soviet Union created its own monetary system built around its currency, the ruble. It was a much less significant monetary system. + +The Bretton Woods Agreement put the dollar in the position of being the world’s leading reserve currency. This was natural because the two world wars made the US the richest and most powerful country by far. It earned this money via its large exports, and by the end of World War II it had amassed the greatest gold/money savings ever. That savings accounted for around two-thirds of the world’s government-held gold/money and was equivalent to eight years of import purchases. Even after the war, it continued to earn a lot of money by continuing to export a lot. In other words, the US was very rich. + +By comparison, other countries were broke, which made it difficult to buy what they needed from the US and other countries. Besides not having any money Europe and Japan had virtually nothing to sell after the war because their economies were destroyed. As a solution, and to fight the spread of communism, the US offered massive aid packages to Western Europe and Japan (known as the Marshall and Dodge plans) which were a) good for these devastated nations, b) good for the US economically because these countries used the money to buy US goods, c) good for the US’s geopolitical influence abroad, and d) good for reinforcing the dollar’s position as the world’s dominant reserve currency because they increased its usage. All leading central banks in history have followed variations on this process. Most recently China’s Belt and Road Initiative has offered similar advantages to China. + +As for monetary policy, from 1933 until 1951 the amount of money, the cost of money (i.e., interest rates), and where that money went was controlled by the Federal Reserve to serve the greater objectives of the country rather + +76 For example, Americans were by and large not allowed to own gold from 1933 to 1974. + +--- + + +than to let the free market allocate money and credit. More specifically it printed a lot of money to buy debt, capped interest rates that lenders could charge, and controlled what money was allowed to go into, so high inflation did not drive interest rates to unacceptable heights and there were no investment options more attractive than the debt the government wanted people to save in. + +Following a brief post-war recession that was due to the government’s war spending declining, the US entered a prolonged period of peace and prosperity because the new and mutually reinforcing Big Cycles transpired. Most importantly a new debt cycle began with the new monetary system, wealth and values gaps were reduced so the environment was one of greater unity in pursuit of peace and prosperity, and there was a dominant power that nobody wanted to fight. Also, stock prices were very cheap. As a result, the US economy and markets were very strong for many years to come. + +During the post-war adjustment period between mid-1945 and mid-1947 over 20 million people were released from the armed forces and related employment so unemployment rate rose from 1.9% to just 3.9%. At the same time pent-up demand and savings to finance that demand had built up so the removal of rationing laws, which had limited people’s ability to buy consumer goods, fueled a consumer spending surge. Cheap mortgages were also available for veterans, which led to a housing boom that fueled the expansion. There was a return to profit making activities, which raised the demand for labor so employment was very strong. Exports were strong because the US government (via the Marshall and Dodge plans) helped build the market for US goods abroad to be strong. Also the US private sector went global and invested abroad from 1945 through the 1970s. That environment was great for business, profits, and stocks because American corporations were extremely profitable after the war at the same time that stocks were very cheap in relation to bonds (e.g., stock earnings and dividend yields were a lot higher than bond yields). Stocks were cheap because those who went through the depression and war years were very risk-averse, so they significantly preferred a safe income stream to a risky one. This set of conditions made a multi-decade prosperity and bull market in stocks that reinforced New York’s dominance as the world’s financial center, bringing in more investment and further strengthening the dollar as a reserve currency. + +This peace and prosperity also provided the funds to improve education, invent fabulous technologies (e.g., go to the moon), and do a lot more. In other words, post-war the United States was in one of those great mutually and self-reinforcing Big Cycle upswings. It was popularly believed in the mid-1960s that economics was a science so we could expect economic prosperity and the stock market always went up with wiggles around the uptrend so one should make “dollar cost average” purchases—i.e., buy consistently so that one would buy on the dips as well as the highs. Because of that confident psychology, which was the opposite of the conservative psychology that existed in the 1950s, the stock market hit its high in 1966, which marked the end of the good times for 16 years, until the 1982 stock market bottom, though nobody knew it at the time because the mood was one of great optimism and the decline from the market top looked like one of those dips that one should buy into. + +It was during the 1960s that my own direct contact with events began. I started investing in 1961 at age 12. Of course I didn’t know what I was doing at the time and had no appreciation for how lucky my contemporaries and I were. I was born at the right time (just after the war at the beginning of a post-war Big Cycle upswing brought about by the early upswing in the long-term debt cycle and a dominant world power that produced decades of peace, prosperity, and bull markets) in the right place (in the United States, which was the most prosperous and powerful country in the world). I was also very lucky to be raised by parents who loved and cared for me in an era when the American Dream of equal opportunity allowed me to get a good public school education and come out into a job market that gave me equal and excellent opportunity at an exciting time of idealism and dreaming big that inspired me. I vividly remember John Kennedy, a charismatic leader who inspired the nation to journey to the + +77 While 1933 to 1951 was the period from the Roosevelt peg break to the Monetary Accord between the Federal Reserve and Treasury, the policy of explicit yield curve control, in which the Federal Reserve controlled the spread between short-term and long-term interest rates, lasted from 1942 to 1947. + +78 https://www.mercatus.org/publications/economic-history/economic-recovery-lessons-post-world-war-ii-period + + + +--- + + +moon and to fight to eliminate poverty and assure civil rights. One could dream big, work hard, and make those dreams happen, and successful people were role models then. In the 1960s it was great to be middle class. The United States was the leading manufacturing country so labor was valuable. Most adults could get a good job, and their kids could get a college education and rise without limitation. Since the majority of people were middle class the majority of people were happy. + +Throughout the prosperous 1960s, the US did the classic things that helped the world to become more dollarized. For example, US banks rapidly increased their operations and lending in foreign markets. In 1965, only 13 US banks had foreign branches. By 1970, 79 banks had them, and by 1980 nearly every major US bank had at least one foreign branch, and the total number of branches had grown to 787. Global lending of dollars by American banks boomed. However, as is typical, a) those that prospered overdid things by operating financially imprudently while b) global competition, especially from Germany and Japan, increased. As a result, the lending and the finances of Americans began to deteriorate at the same time as its trade surpluses disappeared. + +# The Late-1960s Weakening Fundamentals That Led to the End of the Bretton Woods Monetary System + +As explained in Chapter 2, when claims on hard money (i.e., notes or paper money) are introduced, at first there is the same number of claims on the “hard money” as there is hard money in the bank. However, the holders of the paper claims and the banks soon discover the wonders of credit and debt. They can lend these paper claims to the bank in exchange for an interest payment so they get interest. The banks that borrow it from them like it because they lend the money to others, who pay a higher interest rate so the banks make a profit. Those who borrow the money from the bank like it because it gives them buying power that they didn’t have. And the whole society likes it because asset prices and production rise. + +After 1945, foreign central banks had the option of holding interest-rate-paying debt or holding non-interest-rate-earning gold. Because dollar-denominated debt was considered as good as gold, convertible into gold, and higher-earning because it provided interest (which gold didn’t provide), central banks shrank their gold holdings relative to their dollar-denominated debt holdings from 1945 until 1971. As explained in the Appendix to Chapter 2, “The Changing Value of Money,” investors making such a move is a classic behavior and ends when a) the claims on the real money (i.e., gold) substantially exceed the amount of real money in the bank and b) one can see that the amount of real money in the bank (i.e., gold reserves) is going down. That is when no interest rate can be high enough for it to make sense to hold the debt (i.e., claims on the real money) rather than to turn one’s paper money in for gold. At that time a run on the bank occurs and a default and debt restructuring have to happen. That is what led to the breakdown of the gold-linked Bretton Woods monetary system. + +While the following summary repeats some of what was said in prior chapters, it is appropriate to recall it here. + +As is typical of this peaceful and prosperous part of the cycle, in the 1950-70 period there was productive debt growth and equity market developments that were essential for financing innovation and development early on and became overdone later. In the 1960s Americans spent a lot on consumption and Germany and Japan, which had largely recovered from the war, were increasingly effective competitors in producing manufactured goods such as cars so US trade balances were worsening. At the same time, the US government was spending increasing amounts on fighting the Vietnam War and domestic social programs (called “guns and butter”). To finance all this spending, the US Federal Reserve allowed the creation of a lot more claims on gold than could actually be converted into gold at the set $35 price. As the paper money was turned in for the hard money (gold), the quantity of gold in the US central bank went down at the same time as the claims on it continued to rise. + +While I subsequently discovered that the equal opportunity I was afforded wasn’t made available to a lot of people, I learned from all the people around me—so it was a common belief for all of those I knew—that it should be made available to all people regardless of race, creed, color, or gender so programs like the Civil Rights Movement and the War on Poverty were aimed at providing it. Unlike my earlier descriptions of earlier times that were solely based on my research, my descriptions of the post-1960s period comes with vivid memories of what I had contact with. + +Source + + + +--- + + +As a result, the Bretton Woods monetary system broke down on August 15, 1971, when President Nixon, like President Franklin Roosevelt on March 5, 1933, broke the US’s pledge to allow holders of paper dollars to turn them in for gold. As shown in the below charts, as the US was spending more than it was earning and the paper money claims on gold were turned in for gold, US gold reserves went down until the US government realized that they would run out and stopped allowing the conversion at which time the dollar plunged in value relative to gold and the two leading alternative currencies, which were the German deutschmark and the Japanese yen. + +| | | USA Gold Reserves (Mln Oz) | | DEM vs. USD FX (Indexed to 1950) | JPY vs. USD FX (Indexed to 1950) | Gold Price (Indexed to 1950) | | | | | +| - | - | -------------------------- | --- | -------------------------------- | -------------------------------- | ---------------------------- | --- | --- | --- | - | +| | | 5 | 4 | 3 | 2 | 1 | 0 | | | | +| | | | 700 | 600 | 500 | 400 | 300 | 200 | 100 | 0 | + +As I recounted in Chapter 2, I remember the devaluation of the dollar very well. I was clerking on the floor of the New York Stock Exchange at the time. I was watching on TV as President Nixon told the world that the dollar would no longer be tied to gold. I thought, “Oh my God, the monetary system as we know it is ending,” and it was. The next day was Monday. When I got to work I expected there to be pandemonium, with stocks falling. There was pandemonium all right, but stocks were rising. Because I had never seen a devaluation before, I didn’t understand how they worked. Then I looked into history and found that on the evening of March 5, 1933, also a Sunday, President Franklin Roosevelt had given essentially the same speech, doing essentially the same thing, which yielded essentially the same result over the following months (a devaluation, a big stock market rally, and big gains in the gold price). As I looked further, I saw that it had happened many times before in many countries for the same reason—too much debt that needed money to ease the debt burden—with essentially the same proclamations by top government officials. More recent cases that you might remember include the Fed announcing QE on November 25, 2008, which followed Congress approving Treasury Secretary Hank Paulson’s request for the federal government to provide $700 billion for asset purchases; Mario Draghi in July 2012 stating that the ECB would “do whatever it takes,” which was followed by massive printing of money and buying of government debt; and March 15, 2020, when President Trump and leaders of both houses of Congress agreed on an over $2 trillion stimulus plan, and Fed Chair Powell announced big interest rate cuts to 0%, a $700 billion QE plan, and a slew of other supports, with both announcements followed by other big increases in these numbers. + +# The Inflationary and Troubled 1970s + +After the 1971 delinking of the dollar and other currencies from gold, the world moved to an unanchored fiat (Type 3) monetary system and the dollar fell in value against gold, other currencies, stocks, and eventually just about everything. The new monetary system was negotiated by the leading economic policymakers of the United States, Germany, and Japan. If you want to read a great description of this process of figuring out how to go from the old monetary system to the new fiat one, I recommend *Changing Fortunes* by Paul Volcker and Toyoo Gyohten. Volcker was the leading American policymaker to determine how the new post-Bretton Woods monetary system would work. He was the person who knew more about monetary systems and was more at the center of the US dollar system from before the 1971 monetary breakdown (he was the Undersecretary of International Monetary Affairs under Nixon when Nixon severed the link with gold) through the 1970s inflation that resulted from its breakdown. He was eventually called on to break the back of inflation as head of the Federal Reserve from 1979 until 1987. He did more to shape and guide the dollar-based monetary system before, during, and after these years than any other person. I was lucky enough to have gotten to know him well so I can + + + +--- + + +personally attest to the fact that he was a person of great character, capabilities, influence, and humility—a classic hero/role model in a world that lacks hero/role models, especially in economic public service. I believe that he and his thinking deserve to be studied more. + +As a result of going off the gold-linked monetary system that constrained money and credit growth, there was a massive acceleration of money and credit, inflation, oil and commodity prices, and a panic out of bonds and other debt assets that drove interest rates up and caused a run into hard assets like real estate, gold, and collectibles for most of the next 10 years, from 1971 to 1981. + +I remember inflation psychology very well; it led Americans to borrow money and immediately take their pay checks to buy things to “get ahead of inflation.” The panic out of dollar debt also led interest rates to rise and drove the gold price from the $35 that it was fixed at in 1944 and officially stayed at until 1971 to a then-peak of $850 in 1980. I remember inflation becoming the biggest political problem, which led President Nixon to create controls on prices and wages, which created great economic distortions that, along with Vietnam and Watergate, brought him down. Then President Ford passed around buttons that said “WIN,” which stood for “Whip Inflation Now.” I remember President Carter facing even worse inflation problems, and he brought Volcker back as head of the Fed to break the back of inflation. Volcker was effective, but it cost Carter his presidency. I saw up close how the loose money and credit policies of the 1970s led to dollar-denominated debt being liberally lent by banks to borrowers around the world, especially to those in fast-growing, commodity-producing emerging countries, and I saw how the world was in the bubble phase of the debt cycle in the late 1970s. I saw how the panic out of dollars and dollar-debt assets and into inflation-hedge assets, as well as the rapid borrowing of dollars, risked leading dollars and dollar debt to cease being an accepted storehold of wealth. + +While most people didn’t understand how the money and credit dynamic worked, they felt the pain of it in the form of high inflation and high interest rates, so it was a chronic political issue. At the same time, in the 1970s there was a lot of pain, conflict, and rebellion due to the war in Vietnam, oil embargoes that led to high gas prices and gas rationing, labor union fights with companies over wages and benefits, Watergate and the Nixon impeachment, etc. At the time, it was also widely believed that the labor unions were out of control with their demands for more pay and less work and needed to be controlled, so liberalism was losing popularity and conservatism was gaining popularity. These problems peaked in the late 1970s as inflation spiked and 52 Americans were held hostage for 444 days at the US Embassy in Tehran, Iran. Americans felt that the country was falling apart and lacked strong leadership. At the same time economic conditions in communist countries were even worse. + +In China, Mao Zedong’s death in 1976 led Deng Xiaoping to come to power in 1978, which led to a shift in economic policies that included capitalist elements like private ownership of businesses, the development of debt and equities markets, entrepreneurial technological and commercial innovations, and even the flourishing of billionaire capitalists—all under the strict control of the Communist Party. This shift in Chinese leadership and approaches, while seemingly insignificant at the time, was going to germinate into the biggest single force to shape the 21st century. + +# The 1979-82 Move to Tight Money and Conservatism + +President Carter, who like most political leaders didn’t understand the monetary mechanics very well, knew that something had to be done to stop inflation and appointed a strong monetary policy maker, Paul Volcker, as head of the Federal Reserve in August 1979. In October 1979, Volcker announced that he would constrain money (M1) growth at 5.5%. I ran the numbers, which led me to figure that, if he really did what he said he was going to do, there would be a great shortage of money that would send interest rates through the roof and would bankrupt debtors who could not get the credit they needed and would drive up their debt-service expenses to levels that they couldn’t afford to pay. While it was unimaginable that he would do that, Volcker stuck to that plan despite great political backlash and drove interest rates to the highest level “since Jesus Christ,” according to German Chancellor Helmut Schmidt. + +In the 1980 presidential election Jimmy Carter, who was perceived as a nice but weak liberal Democrat, was voted out and Ronald Reagan, who was perceived as a homebody conservative whom Americans expected would + + + +--- + + +# be stronger and impose disciplines where they were needed, was elected. + +Leading countries at the time (reflected in the G7 that consisted of the US, UK, Germany, Japan, France, Italy, and Canada—which reflects how different the world power balance was 40 years ago versus today) made analogous moves in electing conservatives to bring discipline to their inflationary chaos. On January 20, 1981, the same day Reagan was inaugurated as president, the Iranians released the hostages. Early in their terms, both Reagan in the US and Margaret Thatcher in the UK had landmark fights with labor unions. + +Economics and politics have swings between the left and the right in varying extremes as the excesses of each become intolerable and the memories of the problems of the other fade. It’s like fashion—the width of ties and the lengths of skirts. When there is great popularity of one extreme, one should expect that it won’t be too long before there will be a comparable move in the opposite direction. + +The move to monetary tightness broke the backs of debtors and curtailed borrowing, which drove the world economy into its worst downturn since the Great Depression. In seeing the stock market, the economy, and the prices of inflation-hedge assets plunging, the Federal Reserve slowly started to cut interest rates, but the markets continued to decline. Then Mexico defaulted on its debt in August 1982. Interestingly, on the day that Mexico defaulted on its debt (August 23, 1982), the US stock market rallied, which was a straw in the wind that I missed. + +What happened next created another jarringly painful learning experience for me. While I was able to anticipate the debt crisis, which was profitable for me, it also led me to realize that the banks that had lent that money wouldn’t get paid, which led me a) to anticipate a debt-default-triggered depression that never came, b) to lose a lot of money betting on it, and c) to be very publicly wrong. As a result of my personal losses and losses of clients, I had to let everyone in my fledgling Bridgewater Associates go and was so broke I had to borrow $4,000 from my dad to help pay for my family’s bills. At the same time this painful experience was one of the best things that ever happened to me because it changed my whole approach to decision making. It gave me the fear of being wrong and the humility I needed to balance with my audacity without killing my audacity. It led me to make Bridgewater as an idea meritocracy in which I brought in the smartest independent thinkers I could find to argue with me, which resulted in our doing great over the next 40+ years. I still carry that fear of being wrong, which is why I am doing this research, why I want the greatest thinkers in the world to challenge my thinking and to stress test it, and why I am passing this research to you for you to take or leave as you see fit. + +# Why was I wrong in 1982, and what did I learn that would be an important principle for the future? + +What I had missed and learned from this experience was that when debts are in the currencies that central banks have the ability to print and restructure, debt crises can be well-managed, so they are not systemically threatening. Because the Federal Reserve could provide the banks that made the loans that weren’t being paid back with money, they didn’t have a cash flow problem, and because the American accounting system didn’t require the banks to account for these bad debts as losses, there was no big problem that couldn’t be worked out. I also learned that the value of assets is the reciprocal of the value of money and credit (i.e., the cheaper money and credit are, the more expensive asset prices are) and the value of money is the reciprocal of the quantity of it in existence, so when central banks are producing a lot of money and credit and making it cheaper, it is wise to be more aggressive in owning assets. + +# The Disinflationary and Booming 1980s + +In the 1980s there was a stock market and economic boom that was accompanied by falling inflation and falling interest rates in the United States at the same time as there were inflationary depressions in the debt-burdened emerging economies that didn’t have a central bank to bail them out. The debt-restructuring process progressed slowly from 1982 until 1989 when an agreement called the Brady Bond agreement, named after Nicholas Brady, who was the US Treasury Secretary at the time, was created and started to bring to an end to “the lost decade” in these countries (as agreements were reached with different countries through the early ’90s). This whole 1971-91 up-and-down debt cycle, which profoundly affected just about everyone in the world, was the result of the US going off the gold standard, the inflation that resulted from it, and having to break the back of the inflation. + +© 2020 Bridgewater Associates, LP + +--- + + +through tight money policies that led to the strength in the dollar and dramatic fall in inflation. In the markets that big cycle showed up via a) the soaring of inflation and inflation-hedge assets and bear markets in bonds in the 1970s, b) the 1979-81 bone-crushing monetary tightening that made cash the best investment and led to a lot of deflationary debt restructuring by non-American debtors, and then c) falling inflation rates and the 1980s’ excellent performance of bonds, stocks, and other deflationary assets. The charts below convey it very well, as they show the swings up and down in dollar-denominated inflation rates and interest rates from 1945 to the present. One needs to keep these moves and the mechanics behind them in mind in thinking about the future. + +| USA Long Rates | USA Short Rates | USA Core Inflation | USA Headline Inflation | +| -------------- | --------------- | ------------------ | ---------------------- | +| | | 20% | 20% | +| | | 18% | 18% | +| | | 16% | 16% | +| | | 14% | 14% | +| | | 12% | 12% | +| | | 10% | 10% | +| | | 8% | 8% | +| | | 6% | 6% | +| | | 4% | 4% | +| | | 2% | 2% | +| | | 0% | 0% | +| | | -2% | -2% | + +Through it all the dollar remained the world’s leading reserve currency. The entire period was a forceful demonstration of the benefits to the US of having the world’s reserve currency that most of the world’s debts and money are denominated in. + +# 1990-2008: Globalizing, Digitalizing, and Booming Financed by Debt + +Geopolitically, because of its economic failures, the Soviet Union could not afford to support a) its empire, b) its economy, and c) its military at the same time in the face of US President Ronald Reagan’s arms race spending. As a result the Soviet Union broke down in 1991 and abandoned communism. + +It was apparent that communism failed or was failing everywhere, so many countries moved away from it. The breakdown of the Soviet Union’s money/credit/economic system and its large foreign debts were disastrous for the Soviet Union economically and geopolitically through most of the 1990s. That is a whole other interesting story that we won’t get into now. In any case, it is notable that in the 1980-95 period most communist countries abandoned classic communism, and the world entered a very prosperous period of globalization and free-market capitalism. + +Since the early 1990s there have been three economic cycles that brought us to where we now are—one that peaked in the 2000 dot-com bubble that led to the recession that followed, one that peaked in the 2007 bubble that led to the 2008 global financial crisis, and one that peaked in 2019 just before the 2020 coronavirus-triggered downturn. During this 1990-2000 period we also saw the decline of the Soviet Union, the rise of China, globalization, and advances in technologies that replaced people, which was good for corporate profits and widened the wealth and opportunity gaps. + +Notable markers that reflected these developments were making the internet (i.e., the World Wide Web) available to the public on August 6, 1991, which kicked off the dot-com/tech boom, and the creation of the World Trade Organization on January 1, 1995, to facilitate globalization. “Technology development” and globalization that replaced American workers’ jobs, especially those in the manufacturing sector, flourished from the 1990s until around Donald Trump’s election in 2016. In that roughly 30-year period countries and country borders faded in importance, and items and the incomes they produced were generally made wherever they could be most cost-effectively produced, which led to production and development in emerging countries, accelerating mobility of + + + +--- + + + +people between countries, narrowing wealth gaps between countries, and ballooning wealth gaps within them. Lower-income workers in developed countries suffered, while higher-income workers in productive emerging countries made fortunes. Though a bit of an oversimplification, it’s accurate to say that this was a period in which workers in other countries (especially those in China) and machines replaced middle-class workers in the United States. + +# The chart below shows the balances of goods and services for the United States and China since 1990 in real (i.e., inflation-adjusted) dollars. + +As you will see when we look at China in the next section of this book, China’s economic reform and open-door policies after Deng Xiaoping came to power in 1978 and the welcoming of China into the World Trade Organization in 2001 led to the explosion of Chinese competitiveness and exports. Note the accelerations in China’s surpluses and the US deficits from around 2000 to around 2010 and then some narrowing of these differences, with China still tending to run surpluses and the US still running deficits. + +# Exports of Goods and Services Minus Imports of Goods and Services (Real, USD Bln, 12mma) + +| Country | USA | | CHN | | | | +| ------------------- | ------ | ------ | ---- | ---- | - | - | +| 600 | 400 | 200 | 0 | | | | +| Country gets richer | -200 | -400 | -600 | -800 | | | +| Country gets poorer | -1,000 | -1,200 | | | | | + +1990 2000 2010 2020 + +During this period debt and non-debt liabilities like pension and healthcare liabilities grew a lot in the US and debts were used to finance speculations leading up to the dot-com bubble of 2000 and the mortgage bubble of the mid-2000s that led to busts that were stimulated out of by the creation of more money and debt. These debt cycles are both undesirable and understandable because there is a tendency to favor immediate gratification over long-term financial safety, particularly by politicians. + +Most people pay attention to what they get and not where the money comes from to pay for it, so there are strong motivations for elected officials to spend a lot of borrowed money and make a lot of promises to give voters what they want and to take on debt and non-debt liabilities that cause problems down the road. That was certainly the case in the 1990-2008 period. + +Throughout the long-term debt cycle, from 1945 until 2008, whenever the Federal Reserve wanted the economy to pick up it would lower interest rates and make money and credit more available, which would increase stock and bond prices and increase demand. That was how it was done until 2008—i.e., interest rates were cut, and debts were increased faster than incomes to create an unsustainable bubble economy that peaked in 2007. When in 2008 the bubble burst and interest rates hit 0% for the first time since the Great Depression, that changed. As explained more comprehensively in my book Principles for Navigating Big Debt Crises there are three types of monetary policy—1) interest-rate-driven monetary policy (which I call Monetary Policy 1 because it is the first to be used and is the preferable way to run monetary policy), 2) printing money and buying financial assets, most importantly bonds (which I call Monetary Policy 2 and is now popularly called “quantitative easing”), and 3) coordination between fiscal policy and monetary policy in which the central government does a lot of debt-financed spending and the central bank buys that debt (which I call Monetary Policy 3 because it is the third and last approach to be used when the first two cease to be effective in doing what needs to be done). + +© 2020 Bridgewater Associates, LP 103 + +--- + + +# The charts below show how the debt crises of 1933 and 2008 both led to interest rates hitting 0% and were followed by big money printing by the Federal Reserve. + +# Private Sector Non-Fin Debt (%GDP, 6mma) + +| | 180% | 160% | 140% | 120% | 100% | 80% | 60% | 40% | 20% | 0% | | | +| ---------------------- | ---- | ---- | ---- | ---- | ---- | ---- | ---- | ---- | ---- | ---- | ---- | ---- | +| When the cycle changed | | | | | | | | | | | | | +| 1900 | 1910 | 1920 | 1930 | 1940 | 1950 | 1960 | 1970 | 1980 | 1990 | 2000 | 2010 | 2020 | + +# Interest Rates + +# Monetary Base (%GDP) + +| | 28% | 24% | | | 20% | 16% | 12% | 8% | 4% | 0% | | | +| ---------------------- | ---- | ---- | ---- | ---- | ---- | ---- | ---- | ---- | ---- | ---- | ---- | ---- | +| When the cycle changed | | | | | | | | | | | | | +| 1900 | 1910 | 1920 | 1930 | 1940 | 1950 | 1960 | 1970 | 1980 | 1990 | 2000 | 2010 | 2020 | + +This shift had big effects and implications. + +# The 2008-20 Money-Financed Capitalist Boom Period + +In 2008 the debt crisis led to interest rates being lowered until they hit 0%, which led the three main reserve currency countries’ central banks (led by the Fed) to move from an interest-rate-driven monetary policy (MP1) to a printing-of-money- and buying-financial-assets-driven monetary policy (MP2). Central banks printed money and bought financial assets, which put money in the hands of investors who bought other financial assets, which caused financial asset prices to rise, which was helpful for the economy and particularly beneficial to those who were rich enough to own financial assets, so it increased the wealth gap. The putting of a lot of money into the financial system and the driving down of bond yields provided companies with a lot of cheap funding that they used to buy back their own stocks and stocks of related companies that they wanted to acquire, which further bid up stock prices. Basically, borrowed money was essentially free, so investment borrowers and corporate borrowers took advantage of this to get it and use it to make purchases that drove stock prices and corporate profits up. This money did not trickle down proportionately, so the wealth and + +© 2020 Bridgewater Associates, LP + +--- + +Income gaps continued to grow. As shown in the charts below, the wealth and income gaps are now the largest since the 1930-45 period. + +# USA Income Shares + +| | Top 10% | Bottom 90% | +| --- | ------- | ---------- | +| 80% | | | +| 70% | | | +| 60% | | | +| 50% | | | +| 40% | | | +| 30% | | | +| 20% | | | +| 10% | | | +| 0% | | | + +# USA Wealth Shares + +| | Top 0.1% | Bottom 90% | +| --- | -------- | ---------- | +| 50% | | | +| 45% | | | +| 40% | | | +| 35% | | | +| 30% | | | +| 25% | | | +| 20% | | | +| 15% | | | +| 10% | | | +| 5% | | | +| 0% | | | + +In 2016, appealing to those white, socially and economically conservative voters who were hurt by these trends, Donald Trump, a blunt-speaking businessman/capitalist populist of the right, led a revolt against establishment politicians and “elites” to get elected president by promising to support people with conservative values who had lost jobs and were struggling. He went on to cut corporate taxes and run big budget deficits that the Fed accommodated. This was good for stocks, capital markets, businesses, and the capitalists who owned them. While this debt growth financed relatively strong market-economy growth and created some improvements for lower-income earners, it was accompanied by a further widening of the wealth and values gap leading the “have-nots” to become increasingly resentful of the “haves.” At the same time the political gap grew increasingly extreme with intransigent capitalist Republicans on the one side and intransigent socialist Democrats on the other. This is reflected in the two charts below. The first one shows how conservative Republicans in the Senate and House (via the dashed and solid red lines) and how liberal Democrats in the Senate and House (via the dashed and solid blue lines) have become relative to the past. Based on this measure they have become more extreme, and their divergence has become larger than ever before. While I’m not sure that’s exactly right, I think it’s by and large right. + +# Ideological Positions of the Major Parties + +| House Rep. | Senate Rep. | House Dem. | Senate Dem. | +| ---------- | ----------------- | ---------- | ----------- | +| 0% | | | 60% | +| -5% | More Conservative | | 50% | +| -10% | | | 40% | +| -15% | | | 30% | +| -20% | | | 20% | +| -25% | | | 10% | +| -30% | | | 0% | +| -35% | | | | +| -40% | | | | +| -45% | | | | + +Charts based on data from World Inequality Database. + +Based on data from voteview.com. + +© 2020 Bridgewater Associates, LP + +--- + + +The next chart shows the percentage of votes along party lines. As shown approximately 95% of the votes in the House and the Senate have been along ideological lines as of 2016, the highest level in over a century. It continues to be reflected in the reduced willingness to cross party lines to compromise and reach agreements. In other words, the political splits in the country have become deep and intransigent. + +# Share of Congressional Votes Cast Along Party Lines + +| | 100 | +| ---- | --- | +| | 95 | +| | 90 | +| | 85 | +| | 80 | +| | 75 | +| | 70 | +| 1790 | | +| 1810 | | +| 1830 | | +| 1850 | | +| 1870 | | +| 1890 | | +| 1910 | | +| 1930 | | +| 1950 | | +| 1970 | | +| 1990 | | +| 2010 | | + +At the same time, as the US dominance and relative wealth decline and rivalries are intensifying in the US under Trump, this more populist and nationalist leader has taken a more aggressive negotiating posture concerning economic and geopolitical disagreements a) with international rivals, particularly China and Iran, and b) with allies such as Europe and Japan regarding trade and paying for military expenditures. The conflicts with China over trade, technology, geopolitics, and capital are the most important and are intensifying. Economic sanctions such as those that were used in the 1930-45 period are being used or put on the table for possible use. + +Then, in March 2020 after the coronavirus pandemic came along and with it the isolation it necessitated, incomes, employment, and economic activity plunged, the US central government took on a lot of debt to give people and companies a lot of money, and the Federal Reserve printed a lot of money and bought a lot of debt. So did other central banks. As a reflection of this the charts below show the unemployment rates and central bank balance sheets of major countries for as far back as data is available. As shown, all the levels of central bank printing of money and buying of financial assets are near or beyond the previous record amounts in the war years. + +# The United States + +| USA Unemployment Rate | USA CB Balance Sheet (%GDP) | +| --------------------- | --------------------------- | +| 30% | 35% | +| 25% | 30% | +| 20% | 25% | +| | 20% | +| 15% | 15% | +| 10% | 10% | +| 5% | 5% | +| 0% | 0% | + +83 Based on data from voteview.com. + +© 2020 Bridgewater Associates, LP + +106 + + + +--- + +Europe + +# EUR Unemployment Rate + +| 14% | 60% | +| --- | --- | +| 12% | 50% | +| 10% | 40% | +| 8% | 30% | +| 6% | | +| 4% | 20% | +| 2% | 10% | +| 0% | 0% | + +# United Kingdom + +# GBR Unemployment Rate + +| 25% | 40% | +| --- | --- | +| 35% | | +| 20% | 30% | +| 15% | 25% | +| 20% | | +| 10% | 15% | +| 5% | 10% | +| 5% | | +| 0% | 0% | + +# Japan + +# JPN Unemployment Rate + +| 8% | 140% | +| -- | ---- | +| 7% | 120% | +| 6% | 100% | +| 5% | 80% | +| 4% | | +| 3% | 60% | +| 2% | 40% | +| 1% | 20% | +| 0% | 0% | + +As history has shown and as explained in the appendix to Chapter 2, “The Changing Value of Money,” when there is a great increase in money and credit, it drives down the value of money and credit, which drives up the value of other investment assets —much like Nixon’s August 1971 move, which led me to realize that it was the same as Roosevelt’s March 1933 move, which was like Volcker’s August 1982 move, which was like Ben Bernanke’s November 2008 move, which was like Mario Draghi’s July 2012 move, and has become standard operating procedure by central banks that will persist until that approach no longer works. + +That brings us up to now. + +© 2020 Bridgewater Associates, LP + +--- + + +The Post-1945 Story in More Charts and Tables + +What follows is a series of charts that show the most important financial and economic shifts over the period that we just covered. They tell an interesting story of how things have changed. Before I show you them I’d like to remind you of what the archetypical cycle looks like so you can keep it in mind while reviewing these charts. + +As explained in Chapter 2, “The Big Cycle of Money, Credit, Debt, and Economic Activity,” for all countries—like for all individuals, companies, nonprofit organizations, and local governments—the basic money equation is reflected in a simple income statement of revenue and expenses and a simple balance sheet of assets and liabilities. When one’s revenue, most importantly from what one sells, is greater than one’s expenditures, there is positive net income, which leads one’s assets to rise relative to one’s liabilities (most importantly debt), which, all else being equal, raises one’s net savings. When one’s income is less than one spends the reverse happens. + +Exports are the main revenue source between countries. To convey the picture of export earnings, the chart below shows the share of global export sales of the United States, Britain, the Soviet Union/Russia, and China from 1900 until the present. It shows which countries were and are the biggest export earners. As you can see, + +- a) US exports soared while British exports plunged in each of the two world wars (which made the US rich), +- b) British exports fell from about 30% of the total in 1900 to less than 5% today (which made Britain a lot less rich), +- c) after World War II US exports were relatively steady between 20% and 25% until around 2000 when +- d) Chinese exports rose from around 5% to around 15% now (making China much richer), which is now the largest in the world, and US exports fell to about 14% (making it a much less strong export-income earner). + +# Est Share of Global Exports + +| | | | USA | CHN | GBR | RUS | | +| ----------------------------------------------------------- | - | ---- | ---- | ---- | ---- | ---- | ---- | +| ![Est Share of Global Exports Chart](chart_placeholder.png) | | | | | | | | +| | | | | 50% | | | | +| | | | | 45% | | | | +| | | | | 40% | | | | +| | | | | 35% | | | | +| | | 30% | | | | | | +| | | | | 25% | | | | +| | | | | 20% | | | | +| | | | 15% | | | | | +| | | | | 10% | | | | +| | | | 5% | | | | | +| | | 0% | | | | | | +| 1900 | | 1920 | 1940 | 1960 | 1980 | 2000 | 2020 | + +But exports are only half the net-income picture. It is export earnings minus import spending (i.e., the balance of goods and services) that makes the net income of a country that comes from trading with foreigners. To convey that picture for the US, the next chart shows US exports of goods and services minus US imports of goods and services since 1900. As shown the US sold more than it bought until around 1970 and then started to buy more than it sold. + +© 2020 Bridgewater Associates, LP + + +--- + +USA Exports of Goods and Services Minus Imports of Goods and Services (%GDP) + +# Persistent trade balance deficit + +| | 6% | +| - | --- | +| | 4% | +| | 2% | +| | 0% | +| | -2% | +| | -4% | +| | -6% | +| | -8% | + +1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010 2020 2030 + +Naturally, if one buys more than one sells one has to finance the difference by some mix of drawing down one’s savings and/or borrowing. One can think of a country’s savings as being its foreign-exchange reserves. The United States financed its deficits by running down its reserves/savings and building up a lot of debt that is owed to foreigners. + +# USA Net International Investment Position (%GDP) + +| | 30% | +| - | ---- | +| | 20% | +| | 10% | +| | 0% | +| | -10% | +| | -20% | +| | -30% | +| | -40% | +| | -50% | +| | -60% | +| | -70% | + +1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010 2020 2030 + +The charts below show the debt piece—i.e., a) the total debt the United States owes the rest of the world and b) the total debt the United States owes the rest of the world minus the total debt the rest of the world owes the United States. As shown, while the US had no significant foreign debt at the beginning of this new world order, it now has large foreign debts. Fortunately for the US (and less fortunately for others), this debt is in US dollars. + +84 Spliced back with goods balance only prior to 1930. + +© 2020 Bridgewater Associates, LP 109 + +--- + + + +# USA External Debt (%GDP) + +| | 0% | 10% | 20% | 30% | 40% | 50% | 60% | 70% | 80% | 90% | 100% | | +| --------------------------------------- | -- | --- | --- | --- | --- | --- | --- | --- | --- | --- | ---- | --- | +| USA Govt Debt Held by Foreigners (%GDP) | | | | | 5% | 10% | 15% | 20% | 25% | 30% | 35% | 40% | + +# USA Net Debt Owed (%GDP) + +| | 0% | 10% | 20% | 30% | 40% | 50% | 60% | -10% | | | +| - | -- | --- | --- | --- | --- | --- | --- | ---- | --- | --- | +| | | | | | 10% | 20% | 30% | 40% | 50% | 60% | + +As for reserve assets, the charts below show both gold and non-gold reserves for these four major powers since 1900. + +The first set of charts below shows a) the total amount of gold reserves (in volume of gold terms), b) the total value of the gold reserves as a percent of the country’s imports, and c) the total value of gold reserves as a percent of the size of the economy for the US, Britain, the Soviet Union/Russia, and China. They are meant to convey a picture of how much savings in gold these countries had and have a) in total, b) in relation to their needs to import from abroad, and c) in relation to the size of their economies. As shown, the United States had enormous gold reserves—approximately 10x those in the UK—and was tremendously rich by these standards in 1945, which came about by its large net earnings previously shown, and the US spent down these gold reserves until 1971 when it was forced to stop redeeming its paper money for gold. Since then the quantity of US gold reserves has remained virtually unchanged and the value of these reserves has changed with changes in its market price. As shown below the UK drew down its gold reserves to very low levels, while Russia and China have built theirs up in recent years, though they remain low. + +© 2020 Bridgewater Associates, LP + +--- + + +# Gold Reserves (Mln Oz) + +| | GBR | USA | RUS | CHN | +| --- | --- | --- | --- | --- | +| 800 | | | | | +| 700 | | | | | +| 600 | | | | | +| 500 | | | | | +| 400 | | | | | +| 300 | | | | | +| 200 | | | | | +| 100 | | | | | +| 0 | | | | | + +# (% Gold Reserves) + +# Goods Imports, 12mma + +| | GBR | USA | RUS | CHN | +| ---- | --- | --- | --- | --- | +| 900% | | | | | +| 800% | | | | | +| 700% | | | | | +| 600% | | | | | +| 500% | | | | | +| 400% | | | | | +| 300% | | | | | +| 200% | | | | | +| 100% | | | | | +| 0% | | | | | + +However, gold reserves are not a country’s only reserves, especially lately. Since central banks hold foreign-currency debt assets (e.g., bonds) as well as gold assets in their reserve savings, the size of their total reserves does a better job of conveying their savings. The picture of the changes in this measure of relative savings is shown in the charts below. Note in the charts how enormous the US total reserves were in 1945 (accounting for about 8.5 years of imports) relative to those of other countries and note how enormously the relative sizes of these reserves have shifted since then, especially with the rise in total reserves in China. Note that China now has the largest foreign-exchange reserve and the US doesn’t have much. As shown above, the US and the UK have around 70 days of imports in reserves, while for Russia and China that figure is around 700 and 600 days, respectively. The gap in the chart in the war years period was due to an absence of data during that period. As explained in Chapter 1, a classic dynamic is that non-reserve-currency countries that want to save naturally want to save in reserve currencies, which results in them lending to the reserve currency country. That happened with the US and its dollar-denominated debt. It was especially true in the US-Chinese relationship over the 30-40 years when the Chinese produced goods inexpensively and sold these goods to eager American buyers who wanted to pay for them with borrowed money that the Chinese lent them from their export earnings because the Chinese wanted to save in dollars. As a result of that the Chinese are now holding about $1.1 trillion of US debt, which is about a third of their total reserves though less than 5% of US debt. Japan holds about $1.2-1.3 trillion of it. Because these debts are denominated in US dollars the US won’t have a problem paying them back because the US Federal Reserve can print the money and pay them off with depreciated dollars. + +© 2020 Bridgewater Associates, LP + +111 + + + +--- + + +Central Bank Reserves + +# Central Bank Reserves (2019 USD, Tln) + +| USA | GBR | RUS | CHN | +| ------------------------------------------ | --- | --- | --- | +| ![Central Bank Reserves Chart](chart1.png) | | | | + +# Central Bank Reserves (% Goods Imports, 12mma) + +| USA | GBR | RUS | CHN | +| ------------------------------------------------------------ | --- | --- | --- | +| ![Central Bank Reserves (% Goods Imports) Chart](chart2.png) | | | | + +# Central Bank Reserves (% GDP, 12mma) + +| USA | GBR | RUS | CHN | +| -------------------------------------------------- | --- | --- | --- | +| ![Central Bank Reserves (% GDP) Chart](chart3.png) | | | | + +At this time, China has the world’s largest reserves. The United States, while not having large reserves, has the power to print the world’s reserve currency. The ability to print money and have it accepted by the world, which is an ability that only a major world reserve currency country (especially the United States) has, is the most valuable economic power a country can have. At the same time, a country that does not have sizable reserves (which is the position the US is in) is highly vulnerable to not having enough “world money.” That means that the US is now very powerful because it can print the world’s money and would be very vulnerable if it lost its reserve currency status. + +What types of money and credit have been and now are most important? The chart below shows the percentages of reserve assets that are held in all countries’ reserves combined. As shown, gold’s share of total reserves has fallen from 65% in 1945 to about 10% today, though devaluation of the dollar and the surge in gold’s price led gold’s share of central bank reserves to be the largest until the early 1990s, after which its share of world reserves declined to only 10%. The US dollar accounts for over 50% of reserves held and has unwaveringly remained the primary reserve currency since 1945, especially after it replaced gold as the most-held reserve asset after there was a move to a fiat monetary system. European currencies have remained steady at 20-25% since the late 1970s, the yen and sterling are around 5%, and the Chinese RMB is only 2%, which is far below its share of world trade and world economic size, for reasons we will delve into in the Chinese section of this book. As has been the case with the Dutch guilder and the British pound, the status of the US dollar has significantly lagged and is significantly greater than other measures of its power. That means that if the US dollar were to lose its reserve status and significantly depreciate in value it would have a devastating effect on the finances of those countries holding those reserves as well as private-sector holders of dollar-debt assets. Who would be the winners? Those with dollar-debt liabilities and those with non-dollar assets would be the big winners. In the concluding chapter, “The Future,” we will explore what such a shift might look like. + +© 2020 Bridgewater Associates, LP 112 + + +--- + + +# Currencies Held as Share of Total Central Bank Reserves + +USD EUR JPY GBP CNY Gold + +| Percentage | | | | | | | | +| ---------- | ---- | ---- | ---- | ---- | ----- | ---- | ---- | +| | 100% | 90% | 80% | 70% | 60% | 50% | 40% | +| | 30% | 20% | 10% | 0% | Years | | | +| 1950 | 1960 | 1970 | 1980 | 1990 | 2000 | 2010 | 2020 | + +The next chart shows shares of world production for the US, UK, Russia, and China. It is shown on a purchasing power parity basis, which means after being adjusted for differences in prices of the same items in different countries. For example, if an item in one country was twice the price of the same item in a different country, it would be counted as twice as much production even though it’s the same thing if counted on a non-purchasing power adjusted basis and it would be counted as the same amount of production if counted on a purchasing power parity basis. As shown, the United States produced many times as much as the other major countries produced in 1945, and though its share declined, it remained much higher than any other country until recently when it was surpassed by China. In non-purchasing power parity terms, China’s output is about 70% of the US output and growing at a significantly faster pace. Let’s not split hairs over small differences in imprecise measures. The most important headline is that the United States was the dominant economic producer in 1945 and didn’t have a comparably sized economic competitor anytime in the last 100 years up until recently and now it does in China, which is of comparable size. China is also growing significantly faster, so if this continues, it will soon be as dominant an economic power as the United States was in 1945. + +# Est Share of Global GDP (PPP-Adj) + +| USA | CHN | GBR | RUS | | | | | | | | | +| ---- | ---- | ---- | ---- | ---- | ---- | ---- | --- | --- | --- | -- | -- | +| | | | 40% | 35% | 30% | 25% | 20% | 15% | 10% | 5% | 0% | +| 1900 | 1920 | 1940 | 1960 | 1980 | 2000 | 2020 | | | | | | + +© 2020 Bridgewater Associates, LP + +113 + + + +--- + +Where the US Is in Its Big Cycle + +I think we know roughly where it is. + +As previously explained the Big Cycle of rising and declining empires and their reserve currencies is a cycle that begins with a new world order that comes after a war in which a) there is an environment of peace, prosperity, and productivity in which debt growth is allocated well and sustainably (i.e., most debts are used productively to produce incomes that are greater than debt service so most debts are paid back), equities do well, and the society gets rich with individuals benefiting from the prosperity, though they benefit disproportionately, which eventually leads to b) excessive debt growth to finance speculation and over-consumption, which results in incomes being inadequate to service the debt, which leads to c) central banks lowering interest rates and providing more credit, which produces greater wealth gaps and more over-indebtedness, until d) over-indebtedness becomes so large and central banks lose their ability to create credit growth that produces self-funding debt growth (i.e., in which debts don’t accelerate relative to the incomes needed to service them without central bank subsidies), which e) produces severe economic downturns with large wealth gaps that lead to internal conflict and leads to f) lots of printing of money, big debt restructurings, and big wealth distributions via tax changes g) that create financial, economic, and political vulnerabilities for the leading power relative to emerging powers that lead to wars that define the winners and losers and produce the new world order. + +The stats seem to suggest that the US is roughly 75% through that cycle, +/- 10%. + +# Is it reversible? + +Most world powers that experience this cycle have their “time in the sun,” which is brought about by the uniqueness of their circumstances and the nature of their character and culture (i.e., they have to have the essential elements to work hard and smart, be disciplined, become educated, etc.) and have their decline phases continue through them slipping into relative obscurity. Some do this decline traumatically, and some do it gracefully. + +From studying history we can see that reversing a declining power is very difficult because that requires undoing a lot that has already been done. For example, bringing one’s finances to the point that one’s spending is greater than one’s earnings and one’s assets are greater than one’s liabilities can only be reversed by either working harder or consuming less, which is not easily done. + +Still, this cycle needn’t transpire this way if those in their rich and powerful stages stay productive and safe by continuing to work hard and smart, earn more than they spend, save a lot, and make the system work well for most of the population. A number of empires and dynasties have sustained themselves for hundreds of years and the United States, at 244 years old, has proven itself to be one of the most durable now in existence. I think the most important question is how we adapt and change by asking ourselves and honestly answering some difficult questions. For example, while the capitalist profit-making system allocates resources relatively efficiently, we now need to ask ourselves, “Who is it optimizing these efficiencies for?” and “What should be done if the benefits are not broad-based?” “Will we modify capitalism so that it both increases the size of the pie (by increasing productivity) and divides it well?” These questions are especially important to answer in an era when the greatest efficiencies can be gained by technologies replacing people so employing people will increasingly become unprofitable and inefficient, making one uncompetitive. “Should we, or should we not, invest in people to make them productive even when it’s uneconomic to do so?” “What if our international competitors choose robots over people so we will be uncompetitive if we choose to employ people rather than robots?” “Is our democratic/capitalist system capable of asking and answering such important questions and then doing something to handle them well?” So many more important questions come to mind. When we think about the future, which we will do in the concluding chapter of this book, we will have to wrestle with these questions and many other difficult ones. + +© 2020 Bridgewater Associates, LP + +--- + +# Chapter 6: + +# The Last 500 Years Part 3: + +# The Big Cycle of China and Its Currency + +--- + +NO_CONTENT_HERE + +--- + +Chapter 6: The Last 500 Years Part 3: The Big Cycle of China and Its Currency + +Preface: Several people told me that it is risky for me to write this chapter because the US is in a type of war with China and emotions are running high, so many Americans will be angry at me when I say complimentary things about China, many Chinese will be angry at me when I say critical things about China, many people on both sides who disagree with something I say will be angry at me for saying it, and many in the media will distort what I say. However I can’t not speak openly out of fear of reprisals because the US-China relationship is too important and too controversial to be left untouched by people who know both of these countries well, and for me not to speak honestly about this situation would cost me my self-respect. + +What I am passing along here is just the latest iteration of my learning process. My process is to learn through my direct experiences and through my research, to write up what I have learned, to show it to smart people to have them attack it in order to stress test it, to explore our differences, to evolve it some more, and do that over and over again until I die. So this study is the product of my having done that for the past 36 years up until now. It is incomplete, it is right and wrong in ways yet to be discovered, and it is provided to you to use or to criticize in the spirit of helping us together find out what’s true. + +This chapter is about China and Chinese history brought right up to this moment. It is meant to convey where the Chinese are coming from. The next chapters are about US-China relations and wars that are extensions of the backgrounds covered in the last two chapters and this chapter. + +# My Background + +Though I’m no expert on Chinese culture and the Chinese way of operating, I have had numerous direct experiences with China over nearly four decades, I have done extensive historical and economic research about China, and I have a US and global perspective that has been gained because of my need to make practical macroeconomic bets. That has given me an uncommon perspective of where China has been and what’s going on with it now that might be helpful to those who haven’t had such an extensive exposure. + +More specifically, the perspective I am passing along to you here has been gained from 36 years of interfacing with Chinese people about Chinese and world issues (mostly economics and markets in China and the world) and from doing a lot of research. Through my experiences and by getting to know some of China’s top leaders, in addition to learning about Chinese economics and markets, I learned a lot about Chinese culture, how it operates today, and how it has evolved over thousands of years: from notions of how family members and others should behave with each other to Confucian thinking and neo-Confucian thinking, and through various dynasties and modern leaders to the lessons these events provide about how leaders should lead and how followers should follow. These typical Chinese values and ways of operating are what I’m referring to when I say “Chinese culture,” which I have seen manifested over and over in my experiences and my research. For example, from my personal experiences I could see how Lee Kuan Yew, the Prime Minister of Singapore, and Deng Xiaoping, the leader who initiated China’s reform and opening up, were connected by Confucian values coexisting with capitalist practices so that they together could explore how China could have a “socialist market economy with Chinese characteristics.” + +Over the last couple of years I have also undertaken the study of Chinese history as part of my study of the rises and declines of empires and their currencies in order to learn the timeless and universal principles about how empires rise and decline and to help me understand how the Chinese, especially their leaders, who are greatly influenced by history, think. I did this study by researching deeply with the help of my research team and triangulating with some of the most knowledgeable Chinese, American, and non-American scholars and practitioners on the planet. While I can be pretty sure about my impressions of the people and things that I had direct contact with (which makes me a lot more certain about the assertions I am making about the Chinese than about the Dutch and British empires I described earlier in this book), I of course can’t be as certain about the people and circumstances that I haven’t had direct contact with. So my thoughts about them (e.g., especially historical figures such as Mao Zedong) are more conjecture based on the extensive research I have tapped into. + +© 2020 Bridgewater Associates, LP + +--- + + +# Chapter Title + +Over my 36 years of experience with China, I have come to know many Chinese people from the lowest to some of the highest in rank in an up-close and intimate way, and I have experienced China’s recent history just as I have experienced America’s. As a result, I believe that I see both the American and Chinese perspectives pretty well. I will do my best to convey them here. I urge those of you who haven’t spent considerable time in China to get rid of any stereotypes you might have of the old “communist China” and to look past the pictures that are often painted for you by biased parties who also haven’t spent much time there, because they’re wrong. I urge you to triangulate whatever you are hearing or reading with people who have spent lots of time in China working with the Chinese people. As an aside, I think that the blind and near-violent loyalties and media distortions that stand in the way of thoughtfully exploring different perspectives are a frightening sign of our times. + +To be clear, I’m not ideological and I don’t choose sides ideologically. For example, I don’t choose an American side or a Chinese side based on whether it aligns with American, Chinese, or my own ideological beliefs. I’m practical like a doctor who approaches things through logic and believes in what works well through time. My study of history and my thinking about cause/effect relationships are what have led me to my beliefs about what works well. What I believe is most important in making a country work well was laid out in 17 different measures of strength at the beginning of this book and more narrowly in the eight measures I have been referring to regularly. So, when I look at China, it is through the lens of these factors that I am judging it. I also try to see their circumstances through their eyes. The only thing I can do is beg for your patience and open-mindedness as I share what I’ve learned with you. + +This chapter is a continuation of our look at the leading empires over the last 500 years, starting with the Dutch and British empires in Chapter 3, and the US Empire in Chapter 4. In this chapter, we will touch on China’s long history and the thinking that it has produced, we will briefly review its decline from pre-eminence in the early 1800s to insignificance early in the 20th century, and we will more carefully look at its recent emergence from insignificance to its near comparability to the world’s leading empire today—and its likelihood of becoming the most powerful empire in the world not many years in the future. + +In earlier chapters we saw how the Dutch and then the British each became the richest and most powerful reserve currency empire and then declined into relative insignificance in cycles that were driven by timeless and universal archetypical cause/effect relationships. Then we saw how the United States replaced them as the dominant world empire broadly following the same archetypical cyclical patterns driven by the same archetypical cause/effect relationships. We saw how some of its eight key powers rose and declined (i.e., education, economic competitiveness, shares of world trade and output), while others continued to excel (innovation and technology, reserve currency status, financial market center), and we looked at how a number of the other key drivers (e.g., money and debt cycles, wealth/values/political cycles, etc.) are transpiring in the US. In this chapter we will study China’s way of looking at its past and bring us up to this moment with the aid of objective statistical measures that help paint the picture objectively. As in the US chapter we will cover the older history superficially; the 220 years up until 1949 in a bit greater detail; and the last 40 years, when China evolved from relative insignificance to become a great rival power to the United States, in the most detail. That will complete our examination of the rises and declines of the leading empires over the last 500 years. Then, in the next chapter, we will look at US-China relations and wars as they now exist, and in the concluding chapter of this book, “The Future,” we will try to squint into the future. + +© 2020 Bridgewater Associates, LP 116 + + + +--- + + +Rough Estimates of Relative Standing of Great Empires + +# Major Wars + +| | Spain | Germany | France | +| ----------- | -------------- | ------------- | -------------- | +| India | Japan | Russia | Ottoman Empire | +| Netherlands | United Kingdom | United States | China | + +# Relative Standing of Great Empires + +| | | | | | | | | | | | +| ---- | ---- | ----------- | ---- | --------- | ---- | -------- | ---- | ------------ | ---- | --------- | +| 1.0 | | 0.8 Empires | | 0.6 Other | | All-Time | | 0.4 Relative | | (1 Level) | +| 0.2 | | 0.0 | | 1500 | 1550 | 1600 | 1650 | 1700 | 1750 | 1800 | +| 1850 | 1900 | 1950 | 2000 | | | | | | | | + +# 1. China’s Giant History in Brief + +Anyone who wants to have a fundamental understanding of China needs to know the basics of China’s roughly 4,000-year history, the many patterns that have repeated in it, and the timeless and universal principles that the leaders of China have gained from studying these patterns—even though getting that basic understanding is quite an undertaking. China’s history is so complicated and there are so many opinions about it that I am confident that there is no single source of truth, and I am especially sure that I’m not it. Still there is a lot that knowledgeable people agree on, and I have found many scholars and practitioners, both Chinese and non-Chinese, who have valuable bits that make the exercise of trying to piece them together—along with other bits of history like statistics and written histories—very valuable as well as damned fascinating. While I can’t guarantee that my perspectives about China are the best ones to believe, I can guarantee that they have been well-triangulated with some of the most informed people in the world and are presented here in an exceptionally forthright way. Here it is in brief. + +China’s civilization with its highly civilized behavior has a long and continuous history that began about 4,000 years ago. I can’t possibly recount the extensiveness of it because there are far too many dynasties from the Xia Dynasty around 2000 BC (which lasted about 400 years and was highly civilized and known for creating the Bronze Age) through over 1,000 years of various dynasties to Confucius around 500 BC (whose philosophy greatly influenced how the Chinese behave with each other to this day), to the Qin Dynasty (which united most of the area we now call China for the first time in 221 BC), then through the highly developed Han Dynasty (which developed governance systems that are still in use today) that lasted from around 200 BC to around 200 AD, and then a number of other dynasties until the Tang Dynasty in 618. While I scanned China’s history from the Xia Dynasty through the year 600 AD (i.e., just before the remarkable Tang Dynasty), I looked at most of the dynasties since then more carefully to see the patterns. I wrote up my study of them that I will share later. I will now focus very briefly on the post-600 AD period. + +When I decided to study China’s history to understand its patterns I wanted to begin with the beginning of advanced civilization and I couldn’t find its beginning because it went back so far. I would have had to start more than 2,000 years before Christ and I wouldn’t have started at the beginning. I chose to superficially look at what happened around 2070 BC by looking at the Xia Dynasty, which brought us the Bronze Age, writing, and the stratification of society along political and religious lines. I started to look a bit more carefully around 500-600 BC, so that I could start around the time of Confucius and Confucianism, and Lao Tzu and Taoism, which has shaped how the Chinese are with each other and with others. Understanding them and their thinking is even more important to understanding Chinese thinking than understanding Jesus, Aristotle, and Socrates is to understanding Western thinking. Then I quickly worked my way to the year 600 AD to just before the Tang Dynasty and looked more closely at what has happened since then, though my examination was still very superficial relative to what was there to study. + +© 2020 Bridgewater Associates, LP + + +--- + + +In the chart below I plotted the same overall power gauge that I showed you in the first chart but applied only to China from 600 AD until now. It conveys how powerful China was relative to other empires in the world over that time frame. While there were many more dynasties that existed in various parts of the country and various other slivers in time, I didn’t show them in this chart because that would have produced too much detail for the really big picture to come through. As you can see, for most of that time China was one of the world’s most powerful empires, with the notable exception from around 1840 until around 1950 when it went into a steep decline. As shown, around 1950 it started to rise again, at first slowly and then very rapidly, to regain its position as one of the two most powerful empires in the world. + +| | | Major Wars | | Rough Estimate of China's Relative Standing vs Great Powers | +| ------------ | - | ------------ | - | ----------------------------------------------------------- | +| Tang Dynasty | | | | RC PRC | +| Song Dynasty | | | | | +| Yuan Dynasty | | | | | +| | | Ming Dynasty | | | +| | | | | Qing Dynasty | + +Over most of last 1,400+ years most dynasties were very powerful, civilized, and cultured. Under the Tang Dynasty, China expanded its borders extensively and experienced a cultural flourishing; in the Northern and Southern Song Dynasties (from the 900s to the 1200s), China was the most innovative and dynamic economy in the world; in the Ming Dynasty (1300s to 1600s), China was a great power that enjoyed an extended wonderful period that was both very prosperous and very peaceful; and in the early Qing Dynasty (1600s to 1700s), China had its maximum territorial expansion, governing over a third of the world’s population while having an extremely strong economy. Then in the early 1800s and through the first half of the 1900s, China lost its power while European countries, and especially the British Empire, gained theirs. The shift of relative wealth and power from Asia to Europe from around 1800 until recently, which created one of the biggest wealth and power shifts in world history in which China was uniquely weak, should be considered an anomaly rather than a norm. This evolution and the lessons this history provides are very much in the minds of Chinese leaders and are especially interesting to me. + +In the chart above, note the cyclical ups and downs. The reasons for them are mostly the reasons I explained in my description of the archetypal Big Cycle—because of the gaining and losing of the most important strengths and weaknesses in cyclical and mutually reinforcing ways. (My more detailed descriptions of the rises and falls of these dynasties will be given to you in Part 2 of this book, which covers the major cycles of the major empires and dynasties covered in this book in greater depth.) Notice that these dynasties’ Big Cycles typically lasted about 300 years. Within each of these were the different stages of development and the things done by emperors to bring the dynasties from one stage to the next, and the reasons for setbacks and declines. In other words, there are many lessons embedded in these histories. That is why Chinese leaders study history to learn lessons that help them plan for the future and deal with the cases at hand. Believe me, the lessons learned from these histories are now guiding Chinese leaders’ decision making. What was especially interesting to me was to see the patterns of the archetypal Big Cycle go back much further in history and be described in such detail because China’s continuous history is so ancient and so well-documented. It has also been interesting to see what happened when + +© 2020 Bridgewater Associates, LP + +118 + + + +--- + + +the Eastern and Western worlds met each other and interacted from the 17th through the 19th centuries and how, as the world has become much smaller and more interconnected since then, the Chinese and Western Big Cycles affected each other so that they are now one of the biggest influences on both these two regions and the entire world. + +Probably the most important thing I learned from studying hundreds of years of history carefully and thousands of years of history more superficially in a number of countries is to see things very differently than I did before I did this study. I found shifting my perspective in this way to be similar to going to a much higher level in Google Maps because I could see contours of history that I never saw before. I also could see that the same stories played out over and over again for basically the same reasons, and I learned timeless truths about how the really big movements take place and how to deal with them better. Besides affecting how I view things, I see how studying so much history up to the present has greatly affected how the Chinese think relative to how Americans think. From living in the United States, which is a country that has about 300 years of history (because Americans think their history began when settlers from Europe arrived) and from living in a country that isn’t as much interested in looking at history and the lessons it provides, I can see that the perspectives of Americans and the Chinese are very different. + +For example, to Americans 300 years is a very long time. For the Chinese it is very recent. While having a revolution or a war that will overturn our systems is unimaginable to an American, it is inevitable to a Chinese person (because the Chinese have seen that they have always happened and the Chinese have studied the patterns of why they have happened). While most Americans focus on particular events, especially those that are now happening, most Chinese, especially their leaders, see evolutions over time and put what is happening in the context of them. While Americans fight for what they want in the present, most Chinese strategize how to get what they want in the future. As a result of these different perspectives the Chinese are typically more thoughtful and strategic than Americans, who are more impulsive and tactical. I also found Chinese leaders to be much more philosophical (literally readers of philosophy) than Americans leaders. If you read their writings and their speeches, you will find this to be true. Philosophies of how reality works and how to deal with it well are woven into their thinking, which is expressed in their writings. + +For example, in a meeting with Liu He soon after he had his first negotiation session with President Trump, he conveyed his concerns about the possibility of US-China conflict. Liu He is Vice Premier of China responsible for economic policy and also a member of the Politburo. We have known each other for many years, during which we have had informal conversations about the Chinese and world economies and markets. Over those years we came to develop a friendship. He is a very skilled, wise, humble, and likable man. He explained that going into his meeting with Trump, he was concerned about how it would go, not because of the trade negotiations, which he was confident didn’t have any issues that couldn’t be worked out, but because he was concerned about the worst-case scenario where tit-for-tat escalations could get out of control and lead to more serious consequences. He referred to history and gave a personal story of his father to convey his perspective that wars were so harmful and the damage could be worse if we had another war today. He focused on the World War I example. We exchanged views on long-term cycles in history and his belief in the concept of a community with a shared future for humankind. He talked about reading the Tao Te Ching by Lao Tzu and Critique of Pure Reason by Immanuel Kant, and how he realized that he should do his best, and then the outcomes would take their course. From there he gained his calmness. I told him that I shared that perspective. I told him about the “Serenity Prayer” and suggested meditation to him as a way of helping to obtain that perspective. + +I tell this one story to share with you one Chinese leader’s perspective on the risk of wars and to also give one example of the many interactions I’ve had with this leader and of the many interactions I’ve had with many Chinese leaders and Chinese people in order to help you see them through my eyes and also to help you see the issues through their eyes. + +To understand how Chinese people, especially Chinese leaders, think and what they value, it is as important to understand their history and the values and philosophies that have resulted from generations experiencing that history and reflecting on it. Their history and the philosophies that have come from them, most importantly their Confucian-Taoist-Legalist-Marxist philosophies, have a much bigger effect on how Chinese people, and especially + + + +--- + + +# Chinese Leaders and Their Historical Perspective + +Chinese leaders think that America’s history and its Judeo-Christian-European philosophical roots have an impact on Americans’ thinking. That is because the Chinese, especially their leaders, pay so much attention to history to learn from it. For example, Mao, like most other Chinese leaders, was a voracious reader of history and philosophy, wrote poetry, and practiced calligraphy—e.g., I was told by an esteemed Chinese historian that Mao read Comprehensive Mirror in Aid of Governance, the mammoth 294-volume-long chronicle of China’s history that covers around 16 dynasties and 1,400 years of Chinese history, from around 400 BC to 960 AD, and the even more mammoth Twenty-Four Histories several times as well as numerous other volumes about Chinese history and writings of non-Chinese philosophers, most importantly Marx. I’m told that his favorite book was Zuo Tradition, which focuses on political, diplomatic, and military affairs in a “relentlessly realistic style” in the period from 722 BC to 468 BC, because the lessons it offered were so relevant to what he was encountering. He also wrote and spoke philosophically. If you haven’t read anything he wrote and are interested in how he thought, I suggest you read “On Practice,” “On Contradiction,” and of course The Little Red Book, which is a compendium of his quotations on a number of subjects, which I only had time to skim but was impressed by. It is interesting and informative in ways that are relevant today. + +As a result of their longer history and their more intensive studying of it, the Chinese are much more interested in evolving well over much longer time frames than Americans, who are much more interested in making quick hits—i.e., the Chinese are more strategic than Americans, who are more tactical. The arc that Chinese leaders pay the most attention to is well over a hundred years long (because that’s how long good dynasties last) and they understand that the typical arc of development has different multidecade phases in it, and they plan for them. For example, the first phase, which occurred under Mao, was when the revolution took place, control of the country was won, and power and institutions were solidified. The second phase of building wealth, power, and cohesiveness without threatening the leading world power (i.e., the United States) occurred under Deng and his successors up to Xi. The third phase of building on these accomplishments and moving China toward where it has set out to be on the 100th anniversary of the People’s Republic of China (PRC) in 2049—which is to be “a modern socialist country that is prosperous, strong, democratic, culturally advanced, and harmonious,” which would make the Chinese economy about twice the size of the US economy—is occurring under Xi and his successors. Nearer-term goals and ways for getting toward these goals are set out in nearer-term plans like the Made in China 2025 plan, Xi’s new China Standards 2035 plan, and the usual five-year plans. + +Chinese leaders don’t just plan and try to implement their plans; they set out clear metrics to judge their performance by and they achieve most of their goals. I’m not saying that this process is perfect because it isn’t, and I’m not saying that they don’t have political and other challenges that lead to disagreements, including some brutal fights over what should be done, because they have them (in private). In summary what I am saying is that they have much longer-term and historically based perspectives and planning horizons, they bring those down to shorter-term plans and ways of operating, and they have done an excellent job of achieving what they set out to do by following this approach. By the way, I have coincidentally discovered over many years that my studying history, looking for patterns, and dealing with tactical decisions has had a similar effect on how I see and do things—e.g., I now see the last 500 years as recent history, the most relevant arcs seem about 100+ years long, and the patterns I observe from taking this perspective are very helpful to my anticipating how events are likely to transpire and informing me about how I should be positioned over the coming weeks, months, and years. + +86 John Wang, Tso-chuan, in The Indiana Companion to Traditional Literature, 805. + +87 I’d like to thank Kevin Rudd, former Prime Minister of Australia and current President of the Asia Society Policy Institute, for pointing me to these books and helping me understand Chinese politics. + +88 Because China has a population about four times the US population it only takes an income of half as much per capita to have twice as much in total. There is nothing that I can see that stands in the way of China and the US having comparable per capita incomes with time, which would make China four times the size. + +89 The Made in China 2025 plan is for China to be much more self-sufficient in most areas and to be world leaders in high-tech fields including artificial intelligence, robotics, semiconductors, pharmaceuticals, aerospace, and automotive. + +90 In October they will come up with their 14th five-year plan and targets for 2035. + + + +--- + +China’s Lessons and Its Ways of Operating + +The Chinese culture developed as an extension of the experiences the Chinese had and the lessons they learned over the millennia. They were set out in philosophies about how things work and what ways work best in dealing with these realities. These philosophies made clear how people should be with each other, how political decision making should be done, and how the economic system should work. In the Western world the dominant philosophies are Judeo-Christian, democratic, and capitalist/socialist. Each person pretty much chooses from these to come up with the mix that suits them. In China, the main ones were Confucian, Taoist, and Legalist until the early 20th century when Marxism and capitalism entered the mix. The most desired mix to follow has historically been the emperor’s most desired mix. Emperors typically study Chinese history to see how these have worked and come up with their own preferences, put them into practice, learn, and adapt. If the mix works, the dynasty survives and prospers (in their parlance it has the “Mandate of Heaven”). If it doesn’t, it fails and is replaced by another dynasty. This process has gone on from before history was recorded and will go on as long as there are people who have to decide how to collectively do things. + +While I can’t do these philosophies justice in a couple of sentences each without digressing too deeply (though I will go into them more deeply in Part 2), here is the best I can do: + +- Confucianism seeks to bring about harmony by having people know their roles in the hierarchy and know how to play them well starting from within the family (between the husband and the wife, the father and the son, the older sibling and the younger sibling, etc.) and extending up to the ruler and their subjects, with them bound together by benevolence and obedience. Each person respects and obeys those above them, who are both benevolent and impose standards of behavior on them. All people are expected to be kind, honest, and fair. Confucianism values harmony, broad-based education, and meritocracy. +- Legalism favors conquest and unification of “all under heaven” as soon as possible by an autocratic leader. It believes that the world is a “kill or be killed” jungle in which the strength of the emperor’s central government and strict obedience to it must exist without much benevolence given to the people by the emperor/government. The Western equivalent is fascism. +- Taoism teaches that the laws of nature and living in harmony with them are of paramount importance. Taoists believe that all of nature is composed of opposites and that harmony comes from balancing them well—yin and yang. This plays an important role in how the Chinese seek the balance of opposites. + +Of these, Confucianism and neo-Confucianism have been the most influential through time, usually with some Legalism thrown in, up until the early 20th century when Marxism gained favor with Mao and then with his successors. I will briefly explain Marxism when we get into the 20th century. Naturally all of these have been very fleshed out and have evolved over time, along with the ways that the emperor and government operate. + +All of these Chinese systems from the beginning of recorded history were hierarchical and non-egalitarian. I was told by one of the most senior Chinese leaders, who is also a highly informed historian and an extremely practical top policy maker, that the core difference between Americans and the Chinese is that Americans put the individual above all else and the Chinese put the family and the collective above all else. He explained that Chinese leaders seek to run the country the way they think parents should run the family—from the top down, maintaining high standards of behavior, putting the collective interest ahead of any individual interest, with each person knowing their place and having filial respect for those in the hierarchy so that the system works in an orderly way. He explained that the word “country” consists of two characters, “state” and “family,” which represents how the leaders view their roles in looking after their state/family—like strict parents. So one might say that the Chinese government is run from the top down (like a family) and optimizes for the collective while the American approach is run from the bottom up (e.g., democracy) and optimizes for the individual. + +© 2020 Bridgewater Associates, LP + +--- + + +approach can lead to policies that those on the opposite side find objectionable, which I will explore in more detail in the next chapter. + +As far as how the governance structure works (i.e., who reports to whom in the hierarchy within the central government and how that extends down to interactions with regional and local governments), that has evolved over thousands of years and many dynasties into well-developed approaches that I won’t get into because the digression would be too great. However what is clear is that there are well-established structures in which the emperor has ministers who are responsible for different domains that extend down to interacting with the provinces and municipalities via a large bureaucracy, and, at the same time, there have always been lots of fights to keep and get control of power by the emperors and the people who report to them. I was told by Zhiwu Chen, who is one of the most highly respected contemporary Chinese scholars, that 37% of emperors died unnaturally and that more often than not they were killed by the people around them or others in political struggles. 91 Politics in China has traditionally been brutal. + +Geographically China is basically one giant plain surrounded by big natural borders (mountains and seas) with a giant population in that plain. For that reason most of China’s world was within those borders and most wars were for control of it and were fought within those natural borders, mostly between the Chinese themselves, though sometimes between foreign invaders and the Chinese. + +As far as wars and the philosophies about them are concerned, the goals have traditionally been to ideally win wars not by fighting but by quietly developing one’s power so that it is greater than the opponent’s so that one can then show it and have the opponent capitulate without fighting. There is also the extensive use of psychology to influence the opponents’ behaviors to produce the desired results. 92 Still there have been numerous violent wars inside of China over the dynasties, though there haven’t been many outside of China. Those that were outside China were for the purpose of establishing China’s relative power, security, and trade, not for occupation. Scholars believe that China’s lack of significant expansion of its empire outside of China is because the land mass of China is so large that controlling it has been more than enough to handle, because it is has largely been self-sufficient in resources, and because they have preferred to maintain their culture with a purity that is best achieved through isolation. Unlike other great empires that have conquered and occupied other countries, it was relatively uncommon for China to occupy distant states. Traditionally the Chinese have preferred to enter into relations with empires outside their borders in a manner that is similar to what one might expect from the previously mentioned philosophies—i.e., with the parties knowing their places and acting accordingly and with their places determined by their relative powers. For example, if China is more powerful, which was typically the case in its region, the less powerful states typically paid tribute to China with gifts and favors and in return typically received guarantees of peace, recognition of their authority, and trading opportunities. These subordinate countries typically maintained their customs and experienced no interference in how their countries were run. 93 + +As far as Chinese money, credit, and the economy are concerned, the history is very long and complicated and went through the full range of money/credit/economic systems and cycles that were described in Chapter 2 and its appendix, so what happened in China is basically the same as what happened all around the world through. + +91 Similarly I read an article by Yuhua Wang that said that about half the emperors left office unnaturally, and “of these unnatural exits, about half were deposed by the elites (murdered, overthrown, forced to abdicate, or forced to commit suicide)…The next category is death or deposition in civil wars; very few (seven) were deposed by (or in) external wars.“ He presented a table showing the reasons emperors lost power. These stats make clear that in the past the “biggest threat was friends within.” When I discussed the risks to the emperors and the people around them with a Chinese friend, he said that there is a famous Chinese saying about it, which is “to accompany the leader is to accompany a tiger.” + +92 If you haven’t read The Art of War I suggest you read it to get a flavor for what I am referring to. + +93 The China historian John Fairbank, in his excellent book The Chinese World Order, described relations with non-Chinese states as follows: “The graded and concentric hierarchy of China’s foreign relations included peoples and countries which we may group into three main zones: first, the Sinic Zone, consisting of the most nearby and culturally similar tributaries, Korea and Vietnam, parts of which had anciently been ruled within the Chinese empire, and also the consisting of the most nearby and culturally similar tributaries, Korea and Vietnam, the Ryukyu Islands, and, at brief times, Japan. Secondly, the Inner Asian Zone, consisting of tributary tribes and states of the nomadic or semi-nomadic peoples of Inner Asia, who were not only ethnically and culturally non-Chinese but were also outside or on the fringes of the Chinese cultural area, even though sometimes pressing upon the Great Wall frontier. Third, the Outer Zone, consisting of the ‘outer barbarians’ (wai-i) generally, at further distance over land or sea, including eventually Japan and other states of Southeast and South Asia and Europe that were supposed to send tribute when trading.” + +© 2020 Bridgewater Associates, LP + + +--- + + +# Transitions Across Different Types of Money in Chinese History + +the millennia, though exactly when and exactly how is a bit different. More specifically, inside China like outside China there were the various types of monetary systems used and currencies issued by all sorts of entities with all the systems operating in the ways I described. Within China, the currency most used through the millennia was metal (mostly copper), and debt cycles like those described in Chapter 2 took place for the same reasons (i.e., debts created buying power so providing them made people feel richer and raised the economy and wealth and were allowed to grow to become much greater than the amount of money needed to service them and the amount of money grew much faster than the amount of goods and services that it could buy). In these big debt cycles there were stable periods when debt growth wasn’t excessive, bubble periods when debt growth was excessive relative to levels that could be sustained, debt crisis periods when there wasn’t enough money to service debt, and printing of money periods in which money was printed to alleviate the debt crises, which produced hyperinflations. Internationally (and sometimes domestically) silver was the main metal currency used, though gold was also sometimes used. As for the economy’s changes, the system went from being primarily agricultural and feudal through many manufacturing incarnations such as the Bronze Age and the Iron Age, including various approaches to trading with foreigners/barbarians (most importantly through the Silk Road), which built a rich merchant class that produced cycles of big wealth gaps and the wealthy having their wealth taken away from them. Throughout China’s history private entrepreneurial businesses were sometimes allowed, which typically also produced wealth and wealth disparities that led to redistributions of wealth and the businesses and other assets being taken over by the government. These also occurred in big cycles. For example, there were an untold number of changes in approaches created and destroyed for the building and the dividing of wealth. Consistent with China being an intelligent and industrious society, there were many technological inventions created that moved the economy forward. They occurred in the archetypical ways that were described in the earlier chapters. While most things were the same, there were some different monetary and economic tendencies in China. For example, there was a strong tradition of using copper coins, even after China invented paper money in the 9th century and up until the introduction of the yuan in the late 19th century. + +The following charts convey some information about how Chinese money and credit passed through these cycles. As I explained in Chapter 2, “The Big Cycle of Money, Credit, Debt, and Economic Activity,” there are three basic types of monetary systems in which 1) money has intrinsic value (like gold, silver, and copper coins), which I call a Type 1 monetary system, 2) money is linked to assets that have intrinsic value, which is paper money that can be exchanged for gold or silver at a fixed price (a Type 2 monetary system) and 3) money that is not linked to anything, which is called a fiat monetary system (a Type 3 monetary system). As explained, these have historically changed from one to another as the weaknesses of each become intolerable. The diagram below conveys an ultra-simplified picture of how these currency systems have rotated through China’s history since the Tang Dynasty. In fact it was much more complicated than this as different parts of China often had different currencies and at times coins and ingots from other countries (e.g., Spanish silver dollars in the late 16th century) that changed more frequently than what is conveyed in the chart. Still the chart is broadly indicative and meant to show that they had the full range of monetary systems that worked essentially the same as elsewhere in the world, most importantly with the cycles of hard money leading to debt problems leading to the abandonment of hard money leading to high or hyperinflations leading to the return to hard money. + +| | Northern | Southern | | | Early-Mid | People's Rep of China | of China | | +| ------- | -------- | --------- | --------- | --------- | --------- | --------------------- | --------- | ---------- | +| Tang | Song | | Yuan | | | | | | +| 618-907 | 960-1127 | 1127-1279 | 1279-1368 | 1368-1644 | 1644-1800 | \~1800-1911 | 1911-1949 | 1949-Pres. | + +Type I + +Type II + +Type III + +94 I produced the diagram to apply this template to Chinese monetary history through working with Professor Jiaming Zhu. + + + +--- + + +# Inflation Rates Over Time + +The chart below shows inflation rates going back to 1750, which reflects the changing value of money. The periods of relatively stable inflation early on were largely the result of China using metals (silver and copper) as money. Instead of a central currency being printed, raw weights of metals were exchanged as money (i.e., there was a Type 1 monetary system). When the Qing Dynasty broke down, provinces declared independence and issued their own currencies through their silver and copper and valued by their weights (i.e., the Type 1 monetary system was retained), which held their value which is why, even during this terrible period, there was not an exceptionally high level of inflation measured in this money. However, debt (i.e., promises to deliver this money) grew in the 1920s and 1930s, which led to the classic debt cycle in which the promises to deliver money far exceeded the capacities to come up with the monies to deliver so there was a default problem, which led to the classic abandonment of the metal standard and the outlawing of metal coins and private ownership of silver. + +As previously explained, currencies are used for 1) domestic transactions, which the government has a monopoly in controlling and can get away with them being fiat and flimflam, and 2) international transactions, in which case the currencies must be of real value or they won’t be accepted. As a rule, the better money is that which is used for international transactions. The test of the real value of a domestic currency is whether or not it is actively used and traded internationally at the same exchange internationally as domestically. When there are capital controls that prevent the free exchange of one’s domestic currency internationally that currency is more susceptible to being devalued, which is also why one of the standards for being a reserve currency is that there are no capital controls on it. So, as a principle, when you see capital controls being put on a currency, especially when there is a big domestic debt problem, run out of that currency. + +In China in the mid-1930s two currencies existed—one that was fiat paper that was used domestically and one that was gold and silver that was used for international payments. The fiat paper one that was used domestically was printed abundantly and devalued a lot, even as the government issuing it controlled less and less territory as it lost the civil war, which is why we see the hyperinflation shown in the chart during that period. Remember, as a principle, get out of fiat currencies during debt crises and wars because they will be printed a lot to fund debt payments, which will lead them to be devalued and to high or hyperinflation. + +As shown in the chart below, after the turbulence of World War II and the civil war, in December 1948, the first RMB was issued as a fiat currency that was kept in limited supply to end the hyperinflation. In 1955 a second issuance of RMB was made, and in 1962 a third was issued. From 1955 to 1971 the exchange rate was fixed at 2.46 to the US dollar. From 1972 through the late 1970s, China did a better job of restraining money and credit. You can see another round of high inflation from the late 1970s to the early ’90s. It was caused by the global devaluation of money against gold in 1971, global inflationary pressures, China phasing out its price controls, easy credit, and lack of spending controls among state-owned enterprises. In 1996 convertibility was allowed for current account items but not for the capital account. From 1997 until 2005 the exchange rate to the dollar was kept at 8.3. In 2005 the peg with the dollar was ended. + +# Chinese Inflation (Y/Y) + +| | | 30% | Hyperinflation | 25% | +| - | - | ---- | -------------- | ---- | +| | | 20% | | 15% | +| | | 10% | | 5% | +| | | 0% | | -5% | +| | | -10% | | -15% | + +Note: Inflation pre-1926 quoted in silver terms, post-1926 in RMB + +1750 1775 1800 1825 1850 1875 1900 1925 1950 1975 2000 2025 + +© 2020 Bridgewater Associates, LP 124 + +--- + + +# Chinese Currency Value and Economic Growth + +The charts below show the value of Chinese currency in dollar terms and in gold terms since 1920, plus the inflation and growth rates over this period. The history for the currency rates is so fragmented before that that it is not worth referencing. As you can see, there were two devaluations, one at the setting up of the new exchange rate in 1948, and a series of devaluations from 1980 until the early 1990s, largely aimed at supporting exporters and managing current account deficits, which led to the very high inflation during that period. As shown, growth was relatively fast and erratic until around 1978, then fast and much less erratic since 1978 until the recent brief plunge due to COVID-19. + +# CNY vs USD (Inv) + +| 0 | 0 | +| -- | ----------------- | +| 1 | 2,000 | +| 2 | 4,000 | +| 3 | | +| 4 | 6,000 | +| 5 | Up = stronger RMB | +| 6 | 8,000 | +| 7 | 10,000 | +| 8 | 12,000 | +| 9 | 14,000 | +| 10 | 16,000 | + +# Gold Price (in CNY, Inv) + +| 20 | 30 | 40 | 50 | 60 | 70 | 80 | 90 | 00 | 10 | 20 | +| -- | -- | -- | -- | -- | -- | -- | -- | -- | -- | -- | + +# CHN Inflation (Y/Y) + +| 50% | 30% | +| ---- | ---- | +| 40% | 20% | +| 30% | 10% | +| 20% | | +| 10% | 0% | +| 0% | -10% | +| -10% | -20% | +| -20% | -30% | + +# CHN Real Growth (Y/Y) + +| 20 | 30 | 40 | 50 | 60 | 70 | 80 | 90 | 00 | 10 | 20 | +| -- | -- | -- | -- | -- | -- | -- | -- | -- | -- | -- | + +Generally speaking the very long and volatile history of markets and economies has given the Chinese, and especially Chinese economic policy makers, the same sort of deep and timeless perspectives about money, debt, and economies as they have for other history. However, that is not totally true. While it has given most Chinese a strong desire to save and an appropriate sense of risk that innately drives them to save in safe liquid assets (e.g., cash deposits) and tangible assets (e.g., real estate and some gold), most Chinese investors have limited experiences in some riskier assets such as equities and risky debt, so they can be naïve in these areas, though they are learning very fast. When it comes to policy makers understanding how money, credit, monetary policy, fiscal policy, and the economy work, and how to restructure bad debts, I have found China to have great perspective and to be world-class. + +Now let’s look a bit more closely at China’s history from 1800 until now. + +For instance, the devaluations in 1985-86 and 1993 came after a period of opening up trade and an expansion in Special Economic Zones. These openings created immense demand for foreign FX and imports to build production capacity—but it would still be a couple more years until those SEZs yielded much higher exports. That mismatch contributed to growing current account deficits. + +© 2020 Bridgewater Associates, LP + + +--- + + +# From 1800 until Now + +To bring you up to date to where we are now, I want to superficially look at the post-1800 period until the beginning of the People’s Republic of China in 1949, then look at the Mao period until 1976 a bit more closely, then look at the period of Deng Xiaoping (from 1978 to 1997) and his successors up to Xi Jinping (in 2012) more carefully, and then look at the period of Xi Jinping up until now. Then we will look at US-China relations more closely. We will do all that in about 20 pages. + +To begin, I will draw your attention to the eight measures of power that I showed you before for other countries and for China since 1800. It is shown in the chart below. Notably, unlike the cycles for the Dutch, the British, and the American empires that we looked at before, which went from their rises through or into their declines, the cycle that we are examining for China goes from its decline at first into rising most recently. While in a different order, as you will see, the same forces were behind China’s decline and rise as were behind the other empires declines and rises. + +# China Arcs Since 1800 + +| Major Wars | Education | Innovation and Technology | +| --------------- | ---------------- | ------------------------- | +| Competitiveness | Military | Trade | +| Output | Financial Center | Reserve Status | + +As conveyed, the low point in these eight measures of power—i.e., education, innovation and technology, competitiveness, military, trade, output, financial center, and reserve currency status—was in the 1940-50 period. Since then most powers—most notably economic competitiveness, education, and military—improved gradually96 until around 1980 when China’s economic competitiveness and trade took off. Since then until around 2008 growth was very strong with debt growth being in line with economic growth. Then the 2008 financial crisis came along and China, like the rest of the world, used a lot of debt growth to stimulate its economy so debts rose relative to incomes, Xi Jinping came to power, improved China’s debt management, continued innovation and technology, more boldly expanded globally, and encountered greater conflict with the US. As shown in this chart China is now a leading power in trade, military, and innovation and technology, and its relative powers in these areas are increasing quickly. While China is still highly competitive economically in world markets, its rate of improvement in this area is slowing. At the same time China remains a lagging power in its reserve currency and its financial center. + +While these indices are broadly indicative, they aren’t precise because each of these powers can’t be precisely measured. For example, as far as the power of its education system is concerned, while our index rises at a fairly brisk pace it fails to fully capture the relative improvements in China because this measure is made up of average. + +96 China began its nuclear-weapon research in the early 1950s and acquired nuclear-weapon capability in 1964. + + + +--- + + +levels of education as well as total levels of education. This is best conveyed in the table below, which shows some of the most important stats in this index. As shown, while the average education level in China is considerably below the average education level in the US, the total number of highly educated people is significantly higher in China than the United States. For example, the total number of college graduates in science, technology, engineering, and math is about three times that in the United States (see table below). At the same time there are reasons to believe that the average quality level of education isn’t as high, especially at the college level. For example, there is only one Chinese university—Tsinghua University, which is No. 36—that appears in the top 50 universities in the world, while 29 American universities do. This picture in which the average of something in China is below the average of the same thing in the United States but the total in China is greater than the total in the US is because the average level of development in China is less while the Chinese population is over four times as large as the American population. That comes across in a number of stats. For example, while the United States is militarily stronger in total all over the world, the Chinese appear to be militarily stronger in the East and South China Seas area, and there is a lot that is unknown about both countries’ military powers because they are kept secret. For this reason and for other reasons these measures of power are broadly indicative rather than precise. + +| USA | | 1980 | Today | Change | Change (%) | CHN | | 1980 | Today | Change | Change (%) | +| ---------------------------------------------------- | - | ----- | ----- | ------ | ---------- | ----- | - | ----- | ----- | ------ | ---------- | +| Average Years of Basic Schooling | | 11.9 | 13.6 | +1.7 | +14% | 4.6 | | 7.9 | +3.3 | +72% | | +| Govt Spending on Education (% of GDP) | | 5.30% | 5.50% | 0.20% | +4% | 1.90% | | 5.20% | 3.30% | +174% | | +| Est Population w/Tertiary Education (mln) | | 25 | 60 | +35 | +140% | 3 | | 120 | +117 | +3900% | | +| Population w/Tertiary education (% Working Age Pop.) | | 17% | 28% | 11% | +68% | 1% | | 12% | 11% | +2272% | | +| Population w/Tertiary education (% World) | | 35% | 15% | -20% | -57% | 4% | | 31% | +27% | +590% | | +| STEM Majors (mln) | | 3 | 8 | +5 | +141% | 1 | | 21 | +21 | +4120% | | +| STEM Majors (% World) | | 29% | 11% | -18% | -62% | 5% | | 31% | +26% | +535% | | + +# The Decline from 1800 until 1949 + +In brief, the post-1800 decline happened when a) the last Chinese royal dynasty (the Qing Dynasty) became decadent and weak at the same time that b) the British and some other Western capitalist countries became strong, which led the British capitalist-colonialists and a number of other foreign capitalist-colonialists to increasingly take control of China economically, at the same time that c) the financial and monetary system broke down under the burdens of debts that couldn’t be paid and the printing of money that caused the collapse in the value of money and debt, at the same time that d) there were massive domestic rebellions and civil wars. That severe Big Cycle decline in which all the major strengths were in mutually reinforcing declines continued from around 1840 until 1949. The end of World War II in 1945 led to the repatriation of most foreigners in China (except for Hong Kong and Taiwan) and a civil war to determine how the wealth and power would be divided—i.e., a war between the communists or the capitalists—on the Chinese mainland. This over 100-year-long period of decline, which the Chinese call the “Century of Humiliation,” was a classic case of the archetypical Big Cycle decline occurring due to a number of the classic weaknesses existing, leading to mutually and self-reinforcing declines adding up to the big decline. It was followed by the classic case of a Big Cycle upswing in which the new leader wins control, consolidates power, and begins building the basic structures that are passed onto subsequent generations, who build on their predecessors’ accomplishments. + +More specifically, in the 1800s, the British East India Company and other merchants wanted tea, silk, and porcelain from China because it was extremely lucrative to sell back home. However, the British didn’t have anything that the Chinese wanted to trade for so they had to pay for these goods in silver, which was a global money at the time. The British paid out of their savings but were running out of this money, which led the British to smuggle opium into China from India which they sold for silver which was used to pay for the Chinese goods. The Chinese fought to stop these sales, which led to the First Opium War in which the technologically superior British Navy defeated the Chinese in 1839-42 and led the British to impose a treaty on the Chinese that gave the British and other powers. + +From US News & World Report: https://www.usnews.com/education/best-global-universities/rankings + +The massive Taiping Rebellion, one of the bloodiest wars in human history, which led to an estimated 20 to 30 million killed, along with other internal and external conflicts, caused giant fiscal crises that led to an issuance of debt. + + + +--- + + +control of China’s main ports (most notably Shanghai, Canton, and Hong Kong) and 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. The Qing government borrowed from foreigners to fight internal rebellions and owed huge reparations from these wars. Reparations, especially out of the Boxer Rebellion (a Chinese rebellion against foreigners in 1901) created a huge liability—17,000 tons of silver equivalent—which was structured as around a 40-year debt. The foreign powers were able to use tariff income on the ports they effectively controlled as a guarantee of the debt. The Qing government, starved of financial resources, faced many uprisings over the couple decades following the Opium Wars and spent down their saving to finance fighting them. That combination of 1) not having strong leadership, 2) not having sound finances, 3) having internal rebellions that undermined productivity and were costly in money and lives, 4) fighting foreigners, which was costly financially and in lives, and 5) experiencing some big disruptive acts of nature produced the mutually and self-reinforcing decline known as the “Century of Humiliation.” + +It is easy to see how that period had an important role in shaping Chinese leaders’ perspectives—e.g., why Mao saw capitalism as a system in which companies pursued profits through imperialism (i.e., through the controlling and exploiting of countries, the way the British and other capitalist powers did to China) in a way that enriched greedy rich people while exploiting workers. After all this is what happened to China over the prior 100 years, and the world in the 1930-45 period was in one of the most extreme wars between the “rich capitalists” and the “working class communists.” It was interesting to me to see how Mao’s view of capitalism differed from my view of capitalism because his experience with it was so different from mine, though both of our views about it were true. Because capitalism provided me and most others I knew, including immigrants from all over the world, with enormous opportunity, America was both fair and a land of opportunity in which one could learn, contribute, and be rewarded without boundaries. I was from a working-class background and always admired and appreciated the hard-working people who worked together to be productive and the motivated entrepreneurs innovating and working with devoted workers to convert their dreams into realities that the whole society benefited from. This experience of my trying to see something (capitalism) through both my eyes and through Mao’s eyes was another reminder for me of how important radical open-mindedness and thoughtful disagreement are in order to find out what is true. That desire led me to study Marxism a bit so that I could imagine how it made a lot of sense to Mao and others as a philosophy. My inclination up until then was to think of it as at its best obviously impractical and at its worse possibly an evil threat, yet I was ignorant about what Marx actually said. + +# Enter Marxism-Leninism + +My desire to see Marxism-Leninism through Mao’s and other Chinese leaders’ eyes, and my realization that as a capitalist interested in economics I needed to understand it better, led me to study it more carefully, which altered my perspective of it. As mentioned, before I examined it, I assumed Marxism was a dysfunctional resource allocation system in which resources were theoretically distributed “from each according to their abilities, to each according to their needs” but failed to produce much because of a lack of incentives to be inventive and efficient. I didn’t really understand what dialectical materialism was, and I didn’t realize that Marx was a brilliant man whose thoughts were worth better understanding. It was the process of needing to understand what Mao and those who succeeded him, especially Xi now, found appealing in this philosophy that led me to dig more into Marx’s writings. + +Marx’s most important theory/system is about how evolution takes place. It’s called dialectical materialism. “Dialectical” refers to how opposites go together to produce change, and “materialism” means that everything has a material (i.e., physical) existence that interacts with other things in a mechanical way. Marx had disdain for theories that were not connected to reality and that didn’t produce good change. So I wondered how Marx, a very practical man who believed that philosophies could only be judged in the successes and failures they produced, would have diagnosed communism’s near-total and universal failures and changed his thinking and modified how communism worked using his dialectical materialism approach to do that. + +In a nutshell dialectical materialism, Marx’s system for producing change, is a systematic way of observing events transpire and influencing them by watching and influencing “contradictions” of “opposites” that produce “struggles” that, when resolved, produce progress. Marx meant it to apply to everything. The conflict and + + + +--- + + +The struggle between the classes that is manifest in the conflict between capitalism and communism is just one of many such conflicts. + +Thus far that sounds right to me—i.e., that 1) contradictions/opposites produce struggles and that having these conflicts and reflecting on them and trying to struggle through them well is a process for making progress, and 2) there is a struggle between “classes” that is manifest in the conflict between capitalism and communism. As you will recall, I believe that conflicts produce struggles and that having conflicts and struggling through them produces progress and I consider the conflicts between the classes (i.e., the “haves” and the “have nots”) to be one of the three most important forces in driving history. You will recall that from studying history I have come to believe that the three most powerful forces that have been behind the rises and declines of empires are 1) the money/debt/capital market cycle, 2) the internal wealth/opportunity/political gap cycle, and 3) the external power(s) challenging the existing power(s) cycle, which is somewhat similar, though I believe there are about 17 important factors in total. In any case, I don’t think that these two main points about dialectical materialism by Marx are wrong. + +Whether in his words or mine, in the 1930-45 period these forces were in the decline/conflict phases of their cycles, which led to revolutions and wars around the world that brought the two big ideological approaches—capitalism and communism—into conflict which shaped the landscape of the 20th century. These forces that Marx was referring to were the big things that affected China throughout Mao’s lifetime. As always happens, these forces of decline ran their courses and new domestic and world orders began. More specifically, the external war ended in 1945, which then led to the new world order being created and foreign forces leaving most of mainland China. Then China had its internal war, which was between the communists and the capitalists that ended in 1949 and led to a new domestic order, which was communism under Mao. Put yourself in Mao’s position during the 1900-49 period, and imagine him reading what Marx wrote and think about his actions during that period and in the post-1949 period. It makes sense why Mao was a Marxist and pursued his version of Marxist policies and held the established Confucian approach to harmony in disdain. + +As far as ideological inclinations for Chinese people and Chinese leaders more generally, Confucianism, Marxism, and some strict Legalism were all part of the mix. Note that all of these emphasize the importance of knowing one’s role and place in the hierarchy and playing that role in the designated way, so being that way is deeply rooted. Democracy as we know it doesn’t have any roots in China. Capitalism on the other hand existed in China (as did revolts against it) and is currently growing, though it grows like a productive beast that is kept under the government’s control. + +I will start by very briefly summarizing what happened between 1949 and now, and then delve into each of the different phases that took China from then to now.99 + +99 Though I’m no expert on Marxism the dialectical materialism process sounds similar to the process that I discovered works well for me by struggling with conflicts, reflecting on them, writing down the principles, and improving—and doing that over and over again in a never-ending evolutionary “looping” way. Also, for reasons previously explained, it is my opinion that capitalism—an incentive system that rewards people who are the most inventive and productive and that has capital markets that allocate resources in ways in which people are rewarded for good capital allocation decisions and penalized for bad ones—will lead to a) more productivity over the long run (hence a bigger total pie), b) big wealth differences, and c) capital markets (especially debt markets) that become overextended and then break down and, when there is a capital market/economic breakdown at the same time, there are big wealth and values differences, which will lead to some form of revolution (i.e., there can be harmonious productive ones, though most have great conflict and are destructive before they are productive). So, thus far the way Marx appeared to see things and the way I see things isn’t radically different, though what we would choose and what we would think should be done is probably radically different. If you asked me a) whether I’d rather have what capitalism has delivered or what communism had delivered, and b) if I think the capitalist path we have seen is more logical than the communist path we have seen, I’d say yes to both questions. On the other hand if you asked me a) if both the capitalist and the communist systems need to be reformed to make the pie grow better and to have it distributed better, and b) if Marx’s dialectical materialism approach to evolving and my 5-Step Process to evolving are broadly similar and the best ways of evolving well, I would also say yes to both questions (without getting hung up on how exactly these two approaches are different). In other words I believe, and it sounds like Marx believed, that evolving from conflicts, mistakes, and the learning from having these is the best approach. Also, as far as the wealth gap goes, we both see that it has been a big issue throughout history that can threaten all systems. Lenin built on what Marx said to create a two-step process of building the state in which there is at first dictatorship by workers through “democratic centralism” in which there is a voting process of members of the party which would eventually lead to a higher communist state in which greater prosperity would exist, which is the second stage. Mao liked the Marxist-Leninist approach in which the + + + +--- + + +The Rise from 1949 until Now + +Though a bit of an oversimplification, we can think of China’s evolution from 1949 until now as occurring in three phases from 1) the Mao phase from 1949 until 1976 to 2) the Deng and Deng’s successors phase from 1978 until 2013 when Xi Jinping came to power, which led to 3) the Xi Jinping phase from 2013 until now. Each phase moved China along the long-term development arc so that accomplishments were made in each phase that the subsequent phases built upon. In brief these phases transpired along this arc as follows: + +- From 1949 until 1976 Mao (with his various ministers, most importantly Zhou Enlai) a) consolidated power, b) built China’s foundation of institutions, governance, and infrastructure, and c) ruled China as a communist emperor until he died in 1976. During that period, he ruled China for the workers and against the capitalists, he kept China in isolation from the rest of the world, and he followed a strict communist system in which there was government ownership and tight government bureaucratic controls over everything. Immediately following the deaths of Mao and Zhou Enlai, there was a power struggle in 1976-78 between the hardliners (i.e., the Gang of Four) and the reformists that Deng Xiaoping won, which led to the second phase. +- Deng (with his various ministers) ran China directly or indirectly until his death in 1997. During that phase China moved to a more collective leadership model, opened up to the outside world, introduced and developed capitalist practices, and became much stronger financially and more powerful in other ways that didn’t appear threatening to the United States and to other countries. During most of Deng’s tenure the primary enemy of China was Russia, so he viewed building a symbiotic relationship with the United States as helpful geopolitically. Economically the relationship was symbiotic because the US bought items that were attractively priced from China and the Chinese lent back to the Americans a lot of the money they earned to make those purchases. As a result, the US acquired US-dollar-denominated debt liabilities to the Chinese, and the Chinese acquired dollar-denominated assets owed to them by the Americans. After Deng’s death his successors Jiang Zemin and Hu Jintao (and those who led China with them) continued in the same directions so China continued to quietly become richer and more powerful in fundamentally sound ways that did not appear threatening to the US. In 2008 the global financial crisis led to greater tensions over wealth in the United States and other developed countries, increased resentment at job losses that were going to China, and increased debt-financed growth in all countries including China. That, and the development of China that began to appear more threatening, started to change the relationship. +- Xi Jinping came to power in 2013 presiding over a richer, more powerful China that was becoming overly indebted itself (though its debt was internal debt) and increasingly at odds with the United States. Xi accelerated economic reforms, took on the challenge of trying to contain debt growth while aggressively reforming the economy, and supported the building of leading technologies and going global. He also became more proactive in reducing the gaps in educational and financial conditions and in protecting the environment and consolidating political control. As China’s powers grew and Xi’s bold objectives (e.g., the Belt and Road Initiative and the Made in China 2025 plan) party represents the working people who rule over a socialist state that will achieve higher levels of development and eventually achieve communism in which there is common ownership of the means of production and social and economic equality. In other words they believe that achieving the ideal of communism of “the distribution of wealth from each according to their abilities to each according their needs” comes at the end of a very long evolutionary process. Deng Xiaoping reiterated this view that communism and the capitalism he was employing were not at odds in an interview with an American TV journalist when he said, “According to Marxism, communist society is based on material abundance…Only when there is material abundance can the principle of a communist society—that is, ‘from each according to his ability to each according to his needs’—be applied. Socialism is the first stage of communism…We permit some people and some regions to become prosperous first for the purpose of achieving common prosperity faster...The first stage of socialism takes a long time…Despite the rich/poor divide, wealth in China is more evenly distributed than in any time in history…The CPC can see the gap widening and is taking action…” Maybe that’s true and maybe it’s not. Time will tell. To me thus far capitalism—in China or anywhere else—is winning the competition. However, nobody can argue that the Chinese mix of communism and capitalism has not produced remarkable economic results over the last 40 years. + +© 2020 Bridgewater Associates, LP + + +--- + + +became more apparent, especially after Donald Trump (a populist/nationalist who was elected largely by appealing to those who were suffering from the loss of jobs) was elected president, US conflicts with China rose in a way that was analogous to the rise of Japan and Germany to challenge the then-existing powers in the 1930s. + +Let’s look at these a bit more closely. + +# Phase 1, 1949 to 1976: The Mao Phase of Building the Foundation + +Mao and the communists won the civil war and started the People’s Republic of China in 1949 and quickly consolidated power. In 1949 Mao was a philosopher-revolutionary who was leading a class war of workers against the capitalists, had won the revolution, and was in the position of being the de facto emperor of China (titled “president and chairman of the Central Military Commission”) and Zhou Enlai became his prime minister (titled “premier”) in pursuit of the overarching mission of ruling the country on behalf of the proletariat. To do that he turned to Marxism-Leninism and away from Confucianism. He also dealt with the practical aspects of building a government to take care of basic services. The new government quickly repaired transportation and communications and nationalized the banking system, which it put under the new central bank, the People’s Bank of China. Needing to bring down inflation the new central bank tightened credit and stabilized the value of the currency. The government nationalized most businesses and redistributed agricultural land from large landowners to those who farmed the land. It also created “public institutions” for “education, science, technology, and public hygiene.” No matter whether one worked or not, one got a basic pay. There was no merit-based pay. The protections that these guaranteed basic incomes and benefits provided everyone were collectively called “the iron rice bowl.” These changes created a stable economy but little motivation beyond the commitment to the mission of motivating workers. But Mao was on his way to achieving his first goal of having China’s mainland free of foreigners, shifting wealth and power to the proletariat led by him, and establishing basic institutions to govern. In other words, he focused primarily on building a new internal order. + +While China under Mao was isolationist, it wasn’t long before the new government found itself in a war. As explained in the last chapter, in 1945 the new world order divided the world into two main ideological camps—the democratic capitalists led by the United States and the autocratic communists led by the Soviet Union—with a third group of countries not aligned to either side. Many of these nonaligned countries were still colonized, most notably by the declining British Empire. China was clearly in the Soviet-led autocratic communist camp, following a Marxist-Leninist approach with a bit of strict Legalism in the mix and opposing Confucianism. In 1950, soon after Mao won the revolution and began the PRC in 1949, he and the Soviets signed the Treaty of Friendship, Alliance, and Mutual Assistance to cooperate and come to each other’s aid militarily. + +As mentioned in Chapter 4, at the end of World War II Korea was split, with the Russians having control of the north and the Americans having control of the south, divided at the 38th parallel. In June 1950, guided by Stalin/the Russians, the North Koreans invaded the South. Initially the Chinese weren’t involved in the fighting as they were preoccupied by their own challenges and didn’t want to be drawn into a war. The United States, in conjunction with the United Nations, responded to the invasion by bringing its forces into the fighting and then taking the fighting into North Korea, which is on the Chinese border. The Chinese viewed this as a threat especially since the American General Douglas MacArthur made clear that he would attack China. China couldn’t have the United States on its border or in its territory, so China had to fight. China, like most countries, was very sensitive about having enemies on its borders. Though the Soviets and the Chinese had a pact to support each other, Stalin didn’t want to go to war with the United States and so he didn’t provide China with the military support it expected. Though the Chinese were ill-prepared for a war against the much greater American power, which had nuclear weapons that China didn’t have, the Chinese entered the war and pushed the US and UN troops back to the previously established border. This was the first great challenge to Mao and China and was considered a great victory by the Chinese. Given China’s history with foreigners Mao/China understandably wanted extreme isolation within its sovereign border and was able to achieve that. + +© 2020 Bridgewater Associates, LP 131 + +--- + + +# Economically from Mao’s founding of the PRC in 1949 until Mao’s death in 1976 + +The Chinese economy grew at a rather good average annual rate of about 6%, with an average annual inflation rate of just around 1-2%, and the Chinese acquired around $4 billion in foreign exchange reserves, so it improved moderately but remained poor. This happened with a lot of volatility. More specifically: + +- Between 1949 and 1952 the new government consolidated power and eliminated opposition. This included wiping out the elites such as the landlord owners of agricultural lands, which included killing many of them. Deng Xiaoping led that move in the southwest and was praised by Mao for doing it well. +- Through most of the 1950s to consolidate power Mao undertook programs to identify capitalists (called “anti-rightist” campaigns) and either disable, imprison, or kill them. +- Between 1952 and 1957, with the help of the Soviets, industrial production grew at 19% per year, national income grew at 9% per year, and agricultural production grew by 4% per year. The Chinese government built industrial facilities and imported lots of equipment from the Soviets. It also reformed agriculture by creating cooperatives to achieve economies of scale by having farmers work together. These were highly productive years. However during this period, after Stalin's death in 1953, Nikita Khrushchev came to power, criticized Stalin and his policies, and alienated Mao, which led to these Chinese and Soviet leaders openly criticizing each other, which began a period of reduced Soviet support. +- Around 1960 the Soviet Union shifted from an ally to an enemy and withdrew economic supports. +- From 1958 through 1962, due to a drought, economic mismanagement from the top-down mandated attempt to become an industrial power called the Great Leap Forward, and reduced Soviet economic support, the economy contracted by 25% and an estimated 16-40 million people died of famine. Industrial output fell by 34% and fell by 12% more in 1962. All parties agree that it was a terrible period, though there is some disagreement about how much it was terrible because of terrible management by Mao versus terrible because of the other causes. +- The economy recovered and went to new highs from 1963 to 1966. Then came the Cultural Revolution. + +As is classic in all cycles, internal political challenges to Mao’s leadership and ideology arose. These internal political battles had traditionally been extremely brutal and risky for the supreme leader. As mentioned earlier, I was told by an esteemed Chinese scholar that 37% of Chinese emperors died in office from unnatural causes and about half of these were because of people close to the emperor. + +In 1964 Khrushchev was overthrown by a coup in Russia, and political and ideological struggles were on Mao’s mind (and everyone else’s). Mao’s Legalist and Marxist inclinations made him a brutal fighter for power and for the proletariat, so to deal with this threat to his power Mao fostered a political revolution to “purify class ranks” called the Cultural Revolution. It was to purge political and ideological opponents and to reinforce “Mao Zedong Thought.” It went from 1966 until 1976, though was most violent roughly between 1966 and 1969. Mao won the political/ideological battle, purging his rival Lin Biao who was accused of a botched coup against Mao; he died in a plane crash and “Mao Zedong Thought” was written into the constitution. The Cultural Revolution curtailed education and cost or damaged millions of lives. These conditions further undermined education and slowed advances in the Chinese economy, especially in the late 1960s. By the early 1970s the situation began to stabilize under the operational leadership of Premier Zhou Enlai, and the economy grew at around 6% per year. In 1969 there was a border war between China and the Soviet Union, which wiped out a Chinese battalion. During this period there was also a political struggle between “the Gang of Four” hard-core Maoists and moderates who favored reforms (most importantly Zhou Enlai and Deng Xiaoping). + +1971 was a year of great change in China. In 1971 the Cultural Revolution was producing great turmoil and Mao’s health continued to decline. That contributed to Zhou Enlai playing an increasing leadership role from the + +100 https://www.jstor.org/stable/652030?seq=2#metadata_info_tab_contents + +101 Estimates of the death toll of the Cultural Revolution range from hundreds of thousands to 20 million. + +© 2020 Bridgewater Associates, LP + + +--- + + +background, which led to him, in 1973, being elected a “vice chairman of the Communist Party,” putting him in the position of appearing to be Mao’s successor. Also in 1971 China was threatened by the Soviet Union, which was militarily much more powerful and shared a 2,500-mile border with China, leading to increasing border threats. In 1975, after the US withdrew from Vietnam, which shares a 900-mile border with southern China, Russia built an alliance with Vietnam and moved in troops and arms. Mao had a geopolitical principle to identify the main enemy, neutralize the enemies’ allies, and draw them away from the enemy. Mao identified the Soviet Union as China’s main enemy and recognized that the Soviets were in a war with the United States that hadn’t yet turned hot but could. That led him to make the strategic move of approaching the US. Henry Kissinger quoted Chinese officials as saying, “The last thing the US imperialists are willing to see is a victory by Soviet revisionists in a Sino-Soviet war, as this would [allow the Soviets] to build up a big empire more powerful than the American empire in resources and manpower.”102 + +I also know that Zhou Enlai, a reformist, had wanted to build a strategic relationship with the United States for decades because a close Chinese friend of mine, Ji Chaozhu, who was Zhou Enlai’s interpreter for 17 years and interpreted in the first Kissinger-Zhou Enlai talks, told me that that was the case.103 China wanted to open a relationship with the United States to neutralize the Russian threat and in the hope that would enhance its geopolitical and economic position. Because in 1971 it was especially clear that it was in the interests of both China and the United States to build a relationship, they both made overtures to establish relations. In July 1971 Henry Kissinger and then in February 1972 Richard Nixon went to China to open relations, and in October 1971 the United Nations recognized the Mao-led communist Chinese government and gave China a seat on the Security Council. During Nixon’s February 1972 visit, Nixon and Zhou Enlai signed an agreement (the Shanghai Communique), in which the US stated that it “acknowledges that all Chinese on either side of the Taiwan Strait maintain that there is but one China and that Taiwan is part of China. The United States government does not challenge that position. It reaffirms its interest in a peaceful settlement of the Taiwan question by the Chinese themselves. With this perspective in mind, it affirms the ultimate objective of the withdrawal of all US forces and military installations from Taiwan. In the meantime, it will progressively reduce its forces and military installations on Taiwan as the tension in the area diminishes.” In US-China relations, the reunification with Taiwan stands out as the most consistently contentious issues with the promise of reunification often offered and then pulled back from the Chinese. + +After these 1971-72 moves of rapprochement and appeasement, US relations with China and trade and other exchanges began. + +1976 was momentous because that was the year Zhou Enlai died (in January 1976), Mao Zedong died (in September 1976), and China faced its first generational change. + +From 1976 to 1978 there was a fight for power between the Gang of Four (hardline conservatives who fostered the Cultural Revolution) and the reformists (who wanted economic modernization and opening up to the outside world and were against the Cultural Revolution). Deng and the reformists won, leading to Deng Xiaoping becoming the paramount leader in 1978. There are always political fights about how to govern and who should have what powers. They are especially brutal when the power transition process is not crystal-clear and abided by all the key players who have power. Amid this political fighting there are different factions that both fight with the other factions and compromise to make decisions to govern. For the governing system of an entity to survive (i.e., of a family, an organization, an empire, a dynasty) these factions must put the entity’s survival and prosperity above all else, certainly above any individual’s opinions and power, and reach compromises to achieve that sustainability. That was the case in China at the time. There were factions of leaders of the communist revolution who cared deeply about this new dynasty’s survival (i.e., the Communist Party’s survival) and were in the positions to make decisions about how it should be managed. In the time between Mao’s death and Deng gaining the primary leadership role, a + +102 As quoted in Henry Kissinger, On China, 211. + +103 Ji Chaozhu was raised in the United States until he was a junior at Harvard. His brother was close to Zhou Enlai and sent the brother and Ji Chaozhu to the United States to try to build good relations with Americans. When the Korean War broke out he returned to China, became Zhou’s interpreter, and later served in the first Chinese delegation to the UN and later as China’s ambassador to England. While he told me a lot that I won’t discuss to respect his privacy, I don’t believe that this is sensitive information. + + + +--- + + +consensus among those powerful leaders was reached to give the interim leadership role to another senior leader (Hua Guofeng), who was a classic compromise choice in that he lacked the strength to be too offensive to most people and to retain the leadership position. The more hardline Gang of Four faction, which was led by Mao’s wife, lacked skills, lacked broad support, and, with Mao gone, lacked the leader’s support, so they were quickly disposed of. Deng, who was very experienced, committed to China’s communist revolution since its earliest days, and widely respected, was an obvious choice to either be a top administrator (i.e., premier) or a rival to Hua. Over time broad support among senior party loyalists, especially the reformists, emerged for Deng to be the primary leader among equals, which led to his gradual ascendency. + +At the same time increased threats from Vietnamese and Soviet activities appeared. In 1978 Vietnam and the Soviet Union signed an agreement to expand their military cooperation, which led to a Russian military buildup in Vietnam, and the Vietnamese government rounded up massive numbers of ethnic Chinese and put them into detention camps. As a principle, when there is weak and divided leadership, especially during leadership transitions, enemies see this as a time of vulnerability in which there is increased likelihood that they will make an attack of some sort. With the leadership transition going on in China and with the moves by Vietnam and the Soviets perceived as threatening, that was feared to be the case. + +# Phase 2, 1978 to 2013: The Deng and Deng Successors Phase of Gaining Strengths Through Economic Reforms and Opening Up Without Creating Threats to Other Countries + +Deng Xiaoping became China’s paramount leader in 1978 at age 74 with a wealth of experience under his belt. He was a “reformer,” so from 1978 until he died in 1997 Deng Xiaoping’s most important policies were conveyed in a single phrase: “reform” and “opening up.” Reform meant “market reforms” which meant using the market to help allocate resources and to help motivate people, and “opening up” meant interacting with the outside world to learn, improve, and trade. This led the Chinese Communist Party to start to bring capitalism into the mix10 and open up to the outside world. Deng knew that these two related directions—to greater “reform” and greater “opening up”—would make China stronger financially if it was not disrupted by the far more powerful foreign powers wanting to prevent the development of the weak China that he inherited, so the key was to pursue these directions in ways that benefited and didn’t threaten those foreign powers, most importantly the United States. In 1979 Deng established full diplomatic relations with the US, which was consistent with his strategy to open up and reform China. At the time China was extremely poor—per capita income was less than $200 per year—so China needed the improvement and was no threat to developed countries, especially the US. + +Early on, in February 1979, Deng invaded Vietnam with an assault that was similar to Mao’s intercession in the Korean War early in his term, in that it was to deal with the growing threat on China’s border and to make a clear display of China’s willingness to fight to defend itself. After a one-month fight, China withdrew, contending that it made its point. + +Early on Deng set out a 70-year plan to a) double incomes and assure that the population had 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 (at the 100th anniversary of the PRC). Underpinning that goal was a plan to dramatically improve China’s education system.105 He wanted to have a socialist market economy, which he referred to as “socialism with Chinese characteristics” that would be achieved by taking in all facts to “seek truth from facts.” He made that radical shift without criticizing Mao or Marxism-Leninism, which he believed meant shared prosperity. Rather than seeing communism and capitalism at odds I am told that these seemingly opposing ideologies were + +104 China started with market-based reforms and then moved on to what has been called “state capitalism” in which the state controls capitalism. Capitalism means private ownership of the means of production. It flourishes when there are well-developed capital markets that allocate resources, people are allowed to save by investing in these markets to make money, and users of the capital have access to it through the markets. The bigger the capital markets are and the more people are making money through ownership of the means of production, the more capitalism there is. However, unlike in many classic capitalist countries where state has very little ability to direct the activities of companies, in China the government has a lot of control over the companies which is what makes it “state capitalism.” + +105 Deng gave a speech in which he said, “Although I realized that it would be a tough job to be in charge of scientific and educational work, I volunteered for the post. China’s four modernizations will get nowhere…if we don’t make a success in such work.” + + + +--- + + +seen through the lens of Marx’s dialectical materialism—i.e., believing that conflicting opposites naturally go together and that the conflicts between them and dealing with those conflicts naturally leads to resolutions of the conflicts, which produces progress along that long development arc. I am told that he saw this coexistence of communism and capitalism as a necessary phase along a development arc toward the ideal communist state. Also the continuity and the legitimacy of the government’s philosophy, while making big reform changes to make China richer and stronger, were very important, so the coexistence of communism and capitalism was clearly the right move for China. + +Deng also reformed government’s decision-making structure. More specifically he moved China’s government decision-making process from one that was dominated by a single leader (previously Mao) to one in which the Politburo Standing Committee made decisions using majority voting when consensus couldn’t be reached. He also changed the system of choosing the Standing Members of the Politburo from the supreme leader personally selecting members to choosing them via consultation and negotiation with experienced party elders, generally drawing from the most qualified government officials. In order to institutionalize his philosophy and how it would be implemented in this government, Deng shaped a new version of the Chinese constitution, which was adopted in 1982. This new constitution also made a number of changes to facilitate the economic reforms and open-door policies that Deng wanted. It established governance changes such as leadership term limits consisting of two five-year terms (10 years) and limiting the power of one leader by making decision making more collective. The new constitution also provided for greater freedoms such as freedom of religion, freedom of opinion, freedom of speech, and freedom of the press. These reforms later led to the first orderly and rule-based transition of power from Deng to others in the next-generation Politburo Standing Committee, at first led by Jiang Zemin, then led by Hu Jintao, with these transitions occurring via the prescribed 10-year term limits. Each successive leadership team followed Deng’s same basic path of making China richer and more powerful by making the economy more market-driven/capitalist and by increasing China’s trade with and learning from those in other countries, with those in other countries feeling more excited than threatened by their interactions and trade with China. + +Reuniting China by regaining the territories that were taken away during the “Century of Humiliation” was also a very important long-term goal. Progress was made by Deng along these lines when in 1984, after a lot of haggling with the UK, it was agreed that Hong Kong would return to Chinese sovereignty in 1997, with its “one country, two systems” approach. Then in 1986 China reached an agreement with Portugal to obtain Macau’s return to Chinese sovereignty in 1999. + +In 1984 I had my first direct contact with China. My direct contact since, along with the facts I’ve learned, has affected my perspective. Because these interactions have been so valuable in helping me gain my perspective and would help you understand my perspective, I will refer to some of them when relevant. At the same time, because I don’t want to be indiscreet, I won’t pass along information that I believe those who gave it to me wouldn’t like to have passed along, and I will avoid mentioning the names of any people now living. + +In 1984 I first visited China at the invitation of China International Trust Investment Corporation (CITIC), which was the only “window company” (which means the only company that was allowed to freely deal with the outside world), to explain to them how the world financial markets work. The company was set up as an extension of Deng’s “reform and opening up” policies and was run by an old Chinese capitalist, Rong Yiren, who chose to stay in China even after his family business was nationalized. CITIC was set up to learn about and experiment with dealing with the outside world and capitalism. + +China was very poor and backward then. However it was immediately clear to me that its people were smart and civilized. In this regard it wasn’t like most other undeveloped countries I was used to because the Chinese backwardness was due to the people simply not knowing about or having access to what was available in the outside world and because they were operating in a demotivating system. For example, I gave $10 calculators as gifts to people, including the highest-ranking people, which they thought were miraculous devices. At the time people couldn’t choose their careers or their jobs, they received no financial incentives for working well, all businesses (including small restaurants) were government-owned and bureaucratically run, there was no ownership of property such as one’s home, and there was no contact with what the world had to offer in terms of best practices and products. + +© 2020 Bridgewater Associates, LP + + +--- + + +Because it was clear that the closed door was a barrier that led to two different economic levels to exist in China and in the developed world, it was clear to me that the removal of that barrier was just beginning that would naturally equalize their economic levels, like unconstrained water naturally seeking the same level. It was easy to visualize that change happening. I remember being on the 10th floor of CITIC’s “Chocolate Building,” giving a lecture and pointing out the window to the two-story hutongs (poor neighborhoods) and telling my audience that it would not be long before the hutongs would be gone and skyscrapers would be there in their place. They didn’t believe me and told me, “You don’t know China,” and I told them they did not know the power of the economic arbitrages that would happen as a result of opening up. That opening up was the biggest force behind the high rates of improvement that we saw over the last 40 years. While the opening up created a great natural opportunity, the Chinese made the most of it and performed even beyond my highest expectations. They did that by making and implementing Deng’s reforms, supported by uniquely Chinese cultural influences. These reforms freed up the Chinese people to achieve the exceptional results laid out in Deng’s plan. Globalization and the world wanting to include China in it also helped a lot. The expressed goal at the time that I heard a lot of was to “break the iron rice bowl,” which was to not provide demotivating guaranteed employment and assured basic benefits and to replace them with more incentive-based compensation. + +Deng was a very smart, eager learner who was helped by knowledgeable outsiders to produce China’s economic advances along its desired development arc. He also directed his policy makers to learn from outsiders in the same way that he did. That is how I and many others got invited there. It is also why Deng turned to other world leaders, especially leaders of the “tiger countries” who were culturally aligned with China, especially to Lee Kuan Yew of Singapore, for advice. I remember having a dinner with the head of China’s MOFTEC (which was their ministry of commerce) in Beijing in which he rattled off lots of details about things like how Singapore’s airport ran (e.g., how long a passenger had to wait to get his bags at baggage claim), how those in Singapore achieved such great results, and how China was going to implement those practices. Many years later I had the opportunity to host Lee Kuan Yew at my house. At that dinner, which included some other esteemed guests, we asked him what he thought about the different leaders at the time, what he thought about great past leaders, and what made great leaders great. We were eager to get his perspective because he had known most of the greatest leaders for much of the last 50 years and was one of the greatest leaders over those 50 years. He said that Deng was the greatest leader of the 20th century. Why? Because Deng open-mindedly learned and changed China to advance his people, he was smart and wise, he was extremely practical, and he delivered great results to his population of about a billion people. + +While Deng formally stepped down from the Politburo’s Standing Committee in 1987, he remained the de facto leader of China, which continued to open up and become more capitalist at a breakneck pace. I got to be a small part of China’s evolution toward capitalism in a number of ways over a number of years. + +In 1989 my friend Wang Li (who was responsible at CITIC for bond trading and setting up the leading bond trading platform) introduced me to a group of seven people (of which she was one) who were appointed by seven companies at the request of the visionary economic reformer and historian Wang Qishan to create an organization (the Stock Exchange Executive Council, known as SEEC) to set up the first stock markets in this new China. China was still very poor so SEEC’s office was in a dingy hotel and the group lacked adequate funding. Still, this small group had what mattered most—a clear mission to create big changes, smart people of good character, open-mindedness to allow rapid learning, and determination to achieve their goals. To them this was not a job; it was a noble mission to help their country. Over the decades that followed, I saw how they and many others built the Chinese financial markets to become among the largest in the world for the same reason. I was thrilled to help them. Through all this I gained a deeper liking and respect for the Chinese people, the Chinese culture, and the rapid rates of improvement that these forces brought about. + +Then, a shock happened that led everyone to question just about everything. In 1989 a movement to democratize China developed and grew and led to demonstrations. The question of how far to allow demonstrations to go that could be either a) healthy expressions of people’s passionate views or b) undesired anarchies or revolutions is encountered and debated by most leaders when internal fights become heated. It is one of the big issues that splits leaders (e.g., that debate is now going on in the United States, splitting those who would impose stronger law-and- + + + +--- + + +order adherence and those who would impose weaker law-and-order adherence). At the time of the Chinese pro-democracy demonstrations there were eight weeks of debate and a split among the leadership about how to handle this movement. As Deng himself as a young man was a demonstrator against the Chinese government and a revolutionary until he won and became part of the establishment, I presume he must have in some ways related to those young protestors. 106 Deng made the defining choice to sideline those who would have tolerated the demonstrations more and go ahead with the conservatives’ crackdown against this movement. At the time most Chinese I spoke with were worried that China would slip back into the old Mao/“Gang of Four”-type ways. A very close Chinese friend of mine from CITIC, Madame Gu, who was traveling to New York and whose brother was China’s Minister of Defense, happened to be with my family at the time so I saw events unfold through her eyes as well as through other Chinese friends’ eyes. Madame Gu had been an idealistic follower of Mao in the early years soon after “liberation.” Then when the Cultural Revolution came along she lost her husband to persecution (he was forced to commit suicide) and she was shunned by friends under the Red Guard’s pressure. She got past that terrible experience to work on behalf of the country she loved and rose to a senior job at CITIC, which is where I met her in 1984. She literally cried at the prospect of slipping back into that time. Like many others she worried that this crackdown marked the end of reforming and opening up China and a return to those old terrible days. The Tiananmen Square protests were a shock to the whole world and significantly set back most countries’ relationships with China. However, they didn’t keep Deng and his government from continuing with their reforms. With time most of my Chinese friends who were heartbroken about the crackdown thought that the government had made the right move because the greatest fear of these friends was of revolutionary disorder. So, the reforms and the opening-up policies continued. + +The economy continued its strong growth, and good relations with other countries resumed. In fact, relations and trade with the West became better than ever as globalization picked up. Globalization, which helped China immensely, can be said to have begun in 1995 with the formation of the World Trade Organization and extended until 2016 with election of Donald Trump. China joined in 2001. Since then China’s position in world trade soared. In 2001 the United States had more trade than China with 80% of countries. Now China is a larger trading partner than the United States in about 70% of countries.107 + +During this period of globalization, a symbiotic relationship developed between China and the US, in which the Chinese sold Americans consumer goods that were produced extremely cost-effectively and sold inexpensively and the Chinese lent the US the money to buy their consumer goods. It was a hell of a “buy now, pay later” deal for the Americans. The Chinese liked it because they built their savings in the world’s reserve currency by owning the American IOUs and the Americans got all the cheap stuff by borrowing the money to get it. It struck me as odd that the Chinese, who were earning about one-fortieth of what Americans earned on average, would be lending money to Americans to buy consumer goods since rich people are in a better position to lend than poor people. To me it was a shocking reflection of how much more Americans were willing to get into debt to finance their overconsumption and how much more the Chinese valued saving. It was also a reflection of how those in emerging countries want to save in the bonds/debt of the leading reserve currency countries, which leads the emerging countries to build debt assets and contributes to the reserve currency countries becoming overindebted. + +At the same time the Chinese had to deal with an internal debt crisis that they allowed to grow. In 1991 the debt and economic problems called the “triangular debt crisis”—because 1) China’s five major government-owned banks had for a number of years lent to 2) large, inefficient, and unprofitable state-owned enterprises with the implicit guarantee of 3) the central government—had to be dealt with to improve the system. Restructuring the economy to become more efficient by “breaking the iron rice bowl” was led by Zhu Rongji, who was a bold reformer at the top of the party. This process was extremely controversial and hurt a lot of people who benefited from the old system, so it took a lot of courage and intelligence, as well as support from the top, to execute. World best practices (e.g., using “bad banks” to take, sell off, and wind down bad debts) were used with practical + +106 In 1919 he demonstrated as part of the May Fourth Movement against the Chinese government being so weak in allowing the Treaty of Versailles, which carved up the world for the winners of World War I, to give the eastern part of Shandong province to the Japanese rather than give it back to China. Also, when on a study program in France, he demonstrated against the Chinese government for not sustaining the program. All through his life he was a revolutionary until he won and became part of the establishment. + +107 https://www.lowyinstitute.org/the-interpreter/chart-week-global-trade-through-us-china-lens + + + +--- + + +understandings for the Chinese environment. It went on to help clean the slate to start over in a better way, which invigorated growth. He also led the putting into place of numerous other economic reforms. The most senior economic policy makers today helped him back then and learned from those experiences, which are helping them in their current jobs. He became premier in 1998 and in that capacity continued to aggressively pursue reforms to modernize and make the Chinese economy more efficient. He retired in 2003. + +In 1995 I had my 11-year-old son, Matt, go to China to live with Madame Gu and her husband and go to what was then a poor local school (Shi Jia Hu Tong Xiao Xue).¹⁰⁸ Matt had been to China with me many times over the years since he was 3 years old. He would tag along to meetings in which the kind Chinese people I was meeting with would give him cookies and milk while we met. He attended lunches and dinners that were fun banquets and had gotten to know Madame Gu well, who was very loving with him so they had a wonderful relationship. So he fell in love with the Chinese people and China. Madame Gu knew that I (and my somewhat hesitant wife) would love for Matt to live in China and have the life of a local Chinese child. We all knew that it would be very tough for him, but good tough. His living conditions would be basic (e.g., there was typically hot water only two days a week). Schools in China then, like most everything else, were poor. He didn’t speak the language so he would have to learn through immersion, which he did. Though his school was poor (e.g., there wasn’t heat until late November so students wore their coats in classes), I saw how they had smart and caring teachers who provided the children with an excellent, complete education that included character development. While Matt’s lifestyle was poor, he was superbly educated, loved, and better developed than in our rich community. He built deep attachments with his teachers and his friends that still exist. The experience changed his life forever and led him to set up a foundation to help Chinese orphans that he ran for 12 years, which brought him and me into many more experiences with Chinese people and Chinese culture in China. Because I was excited about China and its prospects I, via my company Bridgewater, also hired a local investment team that was on the ground to invest American institutional money in Chinese businesses that looked attractive to me, which I pursued for a couple of years and discontinued because I found it too difficult to run it and Bridgewater at home. I did a couple of tiny investments that were profitable and never called on the institutional investors for their money to invest there. These experiences, plus those with the Chinese friends I previously knew, brought me into contact with a wide range of Chinese people, from the humblest to the highest, whom I came to really like and respect. + +In 1995-96 it became widely known that Deng’s health was failing. I was told that Chinese leaders worried that his passing would be viewed as an opportunity for those who opposed Chinese authority to challenge it, and they were especially worried that the Taiwanese would have a referendum in favor of independence, which would be intolerable. A new pro-independence leader in Taiwan (Lee Teng-hui) was just elected and treated in supportive ways that were traditionally avoided. US-China tensions were rising. Madame Gu knew the Chinese official who was in charge of relations with Taiwan and arranged for me to meet with him to help me understand the Chinese perspective. He explained that China would do anything, including going to war, to prevent a referendum in Taiwan from passing and leading to independence, and he reiterated what I conveyed to you before about what reunification with Taiwan meant to the Chinese leaders. He also explained that if a referendum and move toward independence happened and the new leader let it happen, it would be intolerable for the Chinese people because that leader would be shown to be too weak to lead. So it simply could not happen. He also explained that they were watching the weekly poll numbers indicating how widely supported independence was and they observed that Russia’s brutal crushing of rebels in its Chechen republic led to reduced support for independence, and he explained that the Chinese needed to make clear their position via a series of missile tests in the Taiwan Strait. In March 1996, President Clinton, who was approaching a presidential election, sent two aircraft carrier groups into the Taiwan Strait to sail through it, displaying American support. Lots of military movements and threats on both sides happened. The Taiwanese never had the referendum so my Chinese friends thought their moves were successful, and the Chinese never moved beyond the threats, which led the Americans to believe they humiliated the Chinese (which I only recently found out from an American friend who was involved in sending the American carriers to the Taiwan Strait). That put an end to the “Third Taiwan Strait Crisis.” As a result of this crisis, the Chinese never wanted to be in an inferior military position again, so they significantly built their military capabilities for operating in that region. I point this out to convey a) how important Taiwan’s reunification with China is and + +¹⁰⁸ To clarify, while Madame Gu’s first husband passed, she remarried so I’m referring to her second husband. + + + +--- + + +b) how risky the situation was 25 years ago when China was not nearly as strong militarily as it is now, so this is why I would worry a lot if we were to see a “Fourth Taiwan Strait Crisis.” + +Deng died on February 19, 1997. + +Deng’s results, and the Chinese people’s results, speak for themselves. When Deng came to power about 90%109 of the population lived in extreme poverty; at his death that number was around 40% and fell to less than 2% by 2013.110 From the start of Deng’s reforms in 1978 until his death in 1997, the Chinese economy grew at an average rate of 10% for nearly 20 years, so the economy grew over six times in size with an average inflation rate of about 8%. Its reserves grew from $4 billion to nearly $150 billion (inflation-adjusted to today’s dollars, reserves grew by over $250 billion). Reserves went from covering 60% of annual imports in 1978 to over 125% of imports by 1998 (and by that point reserves covered nearly 800% of foreign debt service). + +Deng’s successors, Jiang Zemin and Hu Jintao, and their teams continued the reforms and the advances through many ups and downs (though more ups than downs) like the 1992 recession. During this period, the “triangular debt” problem (in which state-owned banks lent money to state-owned enterprises due to implicit guarantees by the central government) had to be dealt with, and in 1997 the Asian financial crisis came along. China, with Zhu Rongji assigned to run the effort, did a very successful debt and corporate restructuring to resolve the problem, which included the government selling off bureaucratically run and unprofitable state-owned enterprises, the building of exports and foreign exchange reserves, cracking down on corruption, and developing and improving markets and market functioning. These and more market and economic changes were all important evolutionary steps along the way. I felt lucky to be intimately involved at the grassroots level with some of them—e.g., the debt restructuring and asset sales—that gave me an intimacy of contact and the perspectives I now have. Though these events seemed bigger at the time than they appear in retrospect, they were all significant achievements of smart Chinese people who were committed to Chinese progress. Along the way I also ran into cases of corruption and bad behavior, and the ongoing struggle between the good and the bad that led to the reforms and results we have seen. + +This phase in the cycle was a time of great progress in China. As is typically true in postwar periods of peace and prosperity, when the leading power isn’t threatened and the emerging countries aren’t yet threatening, the leading emerging countries (in this case most importantly China) can learn a lot from the leading powers (in this case most importantly the United States) as they work in a symbiotic way until the emerging powers become powerful enough to threaten the leading powers. In addition to benefiting from the learning, they benefit from trading with each other until that becomes disadvantageous, and they benefit from using the capital markets in a symbiotic way until that becomes disadvantageous. + +More specifically, the 1978 to 2008 period of fast growth in China came about because 1) the world was still in the peace-and-prosperity phase of the Big Cycle in which globalization and capitalism—i.e., the beliefs that goods and services should be produced wherever they can most cost-effectively be produced, there should be free flows of talented people without prejudices to their nationalities, nationalism is bad, and global equal opportunity and profit-seeking capitalism are good—were the widely accepted paths to a better world at the same time that 2) in China in 1978 Deng Xiaoping swung the pendulum from communist and isolationist policies that worked terribly to “market”/“state-capitalist” and open-door policies that worked terrifically. That led China to learn a lot, attract a lot of foreign capital, and become a giant exporter and big saver. + +As the Chinese learned and became more capable of producing goods cost-effectively, they provided the world with inexpensive goods at first and more advanced goods later, and in the process became much richer. Other emerging countries did so as well, the world expanded, and the wealth gaps between the richest countries and the poorest countries narrowed as the poorest countries rose the most while the richest countries grew at slower rates. Through this period the system raised almost all boats, especially the boats of the globalist elites, and the threats on the horizon weren’t apparent. During this period China rose to be a nearly comparable power to the United. + + + +--- + +States and together they created most of the new wealth and new technologies while the rest of the world fell back relative to the leaders. Europe, which was the source of the greatest global powers from the 15th century until the 20th century, became relatively weak, and Japan and Russia became secondary powers. All other countries were peripheral; countries like India and a few emerging countries improved their conditions, though none of them achieved world power status. + +© 2020 Bridgewater Associates, LP + +--- + +Since 2008: The Emergence of US-China Conflicts and the End of Globalization + +As is classic, periods of prosperity financed by debt growth lead to a debt bubble and a large wealth gap. The bubble burst in 2008 (like in 1929), so the world economy contracted and middle-class Americans and others in other countries were hurt (like in 1929-32), interest rates were pushed down to 0% (like in 1931), which wasn’t enough easing so central banks printed a lot of money and bought a lot of financial assets in 2008 (like in 1934), which drove financial asset prices in most countries up starting in 2009 (like in 1933-36), which benefited those people who had financial assets (the “haves”) more than the “have nots” so the wealth gaps grew (like in 1933-38). That is when the “have nots” who were losing to globalization, especially those who were seeing their jobs being taken by the Chinese and by immigrants, started to rise up against the elites who were benefiting from globalization. As is typically the case, with economic bad times coinciding with large wealth gaps, populism and nationalism grew around the world, like in the 1930s. That is when the threats of the rising powers challenging the leading world powers started to become more apparent and the era of peace, prosperity, and globalization started to wane and the era of conflicts between the rich and the poor within countries and between the rising country (China) and the dominant world power (the US) began. + +During this period the Chinese held a lot of US-dollar-denominated debt—especially of US government agency lenders Fannie Mae and Freddie Mac. For quite a while the US government didn’t let the Chinese holders of this debt know if the US government would stand behind this debt. I had conversations with the top Chinese holders of this debt as did David McCormick (who is now CEO of Bridgewater and was then the US Treasury Undersecretary for International Affairs) and Hank Paulson (who was then US Treasury Secretary). We all were impressed with their consideration and cooperation as they approached the dilemma that the US caused. + +In November 2008 in the midst of the global financial crisis, leaders of the G20 countries gathered in Washington, DC, and agreed to jointly stimulate their economies through aggressively stimulative fiscal and monetary policies that required substantially increasing government debt and having central banks create money and credit to finance it. During the 2009-12 period, debt growth in China was significantly faster than economic growth as a result of large fiscal and monetary policy stimulations that were deployed to help pull the Chinese and the world economies out of their weakness. + +# Phase 3, 2012 until Now: The Xi Phase of Becoming a World Power + +In 2012 Xi Jinping came to power and a new administration was chosen. Following the well-established sequence, Politburo members were chosen, then ministers were chosen, then vice ministers were chosen, then those in senior subordinate roles were chosen, and then the first rounds of plans were made. As with most new leaders coming into power, there was a lot of excitement and eagerness to make big improvements. The process of coming up with their plans included many brainstorming sessions about what policies and plans were most appropriate. I was lucky enough to participate in a couple of these in which there were very frank conversations about how to deal with many difficult and sensitive situations, including how to deal with corruption, excessive debt, and other such things. It was a wonderful collaboration of people with different perspectives who wanted to help. The frankness, open-mindedness, friendliness, and intelligence that was brought to these discussions was wonderful. These policymakers clearly felt that economic reforms (i.e., moving to more market-driven resource allocations that included providing less support to uneconomic state-owned enterprises and less protection to entities that made bad loans) had to be made, corruption had to be dramatically reduced, and rule of law needed to be increased. + +Since then I have closely studied their financial and economic circumstances and have had numerous conversations with top economic policymakers about their circumstances and policies—about their excessive debt growth, the development and management of their shadow banking system, the development of financial markets, the vulnerabilities in their financial system, the trade dispute with the US, other disputes and cooperations with the United States, and other things that were going on in the world. I tried to see things through their eyes and think about what I would do if I were in their shoes and they tried to see things through my eyes. We discussed how things work (i.e., cause/effect relationships), how they worked throughout history, how they were working at + +© 2020 Bridgewater Associates, LP + +--- + + +the moment, and we discussed principles for dealing with them well. In other words I shared with them what I saw in much the same way that I am sharing it with you in this writing, and we discussed it, looking at the circumstances in much the same way doctors would look at and discuss medical cases. As you probably know by now, I believe that everything works like a machine with timeless and universal cause/effect relationships. Chinese leaders do, too, so we would talk about these cases and how the timeless and universal principles of how to handle such things would apply to the situations at hand. I found that when I gained the complete picture of all the considerations they faced that I almost always would have pursued the same policies that they pursued because the mechanics of the situations warranted these treatments. I of course focused most on economic and market issues, though our discussions encompassed other issues like human nature, culture, and geopolitics as well. + +Let me give you an example. The government is now, for good reason, concerned about preventing a property market financing bubble and preventing dangerous lending practices pertaining to it because of classic signs of that happening. Guo Shuqing—who is an extremely capable man, head of the China Banking Regulatory Commission and also the central bank’s (i.e. the PBoC’s) party general secretary—has put into place three new “red lines” to limit property developer’s corporate debt. They are: + +| 1) | asset-liability ratios above 70 percent. | +| -- | ---------------------------------------- | +| 2) | net debt to equity of 100 percent. | +| 3) | short term debt to cash of 100 percent. | + +He also mandated that property developers’ new bond could not be taken in to be at levels that are greater than 85 percent of their total outstanding debt and many more rules like this. You get the idea. While anyone can quibble over whether these are the exact right restraints, any knowledgeable person would tell you that they are reasonable and that they stand in contrast with the lack of controls that were allowed to exist on US lending institutions before the lending binges that led to the bubble that led to the 2008 bust. So, one will be faced with the philosophical question of whether regulatory activities like these are better or worse than a more free-market approach. While I won’t delve into that question now, I will say that the regulators that I have gotten to know are almost all very capable, committed to doing the right things for the system, and doing the sensible things that I would do if I were in their shoes operating within the more interventionist system mandated from the top. Also, I have found that most people whom I speak with about such things and are critical don’t have adequate knowledge of the circumstance and haven’t heard the perspectives of the people who are setting these policies. + +As far as economics and markets are concerned, under the Xi administration China aggressively pursued policies to reform and open up its markets and its economy, to gain control of and manage its debt growth, to more flexibly manage its currency, to support entrepreneurship and market-oriented decision making especially in industries that China wants to be a world leader in, to establish sensible regulations run by well-developed regulatory organizations, to build its capabilities in technologies and industries of the future, to broaden the economic benefits to extend to those people and those parts of the country that were lagging the most, and to control environmental pollution. It accomplished a lot that was consistent with these objectives. Still, many people don’t see it that way, which I suspect is because: + +- a) they are coming at the same time that other controls are tightening up, +- b) the privatizations and reforms of state-owned enterprises aren’t as fast as some people would like, +- c) some of the supports (like credit availability) for small- and medium-sized organizations are not as good as they are for larger state-owned enterprises (which has more to do with the challenges of getting money and credit to SMEs than with the government’s reduced intentions to foster the development of SMEs), +- d) the government still sometimes expects banks and companies to do uneconomic lending and directs the economy so much from the top down (because it wants to guide policy for what it believes is best for the whole), +- e) China coordinates with its businesses in pursuit of national goals, +- f) China doesn’t let some foreign companies operate on the same terms as Chinese companies in China, and +- g) China coordinates fiscal and monetary policy to regulate the economy to meet its objectives more than is done in the major reserve currency countries —all of which are typically unpopular with capitalist outsiders. + +However, the biggest reason for the criticisms, more important than any of these, is that most people don’t understand the perspectives of those in charge, and they don’t understand the range of circumstances that influence their decisions and how they are weighing them. For many years I have looked at economic and financial issues in China and discussed them many times with top Chinese economic policy. + +111 I never asked questions that would put them in the awkward position of having to choose between conveying confidential information and having to decline my request. I just wanted to see things through their eyes and help, like a doctor looking at cases with other doctors would discuss what’s happening and what one in these positions should do about them. + + + +--- + + +makers and, from this informed perspective, can tell you that I would have done almost the exact same things as they did if I were in their shoes. So, I think the main reason I see what the Chinese have been doing in economics and markets more favorably than most non-Chinese observers is that I have been lucky enough to have had the opportunity to see things through their eyes and to discuss and agree on how the economic and market machines work. + +The biggest difference between the American and Chinese approaches to economics and markets is about the role of the state relative to the role of the market. While I won’t delve into the merits of these alternative approaches, I will say that it is up to all government leaders in all countries to get the best balance between “state” (i.e., government influence and control of the economy) and “capitalism” (free market control of the economy and capital markets) through the proper management and coordination of monetary and fiscal policy. They each do it differently. + +How the Chinese are doing this can be confusing to people who don’t discuss what they are doing with their policy makers and can’t see the consistencies that exist amid these seeming inconsistencies. For example, President Xi has said that he wants to reduce the government’s role in pricing and allocating resources at the micro level, increase capital market development, and stimulate entrepreneurship, at the same time that he wants to strongly direct the macroeconomy, more strongly regulate markets, deliver public services, and follow Marxism. This can be confusing to those who are used to these things not going together, aren’t speaking with the policy makers to understand all of their circumstances and their perspectives about them, and aren’t watching closely the decisions that they are making. + +I believe that I see the consistencies of these seemingly conflicting policies and by and large would do what they are doing to make my financial system, economy, and country stronger if I were in their shoes. In any case, I suggest that you not view what they are doing through a lens of simple stereotypes (e.g., of “what communists do”) and accept that they will run their economy via monetary and fiscal policy in the ways that they believe are best for them and seek to understand those ways better. Since their results are extremely impressive, we should not expect them to abandon their approach for ours and we should study their approach to see what we can learn from it, the same way they have studied and learned from ours. After all, what we have is a competition of approaches and presumably what we want most is to follow the best approach. + +As far as foreign policy is concerned, during the Xi term, China has gotten stronger and more forceful while the United States has become more confrontational. More specifically, from 2012 until now China’s strengths grew; that became increasingly apparent and more openly shown (e.g., the Made in China 2025 plan openly showed bold plans to dominate certain industries that the United States was dominating) at the same time that the American populist backlash emerged. This became most apparent after the election of Donald Trump. + +In 2016 Donald Trump’s election as a populist president of the United States came as he tapped into the sentiment of those who suffered from globalization and were sympathetic to the view that China was unfairly taking their jobs and unfairly competing. That is when globalization began to be smothered and protectionism and nationalism began to be nurtured. At the time, China had become so obviously strong and followed a number of practices that American policy makers and most people found objectionable. Also, President Xi didn’t hide China’s economic strength and its ambitious goals to dominate a number of industries that the US was dominant in, to go global economically, and to more forcefully assert itself in the South and East China Seas and with countries in the ASEAN region. As a result, the perception of China as a threat/enemy emerged, globalization reversed, and the “wars” began, starting with the trade war and economic war, expanding to the technology war, the geopolitical war, and most recently the capital war. + +During these years, China has continued to grow internally and expand its investment and business activities outside its borders. For example, Xi developed the Belt and Road Initiative, which that will cost over $1 trillion and impact around 70 countries, and it invested in many countries beyond that, especially in the developing world. While these moves have been appreciated by many of those who got money, resources, trade, and soft-power benefits (such as roads and other infrastructure), at the same time they were resented by those in recipient countries who are having problems paying back their loans and find China too controlling, and by the United States because it brought about China’s greater influence in these countries, which is coming at the expense of US influence. + +As far as China’s internal politics are concerned, in 2018 Xi a) consolidated power around him and his supporters (called “the core” leadership), b) amended the Chinese constitution to make clear that the Chinese Communist + + + +--- + + +Party has control over everything, c) eliminated term limits for the president and vice president, d) created a supervisory commission to assure that government officials are operating consistent with the party’s wishes, and e) enshrined Xi’s perspective called “Xi Jinping Thought” into the constitution. Some people are concerned about this being a move to more single-leader/autocratic leadership akin to Mao’s leadership. I’m not capable of having a reliable opinion about internal political matters in China, but I will pass along what I am told, which is that this controversial move to tighter controls and more extensive leadership by Xi came about because of beliefs that China is entering a more difficult phase in a more challenging world and that at such times unity and continuity of leadership is especially important, and will be even more important over the next few years. As mentioned earlier, during periods of great crisis more autocratic and less democratic leadership tends to be preferred. + +Conflicts between the US and China over trade, technology, geopolitics, and to some extent, capital intensified. Then we got the pandemic, the economic downturn came, the massive printing creation of money and credit, and the various types of conflicts (most obviously the racially motivated protests and riots) occurred, and we are now where we are. Where is that, and, in a nutshell, how did China get here? + +Conflicts over stealing intellectual property, especially through cyber espionage, have also increased a lot. I am told that China and the United States have both been much more aggressive in cyber and non-cyber spying, though they have done it differently. I’m not an expert on this issue, but I have spoken to many Americans in positions to know who allege that Chinese stealing of intellectual property from companies is much more extensive. For example, in a February 2019 survey, 1 in 5 North America-based companies on the CNBC Global CFO Council said that China had stolen their IP within the last year.¹¹² If you want to read some American studies some are recommended in this footnote.¹¹³ + +# As we conclude our look back at what happened, it is worth a quick recap. + +Over the last 40 years, China’s shift from isolation to opening up and from hard-core communism to “market reforms” and capitalism has had a greater impact on the economies of the Chinese, the US, and the world than anything else. What happened a) in China and in the US, b) between them, and c) between them and the rest of the world have caused the biggest changes in the world. More specifically, as a result of China’s opening up and reforming its system to learn from foreign countries, obtain foreign capital, and incorporate capitalistic techniques, it learned a lot, efficiently produced a lot, exported and earned a lot, lent and invested a lot globally, became a lot richer and more powerful, and radically changed itself and the rest of the world. For most of those years, that occurred in a classic period of global peace and prosperity in which the leading empire wasn’t threatened and globalization and cooperation flourished. The period lasted until around 2008-10 when the United States and the world became more nationalistic, confrontational, and protectionist, following the archetypical Big Cycle progression. Over just these 40 years China transitioned itself from one of the most backward countries judging by my eight measures of power to one of the two most powerful countries, most importantly economically, technologically, militarily and geopolitically. + +The results of their policies are reflected in the table below, which shows just a few representative statistics. They and most other stats are extremely impressive. For example, output per person has increased 25 times, the percentage of people living below the poverty line has fallen from 96% to less than 1%, life expectancy has increased by an average of 10 years, and the average number of years of education has increased by about 80%. I could go on and on rattling off statistics in virtually every area that were equally impressive. China is now clearly a rival of the United States in a number of areas. + +| Statistic | Value | +| -------------------------- | ------------------------ | +| Output per person increase | 25 times | +| Poverty rate reduction | From 96% to less than 1% | +| Life expectancy increase | 10 years | +| Education increase | 80% | + +112 https://www.cnbc.com/2019/02/28/1-in-5-companies-say-china-stole-their-ip-within-the-last-year-cnbc.html + +113 Relevant studies include “How China’s Economic Aggression Threatens the Technologies and Intellectual Property of the United States and the World,” “Section 301 Report into China’s Acts, Policies, and Practices Related to Technology Transfer, Intellectual Property, and Innovation,” “China’s Technology Transfer Strategy: How Chinese Investments in Emerging Technology Enable a Strategic Competitor to Access the Crown Jewels of US Innovation,” and “The Report of the Commission on the Theft of American Intellectual Property.” + +© 2020 Bridgewater Associates, LP + +--- + +China's Development Since 1949 and 1978 + +| | 1949 | 1978 | 2018 | Since 1949 | Since 1978 | +| ------------------------------------------------- | ---- | ---- | ------ | ------------- | ---------- | +| RGDP Per Capita\* | 348 | 609 | 15,243 | 44x | 25x | +| Share of World GDP | 2% | 2% | 22% | 12x | 11x | +| Population Below the Poverty Line ($1.90/day)\*\* | --- | 96% | 1% | at least -96% | -96% | +| Life Expectancy | 41 | 66 | 77 | +36 Yrs | +11 Yrs | +| Infant Mortality Rate (per 1000 births) | 200 | 53 | 7 | -96% | -86% | +| Urbanization | 18% | 18% | 59% | +41% | +41% | +| Literacy | 47% | 66% | 97% | +50% | +31% | +| Avg Yrs of Education | 1.7 | 4.4 | 7.9 | +6.2 Yrs | +3.5 Yrs | + +*USD 2017, PPP-adjusted + +**The World Bank only has poverty data back to 1981 + +As for the value of money, the charts below show the value of Chinese currency measured in dollar terms since the introduction of the RMB in 1948. As shown, the RMB was fixed against the dollar and gold until 1971 when a) the US dollar devalued against gold and most other currencies, including the RMB and b) all currencies (including the RMB) devalued against gold. That is when China, as well as the US and most currencies, went to a fiat monetary system and inflation rates accelerated. The initial appreciation of the RMB relative to the dollar hurt exports and the economy, which led to devaluations of the RMB from 1980 to 1994 totaling 83% (or roughly 12% per year), which pushed the average inflation rate during this period up to 7.8%. From 1997 until 2005 it was firmly pegged at 8.28 yuan per USD though not freely traded. In July 2005 the RMB was de-pegged from the USD and was managed against a basket of foreign currencies (starting at 8.11 yuan per USD). Since then the RMB has had some fluctuations but hasn’t depreciated below the 2005 rate (when de-pegged). The chart on the left shows the spot price in USD terms and the one on the right shows it in gold terms. As shown, since 2014 the RMB has declined a bit (by about 2% per year) versus the dollar and a bit more (8% per year) against gold. + +| CNY vs USD (Inv) | Gold Price (in CNY, Inv) | +| ---------------- | ------------------------ | +| 0 | 0 | +| 1 | 2,000 | +| 2 | 4,000 | +| 3 | | +| 4 | 6,000 | +| 5 | 8,000 | +| 6 | 10,000 | +| 7 | 12,000 | +| 8 | | +| 9 | 14,000 | +| 10 | 16,000 | + +Up = stronger RMB + +Because the interest rate earned from holding the Chinese currency was not included in these spot prices and the interest rate one would have received by holding the Chinese currency was higher than the average interest rate from holding dollars and was higher than the 0% interest rate one gets from holding gold, the total returns of holding China’s RMB were higher than shown in the previous charts. As of now I only have Chinese interest rates going back to 1980; the chart shows the estimated total return of holding the Chinese currency since then in terms of both dollars and gold. + +© 2020 Bridgewater Associates, LP 145 + +--- + + +# RMB Total Return (vs USD) + +| 60% | 100% | +| ---- | ---- | +| 40% | 80% | +| 20% | 60% | +| 0% | 40% | +| -20% | 20% | +| -40% | 0% | +| -60% | -20% | +| | -40% | +| | -60% | + +# RMB Total Return (vs Gold) + +| 80% | 80% | +| ---- | ---- | +| 60% | 60% | +| 40% | 40% | +| 20% | 20% | +| 0% | 0% | +| -20% | -20% | +| -40% | -40% | +| -60% | -60% | + +The key to running a sound currency policy that produces a sound credit system that works for both borrowers and lenders is to not have the currency produce any big rises or declines in relation to either other leading exchange rates or goods and services prices. China has been managing the exchange rates and the interest rates to do that since around 1985. + +114 Total returns vs USD are calculated using tradable market returns where available, extended back with data on interest rates and spot exchange rates. Total returns vs gold are constructed using data for interest rates, spot exchange rates, and USD gold prices. + +© 2020 Bridgewater Associates, LP + + +--- + + +Important Disclosures + +Information contained herein is only current as of the printing date and is intended only to provide the observations and views of Bridgewater Associates, L.P. (“Bridgewater”) as of the date of writing unless otherwise indicated. Bridgewater has no obligation to provide recipients hereof with updates or changes to the information contained herein. Performance and markets may be higher or lower than what is shown herein and the information, assumptions and analysis that may be time sensitive in nature may have changed materially and may no longer represent the views of Bridgewater. Statements containing forward-looking views or expectations (or comparable language) are subject to a number of risks and uncertainties and are informational in nature. Actual performance could, and may have, differed materially from the information presented herein. Past performance is not indicative of future results. + +Bridgewater research utilizes data and information from public, private and internal sources, including data from actual Bridgewater trades. Sources include, the Australian Bureau of Statistics, Barclays Capital Inc., Bloomberg Finance L.P., CBRE, Inc., CEIC Data Company Ltd., Consensus Economics Inc., Corelogic, Inc., CoStar Realty Information, Inc., CreditSights, Inc., Credit Market Analysis Ltd., Dealogic LLC, DTCC Data Repository (U.S.), LLC, Ecoanalitica, EPFR Global, Eurasia Group Ltd., European Money Markets Institute – EMMI, Factset Research Systems, Inc., The Financial Times Limited, GaveKal Research Ltd., Global Financial Data, Inc., Haver Analytics, Inc., The Investment Funds Institute of Canada, Intercontinental Exchange (ICE), International Energy Agency, Lombard Street Research, Markit Economics Limited, Mergent, Inc., Metals Focus Ltd, Moody’s Analytics, Inc., MSCI, Inc., National Bureau of Economic Research, Organisation for Economic Cooperation and Development, Pensions & Investments Research Center, Refinitiv, Renwood Realtytrac, LLC, RP Data Ltd, Rystad Energy, Inc., S&P Global Market Intelligence Inc., Sentix Gmbh, Spears & Associates, Inc., State Street Bank and Trust Company, Sun Hung Kai Financial (UK), Tokyo Stock Exchange, United Nations, US Department of Commerce, Wind Information (Shanghai) Co Ltd, Wood Mackenzie Limited, World Bureau of Metal Statistics, and World Economic Forum. While we consider information from external sources to be reliable, we do not assume responsibility for its accuracy. + +The views expressed herein are solely those of Bridgewater and are subject to change without notice. In some circumstances Bridgewater submits performance information to indices, such as Dow Jones Credit Suisse Hedge Fund index, which may be included in this material. You should assume that Bridgewater has a significant financial interest in one or more of the positions and/or securities or derivatives discussed. Bridgewater’s employees may have long or short positions in and buy or sell securities or derivatives referred to in this material. Those responsible for preparing this material receive compensation based upon various factors, including, among other things, the quality of their work and firm revenues. + +This material is for informational and educational purposes only and is not an offer to sell or the solicitation of an offer to buy the securities or other instruments mentioned. Any such offering will be made pursuant to a definitive offering memorandum. This material does not constitute a personal recommendation or take into account the particular investment objectives, financial situations, or needs of individual investors which are necessary considerations before making any investment decision. Investors should consider whether any advice or recommendation in this research is suitable for their particular circumstances and, where appropriate, seek professional advice, including legal, tax, accounting, investment or other advice. + +The information provided herein is not intended to provide a sufficient basis on which to make an investment decision and investment decisions should not be based on simulated, hypothetical or illustrative information that have inherent limitations. Unlike an actual performance record, simulated or hypothetical results do not represent actual trading or the actual costs of management and may have under or over compensated for the impact of certain market risk factors. Bridgewater makes no representation that any account will or is likely to achieve returns similar to those shown. The price and value of the investments referred to in this research and the income therefrom may fluctuate. + +Every investment involves risk and in volatile or uncertain market conditions, significant variations in the value or return on that investment may occur. Investments in hedge funds are complex, speculative and carry a high degree of risk, including the risk of a complete loss of an investor’s entire investment. Past performance is not a guide to future performance, future returns are not guaranteed, and a complete loss of original capital may occur. Certain transactions, including those involving leverage, futures, options, and other derivatives, give rise to substantial risk and are not suitable for all investors. Fluctuations in exchange rates could have material adverse effects on the value or price of, or income derived from, certain investments. + +# PRINCIPLES + +# BY RAY DALIO + +What follows are three distinct parts that can be read either independently or as a connected whole. Part 1 is about the purpose and importance of having principles in general, having nothing to do with mine. Part 2 explains my most fundamental life principles that apply to everything I do. Part 3 explains my management principles as they are being lived out at Bridgewater. Since my management principles are simply my most fundamental life principles applied to management, reading Part 2 will help you to better understand Part 3, but it’s not required—you can go directly to Part 3 to see what my management principles are and how Bridgewater has been run. One day I’d like to write a Part 4 on my investment principles. If you are looking to get the most bang for your buck (i.e., understanding for the effort), I suggest that you read Parts 1 and 2, and the beginning of Part 3 (through the Summary and Table of Principles) which will give you nearly the whole picture. It’s only about 55 pages of a normal size book. + +Above all else, I want you to think for yourself—to decide 1) what you want, 2) what is true and 3) what to do about it. I want you to do that in a clear-headed thoughtful way, so that you get what you want. I wrote this book to help you do that. I am going to ask only two things of you—1) that you be open-minded and 2) that you honestly answer some questions about what you want, what is true and what you want to do about it. If you do these things, I believe that you will get a lot out of this book. If you can’t do these things, you should reflect on why that is, because you probably have discovered one of your greatest impediments to getting what you want out of life. + + +--- + + +# INTRODUCTION + +Principles are concepts that can be applied over and over again in similar circumstances as distinct from narrow answers to specific questions. Every game has principles that successful players master to achieve winning results. So does life. Principles are ways of successfully dealing with the laws of nature or the laws of life. Those who understand more of them and understand them well know how to interact with the world more effectively than those who know fewer of them or know them less well. Different principles apply to different aspects of life—e.g., there are “skiing principles” for skiing, “parenting principles” for parenting, “management principles” for managing, “investment principles” for investing, etc—and there are over-arching “life principles” that influence our approaches to all things. And, of course, different people subscribe to different principles that they believe work best. + +I am confident that whatever success Bridgewater and I have had has resulted from our operating by certain principles. Creating a great culture, finding the right people, managing them to do great things and solving problems creatively and systematically are challenges faced by all organizations. What differentiates them is how they approach these challenges. The principles laid out in the pages that follow convey our unique ways of doing these things, which are the reasons for our unique results. Bridgewater’s success has resulted from talented people operating by the principles set out here, and it will continue if these or other talented people continue to operate by them. Like getting fit, virtually anyone can do it if they are willing to do what it takes. + +What is written here is just my understanding of what it takes: my most fundamental life principles, my approach to getting what I want, and my “management principles,” which are based on those foundations. Taken together, these principles are meant to paint a picture of a process for the systematic pursuit of truth and excellence and for the rewards that accompany this pursuit. I put them in writing for people to consider in order to help Bridgewater and the people I care about most. + + + +--- + + +Until recently, I didn’t write out these principles because I felt that it was presumptuous for me to tell others what would work best for them. But over time, I saw the people who I cared about most struggling with problems and wanted to help them; I also found that their problems were almost always the result of violating one or more of these principles, and that their problems could be solved by applying these principles. So I began writing down the types of problems and the broken principles that caused them. + +When I began, I didn’t know how many principles I would end up with but, through this process, I discovered that about 200 principles pretty much cover all the problems.1 I’m sure that I will come up with more as I learn more. + +When I say that these are my principles, I don’t mean that in a possessive or egotistical way. I just mean that they are explanations of what I personally believe. I believe that the people I work with and care about must think for themselves. I set these principles out and explained the logic behind them so that we can together explore their merits and stress test them. While I am confident that these principles work well because I have thought hard about them, they have worked well for me for many years, and they have stood up to the scrutiny of the hundreds of smart, skeptical people, I also believe that nothing is certain. I believe that the best we can hope for is highly probable. + +By putting them out there and stress testing them, the probabilities of their being right will increase. + +I also believe that those principles that are most valuable to each of us come from our own encounters with reality and our reflections on these encounters – not from being taught and simply accepting someone else’s principles. So, I put these out there for you to reflect on when you are encountering your realities, and not for you to blindly follow. What I hope for most is that you and others will carefully consider them and try operating by them as part of your process for discovering what works best for you. + +Through this exploration, and with their increased usage, not only will they be understood, but they will evolve from “Ray’s principles” to “our principles,” and Ray will fade out of the picture in much the same way as memories of one’s ski or tennis instructor fade and people only pay attention to what works.2 So, when digesting each principle, please... + + + +--- + + +# Management Principles + +...ask yourself: “Is it true?” + +Before I discuss the management principles themselves, it’s important for me to articulate my own most fundamental life principles because my management principles are an extension of them. + +# Part 1 + +I explain what I mean by principles, why I believe they are important, and how they are essential for getting what you want out of life. + +# Part 2 + +Part 2 explains my most fundamental life principles. I describe what I believe are the best ways of interacting with reality to learn what it’s like, and how to most effectively deal with it to get what you want. I also discuss what I believe are the most common traps that people fall into that prevent them from getting what they want, and how people’s lives can be radically better by avoiding them. I wrote this so you can better understand why my other principles are what they are, though you don’t need to read this part to understand the others. + +# Part 3 + +Part 3 is about my management principles. As I have run Bridgewater for more than 35 years, it explains Bridgewater’s approach up till now. It begins at the big-picture, conceptual level, with an explanation of why I believe that any company’s results are primarily determined by its people and its culture. It then drills down into what I believe are the important principles behind creating a great culture, hiring the right people, managing them to achieve excellence, solving problems systematically and making good decisions. + +There are of course lots of other types of principles. For example, I hope to one day write about my investment principles. However, management principles are now what we need most, so here are the ones that I think make sense and have worked for me. + + + +--- + + +# PART 1: THE IMPORTANCE OF PRINCIPLES + +I believe that having principles that work is essential for getting what we want out of life. I also believe that to understand each other we have to understand each other’s principles.3 That is why I believe we need to talk about them. + +We will begin by examining the following questions: + +- What are principles? +- Why are principles important? +- Where do principles come from? +- Do you have principles that you live your life by? What are they? +- How well do you think they will work, and why? + +Answer all questions with complete honesty, without worrying what I or others might think. That honesty will allow you to be comfortable living with your own principles, and to judge yourself by how consistently you operate by them. If you don’t have many well-thought-out principles, don’t worry. We will get there together, if we remain open-minded. + +# 1) WHAT ARE PRINCIPLES? + +Your values are what you consider important, literally what you “value.” Principles are what allow you to live a life consistent with those values. Principles connect your values to your actions; they are beacons that guide your actions, and help you successfully deal with the laws of reality. It is to your principles that you turn when you face hard choices. + +# 2) WHY ARE PRINCIPLES IMPORTANT? + +All successful people operate by principles that help them be successful. Without principles, you would be forced to react to circumstances that come at you without considering what you value most and how to make choices to get what you want. This would prevent you from making the most of your life. While operating without principles is bad for individuals, it is + + + +--- + + +# 3) WHERE DO PRINCIPLES COME FROM? + +Sometimes we forge our own principles and sometimes we accept others’ principles, or holistic packages of principles, such as religion and legal systems. While it isn’t necessarily a bad thing to use others’ principles—it’s difficult to come up with your own, and often much wisdom has gone into those already created—adopting pre-packaged principles without much thought exposes you to the risk of inconsistency with your true values. Holding incompatible principles can lead to conflict between values and actions—like the hypocrite who has claims to be of a religion yet behaves counter to its teachings. Your principles need to reflect values you really believe in. + +# 4) DO YOU HAVE PRINCIPLES THAT YOU LIVE YOUR LIFE BY? WHAT ARE THEY? + +Your principles will determine your standards of behavior. When you enter into relationships with other people, your and their principles will determine how you interact. People who have shared values and principles get along. People who don’t will suffer through constant misunderstandings and conflict with one another. Too often in relationships, people’s principles are unclear. Think about the people with whom you are closest. Are their values aligned with yours? + +What do you value most deeply? + +# 5) HOW WELL DO YOU THINK THEY WILL WORK, AND WHY? + +Those principles that are most valuable come from our own experiences and our reflections on those experiences. Every time we face hard choices, we refine our principles by asking ourselves difficult questions. For example, when our representatives in Washington are investigating whether various segments of society are behaving ethically, they are simultaneously grappling with questions such as, “Should the government punish people for bad ethics, or should it just write and enforce the laws?” Questions of this kind—in this case, about the nature of government—prompt thoughtful + + + +--- + +assessments of alternative approaches. These assessments in turn lead to principles that can be applied to similar occasions in the future. As another example, “I won’t steal” can be a principle to which you refer when the choice of whether or not to steal arises. But to be most effective, each principle must be consistent with your values, and this consistency demands that you ask: Why? Is the reason you won’t steal because you feel empathy for your potential victim? Is it because you fear getting caught? By asking such questions, we refine our understanding, and the development of our principles becomes better aligned with our core values. To be successful, you must make correct, tough choices. You must be able to “cut off a leg to save a life,” both on an individual level and, if you lead people, on a group level. And to be a great leader, it is important to remember that you will have to make these choices by understanding and caring for your people, not by following them. + +You have to answer these questions for yourself. What I hope for most is that you will carefully consider the principles we will be exploring in this document and try operating by them, as part of the process of discovering what works best for you. In time, the answers to these questions will evolve from “Ray’s principles” to “my principles,” and “Ray” will fade from the picture in much the same way as memories of your ski instructor or basketball coach fade after you have mastered the sport. + +So, as I believe that adopting pre-packaged principles without much thought is risky, I am asking you to join me in thoughtfully discussing the principles that guide how we act. When considering each principle, please ask yourself, “Is it true?” While this particular document will always express just what I believe, other people will certainly have their own principles, and possibly even their own principles documents, and future managers of Bridgewater will work in their own ways to determine what principles Bridgewater will operate by. At most, this will remain as one reference of principles for people to consider when they are deciding what’s important and how to behave. + +--- + + +# PART 2: MY MOST FUNDAMENTAL LIFE PRINCIPLES + +Time is like a river that will take you forward into encounters with reality that will require you to make decisions. You can’t stop the movement down this river, and you can’t avoid the encounters. You can only approach these encounters in the best way possible. That is what this part is all about. + +# WHERE I’M COMING FROM + +Since we are all products of our genes and our environments and approach the world with biases, I think it is relevant for me to tell you a bit of my background so that you can know where I’m coming from. + +I grew up in a middle-class neighborhood on Long Island, the only son of a jazz musician and a stay-at-home mom. I was a very ordinary kid, and a less-than-ordinary student. I liked playing with my friends—for example, touch football in the street—and I didn't like the school part of school, partly because I had, and still have, a bad rote memory4 and partly because I couldn’t get excited about forcing myself to remember what others wanted me to remember without understanding what all this work was going to get me. In order to be motivated, I needed to work for what I wanted, not for what other people wanted me to do. And in order to be successful, I needed to figure out for myself how to get what I wanted, not remember the facts I was being told to remember. + +One thing I wanted was spending money. So I had a newspaper route, I mowed lawns, I shoveled the snow off driveways, I washed dishes in a restaurant, and, starting when I was 12 years old, I caddied. + +It was the 1960s. At the time the stock market was booming and everyone was talking about it, especially the people I caddied for. So I started to invest. The first stock I bought was a company called Northeast Airlines, and the only reason I bought it was that it was the only company I had heard of that was trading for less than $5 per share, so I could buy more shares, which I figured was a good thing. It went up a lot. It was about to go broke but another company acquired it, so it tripled. I made money because + + + +--- + + +I was lucky, though I didn’t see it that way then. I figured that this game was easy. After all, with thousands of companies listed in the newspaper, how difficult could it be to find at least one that would go up? By comparison to my other jobs, this way of making money seemed much more fun, a lot easier, and much more lucrative. Of course, it didn’t take me long to lose money in the markets and learn about how difficult it is to be right and the costs of being wrong. + +So what I really wanted to do now was beat the market. I just had to figure out how to do it. The pursuit of this goal taught me: + +1. It isn't easy for me to be confident that my opinions are right. In the markets, you can do a huge amount of work and still be wrong. +2. Bad opinions can be very costly. Most people come up with opinions and there’s no cost to them. Not so in the market. This is why I have learned to be cautious. No matter how hard I work, I really can’t be sure. +3. The consensus is often wrong, so I have to be an independent thinker. To make any money, you have to be right when they’re wrong. + +So ... + +1. I worked for what I wanted, not for what others wanted me to do. For that reason, I never felt that I had to do anything. All the work I ever did was just what I needed to do to get what I wanted. Since I always had the prerogative to not strive for what I wanted, I never felt forced to do anything. +2. I came up with the best independent opinions I could muster to get what I wanted. For example, when I wanted to make money in the markets, I knew that I had to learn about companies to assess the attractiveness of their stocks. At the time, Fortune magazine had a little tear-out coupon that you could mail in to get the annual reports of any companies on the Fortune 500, for free. So I ordered all the annual reports and worked my way through the most interesting ones and formed opinions5 about which companies were exciting. +3. I stress-tested my opinions by having the smartest people I could find challenge them so I could find out where I was wrong.6 I never cared + + + +--- + + +much about others’ conclusions—only for the reasoning that led to these conclusions. That reasoning had to make sense to me. Through this process, I improved my chances of being right, and I learned a lot from a lot of great people. + +1. I remained wary about being overconfident, and I figured out how to effectively deal with my not knowing. I dealt with my not knowing by either continuing to gather information until I reached the point that I could be confident or by eliminating my exposure to the risks of not knowing.7 +2. I wrestled with my realities, reflected on the consequences of my decisions, and learned and improved from this process. + +By doing these things, I learned how important and how liberating it is to think for myself. + +In a nutshell, this is the whole approach that I believe will work best for you—the best summary of what I want the people who are working with me to do in order to accomplish great things. I want you to work for yourself, to come up with independent opinions, to stress-test them, to be wary about being overconfident, and to reflect on the consequences of your decisions and constantly improve. + +After I graduated from high school, I went to a local college that I barely got in to. I loved it, unlike high school, because I could learn about things that interested me; I studied because I enjoyed it, not because I had to. + +At that time the Beatles had made a trip to India to learn how to meditate, which triggered my interest, so I learned how to meditate. It helped me think more clearly and creatively, so I’m sure that enhanced my enjoyment of, and success at, learning.8 Unlike in high school, in college I did very well. + +And of course I continued to trade markets. Around this time I became interested in trading commodities futures, though virtually nobody traded them back then. I was attracted to trading them just because they had low margin requirements so I figured I could make more money by being right (which I planned to be). + + + +--- + + +By the time I graduated college, in 1971, I had been admitted to Harvard Business School, where I would go in the fall. That summer between college and HBS I clerked on the floor of the New York Stock Exchange. This was the summer of the breakdown of the global monetary system (i.e., the Bretton Woods system). It was one of the most dramatic economic events ever and I was at the epicenter of it, so it thrilled me. It was a currency crisis that drove all market behaviors, so I delved into understanding the currency markets. The currency markets would be important to me for the rest of my life. + +That fall I went to Harvard Business School, which I was excited about because I felt that I had climbed to the top and would be with the best of the best. Despite these high expectations, the place was even better than I expected because the case study method allowed open-ended figuring things out and debating with others to get at the best answers, rather than memorizing facts. I loved the work-hard, play-hard environment. + +In the summer between my two years at HBS, I pursued my interest in trading commodities futures by convincing the Director of Commodities for Merrill Lynch to give me a job as his assistant. At the time, commodities trading was still an obscure thing to do. + +In the fall I went back to HBS, and in that academic year, 1972-73, trading commodities futures became a hot thing to do. That is because the monetary system’s breakdown that occurred in 1971 led to an inflationary surge that sent commodity prices higher. As a result of this, the first oil shock occurred in 1973. As inflation started to surge, the Federal Reserve tightened monetary policy to fight it, so stocks went down in the worst bear market since the Great Depression. So, commodities futures trading was hot and stock market investing was not. Naturally, brokerage houses that didn’t have commodities trading departments wanted them, and there was a shortage of people who knew anything about it. Virtually nobody in the commodities futures business had the type of Harvard Business School background that I had. So I was hired as Director of Commodities at a moderate-size brokerage and given an old salt who had lots of commodities brokerage experience to help me set up a commodities division. The bad stock market environment ended up taking this brokerage house down before we could get the commodities futures trading going. I went to a + + + +--- + + +bigger, more successful brokerage, where I was in charge of its institutional/hedging business. But I didn’t fit into the organization well, so I was fired essentially for insubordination. + +So in 1975, after a quick two-year stint on Wall Street after school, I started Bridgewater. Soon after, I got married and began my family. + +Through this time and till now I followed the same basic approach I used as a 12-year-old caddie trying to beat the market, i.e., by 1) working for what I wanted, not for what others wanted me to do; 2) coming up with the best independent opinions I could muster to move toward my goals; 3) stress-testing my opinions by having the smartest people I could find challenge them so I could find out where I was wrong; 4) being wary about overconfidence, and good at not knowing; and 5) wrestling with reality, experiencing the results of my decisions, and reflecting on what I did to produce them so that I could improve. + +Since I started Bridgewater, I have gained a lot more experience that taught me a lot more, mostly by making mistakes and learning from them. Most importantly: + +- I learned that failure is by and large due to not accepting and successfully dealing with the realities of life, and that achieving success is simply a matter of accepting and successfully dealing with all my realities. +- I learned that finding out what is true, regardless of what that is, including all the stuff most people think is bad—like mistakes and personal weaknesses—is good because I can then deal with these things so that they don’t stand in my way. +- I learned that there is nothing to fear from truth. While some truths can be scary—for example, finding out that you have a deadly disease—knowing them allows us to deal with them better. +- Being truthful, and letting others be completely truthful, allows me and others to fully explore our thoughts and exposes us to the feedback that is essential for our learning. +- I learned that being truthful was an extension of my freedom to be me. I believe that people who are one way on the inside and + + + +--- + +believe that they need to be another way outside to please others become conflicted and often lose touch with what they really think and feel. It’s difficult for them to be happy and almost impossible for them to be at their best. I know that’s true for me. I learned that I want the people I deal with to say what they really believe and to listen to what others say in reply, in order to find out what is true. I learned that one of the greatest sources of problems in our society arises from people having loads of wrong theories in their heads—often theories that are critical of others—that they won’t test by speaking to the relevant people about them. Instead, they talk behind people’s backs, which leads to pervasive misinformation. I learned to hate this because I could see that making judgments about people so that they are tried and sentenced in your head, without asking them for their perspective, is both unethical and unproductive.9 So I learned to love real integrity (saying the same things as one believes)10 and to despise the lack of it.11 + +I learned that everyone makes mistakes and has weaknesses and that one of the most important things that differentiates people is their approach to handling them. I learned that there is an incredible beauty to mistakes, because embedded in each mistake is a puzzle, and a gem that I could get if I solved it, i.e., a principle that I could use to reduce my mistakes in the future. I learned that each mistake was probably a reflection of something that I was (or others were) doing wrong, so if I could figure out what that was, I could learn how to be more effective. I learned that wrestling with my problems, mistakes, and weaknesses was the training that strengthened me. Also, I learned that it was the pain of this wrestling that made me and those around me appreciate our successes.12 + +I learned that the popular picture of success—which is like a glossy photo of an ideal man or woman out of a Ralph Lauren catalog, with a bio attached listing all of their accomplishments like going to the best prep schools and an Ivy League college, and + +--- + +Getting all the answers right on tests—is an inaccurate picture of the typical successful person. I met a number of great people and learned that none of them were born great—they all made lots of mistakes and had lots of weaknesses—and that great people become great by looking at their mistakes and weaknesses and figuring out how to get around them. So I learned that the people who make the most of the process of encountering reality, especially the painful obstacles, learn the most and get what they want faster than people who do not. I learned that they are the great ones—the ones I wanted to have around me. + +In short, I learned that being totally truthful, especially about mistakes and weaknesses, led to a rapid rate of improvement and movement toward what I wanted. + +While this approach worked great for me, I found it more opposite than similar to most others’ approaches, which has produced communications challenges. Specifically, I found that: + +- While most others seem to believe that learning what we are taught is the path to success, I believe that figuring out for yourself what you want and how to get it is a better path.[13] +- While most others seem to believe that having answers is better than having questions, I believe that having questions is better than having answers because it leads to more learning.[14] +- While most others seem to believe that mistakes are bad things, I believe mistakes are good things because I believe that most learning comes via making mistakes and reflecting on them. +- While most others seem to believe that finding out about one’s weaknesses is a bad thing, I believe that it is a good thing because it is the first step toward finding out what to do about them and not letting them stand in your way. +- While most others seem to believe that pain is bad, I believe that pain is required to become stronger.[15] + +--- + + +One of the advantages of my being over 60 years old—and there aren’t many—is that we can look back on my story to see how I came by these beliefs and how they have worked for me. It is now more than 35 years after I started Bridgewater and about the same number of years since I got married and began my family. I am obviously not your Ralph Lauren poster child for success, yet I’ve had a lot of successes, though they’re probably not what you’re thinking. + +Yes, I started Bridgewater from scratch, and now it’s a uniquely successful company and I am on the Forbes 400 list. But these results were never my goals—they were just residual outcomes—so my getting them can’t be indications of my success. And, quite frankly, I never found them very rewarding.16 + +What I wanted was to have an interesting, diverse life filled with lots of learning—and especially meaningful work and meaningful relationships. I feel that I have gotten these in abundance and I am happy. And I feel that I got what I wanted by following the same basic approach I used as a 12-year-old caddie trying to beat the market, i.e., by 1) working for what I wanted, not for what others wanted me to do; 2) coming up with the best independent opinions I could muster to move toward my goals; 3) stress-testing my opinions by having the smartest people I could find challenge them so I could find out where I was wrong; 4) being wary about overconfidence, and good at not knowing; and 5) wrestling with reality, experiencing the results of my decisions, and reflecting on what I did to produce them so that I could improve. I believe that by following this approach I moved faster to my goals by learning a lot more than if I hadn’t followed it. + +# MY MOST FUNDAMENTAL PRINCIPLES + +In pursuing my goals I encountered realities, often in the form of problems, and I had to make decisions. I found that if I accepted the realities rather than wished that they didn’t exist and if I learned how to work with them rather than fight them, I could figure out how to get to my goals. It might take repeated tries, and seeking the input of others, but I could eventually get there. As a result, I have become someone who believes that we need to + + + +--- + + +deeply understand, accept, and work with reality in order to get what we want out of life. Whether it is knowing how people really think and behave when dealing with them, or how things really work on a material level—so that if we do X then Y will happen—understanding reality gives us the power to get what we want out of life, or at least to dramatically improve our odds of success. In other words, I have become a “hyperrealist.” + +When I say I’m a hyperrealist, people sometimes think I don’t believe in making dreams happen. This couldn’t be further from the truth. In fact, I believe that without pursuing dreams, life is mundane. I am just saying that I believe hyperrealism is the best way to choose and achieve one’s dreams. The people who really change the world are the ones who see what’s possible and figure out how to make that happen. I believe that dreamers who simply imagine things that would be nice but are not possible don’t sufficiently appreciate the laws of the universe to understand the true implications of their desires, much less how to achieve them. + +Let me explain what I mean. + +I believe there are an infinite number of laws of the universe and that all progress or dreams achieved come from operating in a way that’s consistent with them. These laws and the principles of how to operate in harmony with them have always existed. We were given these laws by nature. Man didn’t and can’t make them up. He can only hope to understand them and use them to get what he wants. For example, the ability to fly or to send cellular phone signals imperceptibly and instantaneously around the world or any other new and beneficial developments resulted from understanding and using previously existing laws of the universe. These inventions did not come from people who were not well-grounded in reality.17 The same is true for economic, political, and social systems that work. Success is achieved by people who deeply understand reality and know how to use it to get what they want. The converse is also true: idealists who are not well-grounded in reality create problems, not progress. For example, communism was a system created by people with good intentions who failed to recognize that their idealistic system was inconsistent with human nature. As a result, they caused more harm than good. + +This brings me to my most fundamental principle: + + + +--- + +Truth —more precisely, an accurate understanding of reality— is the essential foundation for producing good outcomes. + +While I spend the most time studying how the realities that affect me most work—i.e., those that drive the markets and the people I deal with—I also love to study nature to try to figure out how it works because, to me, nature is both beautiful and practical. + +Its perfection and brilliance staggers me. When I think about all the flying machines, swimming machines, and billions of other systems that nature created, from the microscopic level to the cosmic level, and how they interact with one another to make a workable whole that evolves through time and through multi-dimensions, my breath is taken away. It seems to me that, in relation to nature, man has the intelligence of a mold growing on an apple—man can’t even make a mosquito, let alone scratch the surface of understanding the universe. + +Though how nature works is way beyond man’s ability to comprehend, I have found that observing how nature works offers innumerable lessons that can help us understand the realities that affect us. That is because, though man is unique, he is part of nature and subject to most of the same laws of nature that affect other species. + +For example, I have found that by looking at what is rewarded and punished, and why, universally—i.e., in nature as well as in humanity—I have been able to learn more about what is “good” and “bad” than by listening to most people’s views about good and bad. It seems to me that what most people call “good” and “bad” typically reflects their particular group’s preferences: the Taliban’s definitions are different than Americans’, which are different than others’—and within each group there are differences and they are intended to paint a picture of the world the way they’d like it to be rather than the way it really is. So there are many different takes on what is good and bad that each group uses to call others “bad” and themselves “good,” some of which are practical and others of which are impractical. Yet all of them, and everything else, are subject to the same laws of nature–i.e., I believe that we all get rewarded and punished according to whether we operate in harmony or in conflict with. + +--- + + +nature’s laws, and that all societies will succeed or fail in the degrees that they operate consistently with these laws. + +This perspective gives me a non-traditional sense of good and bad: “good,” to me, means operating consistently with the natural laws, while “bad” means operating inconsistently with these laws. In other words, for something to be “good” it must be grounded in reality. And if something is in conflict with reality—for example, if morality is in conflict with reality—it is “bad,” i.e., it will not produce good outcomes. + +In other words, I believe that understanding what is good is obtained by looking at the way the world works and figuring out how to operate in harmony with it to help it (and yourself) evolve. But it is not obvious, and it is sometimes difficult to accept. + +For example, when a pack of hyenas takes down a young wildebeest, is this good or bad? At face value, this seems terrible; the poor wildebeest suffers and dies. Some people might even say that the hyenas are evil. Yet this type of apparently evil behavior exists throughout nature through all species and was created by nature, which is much smarter than I am, so before I jump to pronouncing it evil, I need to try to see if it might be good. When I think about it, like death itself, this behavior is integral to the enormously complex and efficient system that has worked for as long as there has been life. And when I think of the second- and third-order consequences, it becomes obvious that this behavior is good for both the hyenas, who are operating in their self-interest, and in the interests of the greater system, which includes the wildebeest, because killing and eating the wildebeest fosters evolution, i.e., the natural process of improvement. In fact, if I changed anything about the way that dynamic works, the overall outcome would be worse. + +I believe that evolution, which is the natural movement toward better adaptation, is the greatest single force in the universe, and that it is good. [18] It affects the changes of everything from all species to the entire solar system. It is good because evolution is the process of adaptation that leads to improvement. So, based on how I observe both nature and humanity working, I believe that what is bad and most punished are those things that + + + +--- + + +don’t work because they are at odds with the laws of the universe and they impede evolution. + +I believe that the desire to evolve, i.e., to get better, is probably humanity’s most pervasive driving force. Enjoying your job, a craft, or your favorite sport comes from the innate satisfaction of getting better. Though most people typically think that they are striving to get things (e.g., toys, better houses, money, status, etc.) that will make them happy, that is not usually the case. Instead, when we get the things we are striving for, we rarely remain satisfied.19 It is natural for us to seek other things or to seek to make the things we have better. In the process of this seeking, we continue to evolve and we contribute to the evolution of all that we have contact with. The things we are striving for are just the bait to get us to chase after them in order to make us evolve, and it is the evolution and not the reward itself that matters to us and those around us. + +It is natural that it should be this way—i.e., that our lives are not satisfied by obtaining our goals rather than by striving for them—because of the law of diminishing returns.20 For example, suppose making a lot of money is your goal and suppose you make enough so that making more has no marginal utility. Then it would be foolish to continue to have making money be your goal. People who acquire things beyond their usefulness not only will derive little or no marginal gains from these acquisitions, but they also will experience negative consequences, as with any form of gluttony. So, because of the law of diminishing returns, it is only natural that seeking something new, or seeking new depths of something old, is required to bring us satisfaction. + +In other words, the sequence of 1) seeking new things (goals); 2) working and learning in the process of pursuing these goals; 3) obtaining these goals; and 4) then doing this over and over again is the personal evolutionary process that fulfills most of us and moves society forward. + +I believe that pursuing self-interest in harmony with the laws of the universe and contributing to evolution is universally rewarded, and what I call “good.” Look at all species in action: they are constantly pursuing their own interests and helping evolution in a symbiotic way, with most of them not even knowing that their self-serving behaviors are contributing to + + + +--- + + +evolution. Like the hyenas attacking the wildebeest, successful people might not even know if or how their pursuit of self-interest helps evolution, but it typically does.21 + +Self-interest and society’s interests are generally symbiotic: more than anything else, it is pursuit of self-interest that motivates people to push themselves to do the difficult things that benefit them and that contribute to society. In return, society rewards those who give it what it wants. That is why how much money people have earned is a rough measure of how much they gave society what it wanted—NOT how much they desired to make money. Look at what caused people to make a lot of money and you will see that usually it is in proportion to their production of what the society wanted and largely unrelated to their desire to make money. There are many people who have made a lot of money who never made making a lot of money their primary goal. Instead, they simply engaged in the work that they were doing, produced what society wanted, and got rich doing it.22 + +And there are many people who really wanted to make a lot of money but never produced what the society wanted and they didn’t make a lot of money. In other words, there is an excellent correlation between giving society what it wants and making money, and almost no correlation between the desire to make money and how much money one makes. I know that this is true for me—i.e., I never worked to make a lot of money, and if I had I would have stopped ages ago because of the law of diminishing returns. I know that the same is true for all the successful, healthy (i.e., non-obsessed) people I know.23 + +This process of productive adaptation—i.e., the process of seeking, obtaining, and pursuing new goals—does not just pertain to how individuals and society move forward. It is equally relevant when dealing with setbacks, which are inevitable. That is why many people who have had setbacks that seemed devastating at the time ended up as happy as (or even happier than) they were before, once they successfully adapted to them. The faster that one appropriately adapts, the better. As Darwin described, adaptation—i.e., adjusting appropriately to changes in one’s circumstances—is a big part of the evolutionary process, and it is rewarded.24 + + + +--- + + +why some of the most successful people are typically those who see the changing landscape and identify how to best adapt to it.25 + +So, it seems to me that desires to evolve are universal and so are symbiotic relationships that lead to the evolution of the whole to occur via the pursuit of individuals’ self-interests. However, what differentiates man from other species is man’s greater ability to learn. Because we can learn, we can evolve more and faster than other species. + +I also believe that all things in nature have innate attributes that are both good and bad, with their goodness and their badness depending on what they are used for. For example, the thorns on a rose bush, the stinger on a bee, the aggressiveness of a lion, the timidity of a gazelle are all both good and bad, depending on their applications. Over time, nature evolves toward the right balance through the process of natural selection—e.g., an overly aggressive animal will die prematurely, as will an overly timid animal. However, because man has the ability to look at himself and direct his own change, individuals have the capacity to evolve. + +Most of us are born with attributes that both help us and hurt us, depending on their applications, and the more extreme the attribute, the more extreme the potential good and bad outcomes these attributes are likely to produce. For example, highly creative, goal-oriented people who are good at imagining the big picture often can easily get tripped up on the details of daily life, while highly pragmatic, task-oriented people who are great with the details might not be creative. That is because the ways their minds work make it difficult for them to see both ways of thinking. In nature everything was made for a purpose, and so too were these different ways of thinking. They just have different purposes. It is extremely important to one’s happiness and success to know oneself—most importantly to understand one’s own values and abilities—and then to find the right fits. We all have things that we value that we want and we all have strengths and weaknesses that affect our paths for getting them. The most important quality that differentiates successful people from unsuccessful people is our capacity to learn and adapt to these things. + +Unlike any other species, man is capable of reflecting on himself and the things around him to learn and adapt in order to improve. He has this + + + +--- + + +capability because, in the evolution of species man’s brain developed a part that no other species has—the prefrontal cortex. It is the part of the human brain that gives us the ability to reflect and conduct other cognitive thinking. Because of this, people who can objectively reflect on themselves and others —most importantly on their weaknesses are—can figure out how to get around these weaknesses, can evolve fastest and come closer to realizing their potentials than those who can’t. + +However, typically defensive, emotional reactions—i.e., ego barriers—stand in the way of this progress. These reactions take place in the part of the brain called the amygdala. As a result of them, most people don’t like reflecting on their weaknesses even though recognizing them is an essential step toward preventing them from causing them problems. Most people especially dislike others exploring their weaknesses because it makes them feel attacked, which produces fight or flight reactions; however, having others help one find one’s weaknesses is essential because it’s very difficult to identify one’s own. Most people don’t like helping others explore their weaknesses, even though they are willing to talk about them behind their backs. For these reasons most people don’t do a good job of understanding themselves and adapting in order to get what they want most out of life. In my opinion, that is the biggest single problem of mankind because it, more than anything else, impedes people’s abilities to address all other problems and it is probably the greatest source of pain for most people. + +Some people get over the ego barrier and others don’t. Which path they choose, more than anything else, determines how good their outcomes are. Aristotle defined tragedy as a bad outcome for a person because of a fatal flaw that he can’t get around. So it is tragic when people let ego barriers lead them to experience bad outcomes. + +# THE PERSONAL EVOLUTIONARY PROCESS + +As I mentioned before, I believe that life consists of an enormous number of choices that come at us and that each decision we make has consequences, so the quality of our lives depends on the quality of the decisions we make. + +We aren’t born with the ability to make good decisions; we learn it.26 We all start off as children with others, typically parents, directing us. But, as + + + +--- + +we get older, we increasingly make our own choices. We choose what we are going after (i.e., our goals), which influences our directions. For example, if you want to be a doctor, you go to med school; if you want to have a family, you find a mate; and so on. As we move toward our goals, we encounter problems, make mistakes, and run into personal weaknesses. Above all else, how we choose to approach these impediments determines how fast we move toward our goals. + +I believe that the way we make our dreams into reality is by constantly engaging with reality in pursuit of our dreams and by using these encounters to learn more about reality itself and how to interact with it in order to get what we want—and that if we do this with determination, we almost certainly will be successful. In short: + +# Reality + +# + + +# Dreams + +# + + +# Determination + +# = + +# A Successful Life + +So what is success? I believe that it is nothing more than getting what you want—and that it is up to you to decide what that is for you. I don’t care whether it’s being a master of the universe, a couch potato, or anything else —I really don’t. What is essential is that you are clear about what you want and that you figure out how to get it. + +However, there are a few common things that most people want. As I mentioned, for most people success is evolving as effectively as possible, i.e., learning about oneself and one’s environment and then changing to improve. Personally, I believe that personal evolution is both the greatest accomplishment and the greatest reward. + +Also, for most people happiness is much more determined by how things turn out relative to their expectations rather than the absolute level of their conditions. For example, if a billionaire loses $200 million he will probably be unhappy, while if someone who is worth $10 thousand unexpectedly gets another $2 thousand, he will probably be happy. This basic principle + +--- + + +suggests that you can follow one of two paths to happiness: 1) have high expectations and strive to exceed them, or 2) lower your expectations so that they are at or below your conditions. Most of us choose the first path, which means that to be happy we have to keep evolving. + +Another principle to keep in mind is that people need meaningful work and meaningful relationships in order to be fulfilled.27I have observed this to be true for virtually everyone, and I know that it’s true for me.28 Regardless of others’ principles, you will need to decide for yourself what you want and go after it in the best way for you. + +# YOUR MOST IMPORTANT CHOICES + +As I mentioned, as we head toward our goals we encounter an enormous number of choices that come at us, and each decision we make has consequences. So, the quality of our lives depends on the quality of the decisions we make. We literally make millions of decisions that add up to the consequences that are our lives. + +Of these millions, I believe that there are five big types of choices that we continually must make that radically affect the quality of our lives and the rates at which we move toward what we want. Choosing well is not dependent on our innate abilities such as intelligence or creativity, but more on what I think of as character. For this reason, I believe that most people can make the right choices. + +The following five decision trees show these choices. I believe that those who don’t move effectively to their goals do the things on the top branches, and those who do move to them most quickly do the things on the bottom branches. + +# FIRST: + +| BAD | .. Allow pain to stand in the way of their progress. | +| ---- | ------------------------------------------------------ | +| GOOD | ... Understand how to manage pain to produce progress. | + + + +--- + + +It is a fundamental law of nature that to evolve one has to push one’s limits, which is painful, in order to gain strength—whether it’s in the form of lifting weights, facing problems head-on, or in any other way. Nature gave us pain as a messaging device to tell us that we are approaching, or that we have exceeded, our limits in some way. At the same time, nature made the process of getting stronger require us to push our limits. Gaining strength is the adaptation process of the body and the mind to encountering one’s limits, which is painful. In other words, both pain and strength typically result from encountering one’s barriers. When we encounter pain, we are at an important juncture in our decision-making process. + +Most people react to pain badly. They have “fight or flight” reactions to it: they either strike out at whatever brought them the pain or they try to run away from it. As a result, they don’t learn to find ways around their barriers, so they encounter them over and over again and make little or no progress toward what they want.29 + +Those who react well to pain that stands in the way of getting to their goals—those who understand what is causing it and how to deal with it so that it can be disposed of as a barrier—gain strength and satisfaction. This is because most learning comes from making mistakes, reflecting on the causes of the mistakes, and learning what to do differently in the future. Believe it or not, you are lucky to feel the pain if you approach it correctly, because it will signal that you need to find solutions and to progress. Since the only way you are going to find solutions to painful problems is by thinking deeply about them—i.e., reflecting30—if you can develop a knee-jerk reaction to pain that is to reflect rather than to fight or flee, it will lead to your rapid learning/evolving.31 + +So, please remember that: + +Pain + Reflection = Progress + +# How big of an impediment is psychological pain to your progress? + + + +--- + + +BAD .. Avoid facing "harsh realities." + +GOOD .…. Face "harsh realities." + +People who confuse what they wish were true with what is really true create distorted pictures of reality that make it impossible for them to make the best choices. They typically do this because facing “harsh realities” can be very difficult. However, by not facing these harsh realities, they don’t find ways of properly dealing with them. And because their decisions are not based in reality, they can’t anticipate the consequences of their decisions.32 In contrast, people who know that understanding what is real is the first step toward optimally dealing with it make better decisions. + +So, remember... + +Ask yourself, “Is it true?” + +...because knowing what is true is good. + +How much do you let what you wish to be true stand in the way of seeing what is really true? + +# THIRD: + +BAD ... Worry about appearing good. + +GOOD ...Worry about achieving the goal. + +People who worry about looking good typically hide what they don’t know and hide their weaknesses, so they never learn how to properly deal with them and these weaknesses remain impediments in the future.33 These people typically try to prove that they have the answers, even when they really don’t. Why do they behave in this unproductive way? They typically believe the senseless but common view that great people are those who + + + +--- + +have the answers in their heads and don’t have weaknesses. Not only does this view not square with reality, but it also stands in the way of progress. I have never met a great person who did not earn and learn their greatness. [34] They have weaknesses like everyone else—they have just learned how to deal with them so that they aren’t impediments to getting what they want. In addition, the amounts of knowledge and the capabilities that anyone does not have, and that could be used to make the best possible decisions, are vastly greater than that which anyone (no matter how great) could have within them.[35] + +This explains why people who are interested in making the best possible decisions rarely are confident that they have the best possible answers. So they seek to learn more (often by exploring the thinking of other believable people, especially those who disagree with them) and they are eager to identify their weaknesses so that they don’t let these weaknesses stand in the way of them achieving their goals. + +So, what are your biggest weaknesses? Think honestly about them because if you can identify them, you are on the first step toward accelerating your movement forward. So think about them, write them down, and look at them frequently. + +One of my biggest weaknesses is my poor rote memory: I have trouble remembering things that don’t have reasons for being what they are, such as names, phone numbers, spelling, and addresses. Also, I am terrible at doing tasks that require little or no logic, especially if I have to do them repeatedly. On the other hand, I have a great contextual memory and good logic, and I can devote myself to things that interest me for untold hours. I don’t know how much of what I am bad at is just the other side of what I am good at—i.e., how much of what I am good at is due to my brain working in a certain way that, when applied to certain tasks, does well and when applied to others does poorly—and how much of what I am good at was developed in order to help compensate for what I am bad at. But I do know that I have created compensating approaches so that what I am bad at doesn’t hurt me much; e.g., I surround myself with people who have good rote memories who do the things that I am bad at, and I carry around tools like my BlackBerry. + +--- + + +# FOURTH: + +| **BAD** | ... Make their decisions on the basis of first-order consequences. | +| -------- | -------------------------------------------------------------------------------------- | +| **GOOD** | ... Make their decisions on the basis of first-, second- and third-order consequences. | + +People who overweigh the first-order consequences of their decisions and ignore the effects that the second- and subsequent-order consequences will have on their goals rarely reach their goals.36 This is because first-order consequences often have opposite desirabilities from second-order consequences, resulting in big mistakes in decision-making. For example, the first-order consequences of exercise (pain and time-sink) are commonly considered undesirable, while the second-order consequences (better health and more attractive appearance) are desirable. Similarly, food that tastes good is often bad for you and vice versa, etc. If your goal is to get physically fit and you don’t ignore the first-order consequences of exercise and good-tasting but unhealthy food and connect your decisions with their second- and third-order consequences, you will not reach your goal. + +Quite often the first-order consequences are the temptations that cost us what we really want, and sometimes they are barriers that stand in our way of getting what we want. It’s almost as though the natural selection process sorts us by throwing us trick choices that have both types of consequences and penalizing the dummies who make their decisions just on the basis of the first-order consequences alone. + +By contrast, people who choose what they really want, and avoid the temptations and get over the pains that drive them away from what they really want, are much more likely to have successful lives. + +# How much do you respond to 1st order consequences at the expense of 2nd and 3rd order consequences? + + + +--- + +# Fifth: + +BAD ... Don't hold themselves accountable. + +GOOD ... Hold themselves accountable. + +People who blame bad outcomes on anyone or anything other than themselves are behaving in a way that is at variance with reality, and subversive to their progress. Blaming bad outcomes on anyone or anything other than one’s self is essentially wishing that reality is different than it is, which is silly.37 And it is subversive because it diverts one’s attention away from mustering up the personal strength and other qualities that are required to produce the best possible outcomes. + +Successful people understand that bad things come at everyone and that it is their responsibility to make their lives what they want them to be by successfully dealing with whatever challenges they face.38 Successful people know that nature is testing them, and that it is not sympathetic.39 + +How much do you let yourself off the hook rather than hold yourself accountable for your success? + +In summary, I believe that you can probably get what you want out of life if you can suspend your ego and take a no-excuses approach to achieving your goals with open-mindedness, determination, and courage, especially if you rely on the help of people who are strong in areas that you are weak. + +If I had to pick just one quality that those who make the right choices have, it is character. Character is the ability to get one’s self to do the difficult things that produce the desired results. In other words, I believe that for the most part, achieving success—whatever that is for you—is mostly a matter of personal choice and that, initially, making the right choices can be... + +--- + + +difficult. However, because of the law of nature that pushing your boundaries will make you stronger, which will lead to improved results that will motivate you, the more you operate in your “stretch zone,” the more you adapt and the less character it takes to operate at the higher level of performance. So, if you don’t let up on yourself, i.e., if you operate with the same level of “pain,” you will naturally evolve at an accelerating pace. Because I believe this, I believe that whether or not I achieve my goals is a test of what I am made of. It is a game that I play, but this game is for real. In the next part I explain how I go about playing it. + +In summary, I don’t believe that limited abilities are an insurmountable barrier to achieving your goals, if you do the other things right. As always, it is up to you to ask yourself if what I am saying is true. As the next part delves into this concept more, you might want to reserve your judgment until after you have read it. + +# YOUR TWO YOUS AND YOUR MACHINE + +Those who are most successful are capable of “higher level thinking” —i.e., they are able to step back and design a “machine” consisting of the right people doing the right things to get what they want. They are able to assess and improve how their “machine” works by comparing the outcomes that the machine is producing with the goals. Schematically, the process is as shown in the diagram below. It is a feedback loop: + +| GOALS | MACHINE | OUTCOMES | +| ------ | ------- | -------- | +| DESIGN | PEOPLE | | + +That schematic is meant to convey that your goals will determine the “machine” that you create to achieve them; that machine will produce outcomes that you should compare with your goals to judge how your + + + +--- + + +machine is working. Your “machine” will consist of the design and people you choose to achieve the goals. For example, if you want to take a hill from an enemy you will need to figure out how to do that— e.g., your design might need two scouts, two snipers, four infantrymen, one person to deliver the food, etc. While having the right design is essential, it is only half the battle. It is equally important to put the right people in each of these positions. They need different qualities to play their positions well—e.g., the scouts must be fast runners, the snipers must be precise shots, etc. If your outcomes are inconsistent with your goals (e.g., if you are having problems), you need to modify your “machine,” which means that you either have to modify your design/culture or modify your people. Do this often and well and your improvement process will look like the one on the left and do it poorly and it will look like the one on the right, or worse: + +o + +I call it “higher level thinking” because your perspective is of one who is looking down on at your machine and yourself objectively, using the feedback loop as I previously described. In other words, your most important role is to step back and design, operate and improve your “machine” to get what you want. + + + +--- + + +# GOALS + +# MACHINE → OUTCOMES + +# DESIGN + +# PEOPLE + +Think of it as though there are two yous—you as the designer and overseer of the plan to achieve your goals (let’s call that one you(1)) and you as one of the participants in pursuing that mission (which we will call you(2)). You(2) are a resource that you(1) have to get what you(1) want, but by no means your only resource. To be successful you(1) have to be objective about you(2). + +Let’s imagine that your goal is to have a winning basketball team. Wouldn’t it be silly to put yourself in a position that you don’t play well? If you did, you wouldn’t get what you want. Whatever your goals are, achieving them works the same way. + +If you(1) see that you(2) are not capable of doing something, it is only sensible for you(1) to have someone else do it. In other words, you(1) should look down on you(2) and all the other resources at your(1) disposal and create a “machine” to achieve your(1) goals, remembering that you(1) don’t necessarily need to do anything other than to design and manage the machine to get what you(1) want. If you(1) find that you(2) can’t do something well fire yourself(2) and get a good replacement! You shouldn’t be upset that you found out that you(2) are bad at that—you(1) should be happy because you(1) have improved your(1) chances of getting what you(1) want. If you(1) are disappointed because you(2) can’t be the best + + + +--- + + +person to do everything, you(1) are terribly naïve because nobody can do everything well. + +The biggest mistake most people make is to not see themselves and others objectively. If they could just get around this, they could live up to their potentials. + +How much do you intellectually agree with what I just said? + +How good are you in approaching life as a “higher level thinker” rather than as a doer? + +How much would you like to get better at this? + +How much do you think that reading this is a waste of time? + +# MY 5-STEP PROCESS TO GETTING WHAT YOU WANT OUT OF LIFE + +There are five things that you have to do to get what you want out of life. First, you have to choose your goals, which will determine your direction. Then you have to design a plan to achieve your goals. On the way to your goals, you will encounter problems. As I mentioned, these problems typically cause pain. The most common source of pain is in exploring your mistakes and weaknesses. You will either react badly to the pain or react like a master problem solver. That is your choice. To figure out how to get around these problems you must be calm and analytical to accurately diagnose your problems. Only after you have an accurate diagnosis of them can you design a plan that will get you around your problems. Then you have to do the tasks specified in the plan. Through this process of encountering problems and figuring out how to get around them, you will become progressively more capable and achieve your goals more easily. Then you will set bigger, more challenging goals, in the same way that someone who works with weights naturally increases the poundage. This is the process of personal evolution, which I call my 5-Step Process. + +In other words, “The Process” consists of five distinct steps: + +1. Have clear goals. +2. Identify and don’t tolerate the problems that stand in the way of achieving your goals. + + + +--- + +Accurately diagnose these problems. + +Design plans that explicitly lay out tasks that will get you around your problems and on to your goals. + +Implement these plans—i.e., do these tasks. + +You need to do all of these steps well in order to be successful. + +Before discussing these individual steps in more detail, I want to make a few general points about the process. + +1. You must approach these as distinct steps rather than blur them together. For example, when setting goals, just set goals (don’t think how you will achieve them or the other steps); when diagnosing problems, just diagnose problems (don’t think about how you will solve them or the other steps). Blurring the steps leads to suboptimal outcomes because it creates confusion and short-changes the individual steps. Doing each step thoroughly will provide information that will help you do the other steps well, since the process is iterative. +2. Each of these five steps requires different talents and disciplines. Most probably, you have lots of some of these and inadequate amounts of others. If you are missing any of the required talents and disciplines, that is not an insurmountable problem because you can acquire them, supplement them, or compensate for not having them, if you recognize your weaknesses and design around them. So you must be honestly self-reflective. +3. It is essential to approach this process in a very clear-headed, rational way rather than emotionally. Figure out what techniques work best for you; e.g., if emotions are getting the better of you, take time out until you can reflect unemotionally, seek the guidance of calm, thoughtful others, etc. + +To help you do these things well—and stay centered and effective rather than stressed and thrown off by your emotions—try this technique for reducing the pressure: treat your life like a game or a martial art. Your + +--- + + +mission is to figure out how to get around your challenges to get to your goals. In the process of playing the game or practicing this martial art, you will become more skilled. As you get better, you will progress to ever-higher levels of the game that will require—and teach you—greater skills. I will explain what these skills are in the next section. However, the big and really great news is that you don’t need to have all of these skills to succeed! You just have to 1) know they are needed; 2) know you don’t have some of them; and 3) figure out how to get them (i.e., either learn them or work with others who have them). + +This particular game—i.e., your life—will challenge you in ways that will be uncomfortable at times. But if you work through this discomfort and reflect on it in order to learn, you will significantly improve your chances of getting what you want out of life. By and large, life will give you what you deserve and it doesn’t give a damn what you “like.” So it is up to you to take full responsibility to connect what you want with what you need to do to get it, and then to do those things—which often are difficult but produce good results—so that you’ll then deserve to get what you want. That’s just the way it is, so you might as well accept it. + +Once you accept that playing the game will be uncomfortable, and you do it for a while, it will become much easier (like it does when getting fit). When you excel at it, you will find your ability to get what you want thrilling. You’ll see that excuses like “That’s not easy” are of no value and that it pays to “push through it” at a pace you can handle. Like getting physically fit, the most important thing is that you keep moving forward at whatever pace you choose, recognizing the consequences of your actions. When you think that it’s too hard, remember that in the long run, doing the things that will make you successful is a lot easier than being unsuccessful. The first-order consequences of escaping life’s challenges may seem pleasurable in the moment, but the second- and third-order consequences of this approach are your life and, over time, will be painful. + +With practice, you will eventually play this game like a ninja, with skill and a calm centeredness in the face of adversity that will let you handle most of your numerous challenges well. However, you will never handle them all well: mistakes are inevitable, and it’s important to recognize and accept this fact of life. The good news, as I have mentioned, is that most learning comes through making mistakes—so + + + +--- + + +there is no end to learning how to play the game better. You will have an enormous number of decisions to make, so no matter how many mistakes you make, there will be plenty of opportunities to build a track record of success. + +That’s basically the whole concept. Let’s pause and reflect on this before moving on. + +Does what I am saying make sense to you? + +Do you agree that it is true? + +If not, why not? + +If you can’t work through your doubts alone, speak to me or to others about it, but PLEASE do not proceed until you agree with the basic logic behind the 5-Step Process. Either you will get comfortable with it and internalize it or you will point out something that is wrong and the process will get better. + +What follows now is a closer examination of each of the five steps. + +# THE 5 STEPS CLOSE-UP + +# 1) Setting Goals + +You can have virtually anything you want, but you can’t have everything you want. + +The first, most important, and typically most difficult step in the 5-Step Process is setting goals, because it forces you to decide what you really want and therefore what you can possibly get out of life. This is the step where you face the fundamental limit: life is like a giant smorgasbord of more delicious alternatives than you can ever hope to taste. So you have to reject having some things you want in order to get other things you want more. + +Some people fail at this point, afraid to reject a good alternative for fear that the loss will deprive them of some essential ingredient to their personal happiness. As a result, they pursue too many goals at the same time, achieving few or none of them. + + + +--- + +So it’s important to remember: it doesn’t really matter if some things are unavailable to you, because the selection of what IS available is so great. (That is why many people who had major losses—e.g., who lost their ability to walk, to see, etc.—and who didn’t narrow-mindedly obsess about their loss but rather open-mindedly accepted and enjoyed what remained, had equally happy lives as those who didn’t ever have these losses.) + +In other words, you can have an enormous amount: much, much more than what you need to have for a happy life. So don’t get discouraged by not being able to have everything you want, and for God’s sake, don’t be paralyzed by the choices. That’s nonsensical and unproductive. Get on with making your choices. + +Put another way, to achieve your goals you have to prioritize, and that includes rejecting good alternatives (so that you have the time and resources to pursue even better ones—time being probably your greatest limiting factor, though, through leverage, you can substantially reduce time’s constraints). + +It is important not to confuse “goals” and “desires.” Goals are the things that you really want to achieve, while desires are things you want that can prevent you from reaching your goals—as I previously explained, desires are typically first-order consequences. For example, a goal might be physical fitness, while a desire is the urge to eat good-tasting, unhealthy food (i.e., a first-order consequence) that could undermine you obtaining your fitness goal. So, in terms of the consequences they produce, goals are good and desires are bad.41 + +Don’t get me wrong; I believe you can choose to pursue any goal you want as long as you consider the consequences. So, staying with this example, I think it is perfectly OK for you to make your goal to enjoy eating good-tasting, unhealthy food if that choice will bring you what you really want. As I said earlier, if you want to be a couch potato, that’s fine with me—seriously. But if that’s not what you want, you better not open that bag of chips. In other words, failing to make the distinction between goals and desires will lead you in the wrong direction, because you will be inclined to pursue things you want that will undermine your ability to get things you. + +--- + +want more. In short, you can pursue anything you desire—just make sure that you know the consequences of what you are doing. + +Another common reason people fail at this stage is that they lose sight of their goals, getting caught up in day-to-day tasks. + +Avoid setting goals based on what you think you can achieve. As I said before, do each step separately and distinctly without regard to the others. In this case, that means don’t rule out a goal due to a superficial assessment of its attainability. Once you commit to a goal, it might take lots of thinking and many revisions to your plan over a considerable time period in order to finalize the design and do the tasks to achieve it. So you need to set goals without yet assessing whether or not you can achieve them. + +This requires some faith that you really can achieve virtually anything,42 even if you don’t know how you will do it at that moment. Initially you have to have faith that this is true, but after following this process and succeeding at achieving your goals, you will gain confidence. If you like, you can start with more modest goals and, when you build up the track record to give you faith, increase your aspirations. + +Every time I set goals, I don’t yet have any idea how I am going to achieve them because I haven’t yet gone through the process of thinking through them. But I have learned that I can achieve them if I think creatively and work hard.43 + +I also know that I can “cheat.” Unlike in school, in life you don’t have to come up with all the right answers. You can ask the people around you for help—or even ask them to do the things you don’t do well. + +In other words, there is almost no reason not to succeed if you take the attitude of 1) total flexibility—good answers can come from anyone or anywhere (and in fact, as I have mentioned, there are far more good answers “out there” than there are in you) and 2) total accountability: regardless of where the good answers come from, it’s your job to find them. + +This no-excuses approach helps me do whatever it takes to get whatever I want most. Not all goals are achievable, of course. There are some impossibilities or near-impossibilities, such as living forever, or flying with + +--- + + +just the power of your arms. But it’s been my experience that if I commit to bringing creativity, flexibility, and determination to the pursuit of my goals, I will figure out some way to get them, i.e., almost all goals are attainable. And as I don’t limit my goals to what seems attainable at the moment I set them, the goals I set tend to be higher than they would otherwise be. Since trying to achieve high goals makes me stronger, I become increasingly capable of achieving more. Great expectations create great capabilities, in other words. And if I fail to achieve my goal, it just tells me that I have not been creative or flexible or determined enough to do what it takes, and I circle back and figure out what I need to do about this situation. + +Achieving your goals isn’t just about moving forward. Inevitably, you must deal with setbacks. So goals aren’t just those things that you want and don’t have. They might also be keeping what you do have, minimizing your rate of loss, or dealing with irrevocable loss. Life will throw you challenges, some of which will seem devastating at the time. Your goal is always to make the best possible choices, knowing that you will be rewarded if you do. It’s like playing golf: sometimes you will be in the fairway and sometimes you will be in the rough, so you have to know how to play it as it lies. + +Generally speaking, goal-setting is best done by those who are good at big-picture conceptual thinking, synthesizing, visualizing, and prioritizing. But whatever your strengths and weaknesses are, don’t forget the big and really great news here: it is not essential that you have all of these qualities yourself, because you can supplement them with the help of others. + +In summary, in order to get what you want, the first step is to really know what you want, without confusing goals with desires, and without limiting yourself because of some imagined impediments that you haven’t thoroughly analyzed. + +# How well do you know what you want most out of life? + +# What are your most important goals? + +# Are you good at setting your goals? + + + +--- + + +How confident are you that your assessment of your ability to set goals is right? + +If you are confident of your self-assessment, why should you be confident (e.g. because you have a demonstrated track-record, because many believable people have told you, etc)? + +# 2) IDENTIFYING AND NOT TOLERATING PROBLEMS + +After you set your goals, you must come up with a plan or a design to achieve them and then you must execute that plan by doing the tasks. On the way to achieving your goals and executing your design, you will encounter problems that have to be diagnosed, so that the design can be modified to get around these obstacles. That’s why you need to identify and not tolerate problems. + +Most problems are potential improvements screaming at you. Whenever a problem surfaces, you have in front of you an opportunity to improve. The more painful the problem, the louder it is screaming.44 In order to be successful, you have to 1) perceive problems and 2) not tolerate them. + +If you don’t identify your problems, you won’t solve them, so you won’t move forward toward achieving your goals. As a result, it is essential to bring problems to the surface. + +Most people don’t like to do this. But most successful people know that they have to do this. + +The most common reasons people don’t successfully identify their problems are generally rooted either in a lack of will or in a lack of talent or skill: + +- They can be “harsh realities” that are unpleasant to look at, so people often subconsciously put them “out of sight” so they will be “out of mind.” +- Thinking about problems that are difficult to solve can produce anxiety that stands in the way of progress. + + + +--- + + +People often worry more about appearing to not have problems than about achieving their desired results, and therefore avoid recognizing that their own mistakes and/or weaknesses are causing the problems. This aversion to seeing one’s own mistakes and weaknesses typically occurs because they’re viewed as deficiencies you’re stuck with rather than as essential parts of the personal evolution process. + +Sometimes people are simply not perceptive enough to see the problems. Some people are unable to distinguish big problems from small ones. Since nothing is perfect, it is possible to identify an infinite number of problems everywhere. If you are unable to distinguish the big problems from the little ones, you can’t “successfully” (i.e., in a practical way) identify problems. Remember, you don’t have to be good at any of the five steps (in this case, identifying problems) to be successful if you get help from others. So push through the pain of facing your problems, knowing you will end up in a much better place. + +When identifying problems, it is important to remain centered and logical. While it can be tempting to react emotionally to problems and seek sympathy or blame others, this accomplishes nothing.45 Whatever the reasons, you have to get over the impediments to succeed. Remember that the pains you are feeling are “growing pains” that will test your character and reward you if you push through them. Try to look at your problems as a detached observer would. Remember that identifying problems is like finding gems embedded in puzzles; if you solve the puzzles you will get the gems that will make your life much better. Doing this continuously will lead to your rapid evolution. So, if you’re logical, you really should get excited about finding problems because identifying them will bring you closer to your goals. + +# How good are you at perceiving problems? + +# How confident are you that your assessment of your ability to perceive problems is right? + +# If you are confident of your self-assessment, why should you be confident (e.g. because you have a demonstrated track-record, because many believable people have told you, etc)? + + + +--- + +Be very precise in specifying your problems. It is essential to identify your problems with precision, for different problems have different solutions. For example, if your impediments are due largely to issues of will—to your unwillingness to confront what is really happening—you have to strengthen your will, for example by starting small and building up your confidence. + +If your problems are related to lack of skill or innate talent, the most powerful antidote is to have others point things out to you and objectively consider whether what they identify is true. Problems due to inadequate skill might then be solved with training, whereas those arising from innate weaknesses might be overcome with assistance or role changes. It doesn’t matter which is the case; it only matters that the true cause is identified and appropriately addressed. + +The more precise you are, the easier it will be to come up with accurate diagnoses and successful solutions. For example, rather than saying something like “People don’t like me,” it is better to specify which people don’t like you and under what circumstances. + +Don’t confuse problems with causes. “I can’t get enough sleep” is not a problem; it is a cause of some problem. What exactly is that problem? To avoid confusing the problem with its causes, try to identify the suboptimal outcome, e.g., “I am performing badly in my job because I am tired.” + +Once you identify your problems, you must not tolerate them. Tolerating problems has the same result as not identifying them (i.e., both stand in the way of getting past the problem), but the root causes are different. Tolerating problems might be due to not thinking that they can be solved, or not caring enough about solving them. People who tolerate problems are the worse off because, without the motivation to move on, they cannot succeed. In other words, if you are motivated, you can succeed even if you don’t have the abilities (i.e., talents and skills) because you can. + +--- + + +get the help from others. But if you’re not motivated to succeed, if you don’t have the will to succeed, the situation is hopeless. + +# How much do you tolerate problems? + +How confident are you that your assessment of how much you tolerate problems is right? + +If you are confident of your self-assessment, why should you be confident (e.g. because you have a demonstrated track-record, because many believable people have told you, etc)? + +People who are good at this step—identifying and not tolerating problems—tend to have strong abilities to perceive and synthesize a clear and accurate picture, as well as demonstrate a fierce intolerance of badness (regardless of the severity). + +Remember that you need to do each step independently from the other steps before moving on. + +Can you comfortably identify your problems without thinking about how to solve them? It is a good exercise to just make a list of them, without possible solutions. Only after you have created a clear picture of your problems should you go to the next step. + +For a more detailed explanation of identifying and not tolerating problems, please read My Management Principles. + +# 3) DIAGNOSING THE PROBLEMS + +You will be much more effective if you focus on diagnosis and design rather than jumping to solutions. + +It is a very common mistake for people to move directly from identifying a tough problem to a proposed solution in a nanosecond without spending the hours required to properly diagnose and design a solution. This typically yields bad decisions that don’t alleviate the problem. Diagnosing and designing are what spark strategic thinking. + +You must be calm and logical. + + + +--- + + +When diagnosing problems, as when identifying problems, reacting emotionally, though sometimes difficult to avoid, can undermine your effectiveness as a decision-maker. By contrast, staying rational will serve you well. So if you are finding yourself shaken by your problems, do what you can to get yourself centered before moving forward. + +You must get at the root causes. + +Root causes, like principles, are things that manifest themselves over and over again as the deep-seated reasons behind the actions that cause problems. So you will get many everlasting dividends if you can find them and properly deal with them. + +It is important to distinguish root causes from proximate causes. Proximate causes typically are the actions or lack of actions that lead to problems—e.g., “I missed the train because I didn’t check the train schedule.” So proximate causes are typically described via verbs. Root causes are the deeper reasons behind the proximate cause: “I didn’t check the schedule because I am forgetful”—a root cause. Root causes are typically described with adjectives, usually characteristics about what the person is like that lead them to an action or an inaction. + +Identifying the real root causes of your problems is essential because you can eliminate your problems only by removing their root causes. In other words, you must understand, accept, and successfully deal with reality in order to move toward your goals. + +Recognizing and learning from one’s mistakes and the mistakes of others who affect outcomes is critical to eliminating problems. + +Many problems are caused by people’s mistakes. But people often find it difficult to identify and accept their own mistakes. Sometimes it’s because they’re blind to them, but more often it’s because ego and shortsightedness make discovering their mistakes and weaknesses painful. Because people are often upset when their mistakes are pointed out to them, most people are reluctant to point out mistakes in others. As a result, an objective diagnosis of problems arising from people’s mistakes is often missing and personal evolution is stunted. (As I mentioned in the last chapter, most learning comes from making mistakes and experiencing the pain of them—e.g., putting your hand on a hot stove—and adapting.) It is at this stage that most + + + +--- + + +People fail to progress. More than anything else, what differentiates people who live up to their potential from those who don’t is a willingness to look at themselves and others objectively. + +I call the pain that comes from looking at yourself and others objectively “growing pains,” because it is the pain that accompanies personal growth. No pain, no gain. Of course, anyone who really understands that no one is perfect and that these discoveries are essential for personal growth finds that these discoveries elicit “growing pleasures.” But it seems to be in our nature to overly focus on short-term gratification rather than long-term satisfaction—on first-order rather than second- or third-order consequences—so the connection between this behavior and the rewards it brings doesn’t come naturally. However, if you can make this connection, such moments will begin to elicit pleasure rather than pain. It is similar to how exercise eventually becomes pleasurable for people who hardwire the connection between exercise and its benefits. + +Remember that: + +Pain + Reflection = Progress + +Much as you might wish this were not so, this is a reality that you should just accept and deal with. There is no getting around the fact that achieving success requires getting at the root causes of all important problems, and people’s mistakes and weaknesses are sometimes the root causes. So to be successful, you must be willing to look at your own behavior and the behavior of others as possible causes of problems. + +Of course, some problems aren’t caused by people making mistakes. For example, if lightning strikes, it causes problems that have nothing to do with human error. All problems need to be well-diagnosed before you decide what to do about them. + +The most important qualities for successfully diagnosing problems are logic, the ability to see multiple possibilities, and the willingness to touch people’s nerves to overcome the ego barriers that stand in the way of truth. + +For a more detailed explanation of diagnosing problems, please read My Management Principles. + + + +--- + + +In diagnosing problems, how willing are you to “touch the nerve” (i.e., discuss your and others possible mistakes and weaknesses with them)? Are you willing to get at root causes, like what people are like? Are you good at seeing the patterns and synthesizing them into diagnoses of root causes? How confident are you that your assessment of your ability to diagnose is accurate? If you are confident of your self-assessment, why should you be confident (e.g. because you have a demonstrated track-record, because many believable people have told you, etc)? + +# 4) DESIGNING THE PLAN (DETERMINING THE SOLUTIONS) + +In some cases, you might go from setting goals to designing the plans that will get you to these goals; while in other cases, you will encounter problems on the way to your goals and have to design your way around them. So design will occur at both stages of the process, though it will occur much more often in figuring out how to get around problems. In other words, most of the movement toward your goals comes from designing how to remove the root causes of your problems. Problems are great because they are very specific impediments, so you know that you will move forward if you can identify and eliminate their root causes. + +Creating a design is like writing a movie script in that you visualize who will do what through time in order to achieve the goal. Visualize the goal or problem standing in your way, and then visualize practical solutions. When designing solutions, the objective is to change how you do things so that problems don’t recur—or recur so often. Think about each problem individually, and as the product of root causes—like the outcomes produced by a machine. Then think about how the machine should be changed to produce good outcomes rather than bad ones. There are typically many paths toward achieving your goals, and you need to find only one of them that works, so it’s almost always doable. + +But an effective design requires thinking things through and visualizing how things will come together and unfold over time. It’s essential to + + + +--- + +Visualize the story of where you have been (or what you have done) that has led you to where you are now and what will happen sequentially in the future to lead you to your goals. You should visualize this plan through time, like watching a movie that connects your past, present, and future. Then write down the plan so you don’t lose sight of it, and include who needs to do what and when. The list of tasks falls out from this story (i.e., the plan), but they are not the same. The story, or plan, is what connects your goals to the tasks. For you to succeed, you must not lose sight of the goals or the story while focusing on the tasks; you must constantly refer back and forth. In My Management Principles (Part 3), you can see one such plan. + +When designing your plan, think about the timelines of various interconnected tasks. Sketch them out loosely and then refine them with the specific tasks. This is an iterative process, alternating between sketching out your broad steps (e.g., hire great people) and filling these in with more specific tasks with estimated timelines (e.g., in the next two weeks choose the headhunters to find the great people) that will have implications (e.g., costs, time, etc.). These will lead you to modify your design sketch until the design and tasks work well together. Being as specific as possible (e.g., specifying who will do what and when) allows you to visualize how the design will work at both a big-picture level and in detail. It will also give you and others the to-do lists and target dates that will help direct you. + +Of course, not all plans will accomplish everything you want in the desired time frame. In such cases, it is essential that you look at what won’t be accomplished and ask yourself if the consequences are acceptable or unacceptable. This is where perspective is required, and discussing it with others can be critical. If the plan will not achieve what’s necessary in the required time, so that the consequences have an unacceptably high probability of preventing you from achieving your goal, you have to either think harder (probably with the advice of other believable people) to make the plan do what is required or reduce your goals. + +It doesn’t take much time to design a good plan—literally just hours spread out over days or weeks—and whatever amount of time you spend designing it will be only a small fraction of the time you spend executing it. But designing is very important because it determines what you will have to do. + +--- + + +to be effective. Most people make the very big mistake of spending virtually no time on this step because they are too preoccupied with execution. This process is explained in detail in My Management Principles. + +People successful with this stage have an ability to visualize and a practical understanding of how things really work. Remember, you don’t have to possess all these qualities if you have someone to help you with the ones you are missing. + +How good is your ability to visualize? + +How confident are you that your assessment of your ability to visualize is accurate? + +If you are confident of your self-assessment, why should you be confident (e.g. do have an excellent track record of visualizing and making what you visualized happen, have other believable parties told you that you are good at this)? + +Remember: Designing precedes doing! The design will give you your to-do list (i.e., the tasks). + +# 5) DOING THE TASKS + +Next, you and the others you need to rely on have to do the tasks that will get you to your goals. Great planners who don’t carry out their plans go nowhere. You need to “push through” to accomplish the goals. This requires the self-discipline to follow the script that is your design. I believe the importance of good work habits is vastly underrated. There are lots of books written about good work habits, so I won’t digress into what I believe is effective. However, it is critical to know each day what you need to do and have the discipline to do it. People with good work habits have to-do lists that are reasonably prioritized, and they make themselves do what needs to be done. By contrast, people with poor work habits almost randomly react to the stuff that comes at them, or they can’t bring themselves to do the things they need to do but don’t like to do (or are + + + +--- + +unable to do). There are lots of tools that can help (e.g., thank God for my BlackBerry!) + +You need to know whether you (and others) are following the plan, so you should establish clear benchmarks. Ideally you should have someone other than yourself objectively measure if you (and others) are doing what you planned. If not, you need to diagnose why and resolve the problem. + +People who are good at this stage can reliably execute a plan. They tend to be self-disciplined and proactive rather than reactive to the blizzard of daily tasks that can divert them from execution. They are results-oriented: they love to push themselves over the finish line to achieve the goal. If they see that daily tasks are taking them away from executing the plan (i.e., they identify this problem), they diagnose it and design how they can deal with both the daily tasks and moving forward with the plan. + +As with the other steps, if you aren’t good at this step, get help. There are many successful, creative people who are good at the other steps but who would have failed because they aren’t good at execution. But they succeeded nonetheless because of great symbiotic relationships with highly reliable task-doers. + +For a more detailed explanation of doing what you set out to do, please see My Management Principles. + +# How good are you at pushing through? + +# How confident are you that your assessment of your ability to push through is accurate? + +If you are confident of your self-assessment, why should you be confident (e.g. because you have a demonstrated track-record, because many believable people have told you, etc)? + +# THE RELATIONSHIPS BETWEEN THESE STEPS + +Designs and tasks have no purpose other than to achieve your goals. Said differently, goals are the sole purpose of designs and tasks. So you mustn’t forget how they’re related. Frequently I see people feel great about doing their tasks while forgetting the goals they were designed to achieve, + +--- + + +resulting in the failure to achieve their goals. This doesn’t make any sense, because the only purpose of tasks is to achieve goals. In order to be successful, your goals must be riveted in your mind: they are the things you MUST do. To remember the connections between the tasks and the goals that they are meant to achieve, you just have to ask, “Why?” It is good to connect tasks to goals this way (with the “Why?”), because losing sight of the connections will prevent you from succeeding. + +Again, this 5-Step Process is iterative. This means that after completing one of the steps you will probably have acquired relevant information that leads you to modify the other steps. + +If this process is working, goals will change much more slowly than designs, which will change more slowly than tasks. Designs and tasks can be modified or changed often (because you might want to reassess how to achieve the goal), but changing goals frequently is usually a problem because achieving them requires a consistent effort. I often find that people who have problems reaching their goals handle these steps backwards; that is, they stick too rigidly to specified tasks and are not committed enough to achieving their goals (often because they lose sight of them). + +# WEAKNESSES DON’T MATTER IF YOU FIND SOLUTIONS + +To repeat, the best advice I can give you is to ask yourself what you want, then ask ‘what is true,’ and then ask yourself ‘what should be done about it.’ If you honestly ask and answer these questions you will move much faster towards what you want to get out of life than if you don’t! + +Most importantly, ask yourself what is your biggest weakness that stands in the way of what you want. + +As I mentioned before, everyone has weaknesses. The main difference between unsuccessful and successful people is that unsuccessful people don’t find and address them, and successful people do. + +It is difficult to see one’s own blind spots for two reasons: + +1. Most people don’t go looking for their weaknesses because of “ego barriers”—they find having weaknesses painful because society has taught them that having weaknesses is bad. As I said + + + +--- + + +early on, I believe that we would have a radically more effective and much happier society if we taught the truth, which is that everyone has weaknesses, and knowing about them and how to deal with them is how people learn and succeed. + +1. Having a weakness is like missing a sense—if you can’t visualize what it is, it’s hard to perceive not having it. + +For these two reasons, having people show you what you are missing can be painful, though its essential for your progress. When you encounter that pain, try to remember that you can get what you want out of life if you can open-mindedly reflect, with the help of others, on what is standing in your way and then deal with it. + +What do you think is the biggest weakness you have that stands in the way of what you want – the one that you repeatedly run into? + +People who don’t get what they want out of life fail at one or more of the five steps. But being weak at any one of these steps is not a problem if you understand what you are weak at and successfully compensate for that weakness by seeking help. For example, a good goal-setter who is bad at doing tasks might work well with a bad goal-setter who is great at doing tasks—i.e., they will be much more successful working together. It is easy to find out what weaknesses are standing in your way by 1) identifying which steps you are failing at and 2) getting the feedback of people who are successful at doing what you are having problems with. + +Because I believe that you will achieve your goals if you do these five steps well, it follows that if you are not achieving your goals you can use the 5-Step Process as a diagnostic tool. You would do this by 1) identifying the step(s) that you are failing at; 2) noting the qualities required to succeed at that step; and 3) identifying which of these qualities you are missing. + +To repeat, the five steps and the qualities that I believe are required to be good at them are as follows: + + + +--- + +# 5-Step Process: Qualities Needed + +| 1) Set Goals | Higher-level thinking, synthesis, visualization, prioritization | +| --------------------------------------------- | -------------------------------------------------------------------------- | +| 2) Identify and don't tolerate problems | Perception, intolerance of badness (regardless of severity), synthesis | +| 3) Diagnose the problems to root causes | Hyper-logical, willing to "touch the nerve," seeing multiple possibilities | +| 4) Design a plan for eliminating the problems | Visualization, practicality, creativity | +| 5) Do what is set out in the plan | Self discipline, good work habits, results orientation, proactivity | + +At which step do you have the most problem? + +Which qualities needed do you wish you had more of? + +# In a nutshell, my 5-Step process for achieving what you want is: + +Values → 1) Goals → 2) Problems → 3) Diagnoses → 4) Designs → 5) Tasks + +Your values determine what you want, i.e., your goals. In trying to achieve your goals, you will encounter problems that have to be diagnosed. Only after determining the real root causes of these problems can you design a plan to get around them. Once you have a good plan, you have to muster the self-discipline to do what is required to make the plan succeed. Note that this process starts with your values, but it requires that you succeed at all five steps. While these steps require different abilities, you don’t have to be good at all of them. If you aren’t good at all of them (which is true for almost everyone), you need to know what you are bad at and how to compensate for your weaknesses. This requires you to put your ego aside, objectively reflect on your strengths and weaknesses, and seek the help from others. + +--- + +As you design and implement your plan to achieve your goals, you may find it helpful to consider that: + +- Life is like a game where you seek to overcome the obstacles that stand in the way of achieving your goals; +- You get better at this game through practice; +- The game consists of a series of choices that have consequences; +- You can’t stop the problems and choices from coming at you, so it’s better to learn how to deal with them; +- You have the freedom to make whatever choices you want, though it’s best to be mindful of their consequences; +- The pain of problems is a call to find solutions rather than a reason for unhappiness and inaction, so it’s silly, pointless, and harmful to be upset at the problems and choices that come at you (though it’s understandable); +- We all evolve at different paces, and it’s up to you to decide the pace at which you want to evolve;[48] +- The process goes better if you are as accurate as possible in all respects, including assessing your strengths and weaknesses and adapting to them. + +While all this may sound very theoretical, it is integral to how we operate every day. For example, my management principles, which are explained in the next section, are based on the principles that I described in this section. + +So, Bridgewater is based on the core belief that everyone here is evolving together. How well and how quickly we do that will have a huge effect on our well-being and the well-being of all the people we have contact with (e.g., our clients, our families, etc.). These two things are inextricably linked. Bridgewater is also based on the belief that to be successful and happy, not only do we have to be excellent, we have to continue to improve at a surprisingly fast rate. Bridgewater operates consistently with the belief that to be excellent and improve at a fast rate, we must be hyperrealistic and hypertruthful. We therefore need to overcome any impediments to being. + +--- + +realistic and truthful, and the biggest impediment is people’s reluctance to face their own mistakes and weaknesses and those of others. Bridgewater is based on the belief that both meaningful work and meaningful relationships are required to be happy and successful. So, our relationships, like our work, must be excellent; as a result, we expect people to be extremely considerate and caring with each other. This does not mean being soft on each other, especially if that means avoiding harsh realities to avoid causing discomfort. It means true caring, which requires recognizing and successfully dealing with our realities, whatever they are. + +The management principles that follow reflect these core values and the specific ways that they are lived out at Bridgewater. + +--- + +# PART 3: MY MANAGEMENT PRINCIPLES + +In Part 1 I explained why I believe having principles is important and that I believe that it is up to each person to decide what principles are best for them. In Part 2 I explained my most fundamental principles. In this part I explain my management principles. Naturally, my management principles reflect the principles I believe are best throughout my life. But before I get into my particular management principles, I’d like to touch on management principles in general. + +If you read any of the earlier parts you know that I believe that having principles is essential for getting what you want out of life. That is as true for groups of people (e.g., companies, schools, governments, foundations, etc.) as it is for individuals. While individuals operating individually can choose whatever values and principles they like, when working in a group the people must agree on the group’s values and principles. If the group is not clear about them, confusion and eventually gravitation toward the population’s averages will result. If the group’s values and principles are clear, their way of being (i.e., their culture) will permeate everything they do. It will drive how the people in the group set goals, identify problems, diagnose problems, design solutions and make sure that these designs are implemented. So I believe this relationship looks like this: + +| The Group's Values and Ways of Being, i.e., its Culture | | | | | +| ------------------------------------------------------- | -------------- | --------------- | ------------- | -------------- | +| 1) Group Goals | Group Problems | Group Diagnoses | Group Designs | 5) Group Doing | + +While having a clearly conveyed great culture is important, that’s only half of the magic formula. The other half is having great people—i.e., people who have the values, abilities, skills that fit the organization’s culture. In other words, I believe that to have a great company you have to make two things great —the culture and the people. If these two things are great your organization can navigate the twists and turns to get you where you want to go. + +--- + +Of course, you have to know where you want to go. Organizations, like individuals, have to choose what they are going after (i.e., their goals), which influences their directions. As they move toward their goals, they encounter problems, make mistakes and discover weaknesses. Above all else, how they choose to approach these impediments determines how fast they move toward their goals. + +Every organization works like a machine to achieve its goals. This machine produces outcomes. By comparing the outcomes to the goals, those running the machine can see how well the machine is working. This is the feedback loop that those who are responsible for the machine need to run well in order to improve the machine. Based on the feedback, the machine can be adjusted to improve. The machine consists of two big parts—the culture and the people. If the outcomes are inconsistent with the goals, something must be wrong with the machine, which means that something must be wrong with the culture and/or the people. By diagnosing what is wrong, designing improvements and implementing those improvements, the machine will evolve. In short, the evolutionary process is as follows. Take a minute to look it over and see what you think. + +| GOALS | "MACHINE" | OUTCOMES | +| ------- | --------- | -------- | +| CULTURE | | PEOPLE | + +The more frequently and effectively those in the machine go through this process, the more rapidly they and the machine will evolve. An effective evolutionary process looks like this—i.e., lots of quality feedback loops produces a steep upward trajectory. + +--- + + + +An ineffective evolutionary process—i.e., one in which mistakes are infrequently looked at and weaknesses are not well identified—looks like that shown below, i.e., fewer and/or less effective feedback loops produces a slower upward trajectory. In fact, if there are too few and/or bad quality feedback loops, there will be a decline because you won’t identify and deal with the problems that will kill you. + +I believe that this is equally true for individuals and organizations. I also believe that the most important difference between great organizations and bad ones is in how well they manage their feedback loops. + +# BRIDGEWATER’S CULTURE AND PEOPLE + +Naturally, the culture and people that I have chosen for Bridgewater are extensions of the principles that I believe work best, which I explained in Part 2. Most importantly I value meaningful work and meaningful relationships that are obtained by striving for truth and excellence with great people. I am confident that through this constant striving, we will evolve rapidly together. + +As you might have guessed from reading Part 2, I want Bridgewater to be a company in which people collectively... + +- work for what they want and not for what others want of them. + + + +--- + +...2) come up with the best independent opinions they can muster to move toward their goals, + +...3) stress-test their opinions by having the smartest people they can find to challenge them so they can find out where they are wrong, + +...4) are wary about overconfidence, and good at not knowing + +...5) wrestle with reality, experiencing the results of their decisions, and reflecting on what they did to produce them so that they can improve. + +And when faced with difficult choices, I want them to see the choices as follows. + +| BAD | .. Allow pain to stand in the way of their progress. | +| ---- | -------------------------------------------------------------------------------------- | +| GOOD | ... Understand how to manage pain to produce progress. | +| BAD | .. Avoid facing "harsh realities." | +| GOOD | .…. Face "harsh realities." | +| BAD | ... Worry about appearing good. | +| GOOD | ...Worry about achieving the goal. | +| BAD | ... Make their decisions on the basis of first-order consequences. | +| GOOD | ... Make their decisions on the basis of first-, second- and third-order consequences. | + + +--- + + +# BAD + +... Don't hold themselves accountable. + +# GOOD + +... Hold themselves accountable. + +While I recognize that being this way is challenging, I am also confident that it is what is required to get the most out of life. I am confident for two reasons. First, it is logical that the cause-effect relationships are such that being this way produces good results. Second, this theory has been tested over the last 40 years and has worked. While 40 years ago being this way seemed logical, back then that was an untested theory. Now that we have 40 years of testing to look back on, we can see that the results verify the theory. + +# FLESHING OUT THIS WAY OF BEING + +The best advice I can give you is to ask yourself what do you want, then ask ‘what is true’—and then ask yourself ‘what should be done about it.’ I believe that if you do this you will move much faster towards what you want to get out of life than if you don’t! + +Because what I have said is pretty abstract, I need to spell out exactly what it means to run a company this way. I need to get very specific. Over time I have built a collection of principles that encompasses almost all aspects of managing because I have collected and refined so many over time. I believe that virtually all problems you might encounter are addressed by one or more of the principles that follow. + +There are too many to read as a book. What follows is not a few rules to go by presented in an easily digestible form that’s easy to remember. That wouldn’t have been specific enough to be of much help to you. There are over 200 principles here that are well explained and are meant to be used more as a reference book than a book that is read from cover to cover. + +I’ve created an outline that serves the purposes of being both a summary of my management principles and a table of contents for a more complete explanation of them. Said differently, these principles are presented in a big picture way in this Summary and Table of Principles and in a more + + + +--- + +thoroughly explained way in the section that follows. If you want to understand the principles in brief, just read what’s said in the summary below and if you want to delve into them, go to the individual principles after the outline. + + + +--- + + +# SUMMARY AND TABLE OF PRINCIPLES + +# TO GET THE CULTURE RIGHT... + +1. Trust in Truth +1. Realize that you have nothing to fear from truth. +2. Create an environment in which everyone has the right to understand what makes sense and no one has the right to hold a critical opinion without speaking up about it. +3. Be extremely open. +4. Have integrity and demand it from others. +1. Never say anything about a person you wouldn’t say to them directly, and don’t try people without accusing them to their face. +2. Don’t let “loyalty” stand in the way of truth and openness. +5. Be radically transparent. +1. Record almost all meetings and share them with all relevant people. +6. Don’t tolerate dishonesty. +1. Don’t believe it when someone caught being dishonest says they have seen the light and will never do that sort of thing again. +2. Create a Culture in Which It Is OK to Make Mistakes but Unacceptable Not to Identify, Analyze, and Learn From Them +3. Recognize that effective, innovative thinkers are going to make mistakes +4. Do not feel bad about your mistakes or those of others. Love them! +5. Observe the patterns of mistakes to see if they are a product of weaknesses. +6. Do not feel bad about your weaknesses or those of others. +7. Don’t worry about looking good - worry about achieving your goals. +8. Get over “blame” and “credit” and get on with “accurate” and “inaccurate.” +9. Don’t depersonalize mistakes. + + + +--- + +# 16) Write down your weaknesses and the weaknesses of others to help remember and acknowledge them. + +# 17) When you experience pain, remember to reflect. + +# 18) Be self-reflective and make sure your people are self-reflective. + +# 19) Teach and reinforce the merits of mistake-based learning. + +a) The most valuable tool we have for this is the issues log (explained fully later), which is aimed at identifying and learning from mistakes. + +# 20) Constantly Get in Synch + +# 21) Constantly get in synch about what is true and what to do about it. + +# 22) Talk about “Is it true?” and “Does it make sense?” + +# 23) Fight for right. + +# 24) Be assertive and open-minded at the same time. + +a) Ask yourself whether you have earned the right to have an opinion. + +b) Recognize that you always have the right to have and ask questions. + +c) Distinguish open-minded people from closed-minded people. + +d) Don’t have anything to do with closed-minded, inexperienced people. + +e) Be wary of the arrogant intellectual who comments from the stands without having played on the field. + +f) Watch out for people who think it’s embarrassing not to know. + +# 25) Make sure responsible parties are open-minded about the questions and comments of others. + +# 26) Recognize that conflicts are essential for great relationships because they are the means by which people determine whether their principles are aligned and resolve their differences. + +a) Expect more open-minded disagreements at Bridgewater than at most other firms. + +b) There is giant untapped potential in disagreement, especially if the disagreement is between two or more thoughtful people. + +--- + + +# 27) Know when to stop debating and move on to agreeing about what should be done. + +- a) However, when people disagree on the importance of debating something, it should be debated. +- b) Recognize that “there are many good ways to skin a cat.” +- c) For disagreements to have a positive effect, people evaluating an individual decision or decision-maker must view the issue within a broader context. +- d) Distinguish between 1) idle complaints and 2) complaints that are meant to lead to improvement. + +# 28) Appreciate that open debate is not meant to create rule by referendum. + +# 29) Evaluate whether an issue calls for debate, discussion, or teaching. + +- a) To avoid confusion, make clear which kind of conversation (debate, discussion, or teaching) you are having. +- b) Communication aimed at getting the best answer should involve the most relevant people. +- c) Communication aimed at educating or boosting cohesion should involve a broader set of people than would be needed if the aim were just getting the best answer. +- d) Leverage your communication. + +# 30) Don’t treat all opinions as equally valuable. + +- a) A hierarchy of merit is not only consistent with a meritocracy of ideas but essential for it. + +# 31) Consider your own and others’ “believabilities.” + +- a) Ask yourself whether you have earned the right to have an opinion. +- b) People who have repeatedly and successfully accomplished the thing in question and have great explanations when probed are most believable. +- c) If someone asks you a question, think first whether you’re the responsible party/right person to be answering the question. + + + +--- + +32) Spend lavishly on the time and energy you devote to “getting in synch” because it’s the best investment you can make. + +33) If it is your meeting to run, manage the conversation. + +- a) Make it clear who the meeting is meant to serve and who is directing the meeting. +- b) Make clear what type of communication you are going to have in light of the objectives and priorities. +- c) Lead the discussion by being assertive and open-minded. +- d) A small group (3 to 5) of smart, conceptual people seeking the right answers in an open-minded way will generally lead to the best answer. +- e) 1+1=3. +- f) Navigate the levels of the conversation clearly. +- g) Watch out for “topic slip.” +- h) Enforce the logic of conversations. +- i) Worry about substance more than style. +- j) Achieve completion in conversations. +- k) Have someone assigned to maintain notes in meetings and make sure follow-through happens. +- l) Be careful not to lose personal responsibility via group decision-making. + +34) Make sure people don’t confuse their right to complain, give advice, and debate with the right to make decisions. + +35) Recognize that getting in synch is a two-way responsibility. + +36) Escalate if you can’t get in synch. + +# TO GET THE PEOPLE RIGHT... + +37) Recognize the Most Important Decisions You Make Are Who You Choose to Be Your Responsible Party + +38) Remember that almost everything good comes from having great people operating in a great culture. + +39) First, match the person to the design. + +- a) Most importantly, find people who share your values. +- b) Look for people who are willing to look at themselves objectively and have character. + +--- + +c) Conceptual thinking and common sense are required in order to assign someone the responsibility for achieving goals (as distinct from tasks). + +1. Recognize that the inevitable responsible party is the person who bears the consequences of what is done. +2. By and large, you will get what you deserve over time. +3. The most important responsible parties are those who are most responsible for the goals, outcomes, and machines (they are those higher in the pyramid). +4. Choose those who understand the difference between goals and tasks to run things. + +# Recognize that People Are Built Very Differently + +Think about their very different values, abilities, and skills. +Understand what each person who works for you is like so that you know what to expect from them. +Recognize that the type of person you fit in the job must match the requirements for that job. +Use personality assessment tests and quality reflections on experiences to help you identify these differences. +Understand that different ways of seeing and thinking make people suitable for different jobs. + +People are best at the jobs that require what they do well. +If you’re not naturally good at one type of thinking, it doesn’t mean you’re precluded from paths that require that type of thinking. + +Don’t hide these differences. Explore them openly with the goal of figuring out how you and your people are built so you can put the right people in the right jobs and clearly assign responsibilities. +Remember that people who see things and think one way often have difficulty communicating and relating to people who see things and think another way. + +# Hire Right, Because the Penalties of Hiring Wrong Are Huge + +Think through what values, abilities, and skills you are looking for. + +--- + + +# 54) + +Weigh values and abilities more heavily than skills in deciding whom to hire. + +# 55) + +Write the profile of the person you are looking for into the job description. + +# 56) + +Select the appropriate people and tests for assessing each of these qualities and compare the results of those assessments to what you’ve decided is needed for the job. + +- a) Remember that people tend to pick people like themselves, so pick interviewers who can identify what you are looking for. +- b) Understand how to use and interpret personality assessments. +- c) Pay attention to people’s track records. +- d) Dig deeply to discover why people did what they did. +- e) Recognize that performance in school, while of some value in making assessments, doesn’t tell you much about whether the person has the values and abilities you are looking for. +- f) Ask for past reviews. +- g) Check references. + +# 57) + +Look for people who have lots of great questions. + +# 58) + +Make sure candidates interview you and Bridgewater. + +# 59) + +Don’t hire people just to fit the first job they will do at Bridgewater; hire people you want to share your life with. + +# 60) + +Look for people who sparkle, not just “another one of those.” + +# 61) + +Hear the click: Find the right fit between the role and the person. + +# 62) + +Pay for the person, not for the job. + +# 63) + +Recognize that no matter how good you are at hiring, there is a high probability that the person you hire will not be the great person you need for the job. + +# 64) + +Manage as Someone Who Is Designing and Operating a Machine to Achieve the Goal + +# 65) + +Understand the differences between managing, micromanaging, and not managing. + + + +--- + + +# 66) + +Constantly compare your outcomes to your goals. + +# 67) + +Look down on your machine and yourself within it from the higher level. + +# 68) + +Connect the case at hand to your principles for handling cases of that type. + +# 69) + +Conduct the discussion at two levels when a problem occurs: 1) the “machine” level discussion of why the machine produced that outcome and 2) the “case at hand” discussion of what to do now about the problem. + +# 70) + +Don’t try to be followed; try to be understood and to understand others. + +- a) Don’t try to control people by giving them orders. +- b) Communicate the logic and welcome feedback. + +# 71) + +Clearly assign responsibilities. + +# 72) + +Hold people accountable and appreciate them holding you accountable + +- a) Distinguish between failures where someone broke their “contract” from ones where there was no contract to begin with. + +# 73) + +Avoid the “sucked down” phenomenon. + +- a) Watch out for people who confuse goals and tasks, because you can’t trust people with responsibilities if they don’t understand the goals. + +# 74) + +Think like an owner, and expect the people you work with to do the same. + +# 75) + +Force yourself and the people who work for you to do difficult things. + +- a) Hold yourself and others accountable. + +# 76) + +Don’t worry if your people like you; worry about whether you are helping your people and Bridgewater to be great. + + + +--- + +77) Know what you want and stick to it if you believe it’s right, even if others want to take you in another direction. + +78) Communicate the plan clearly. + +- a) Have agreed-upon goals and tasks that everyone knows (from the people in the departments to the people outside the departments who oversee them). +- b) Watch out for the unfocused and unproductive “we should ... (do something).” + +79) Constantly get in synch with your people. + +80) Get a “threshold level of understanding.” + +81) Avoid staying too distant. + +- a) Tool: Use daily updates as a tool for staying on top of what your people are doing and thinking. + +82) Learn confidence in your people—don’t presume it. + +83) Vary your involvement based on your confidence. + +84) Avoid the “theoretical should.” + +85) Care about the people who work for you. + +86) Logic, reason, and common sense must trump everything else in decision-making. + +87) While logic drives our decisions, feelings are very relevant. + +88) Escalate when you can’t adequately handle your responsibilities, and make sure that the people who work for you do the same. + +- a) Make sure your people know to be proactive. +- b) Tool: An escalation button. + +89) Involve the person who is the point of the pyramid when encountering material cross-departmental or cross sub-departmental issues. + +# 90) Probe Deep and Hard to Learn What to Expect from Your “Machine” + +91) Know what your people are like, and make sure they do their jobs excellently. + +92) Constantly probe the people who report to you, and encourage them to probe you. + +- a) Remind the people you are probing that problems and mistakes are fuel for improvement. + +93) Probe to the level below the people who work for you. + +--- + + +# 94) Remember that few people see themselves objectively, so it’s important to welcome probing and to probe others. + +# 95) Probe so that you have a good enough understanding of whether problems are likely to occur before they actually do. + +- a) When a crisis appears to be brewing, contact should be so close that it’s extremely unlikely that there will be any surprises. +- b) Investigate and let people know you are going to investigate so there are no surprises and they don’t take it personally. + +# 96) Don’t “pick your battles.” Fight them all. + +# 97) Don’t let people off the hook. + +# 98) Don’t assume that people’s answers are correct. + +# 99) Make the probing transparent rather than private. + +# 100) Evaluate People Accurately, Not “Kindly” + +# 101) Make accurate assessments. + +- a) Use evaluation tools such as performance surveys, metrics, and formal reviews to document all aspects of a person’s performance. These will help clarify assessments and communication surrounding them. +- b) Maintain “baseball cards” and/or “believability matrixes” for your people. + +# 102) Evaluate employees with the same rigor as you evaluate job candidates. + +# 103) Know what makes your people tick, because people are your most important resource. + +# 104) Recognize that while most people prefer compliments over criticisms, there is nothing more valuable than accurate criticisms. + +# 105) Make this discovery process open, evolutionary, and iterative. + +# 106) Provide constant, clear, and honest feedback, and encourage discussion of this feedback. + +- a) Put your compliments and criticisms into perspective. +- b) Remember that convincing people of their strengths is generally much easier than convincing them of their weaknesses. +- c) Encourage objective reflection. + + + +--- + + +# d) Employee reviews: + +107) Understand that you and the people you manage will go through a process of personal evolution. + +108) Recognize that your evolution at Bridgewater should be relatively rapid and a natural consequence of discovering your strengths and weaknesses; as a result, your career path is not planned at the outset. + +109) Remember that the only purpose of looking at what people did is to learn what they are like. + +- a) Look at patterns of behaviors and don’t read too much into any one event. +- b) Don’t believe that being good or bad at some things means that the person is good or bad at everything. + +110) If someone is doing their job poorly, consider whether this is due to inadequate learning (i.e., training/experience) or inadequate ability. + +111) Remember that when it comes to assessing people, the two biggest mistakes are being overconfident in your assessment and failing to get in synch on that assessment. Don’t make those mistakes. + +- a) Get in synch in a non-hierarchical way regarding assessments. +- b) Learn about your people and have them learn about you with very frank conversations about mistakes and their root causes. + +112) Help people through the pain that comes with exploring their weaknesses. + +113) Recognize that when you are really in synch with people about weaknesses, whether yours or theirs, they are probably true. + +114) Remember that you don’t need to get to the point of “beyond a shadow of a doubt” when judging people. + +115) Understand that you should be able to learn the most about what a person is like and whether they are a “click” for the job in their first year. + +116) Continue assessing people throughout their time at Bridgewater. + +# 117) Train and Test People Through Experiences + + + +--- + + +# 118) Understand that training is really guiding the process of personal evolution. + +# 119) Know that experience creates internalization + +# 120) Provide constant feedback to put the learning in perspective + +# 121) Remember that everything is a case study. + +# 122) Teach your people to fish rather than give them fish. + +# 123) Recognize that sometimes it is better to let people make mistakes so that they can learn from them rather than tell them the better decision. + +- a) When criticizing, try to make helpful suggestions. +- b) Learn from success as well as from failure. + +# 124) Know what types of mistakes are acceptable and unacceptable, and don’t allow the people who work for you to make the unacceptable ones. + +# 125) Recognize that behavior modification typically takes about 18 months of constant reinforcement. + +# 126) Train people; don’t rehabilitate them. + +- a) A common mistake: training and testing a poor performer to see if he or she can acquire the required skills without simultaneously trying to assess their abilities. + +# 127) After you decide “what’s true” (i.e., after you figure out what your people are like), think carefully about “what to do about it.” + +# 128) Sort People into Other Jobs at Bridgewater, or Remove Them from Bridgewater + +# 129) When you find that someone is not a good “click” for a job, get them out of it ASAP. + +# 130) Know that it is much worse to keep someone in a job who is not suited for it than it is to fire someone. + +# 131) When people are “without a box,” consider whether there is an open box at Bridgewater that would be a better fit. If not, fire them. + +# 132) Do not lower the bar. + +# TO PERCEIVE, DIAGNOSE, AND SOLVE PROBLEMS... + +# 133) Know How to Perceive Problems Effectively + + + +--- + + +# 134) Keep in mind the 5-Step Process explained in Part 2. + +# 135) Recognize that perceiving problems is the first essential step toward great management. + +# 136) Understand that problems are the fuel for improvement. + +# 137) You need to be able to perceive if things are above the bar (i.e., good enough) or below the bar (i.e., not good enough), and you need to make sure your people can as well. + +# 138) Don’t tolerate badness. + +# 139) “Taste the soup.” + +# 140) Have as many eyes looking for problems as possible. + +- a) “Pop the cork.” +- b) Hold people accountable for raising their complaints. +- c) The leader must encourage disagreement and be either impartial or open-minded. +- d) The people closest to certain jobs probably know them best, or at least have perspectives you need to understand, so those people are essential for creating improvement. + +# 141) To perceive problems, compare how the movie is unfolding relative to your script. + +# 142) Don’t use the anonymous “we” and “they,” because that masks personal responsibility—use specific names. + +# 143) Be very specific about problems; don’t start with generalizations. + +# 144) Tool: Use the following tools to catch problems: issues logs, metrics, surveys, checklists, outside consultants, and internal auditors. + +# 145) The most common reason problems aren’t perceived is what I call the “frog in the boiling water” problem. + +# 146) In some cases, people accept unacceptable problems because they are perceived as being too difficult to fix. Yet fixing unacceptable problems is actually a lot easier than not fixing them, because not fixing them will make you miserable. + +- a) Problems that have good, planned solutions are completely different from those that don’t. + +# 147) Diagnose to Understand What the Problems Are Symptomatic Of + + + +--- + + +# 148) Recognize that all problems are just manifestations of their root causes, so diagnose to understand what the problems are symptomatic of. + +# 149) Understand that diagnosis is foundational both to progress and quality relationships. + +# 150) Ask the following questions when diagnosing. + +# 151) Remember that a root cause is not an action but a reason. + +# 152) Identify at which step failure occurred in the 5-Step Process. + +# 153) Remember that a proper diagnosis requires a quality, collaborative, and honest discussion to get at the truth. + +# 154) Keep in mind that diagnoses should produce outcomes. + +# 155) Don’t make too much out of one “dot”—synthesize a richer picture by squeezing lots of “dots” quickly and triangulating with others. + +# 156) Maintain an emerging synthesis by diagnosing continuously. + +# 157) To distinguish between a capacity issue and a capability issue, imagine how the person would perform at that particular function if they had ample capacity. + +# 158) The most common reasons managers fail to produce excellent results or escalate are... + +# 159) Avoid “Monday morning quarterbacking.” + +# 160) Identify the principles that were violated. + +# 161) Remember that if you have the same people doing the same things, you should expect the same results. + +# 162) Use the following “drilldown” technique to gain an 80/20 understanding of a department or sub-department that is having problems. + +# 163) Put Things in Perspective + +# 164) Go back before going forward. + +# a) Tool: Have all new employees listen to tapes of “the story” to bring them up to date. + +# 165) Understand “above the line” and “below the line” thinking and how to navigate between the two. + +# 166) Design Your Machine to Achieve Your Goals + +# 167) Remember: You are designing a “machine” or system that will produce outcomes. + + + +--- + +a) A short-term goal probably won’t require you to build a machine + +b) Beware of paying too much attention to what is coming at you and not enough attention to what your responsibilities are or how your machine should work to achieve your goals. + +168) Don’t act before thinking. Take the time to come up with a game plan + +169) The organizational design you draw up should minimize problems and maximize capitalization on opportunities. + +170) Put yourself in the “position of pain” for a while so that you gain a richer understanding of what you’re designing for + +171) Recognize that design is an iterative process; between a bad “now” and a good “then” is a “working through it” period. + +172) Visualize alternative machines and their outcomes, and then choose + +173) Think about second- and third-order consequences as well as first-order consequences. + +174) Most importantly, build the organization around goals rather than tasks. + +a) First come up with the best workflow design, sketch it out in an organizational chart, visualize how the parts interact, specify what qualities are required for each job, and, only after that is done, choose the right people to fill the jobs + +b) Organize departments and sub-departments around the most logical groupings. + +c) Make departments as self-sufficient as possible so that they have control over the resources they need to achieve the goals. + +d) The efficiency of an organization decreases and the bureaucracy of an organization increases in direct relation to the increase in the number of people and/or the complexity of the organization. + +175) Build your organization from the top down. + +a) Everyone must be overseen by a believable person who has high standards. + +--- + +b) The people at the top of each pyramid should have the skills and focus to manage their direct reports and a deep understanding of their jobs. + +c) The ratio of senior managers to junior managers and to the number of people who work two levels below should be limited, to preserve quality communication and mutual understanding. + +d) The number of layers from top to bottom and the ratio of managers to their direct reports will limit the size of an effective organization. + +e) The larger the organization, the more important are 1) information technology expertise in management and 2) cross-department communication (more on these later). + +f) Do not build the organization to fit the people. + +176) Have the clearest possible delineation of responsibilities and reporting lines. + +a) Create an organizational chart to look like a pyramid, with straight lines down that don’t cross. + +177) Constantly think about how to produce leverage. + +a) You should be able to delegate the details away. + +b) It is far better to find a few smart people and give them the best technology than to have a greater number of ordinary and less well-equipped people. + +c) Use “leveragers.” + +178) Understand the clover-leaf design. + +179) Don’t do work for people in another department or grab people from another department to do work for you unless you speak to the boss. + +180) Watch out for “department slip.” + +181) Assign responsibilities based on workflow design and people’s abilities, not job titles. + +182) Watch out for consultant addiction. + +183) Tool: Maintain a procedures manual. + +184) Tool: Use checklists. + +a) Don’t confuse checklists with personal responsibility. + +b) Remember that “systematic” doesn’t necessarily mean computerized. + +--- + + +c) Use “double-do” rather than “double-check” to make sure mission-critical tasks are done correctly. + +185) Watch out for “job slip.” + +186) Think clearly how things should go, and when they aren’t going that way, acknowledge it and investigate. + +187) Have good controls so that you are not exposed to the dishonesty of others and trust is never an issue. + +- a) People doing auditing should report to people outside the department being audited, and auditing procedures should not be made known to those being audited. +- b) Remember: There is no sense in having laws unless you have policemen (auditors). + +188) Do What You Set Out to Do + +189) Push through! + +# TO MAKE DECISIONS EFFECTIVELY... + +190) Recognize the Power of Knowing How to Deal with Not Knowing + +191) Recognize that your goal is to come up with the best answer, that the probability of your having it is small, and that even if you have it, you can’t be confident that you do have it unless you have other believable people test you. + +192) Understand that the ability to deal with not knowing is far more powerful than knowing. + +- a) Embrace the power of asking: “What don’t I know, and what should I do about it?” +- b) Finding the path to success is at least as dependent on coming up with the right questions as coming up with answers. + +193) Remember that your goal is to find the best answer, not to give the best one you have. + +194) While everyone has the right to have questions and theories, only believable people have the right to have opinions. + +195) Constantly worry about what you are missing. + +- a) Successful people ask for the criticism of others and consider its merit. +- b) Triangulate your view. + + + +--- + + +# 196) Make All Decisions Logically, as Expected Value Calculations + +Considering both the probabilities and the payoffs of the consequences, make sure that the probability of the unacceptable (i.e., the risk of ruin) is nil. + +- a) The cost of a bad decision is equal to or greater than the reward of a good decision, so knowing what you don’t know is at least as valuable as knowing. +- b) Recognize opportunities where there isn’t much to lose and a lot to gain, even if the probability of the gain happening is low. +- c) Understand how valuable it is to raise the probability that your decision will be right by accurately assessing the probability of your being right. +- d) Don’t bet too much on anything. Make 15 or more good, uncorrelated bets. + +# 198) Remember the 80/20 Rule, and Know What the Key 20% Is + +Distinguish the important things from the unimportant things and deal with the important things first. + +- a) Don’t be a perfectionist. +- b) Since 80% of the juice can be gotten with the first 20% of the squeezing, there are relatively few (typically less than five) important things to consider in making a decision. +- c) Watch out for “detail anxiety.” +- d) Don’t mistake small things for unimportant things, because some small things can be very important. + +# 200) Think about the appropriate time to make a decision in light of the marginal gains made by acquiring additional information versus the marginal costs of postponing the decision. + +# 201) Make sure all the “must do’s” are above the bar before you do anything else. + +# 202) Remember that the best choices are the ones with more pros than cons, not those that don’t have any cons. Watch out for people who tend to argue against something because they can find something wrong with it without properly weighing all the pros against the cons. + + + +--- + + +# 203) Watch out for unproductively identifying possibilities + +without assigning them probabilities, because it screws up prioritization. + +# 204) Understand the concept and use the phrase “by and large.” + +a) When you ask someone whether something is true and they tell you that “It’s not totally true,” it’s probably true enough. + +# 205) Synthesize + +# 206) Understand and connect the dots. + +# 207) Understand what an acceptable rate of improvement is, and that it is the level and not the rate of change that matters most. + +# 208) If your best solution isn’t good enough, think harder or escalate that you can’t produce a solution that is good enough. + +# 209) Avoid the temptation to compromise on that which is uncompromisable. + +# 210) Don’t try to please everyone + +What Follows is the Meat... + + + +--- + + +# TO GET THE CULTURE RIGHT... + +1. # TRUST IN TRUTH + +So... +2. Realize that you have nothing to fear from truth. Understanding, accepting, and knowing how to effectively deal with reality are crucial for achieving success. Having truth on your side is extremely powerful. While the truth itself may be scary—you have a weakness, you have a deadly disease, etc.—knowing the truth will allow you to deal with your situation better. Being truthful, and letting others be truthful with you, allows you to explore your own thoughts and exposes you to the feedback that is essential for your learning. Being truthful is an extension of your freedom to be you; people who are one way on the inside and another on the outside become conflicted and often lose touch with their own values. It’s difficult for them to be happy, and almost impossible for them to be at their best. While the first-order effects of being radically truthful might not be desirable, the second- and third-order effects are great. + +Do you agree with this? +3. Create an environment in which everyone has the right to understand what makes sense and no one has the right to hold a critical opinion without speaking up about it. +4. Be extremely open. Openness leads to truth and trust. Being open about what you dislike is especially important, because things you don’t like need to be changed or resolved. Discuss your issues until you are in synch or until you understand each other’s positions and can determine what should be done. As someone I worked with once explained, “It’s simple - just don’t filter.” The main reason Bridgewater performs well is that all people here have the power to speak openly and equally and because their views are judged on the merits of what they are saying. Through that extreme openness and a meritocracy of thought, we identify and solve problems better. Since we know we can rely on honesty, we succeed more and we ultimately become closer, and since we succeed and are close, we are more committed to this mission and to each other. It is a self-reinforcing, virtuous cycle. + + + +--- + +Do you agree with this? + +# 5) Have integrity and demand it from others. + +Integrity comes from the Latin word integer, meaning “one.” People who are one way on the inside and another way outside lack integrity; they have duality. + +The second- and third-order effects of having integrity and avoiding duality are great. Thinking solely about what’s accurate instead of how it is perceived helps you to be more focused on important things. It helps you sort the people you are around and the environments you are in. It improves the organization’s efficiency and camaraderie because the secret things that people think and don't say to each other drive resentment and key issues underground and don’t lead to improvement. Having nothing to hide relieves stress. It also builds trust. For these reasons: + +# 5a) Never say anything about a person you wouldn’t say to them directly, and don’t try people without accusing them to their face. + +Badmouthing people behind their backs shows a serious lack of integrity and is counterproductive. It doesn’t yield any beneficial change, and it subverts both the people you are badmouthing and the environment as a whole. Next to being dishonest, it is the worst thing you can do at Bridgewater. Criticism is both welcomed and encouraged at Bridgewater, so there is no good reason to talk behind people’s backs. You need to follow this policy to an extreme degree. For example, managers should not talk about people who work for them without those people being in the room. If you talk behind people’s backs at Bridgewater you are called a slimy weasel. + +# 5b) Don’t let “loyalty” stand in the way of truth and openness. + +In some companies, employees hide their employer’s mistakes, and employers do the same in return. In these places, openly expressing your concerns is considered disloyal, and discouraged. Because it prevents people from bringing their mistakes and weaknesses to the surface and because it encourages deception and eliminates the subordinates’ right of appeal, unhealthy loyalty stands in the way of improvement. I believe in a truer, healthier form of loyalty, which does the opposite. Healthy loyalty fosters improvement through openly addressing mistakes and weaknesses. The more people are open about their challenges, the more helpful others can be. In an environment in which mistakes and weaknesses are dealt with + +--- + + +frankly, those who face their challenges have the most admirable character. By contrast, when mistakes and weaknesses are hidden, unhealthy character is legitimized. + +# 6) Be radically transparent. + +Provide people with as much exposure as possible to what’s going on around them. Allowing people direct access lets them form their own views and greatly enhances accuracy and the pursuit of truth. Winston Churchill said, “There is no worse course in leadership than to hold out false hopes soon to be swept away.” The candid question-and-answer process allows people to probe your thinking. You can then modify your thinking to get at the best possible answer, reinforcing your confidence that you’re on the best possible path. + +# 6a) + +Record almost all meetings and share them with all relevant people. Provide tapes of all meetings that don’t contain confidential information to enhance transparency. Of course, there are some times when privacy is required. If someone gives you confidential information, keep it confidential until you have permission to disclose it. + +# 7) Don’t tolerate dishonesty. + +People typically aren’t totally honest, which stands in the way of progress, so don’t tolerate this. There’s an adjustment process at Bridgewater in which one learns to be completely honest and expect the same from others. Increasingly you engage in logical, unemotional discussions in pursuit of truth in which criticisms are not viewed as attacks, but as explorations of possible sources of problems. + +# 7a) + +Don’t believe it when someone caught being dishonest says they have seen the light and will never do that sort of thing again. Chances are they will. The cost of keeping someone around who has been dishonest is likely to be higher than any benefits. + + + +--- + + +# 8) CREATE A CULTURE IN WHICH IT IS OK TO MAKE MISTAKES BUT UNACCEPTABLE NOT TO IDENTIFY, ANALYZE, AND LEARN FROM THEM + +So... + +# 9) Recognize that effective, innovative thinkers are going to make mistakes[49] and learn from them because it is a natural part of the innovation process. For every mistake that you learn from you will save thousands of similar mistakes in the future, so if you treat mistakes as learning opportunities that yield rapid improvements you should be excited by them. But if you treat them as bad things, you will make yourself and others miserable, and you won’t grow. Your work environment will be marked by petty back-biting and malevolent barbs rather than by a healthy, honest search for truth that leads to evolution and improvement. Because of this, the more mistakes you make and the more quality, honest diagnoses you have, the more rapid your progress will be. That’s not B.S. or just talk. That’s the reality of learning.[50] + +# 10) Do not feel bad about your mistakes or those of others. Love them! Remember that 1) they are to be expected, 2) they’re the first and most essential part of the learning process, and 3) feeling bad about them will prevent you from getting better. People typically feel bad about mistakes because they think in a short-sighted way that mistakes reflect their badness or because they’re worried about being punished (or not being rewarded). People also tend to get angry at those who make mistakes because in a short-sighted way they focus on the bad outcome rather than the educational, evolutionary process they’re a part of. That’s a real tragedy. + +I once had a ski instructor who had taught Michael Jordan, the greatest basketball player of all time, how to ski. He explained that Jordan enjoyed his mistakes and got the most out of them. At the start of high school, Jordan was an unimpressive basketball player; he became a champion because he loved using his mistakes to improve. Yet despite Jordan’s example and the example of countless other successful people, it is far more common for people to allow ego to stand in the way of learning. Perhaps it’s because school learning overemphasizes the value of having the right + + + +--- + +answers and punishes wrong answers. Good school learners are often bad mistake-based learners because they are bothered by their mistakes. I particularly see this problem in recent graduates from the best colleges, who frequently shy away from exploring their own weaknesses. Remember that intelligent people who are open to recognizing and learning from their weaknesses substantially outperform people with the same abilities who aren’t similarly open. + +# 11) + +Observe the patterns of mistakes to see if they are a product of weaknesses. Connect the dots without ego barriers. If there is a pattern of mistakes, it probably signifies a weakness. Everyone has weaknesses. The fastest path to success is to know what they are and how to deal with them so that they don’t stand in your way. Weaknesses are due to deficiencies in learning or deficiencies in abilities. Deficiencies in learning can be rectified over time, though usually not quickly, while deficiencies in abilities are virtually impossible to change. Neither is a meaningful impediment to getting what you want if you accept it as a problem that can be designed around. + +# 12) + +Do not feel bad about your weaknesses or those of others. They are opportunities to improve. If you can solve the puzzle of what is causing them, you will get a gem - i.e., the ability to stop making them in the future. Everyone has weaknesses and can benefit from knowing about them. Don’t view explorations of weaknesses as attacks. A person who receives criticism - particularly if he tries to objectively consider if it’s true - is someone to be admired. + +# 13) + +Don’t worry about looking good - worry about achieving your goals. Put your insecurities away and get on with achieving your goals. To test if you are worrying too much about looking good, observe how you feel when you find out you’ve made a mistake or don’t know something. If you find yourself feeling bad, reflect - remind yourself that the most valuable comments are accurate criticisms. Imagine how silly and unproductive it would be if you thought your ski instructor was blaming you when he told you that you fell because you didn’t shift your weight properly. If a criticism is accurate, it is a good thing. You should appreciate it and try to learn from it. + +--- + + +# 14) Get over “blame” and “credit” and get on with “accurate” and “inaccurate.” + +When people hear, “You did XYZ wrong,” they have an instinctual reaction to figure out possible consequences or punishments rather than to try to understand how to improve. Remember that what has happened lies in the past and no longer matters, except as a method for learning how to be better in the future. Create an environment in which people understand that remarks such as “You handled that badly” are meant to be helpful (for the future) rather than punitive (for the past). While people typically feel unhappy about blame and good about credit, that attitude gets everything backwards and can cause major problems. Worrying about “blame” and “credit” or “positive” and “negative” feedback impedes the iterative process essential to learning. + +# 15) Don’t depersonalize mistakes. + +Identifying who made mistakes is essential to learning. It is also a test of whether a person will put improvement ahead of ego and whether he will fit into the Bridgewater culture. A common error is to say, “We didn’t handle this well” rather than “Harry didn’t handle this well.” This occurs when people are uncomfortable connecting specific mistakes to specific people because of ego sensitivities. This creates dysfunctional and dishonest organizations. Since individuals are the most important building blocks of any organization and since individuals are responsible for the ways things are done, the diagnosis must connect the mistake to the specific individual by name. Someone created the procedure that went wrong, or decided we should act according to that procedure, and ignoring that fact will slow our progress toward successfully dealing with the problem. + +# 16) Write down your weaknesses and the weaknesses of others to help remember and acknowledge them. + +It’s unhealthy to hide them because if you hide them, it will slow your progress towards successfully dealing with them. Conversely, if you don’t want them and you stare at them, you will inevitably evolve past them. + +# 17) When you experience pain, remember to reflect. + +You can convert the “pain” of seeing your mistakes and weaknesses into pleasure. If there is only one piece of advice I can get you to remember it is this one. Calm yourself down and think about what is causing your psychological pain. Ask other objective, believable parties for their help to figure it out. Find + + + +--- + +out what is true. Don’t let ego barriers stand in your way. Remember that pains that come from seeing mistakes and weaknesses are “growing pains” that you learn from.51 Don’t rush through them. Stay in them and explore them because that will help build the foundation for improvement. It is widely recognized that 1) changing your deep-seated, harmful behavior is very difficult yet necessary for improvement and 2) doing this generally requires a deeply felt recognition of the connection between your harmful behavior and the pain it causes. Psychologists call this “hitting bottom.” Embracing your failures is the first step toward genuine improvement; it is also why “confession” precedes forgiveness in many societies.52 If you keep doing this you will learn to improve and feel the pleasures of it. + +# 18) Be self-reflective and make sure your people are self-reflective. + +This quality differentiates those who evolve fast from those who don’t. When there is pain, the animal instinct is ‘fight or flight’ (i.e., to either strike back or run away) - reflect instead. When you can calm yourself down, thinking about the dilemma that is causing you pain will bring you to a higher level and enlighten you, leading to progress. That is because the pain you are feeling is due to something being at odds - maybe it’s you encountering reality, such as the death of a friend, and not being able to accept it. If when you are calm, you can think clearly about what things are at odds, you will learn more about what reality is like and how to better deal with it. It really will produce progress. If, on the other hand, the pain causes you to tense-up, not think, feel sorry for yourself, and blame others, it will be a very bad experience. So, when you are in pain, try to remember: Pain + Reflection = Progress. It’s pretty easy to determine whether a person is reflective or deflective: self-reflective people openly and objectively look at themselves while deflective people don’t. + +# 19) Teach and reinforce the merits of mistake-based learning. + +We must bring mistakes into the open and analyze them objectively, so managers need to foster a culture that makes this normal and penalizes suppressing or covering up mistakes. Probably the worst mistake anyone can make at Bridgewater is not facing up to mistakes - i.e., hiding rather than highlighting them. Highlighting them, diagnosing them, thinking about what should be done differently in the future, and then adding that new knowledge to the procedures manual are all essential to our improvement. + +--- + + +19a) The most valuable tool we have for this is the issues log (explained fully later), which is aimed at identifying and learning from mistakes. Using this tool is mandatory because we believe that enforcing this behavior is far better than leaving it optional. + + + +--- + + +# 20) CONSTANTLY GET IN SYNCH + +So… + +# 21) Constantly get in synch about what is true and what to do about it. + +Getting in synch helps you achieve better answers through considering alternative viewpoints. It can take the forms of asking, debating, discussing, and teaching how things should be done. Sometimes it is to make our views on our strengths, weaknesses, and values transparent in order to reach the understanding that helps us move forward. Sometimes it is to be clear about who will do what and the game plan for handling responsibilities. So this process can be both a means of finding the best answers and pushing them ahead. Quality conversations about what is true and what should be done will produce better outcomes and many fewer misunderstandings in the future. + +# 22) Talk about “Is it true?” and “Does it make sense?” + +In a culture that values both independent thinking and innovation, each individual has both the right and the obligation to ensure that what they do, and what we collectively do, in pursuit of excellence, makes sense to them. So, get in synch about these things. + +# 23) Fight for right. + +Discuss or debate important issues with the right relevant parties in an open-minded way until the best answers are determined. This process will maximize learning and mutual understanding. Thrash it out to get to the best answer. + +# 24) Be assertive and open-minded at the same time. + +Just try to find out what is true. Don’t try to ‘win’ the argument. Finding out that you are wrong is even more valuable than being right, because you are learning. + +# 24a) + +Ask yourself whether you have earned the right to have an opinion. Opinions are easy to produce, so bad ones abound. Knowing that you don’t know something is nearly as valuable as knowing it. The worst situation is thinking you know something when you don’t. + +# 24b) + +Recognize that you always have the right to have and ask questions. + + + +--- + + +# 24c) Distinguish open-minded people from closed-minded people. + +Open-minded people seek to learn by asking questions; they realize that what they know is little in relation to what there is to know and recognize that they might be wrong. Closed-minded people always tell you what they know, even if they know hardly anything about the subject being discussed. They are typically made uncomfortable by being around those who know a lot more about a subject, unlike open-minded people who are thrilled by such company. + +# 24d) Don’t have anything to do with closed-minded, inexperienced people. + +They won’t do you any good and there’s no helping them until they open their minds, so they will waste your time in the meantime. If you must deal with them, the first thing you have to do is open their minds. Being open-minded is far more important than being bright or smart. + +# 24e) Be wary of the arrogant intellectual who comments from the stands without having played on the field. + +And avoid that trap yourself. + +# 24f) Watch out for people who think it’s embarrassing not to know. + +They’re dangerous. + +# 25) Make sure responsible parties are open-minded about the questions and comments of others. + +They are required to explain the thinking behind a decision openly and transparently so that all can understand and assess it. Further, in the event of disagreement, an appeal should be made to either the manager’s boss or an agreed-upon, knowledgeable group of others, generally including people more believable than and senior to the decision-maker. The person(s) resolving the dispute must do this objectively and fairly; otherwise our system will fail at maintaining its meritocracy of ideas. + +# 26) Recognize that conflicts are essential for great relationships + +because they are the means by which people determine whether their principles are aligned and resolve their differences. I believe that in all relationships, including the most treasured ones, 1) there are principles and values each person has that must be in synch for the relationship to be successful and 2) there must be give and take. I believe there is always a kind of negotiation or debate between people based on principles and mutual consideration. What you learn about each other via that “negotiation” either draws you together or drives you apart. + + + +--- + +principles are aligned and you can work out your differences via a process of give and take, you will draw closer together. If not, you will move apart. It is through such open discussion, especially when it comes to contentious issues, that people can make sure there are no misunderstandings. If that open discussion of differences doesn’t happen on an ongoing basis, the gaps in perspectives will widen until inevitably there is a major clash. Ironically, people who suppress the mini-confrontations for fear of conflict tend to have huge conflicts later, which can lead to separation, precisely because they let minor problems fester. On the other hand, people who address the mini-conflicts head-on in order to straighten things out tend to have the great, long-lasting relationships. That’s why I believe people should feel free to say whatever they really think. + +# 26a) + +Expect more open-minded disagreements at Bridgewater than at most other firms. They fuel the learning that helps us be at our best. Sometimes when there are disagreements, people get angry. But you should remind them that the management at most other companies doesn’t welcome disagreement or encourage open debate. As a result, there is less of both. So instead of getting angry, they should welcome the fact that disagreements and open debate are encouraged here. + +# 26b) + +There is giant untapped potential in disagreement, especially if the disagreement is between two or more thoughtful people - yet most people either avoid it or they make it an unproductive fight. That’s tragic.[53] + +# 27) + +Know when to stop debating and move on to agreeing about what should be done. I have seen people who agree on the major issues waste hours arguing over details. It’s more important to do big things well than to do small things perfectly. Be wary of bogging down amid minor issues at the expense of time devoted to solidifying important agreements. + +# 27a) + +However, when people disagree on the importance of debating something, it should be debated. Operating otherwise would essentially give someone (typically the boss) a de facto veto right. + +# 27b) + +Recognize that “there are many good ways to skin a cat.” Your assessment of how responsible parties are doing their jobs should not be + +--- + + +based on whether they’re doing it your way but whether they’re doing it in a good way. + +# 27c + +For disagreements to have a positive effect, people evaluating an individual decision or decision-maker must view the issue within a broader context. For example, if the responsible party being challenged has a vision, and the decision under disagreement involves a small detail, evaluate the decision within the context of the broader vision. The ensuing discussion resulting from challenging someone’s decision will help people understand all the considerations behind it. + +# 27d + +Distinguish between 1) idle complaints and 2) complaints that are meant to lead to improvement. + +... 28) Appreciate that open debate is not meant to create rule by referendum. It is meant to provide the decision-maker with alternative perspectives in anticipation of a better answer. It can also be used to enhance understanding of others’ views and abilities and, over time, assess whether someone should be assigned a responsibility. It doesn’t mean there can’t be some designs in which a group oversees a person. But that’s designed and embedded in the organizational structure, specifying the people responsible for oversight who are chosen because of their knowledge and judgment. + +... 29) Evaluate whether an issue calls for debate, discussion, or teaching. Debate, discussion, and teaching are all ways of getting in synch, but they work differently and the approach you choose should reflect your goal and the relative believability of the people involved. Debate is generally among approximate equals; discussion is open-minded exploration among people of various levels of understanding; and teaching is between people of different levels of understanding. + +# 29a + +To avoid confusion, make clear which kind of conversation (debate, discussion, or teaching) you are having and recognize that the purpose is ultimately to get at truth, not to prove that someone is right or wrong. + +# 29b + +Communication aimed at getting the best answer should involve the most relevant people. Not everyone should randomly probe everyone else, because that’s an unproductive waste of time. People should consider their + + + +--- + + +own levels of believability and understanding to assess if the probing makes sense. As a guide, the most relevant people are your managers, direct reports, and/or agreed experts. They are the most impacted by and most informed about the issues under discussion, and so they are the most important parties to be in synch with. If you can’t get in synch, you should escalate the disagreement. + +29c) Communication aimed at educating or boosting cohesion should involve a broader set of people than would be needed if the aim were just getting the best answer. Less experienced, less believable people will be included. They may not be necessary to decide an issue, but if you aren’t in synch with them, that lack of understanding will likely undermine morale and the organization’s efficiency. In cases where you have people who are both not believable and highly opinionated (the worst combination), you will drive their uninformed opinions underground if you don’t get in synch. Conversely, if you are willing to be challenged, and others behave the same way, you can demand that all critical communication be done openly. + +Imagine if a group of us were trying to learn how to play golf with Tiger Woods, and he and a new golfer were debating how to swing the club. Would it be helpful or harmful to our progress to ignore their different track records and experience? Of course it would be harmful and plain silly to treat their points of view equally, because they have different levels of believability. It is better to listen to what Tiger Woods has to say, without constant interruptions by some know-nothing arguing with him. While I believe this is true, it would be most productive if Tiger Woods gave his instructions and then answered questions. However, because I’m pretty extreme in believing that it is important to obtain understanding rather than accepting doctrine at face value, I also think the new golfer shouldn’t accept what Tiger Woods has to say as right only because he has won loads of tournaments and has years of experience playing golf. In other words, I believe the new golfer shouldn’t stop questioning Tiger until he is confident he has found truth. At the same time, I also think the new golfer would be pretty dumb and arrogant to believe he’s probably right and the champion golfer is wrong. So he should approach his questioning with that perspective rather than overblown confidence. It would be really bad for the group’s learning if all the people in the group treated what the new golfer and Tiger Woods had to say as equally valuable. I feel exactly the same way + + + +--- + + +about getting at truth at Bridgewater. While it’s good to be open-minded and questioning, it’s dumb to treat the views of people with great track records and experience the same as those without track records and experience. + +# 29d) Leverage your communication. + +While open communication is very important, the challenge is figuring out how to do it in a time-efficient way. It is helpful to use leveraging techniques like open e-mails posted on a FAQ board. If the reporting ratios are organized as described in the principles on organizational design, there should be ample time for this. The challenges become greater the higher you go in the reporting hierarchy because the number of people affected by your actions and who have opinions and/or questions grows larger than just two reporting levels down. In such cases, you will need even greater leverage and prioritization (e.g., having some of the questions answered by a well-equipped party who works for you, asking people to prioritize their questions by urgency or importance, etc). + +# 30) Don’t treat all opinions as equally valuable. + +Almost everyone has an opinion, but many are worthless or harmful. The views of people without track records are not equal to the views of people with strong track records. Treating all people equally is more likely to lead away from truth than toward it. People without records of success who are nonetheless confident about how things should be done are either naïve or arrogant. In either case, they’re potentially dangerous to themselves and others. However, all views should be considered in an open-minded way, albeit placed in the proper context of experience and track record. Ultimately, the proof is in the pudding: can you handle your responsibilities well? As a general rule, if you can, then you can have an opinion of how to do it—if you can’t, you can’t. + +# 30a) A hierarchy of merit is not only consistent with a meritocracy of ideas but essential for it. + +Not only is better decision-making enhanced, so is time management. It’s not possible for everyone to debate everything all the time and still get work done effectively. + +# 31) Consider your own and others’ “believabilities.” + +By believability, I mean the probability that a person’s view will be right. While we can never know this precisely, we can roughly assess it according to the quality of a person’s reasoning and their track record. Of course, different people will have different views of their own and other’s believability, which is fine. + + + +--- + + +Just recognize that this is a reality that is relevant in a number of ways. Ask, “Why should I believe you?” and “Why should I believe myself?” + +# 31a) + +Ask yourself whether you have earned the right to have an opinion. As a general rule, if you have a demonstrated track record, then you can have an opinion of how to do it—if you don’t, you can’t, though you can have theories and questions. + +# 31b) + +People who have repeatedly and successfully accomplished the thing in question and have great explanations when probed are most believable. Those with one of those two qualities are somewhat believable; people with neither are least believable. + +At the same time, people’s ideas should always be assessed on their merit in order to encourage them to always think in an open-minded way. I have seen that inexperienced people can have great ideas, sometimes far better than more experienced people, though often much worse. So we must be attuned to both the good and the bad and allow people to build their own track records and their own level of believability. Because of Bridgewater’s radical openness, you can see how we make our assessments of that. + +Someone new who doesn’t know much, has little believability, or isn’t confident in his views should ask questions. On the other hand, a highly believable person with experience and a good track record who is highly confident in his views should be assertive. Everyone should be upfront in expressing how confident they are in their thoughts. A suggestion should be called a suggestion; a firmly held conviction should be presented as such. Don’t make the mistake of being a dumb shit with a confident opinion. + +# 31c) + +If someone asks you a question, think first whether you’re the responsible party/right person to be answering the question. + +... 32) Spend lavishly on the time and energy you devote to “getting in synch” because it’s the best investment you can make. You will inevitably need to prioritize because of time constraints, but beware of the tremendous price of skimping on quality communication. + +... 33) If it is your meeting to run, manage the conversation. There are many reasons why meetings go poorly, but frequently it is because of a lack of clarity about the topic or the level at which things are being discussed. + + + +--- + + +# 33. Managing Meetings Effectively + +(e.g., the principle/machine level, the case at hand level, or the specific fact level). To manage the meetings well: + +1. Make it clear who the meeting is meant to serve and who is directing the meeting. Every meeting is for the purpose of meeting someone’s goals; that person is the responsible party for the meeting and decides what s/he wants to get out of it and how s/he will do so. Meetings without a clear responsible party run a high risk of being directionless and unproductive. +2. Make clear what type of communication you are going to have in light of the objectives and priorities. For example, if the goal of the meeting is to have people with different opinions work through their differences to try to get closer to what is true and what to do about it (i.e., open-minded debate), you will run it differently than if the meeting is meant to educate. Debating issues takes time. That time increases geometrically depending on the number of people participating in the discussion, so you have to carefully choose the right people in the right numbers to suit the decision that needs to be made. In any discussion try to limit the participation to those whom you value most in light of your objectives. The worst way to pick people is based on whether their conclusions align with yours. +3. Lead the discussion by being assertive and open-minded. Group-think and solo-think are both dangerous. +4. A small group (3 to 5) of smart, conceptual people seeking the right answers in an open-minded way will generally lead to the best answer. Next best is to have decisions made by a single smart, conceptual decision-maker, but this is a much worse choice than the former. The worst way to make decisions is via large groups without a smart, conceptual leader. Almost everyone thinks they’re smart and conceptual, but only a small percentage of any group really is. Even when there is a large number of smart, conceptual leaders, more than five trying to make a decision is very inefficient and difficult. This is especially the case when people think they need to satisfy everyone. +5. 1+1=3. Two people who collaborate well will be about three times as effective as the two of them operating independently because they will see what the other might miss, they can leverage each other, and they can hold. + + + +--- + + +each other to higher standards. This symbiotic relationship of adding people to a group will have incremental benefits (2+1=4.25) up to a point at which there are no incremental gains and beyond which adding people produces incremental losses in effectiveness. That is because 1) the marginal benefits diminish as the group gets larger—e.g. two or three people might be able to cover most of the important perspectives so adding more people doesn't bring much more, and 2) larger group interactions are less efficient than smaller group interactions. Of course, what's best in practice is a function of 1) the quality of the people and the differences of the perspectives that they bring and 2) how well the group is managed. As noted before, each group should have someone who is responsible for managing the flow to get out of the meeting the most possible. + +# 33f + +Navigate the levels of the conversation clearly. When considering an issue or situation, there should be two levels of discussion: the case at hand and the relevant principles that help you decide how the machine should work. Since the case at hand is a manifestation of one or more relevant principles, you need to clearly navigate between these levels in order to 1) handle the case well, 2) improve the machine so that future cases like this will be handled better in the future, and 3) test the effectiveness of your principles. + +# 33g + +Watch out for “topic slip.” Topic slip is the random and inconclusive drifting from topic to topic without achieving completion. Tip: Avoid topic slip by tracking the conversation on a whiteboard so everyone can see where you are. + +# 33h + +Enforce the logic of conversations. There is a tendency for people’s emotions to heat up when there is a disagreement, so focusing on the logic of your exchange will facilitate communication. If you are calm and analytical in listening to others’ points of view, it is more difficult for them to shut down a logical exchange than if you get emotional or allow them to get emotional. + +# 33i + +Worry about substance more than style. This is not to say that some styles aren’t more effective than others with different people and in different circumstances, but don’t let style or tone prevent you from getting in synch. I often see people complain about the delivery of a criticism in order to deflect from its substance. If you think someone’s style is an issue, + + + +--- + + +box it as a separate issue to get in synch about (start by asking whether it’s true and whether it’s important). + +# 33j) Achieve completion in conversations. + +The main purpose of discussion is to achieve completion and get in synch, which leads to decisions and or actions. Conversations often fail to reach completion. This amounts to a waste of time because they don’t result in conclusions or productive actions. When there is an exchange of ideas, especially if there is a disagreement, it is important to end it by stating the conclusions. If there is agreement, say it; if not, say that. Where further action has been decided, get those tasks on a to-do list, assign people to do them, and specify due dates. Write down your conclusions, working theories, and to-do’s in places that will lead to their being used as foundations for continued progress. + +# 33k) Have someone assigned to maintain notes in meetings and make sure follow-through happens. + +Generally speaking, to avoid distraction during the discussion itself, prioritizing follow-ups and assignments should be done afterwards. + +# 33l) Be careful not to lose personal responsibility via group decision-making. + +Too often groups will make a decision to do something without assigning personal responsibilities so it is not clear who is supposed to do what. Be clear in assigning personal responsibilities. + +# 34) Make sure people don’t confuse their right to complain, give advice, and debate with the right to make decisions. + +Discussion does not mean rule by referendum. While our culture is marked by extreme openness, some people mistakenly assume we have group decision-making in which all views are treated equally and consensus rules. Since not all views are equally valuable, I don’t believe in consensus decision-making or referendums. We operate not only by open debate but also by clearly assigning personal responsibility to specific people. While these two values might seem at odds, personal responsibility and open debate work together to synthesize effective decision-making at Bridgewater. Everyone does not report to everyone here. Instead, responsibility and authority are assigned to individuals based on our assessment of their ability to handle them. I want the most capable individuals assigned to each job. We hold them accountable for their outcomes, but we also give them the authority to achieve those outcomes. It is perfectly okay for a responsible party to carry + + + +--- + + +# 35) Recognize that getting in synch is a two-way responsibility. + +In any conversation there is a responsibility to transmit and a responsibility to receive. Misinterpretations are going to take place. Often, difficulty in communication is due to people having different ways of thinking (e.g., left-brained thinkers talking to right-brained thinkers). The parties involved should 1) realize that what they might be transmitting or receiving might not be what was meant, 2) consider multiple possibilities, and 3) do a back and forth so that they can get in synch. People do the opposite — confidently thinking that they’ve communicated their intent clearly, not considering multiple possibilities and then blaming the other parties for the misunderstanding. Learn lessons from your problems in communications to improve. + +# 36) Escalate if you can’t get in synch. + +If you can’t understand or reconcile points of view with someone else, agree on a third party to provide guidance. This person could be your manager or another agreed-upon, believable person or group who can resolve the conflict objectively, fairly, and sensibly. This mechanism is a key element of our culture and crucial for maintaining a meritocracy of ideas. + + + +--- + + +# 37) RECOGNIZE THE MOST IMPORTANT DECISIONS YOU MAKE ARE WHO YOU CHOOSE TO BE YOUR RESPONSIBLE PARTY + +So... + +# 38) Remember that almost everything good comes from having great people operating in a great culture. I cannot emphasize strongly enough how important the selection, training, testing, evaluation, and sorting out of people is. If you put the goals and the tasks in the hands of people who can do them well, and if you make crystal clear that they are personally responsible for achieving the goals and doing the tasks, they should produce excellent results. This section is about the people part of the feedback loop process, diagramed below. + +| GOALS | > | MACHINE | OUTCOMES | +| ------ | ------ | ------- | -------- | +| DESIGN | PEOPLE | | | + +# 39) First, match the person to the design. Understand what attributes matter most for a job, and then ascertain whether an individual has them. This matching process requires 1) visualizing the job and the qualities needed to do it well and then 2) ascertaining if the individual has those qualities. + +Look for believable responsible parties who love producing great results.55 Remember that values are most important—e.g., if “work” is what people have to do to make money, I don’t want people to “work” here. I only want people at Bridgewater who are joining us on an important, shared mission to do great things. + + + +--- + + +# 39a) + +Most importantly, find people who share your values. At Bridgewater, those key values are a drive for excellence, truth at all costs, a high sense of ownership, and strong character (by character, I mean the willingness to do the good but difficult things). + +# 39b) + +Look for people who are willing to look at themselves objectively and have character. These are not natural talents—they are qualities that anyone can acquire. They are also the qualities that have the biggest influence on whether or not I respect someone. They are essential for success. + +# 39c) + +Conceptual thinking and common sense are required in order to assign someone the responsibility for achieving goals (as distinct from tasks). + +# 40) + +Recognize that the inevitable responsible party is the person who bears the consequences of what is done. Because of this, the RP must choose wisely when delegating responsibilities to others, and he must incentivize and manage them appropriately. There is no escaping that. For example, you are the inevitable RP for taking care of your health because you’re the one who inevitably bears the consequences. If you’re sick, you might choose to delegate the responsibility of figuring out what to do about it to a doctor. However, it is your responsibility to pick the right doctor because you will bear the consequences of that decision. While it is, of course, also the doctor’s responsibility to handle the responsibilities that you delegate to him, you still need to make sure that his incentives are aligned with his responsibilities and that he is doing his job well. The inevitable responsible party can’t delegate all his responsibilities away and expect good outcomes, even in cases in which he has no expertise. So you can’t escape hiring and managing properly. + +# 41) + +By and large, you will get what you deserve over time. The results that you end up with will reflect how you and your people learn to handle things. So take control of your situation and hold yourself and others accountable for producing great results. People who wish for a great result but are unwilling to do what it takes to get there will fail. + +# 42) + +The most important responsible parties are those who are most responsible for the goals, outcomes, and machines (they are those higher + + + +--- + + +in the pyramid). Give me someone who can effectively be responsible for an area—i.e., who can design, hire, and sort to achieve the goal, and I can be comfortable about all that is in that area. Therefore, they are the most important people to choose and manage well. + +... 43) Choose those who understand the difference between goals and tasks to run things. Otherwise you will have to do their jobs for them. The ability to see and value goals is largely innate, though it improves with experience. It can be tested for, though no tests are perfect. + + + +--- + + +# 44) RECOGNIZE THAT PEOPLE ARE BUILT VERY DIFFERENTLY + +So... + +# 45) Think about their very different values, abilities, and skills. + +Values are the deep-seated beliefs that motivate behaviors; people will fight for their values, and values determine people’s compatibility with others. Abilities are ways of thinking and behaving. Some people are great learners and fast processors; others possess common sense; still others think creatively or logically or with supreme organization, etc. Skills are learned tools, such as being able to speak a foreign language or write computer code. + +While values and abilities are unlikely to change much, most skills can be acquired in a limited amount of time (e.g., most master’s degrees can be acquired in two years) and often change in worth (e.g., today’s best programming language can be obsolete in a few years). + +It is important for you to know what mix of qualities is important to fit each role and, more broadly, with whom you can have successful relationships. In picking people for long-term relationships, values are most important, abilities come next, and skills are the least important. + +# 46) Understand what each person who works for you is like so that you know what to expect from them. + +# 47) Recognize that the type of person you fit in the job must match the requirements for that job. + +# How People’s Thinking Abilities Differ + +In my many years of running Bridgewater I have learned that people’s thinking abilities differ and that it is important to understand these differences so that they are appropriately considered when assigning people to roles. I have tried to find experts who understood these differences to help me better understand and test for them. I have found a few truly insightful people amid a mass of mediocrity.56 I have also found that there are all sorts of theories from all sorts of people about how people think and why, so very little should be treated as fact. It seems + + + +--- + + +that “political correctness” and the reluctance to objectively discuss differences in innate abilities have stood in the way of forthright and thoughtful research on this important subject. While the search for good advice and tests has been challenging, it has also been invaluable. What follows is a mix of my theories based on my personal observations and a collection of valuable things I have learned from others.57 I know I have only scratched the surface of learning about how people think, why they think differently, and how to test for these different thinking abilities, so I am excited about the potential of learning more. + +I believe, but am not certain about, the following: + +- There are two big differences in how people think that are due to the brain’s coming in two big halves and different people relying differently on them.58 This was explained by Caltech Professor Roger Sperry, who won a Nobel Prize in medicine for attributing these two ways of thinking to different reliances on the two hemispheres. As a result of this discovery, these two ways of thinking are called “left-brained” and “right-brained.” Professor Sperry helped us understand that: + +Long before I knew that there was a Professor Sperry I saw these differences. I bet you’ve seen them too. + +On a scale of -5 to +5 – left-brained to right-brained – where do you think you fall? + + + +--- + + +# How confident are you that your self-assessment is right? + +• Some people see details (trees), and others see big pictures (forests). Those who “see trees” see the parts most vividly and don’t readily relate the parts to each other in order to see the big picture—e.g., they might prefer more literal, precise paintings. They are typically left-brained. Others connect the dots to pictures. In fact, they typically don’t even see the dots; they just see the pictures. They are typically right-brained. You can detect which type people are by observing what they focus on. Detailed thinkers can lose sight of the big picture and are more likely to focus in on a part than to go to the higher level and see the relationship between parts. For example, a person who focuses on details can be thrown off by word mistakes like “there“ instead of “their,” while big-picture thinkers won’t even notice the mistake. Similarly, big-picture thinkers can often understand the meaning of sentences even when key words are reversed—e.g., when “up” is mistakenly used instead of “down,” they understand that the person speaking couldn’t have meant “up” in that context. That is because their attention is focused on the context first and the details second. When describing the same meeting, these two different types will frequently focus on completely different things and disagree on their interpretations. In discussions, they can frustrate each other and discount what the other is saying. Similarly, a person of one type interviewing another type will usually yield an unsatisfactory result. + +On a scale of -5 to +5 – “detailed” to “big picture” – where do you think you fall? + +# How confident are you that your self-assessment is right? + +• Some people rely more on remembering what they were taught when making decisions, and others rely more on their independent reasoning. Let’s call the first group memory-based learners and the second group reasoning-based thinkers. When + + + +--- + + +using the word “learning” I intend to convey “acquiring knowledge by being taught,” and when using the word “thinking” I mean “figuring it out for oneself.” Memory-based learners approach decision-making by remembering what they were taught. They draw on their memory banks and follow the instructions stored there. They are typically left-brained. Reasoning-based thinkers pay more attention to the principles behind what happens. They are typically right-brained. You can tell the difference when what is learned (e.g., CAPM) conflicts with what is logical (e.g., All Weather). People who rely on memory-based learning will typically be more skeptical of unconventional ideas because their process is to more readily accept what they have been told and because they are less able to assess it for themselves. Those who rely on more on reasoning won’t care much about convention and will assess ideas on their merits. Those who rely on memory-based learning also tend to align themselves with the consensus more than people who rely on reasoning. Memory-based learners are more willing to accept the status quo, while reasoning-based thinkers are less biased by it. They are more likely to be innovative, while those who rely on learning are likelier to be cautious. Performance in school will correlate well with the quality of one’s learning-based thinking, but will not reliably correlate with one’s reasoning-based thinking. The most able learners are easily found, since they are, or were, the best students from the best schools. The best thinkers are tougher to find, as there are no obvious funnels through which they pass, especially before they develop track records in the “real world.” + +On a scale of -5 to +5 –“learning” to “thinking” – where do you think you fall? + +How confident are you that your self-assessment is right? + +- Some people are focused on daily tasks, and others are focused on their goals and how to achieve them. Those who “visualize” best can see the pictures (rather than the dots) over + + + +--- + + +time. They have a strong capacity to visualize and will be more likely to make meaningful changes and anticipate future events. They are the most suitable for creating new things (organizations, projects, etc.) and managing organizations that have lots of change. We call them “creators.” They are typically right-brained thinkers. By contrast, those who are focused on the daily tasks are better at managing things that don’t change much or require repetitive processes done reliably, and are typically best at doing clearly specified tasks. They see things much more literally and tend to make incremental changes that reference what already exists. They are slower to depart from the status quo and more likely to be blindsided by sudden events. They are typically left-brained thinkers. + +On a scale of -5 to +5 – “tasks” to “goals” – where do you think you fall? + +How confident are you that your self-assessment is right? + +- Some people are “planners,” and others are “perceivers.” + +Planners like to focus on a plan and stick with it, while perceivers are prone to focus on what’s happening around them and more readily adapt to it. Perceivers see things happening and work backward to understand the cause and how to respond; they work from the outside in; they also see many more possibilities that they compare and choose from; often they see so many that they are confused by them. In contrast, planners work from the inside out, figuring out first what they want to achieve and then how things should unfold. Planners and perceivers have trouble appreciating each other. While a perceiver likes to see new things and change directions often, this is discomforting to planners, who prefer to stick to a plan. Planners weigh precedent much more heavily in their decision-making, and assume that if it was done before in a certain way, it should be done again in the same way, while perceivers tend to optimize on the spot. Planners are typically left-brained, and perceivers are typically right-brained. + + + +--- + + +# Self-Assessment Scales + +On a scale of -5 to +5 – “planner” to “perceiver” – where do you think you fall? + +How confident are you that your self-assessment is right? + +- Some people are driven more by their emotions, and others are driven more by their intellect. We all have emotions and intellect. When they conflict, some people will give in to their emotions, while others maintain control of their emotions and are driven by their intellect. I am told this is more due to relative reliance on the amygdala and the prefrontal cortex, but I’m not sure. Once again, these two different types typically can’t understand and typically frustrate each other. + +On a scale of -5 to +5 – “driven by emotion” to “driven by intellect” – where do you think you fall? + +How confident are you that your self-assessment is right? + +- Some people are risk-takers, and others are risk-averse. + +On a scale of -5 to +5 – “risk-averse” to “risk-takers” – where do you think you fall? + +How confident are you that your self-assessment is right? + +- Some people are introverts, and others are extroverts. The most important difference between them is their willingness to fight for truth. Introverts tend to find the necessary conflicts more difficult. There are lots of important ways in which people think differently that I won’t continue on about. + +On a scale of -5 to +5 – “introvert” to “extrovert” – where do you think you fall? + +How confident are you that your self-assessment is right? + + + +--- + + +# 48) + +Use personality assessment tests and quality reflections on experiences to help you identify these differences. These should be done openly so that these important differences are embraced and considered in our interactions. + +# 49) + +Understand that different ways of seeing and thinking make people suitable for different jobs. Since nature created different ways of thinking and since nature never creates anything without a purpose,61 each way of thinking has purposes. Often, thinking well for some purposes necessitates thinking poorly for others. It is highly desirable to understand one’s own ways, and others’ ways, of thinking, and their best applications. While there is no best quality, there are certainly some qualities that are more suitable for some jobs (e.g., being a math wiz is important for a job that requires a math wiz). So don’t treat everyone the same. + +Sometimes I see people dealing with each other, especially in groups, without regard for these differences. This is nonsensical. Both people expressing their own views and those considering others’ views need to take into account their differences. These differences are real, so it’s dumb to pretend they don’t exist. + +# 49a) + +People are best at the jobs that require what they do well. + +# 49b) + +If you’re not naturally good at one type of thinking, it doesn’t mean you’re precluded from paths that require that type of thinking, but it does require that you either work with someone who has that required way of thinking (which works best) or learn to think differently (which is very difficult and sometimes impossible). + +# 50) + +Don’t hide these differences. Explore them openly with the goal of figuring out how you and your people are built so you can put the right people in the right jobs and clearly assign responsibilities. This is good for both your team and for Bridgewater as a whole. + +# 51) + +Remember that people who see things and think one way often have difficulty communicating and relating to people who see things and think another way. Keep in mind how difficult it is to convey what it means to think in an alternative way for the same reason it would be difficult to + + + +--- + +convey what the sense of smell is to someone who doesn’t have the ability to smell. + +--- + + +# 52) HIRE RIGHT, BECAUSE THE PENALTIES OF HIRING WRONG ARE HUGE + +So... + +# 53) Think through what values, abilities, and skills you are looking for. + +A lot of time and effort is put into hiring a person, and substantial time and resources are invested in new employees’ development before finding out whether they are succeeding. Getting rid of employees who aren’t succeeding is also difficult, so it pays to be as sure as possible in hiring. Refer to our diagram that shows how to achieve your goals by comparing them with the outcomes you’re getting, and think of the people part as shown below. By constantly comparing the picture of what the people are like with the qualities needed, you will hire better and evolve faster. + +| PEOPLE | | +| ---------------- | -------------------- | +| Qualities Needed | What People Are Like | + +# 54) Weigh values and abilities more heavily than skills in deciding whom to hire. + +Avoid the temptation to think narrowly about filling a job with a specific skill.[62] While having that skill might be important, what’s most important is determining whether you and they are working toward the same goals and can work in the same ways and share the same values. + +# 55) Write the profile of the person you are looking for into the job description. + +# 56) Select the appropriate people and tests for assessing each of these qualities and compare the results of those assessments to what you’ve decided is needed for the job. + +Synthesize the results of those tests to see if there is a “click.” + +# 56a) + +Remember that people tend to pick people like themselves, so pick interviewers who can identify what you are looking for. For example, if you’re looking for a visionary, pick a visionary to do the interview where + + + +--- + + +you test for vision. If there is a mix of qualities you’re looking for, put together a group of interviewers who embody all of these qualities collectively. Don’t choose interviewers whose judgment you don’t trust (in other words, choose believable interviewers). + +# 56b) + +Understand how to use and interpret personality assessments. These can be a fantastic tool in your arsenal for quickly getting a picture of what people are like—abilities, preferences, and style. They are often much more objective and reliable than interviews. + +# 56c) + +Pay attention to people’s track records. + +# 56d) + +Dig deeply to discover why people did what they did. Knowing what they did is valuable only in helping you figure out what they are like. Understanding the “why” behind people’s actions will tell you about their qualities and as a result, what you can probably expect from them. + +# 56e) + +Recognize that performance in school, while of some value in making assessments, doesn’t tell you much about whether the person has the values and abilities you are looking for. Memory and processing speed tend to be the abilities that determine success in school (largely because they’re easier to measure and grade) and are most valued, so school performance is an excellent gauge of these. School performance is also a good gauge for measuring willingness and ability to follow directions as well as determination. However, school is of limited value for teaching and testing common sense, vision, creativity, or decision-making.63 Since those traits all outweigh memory, processing speed, and the ability to follow directions in most jobs, you must look beyond school to ascertain whether the applicant has the qualities you’re looking for. + +# 56f) + +Ask for past reviews. Don’t rely exclusively on the candidate for information about their track record; instead, talk to people who know them (believable people are best), and look for documented evidence. + +# 56g) + +Check references. + +# 57) + +Look for people who have lots of great questions. These are even more important than great answers. + + + +--- + + +58) Make sure candidates interview you and Bridgewater. Show them the real picture. For example, share these principles with them to show how we operate and why. Have them listen to the tapes to see the reality. + +59) Don’t hire people just to fit the first job they will do at Bridgewater; hire people you want to share your life with. The best relationships are long term and based on shared missions and values. Also, turnover is generally inefficient because of the long time it requires for people to get to know each other and Bridgewater. Both the people you work with and the company itself will evolve in ways you can’t anticipate. So hire the kind of people you want to be with on this long-term mission. + +60) Look for people who sparkle, not just “another one of those.” I have too often seen people hired who don’t sparkle, just because they have clearly demonstrated they were “one of those.” If you’re looking for a plumber you might be inclined to fill the job with someone who has years of experience, without confirming whether he has demonstrated the qualities of an outstanding plumber. Yet the difference between hiring an ordinary versus an extraordinary plumber (or any other expert) is huge. So when reviewing a candidate’s background, you must identify how this person has demonstrated himself to be outstanding. The most obvious demonstration is outstanding performance within an outstanding peer group. If you’re less than excited to hire someone for a particular job, don’t do it. The two of you will probably make each other miserable. + +61) Hear the click: Find the right fit between the role and the person. Remember that your goal is to put the right people in the right design. First understand the responsibilities of the role, then what qualities are needed to fulfill them excellently, and then ascertain whether an individual has them. This matching process requires 1) visualizing the job and the qualities needed to do it well and 2) ascertaining if the individual has those qualities. I describe this process as “hearing the click,” because that’s the sound of finding the right fit between the role and the individual. + +62) Pay for the person, not for the job. Look at what they were paid before and what people with comparable credentials get paid and pay some premium to that, but don’t pay based on the job title. + + + +--- + + +63) Recognize that no matter how good you are at hiring, there is a high probability that the person you hire will not be the great person you need for the job. Continue the “interviewing” process as intensely after they are on the job as before, and don’t settle. + + + +--- + + +# 64) MANAGE AS SOMEONE WHO IS DESIGNING AND OPERATING A MACHINE TO ACHIEVE THE GOAL + +So... + +# 65) Understand the differences between managing, micromanaging, and not managing. + +Micromanaging is telling the people who work for you exactly what tasks to do and/or doing their tasks for them. Not managing is having them do their jobs without your oversight and involvement. Managing means: 1) understanding how well your people and designs are operating to achieve your goals and 2) constantly improving them. To be successful, you need to manage. + +# 65a) + +Managing the people who report to you should feel like “skiing together.” Like a ski instructor, you need to have close contact with your people on the slopes so that you can assess their strengths and weaknesses as they are doing their jobs. There should be a good back and forth with trial and error. With time you will be able to decide what they can and can’t effectively handle on their own. + +# 65b) + +An excellent skier is probably going to be more critical and a better critic of another skier than a novice skier. A student probably thinks his ski instructor is fabulous, while an Olympic skier looking at the same ski instructor would assess him to be at a much lower level. + +# 66) + +Constantly compare your outcomes to your goals. Identify problems and diagnose whether the problems are with the way the organization is designed or with the way the people are handling their responsibilities. So remember how the following feedback loop to rapid improvement works. + + + +--- + + +# GOALS + +# MACHINE + +# OUTCOMES + +# DESIGN + +# PEOPLE + +i.e., the Responsible Parties + +# Qualities + +# What People Are Like + +And remember to do this constantly so you have a large sample size. You want to have a large sample size because 1) any one problem can either be a one-off imperfection or symptomatic of root causes that will show up as problems repeatedly; and 2) looking at a large sample size of problems will make clear which it is. Also, the larger your sample size, the clearer the root causes of your problems, and the more obvious your solutions, will be. + +If you do this constantly in this way, your evolutionary process should look like this: + +... 67) Look down on your machine and yourself within it from the higher level. Higher-level thinking doesn’t mean the thinking done by higher-level beings. It means seeing things from a top-down perspective—like looking + + + +--- + + +at a photo of Earth from outer space, which shows you the relationships between the continents, counties, and seas, and then going down to a photo of your country, then down to your neighborhood, then down to your family. If you just saw your family without the perspective of seeing that there are millions of other families, and there have been many millions of other families over thousands of years, and observing how your family compares and how families evolve, you would just be dealing with the items that are coming at you as they transpire without the perspective. + +... 68) Connect the case at hand to your principles for handling cases of that type. Remember that every problem and task is just another “one of those”—i.e., another one of a certain type. Figuring out what type it is and reflecting on principles for handling that type of issue will help you do a better job. Whether or not you use the principles written here, you still must decide on a course of action and what guiding principles will be effective. Through this process you will improve your principles as well as handle your issues better. + +... 69) Conduct the discussion at two levels when a problem occurs: 1) the “machine” level discussion of why the machine produced that outcome and 2) the “case at hand” discussion of what to do now about the problem. Don’t make the mistake of just having the task-level discussion, because then you are micromanaging—i.e., you are doing your managee’s thinking for him and your managee will mistake your doing this as being OK, when that’s not OK (because you will be micromanaging). When having the machine-level discussion, think clearly how things should have gone and explore why they didn’t go that way. If you are in a rush to determine what to do and you have to tell the person who works for you what to do, point out that you are having to do this, make clear that you are having to do this and that is what you are doing, and make it a training experience—i.e., explain what you are doing and why. + +... 70) Don’t try to be followed; try to be understood and to understand others. Your goal is to understand what is true and improve together. If you want to be followed, either for an egotistical reason or because you believe it more expedient to operate that way, you will pay a heavy price in the long run. If you are the only one thinking, the results will suffer. + + + +--- + + +# 70a) + +Don’t try to control people by giving them orders. They will likely resent the orders, and when you aren’t looking, defy them. An authoritarian approach also means you aren’t developing your employees, and over time they will become increasingly dependent on you, which damages all parties. Instead, the greatest power you have over intelligent people—and the greatest influence they will have on you—comes from constantly getting in synch about what is true and what is best so that they and you want the same things. People must desire to do the right things, and this desire must come from them. You can, however, show them the connection between fulfilling their responsibilities and their own well-being. Reaching agreement will come only from radically open discussions in which you are fair, reasonable, and open-minded. + +# 70b) + +Communicate the logic and welcome feedback. When making rules or changes, explain the principles behind the decision. We want reasonable thinkers to operate sensibly. We achieve this through principles that are sound and well understood, applied and tested through open discussion. It is each person’s job to 1) evaluate whether he agrees with a decision, and if not, explain why; and 2) hold each other accountable for operating consistently within the organization’s principles. We want people who understand the principles that allow our community to succeed and possess strong ethics that motivate them to work by our rules, rather than to sneak around them. We want people who know that if the community works well, it will be good for them. We don’t want people who need to be ordered and threatened. We don’t want people who just follow orders. + +# 71) + +Clearly assign responsibilities. Eliminate any confusion about expectations and ensure that people view the failure to achieve their goals and do their tasks as personal failures. The most important person is the one who is given the overall responsibility for accomplishing the mission and has both the vision to see what should be done and the discipline to make sure it’s accomplished by the people who do the tasks. + +# 72) + +Hold people accountable and appreciate them holding you accountable. It’s better for them, for you, and for the community. Slacker standards don’t do anyone any good. People can resent being held accountable, however, and you don’t want to have to tell them what to do all the time. Instead, reason with them, so that they understand the value. + + + +--- + + +and importance of being held accountable. Hold them accountable on a daily basis. Constant examination of problems builds a sample size that helps point the way to a resolution and is a good way to detect problems early on before they become critical. Avoiding these daily conflicts produces huge costs in the end. + +# 72a) + +Distinguish between failures where someone broke their “contract” from ones where there was no contract to begin with. If you didn’t make the expectation clear, you generally can’t hold people accountable for it being fulfilled (with the exception of common sense—which isn’t all that common). If you find that a responsibility fell through the cracks because there was no contract, think about whether you need to edit the design of your machine. + +# 73) + +Avoid the “sucked down” phenomenon. This occurs when a manager is pulled down to do the tasks of a subordinate without acknowledging the problem. The sucked down phenomenon bears some resemblance to job slip, since it involves the manager’s responsibilities slipping into areas that should be left to others. Both situations represent the reality of a job diverging from the ideal of that job. However, the sucked down phenomenon is typically the manager’s response to subordinates’ inabilities to do certain tasks or the manager’s failure to properly redesign how the responsibilities should be handled in light of changed circumstances. You can tell this problem exists when the manager focuses more on getting tasks done than on operating his machine. + +# 73a) + +Watch out for people who confuse goals and tasks, because you can’t trust people with responsibilities if they don’t understand the goals. One way to test this: if you ask a high-level question like, “How is goal XYZ going?” a good answer will provide a synthesis upfront (of how XYZ is in fact going overall), and then support that assessment with the tasks done to achieve the goal. People who see the tasks and lose sight of the goals will just explain the tasks that were done and not make the connection to how those tasks relate to the machine that produces outcomes and achieves goals. + + + +--- + + +# Synthesized + +| Question | GOOD | Answer | BAD | What We Did | +| -------- | ---- | ------ | --- | ----------- | + +74) Think like an owner, and expect the people you work with to do the same. You must act in the interest of our community and recognize that your well-being is directly connected to the well-being of Bridgewater. For example, spend money like it’s your own. + +75) Force yourself and the people who work for you to do difficult things. It’s usually easy to make things go well if you’re willing to do difficult things. We must act as trainers in gyms act in order to keep each other fit. That’s what’s required to produce the excellence that benefits everyone. It is a law of nature that you must do difficult things to gain strength and power. As with working out, after a while you make the connection between doing difficult things and the benefits you get from doing them, and you come to look forward to doing these difficult things. + +75a) Hold yourself and others accountable. It is unacceptable for you to say you won’t fight for quality and truth because it makes you or other people uncomfortable. Character is the ability to get yourself to do the difficult but right things. Get over the discomfort, and force yourself to hold people accountable. The choice is between doing that properly or letting our community down by behaving in a way that isn’t good for you or the people you are “probing” and coaching. + +76) Don’t worry if your people like you; worry about whether you are helping your people and Bridgewater to be great. One of the most essential and difficult things you have to do is make sure the people who work for you do their jobs excellently. That requires constantly challenging them and doing things they don’t like you to do, such as probing them. Even your best people, whom you regularly praise and reward, must be challenged and. + + + +--- + + +# 77) Know what you want and stick to it if you believe it’s right, even if others want to take you in another direction. + +# 78) Communicate the plan clearly. + +People should know the plans and designs within their departments. When you decide to divert from an agreed-upon path, be sure to communicate your thoughts to the relevant parties and get their views so that you are all clear about taking the new path. + +# 78a) + +Have agreed-upon goals and tasks that everyone knows (from the people in the departments to the people outside the departments who oversee them). This is important to ensure clarity on what the goals are, what the plan is, and who is responsible to do what in order to achieve the goals. It allows people to buy into the plan or to express their lack of confidence and suggest changes. It also makes clear who is keeping up his end of the bargain and who is falling short. These stated goals, tasks, and assigned responsibilities should be shown at department meetings at least once a quarter, perhaps as often as once a month. + +# 78b) + +Watch out for the unfocused and unproductive “we should ... (do something).” Remember that to really accomplish things we need believable responsible parties who should determine, in an open-minded way, what should be done; so it is important to identify who these people are by their names rather than with a vague “we,” and to recognize that it is their responsibility to determine what should be done. So it is silly for a group of people who are not responsible to say things like “we should...” to each other. On the other hand, it can be desirable to speak to the responsible party about what should be done. + +# 79) Constantly get in synch with your people. + +Being out of synch leads to confused and inefficient decision-making. It can also lead you in conflicting directions either because 1) you are not clear with each other, which often generates wildly differing assumptions, or 2) you have unresolved differences in your views of how things should proceed and why. Getting in synch by discussing who will do what and why is essential for mutual progress. It doesn’t necessarily entail reaching a consensus. + + + +--- + + +Often there will be irreconcilable differences about what should be done, but a decision still needs to be made, which is fine. The process of getting in synch will make it clear what is to be done and why, even if it cannot eliminate difference. One of the most difficult and most important things you must do, and have others do, is bring forth disagreement and work through it together to achieve a resolution. Recognize that this process takes time. It can happen any way people prefer: discussion, e-mail, etc. You must have a workable process for making decisions even when disagreements remain. I discuss such a process in the earlier section on getting in synch. + +... 80) Get a “threshold level of understanding”—i.e., a rich enough understanding of the people, processes and problems around you to make well-informed decisions. + +... 81) Avoid staying too distant. You need to know your people extremely well, provide and receive regular feedback, and have quality discussions. Your job design needs to build in the time to do these things. + +81a) Tool: Use daily updates as a tool for staying on top of what your people are doing and thinking. Daily updates are brief descriptions of what the person did that day, what they are planning to do the next day, their problems, their questions, and their observations. They typically take about five minutes to write and do wonders for staying in touch. + +... 82) Learn confidence in your people—don’t presume it. It takes time to learn about people and what confidences can be placed in them. Sometimes new people are offended we don’t yet have confidence in how they are handling their responsibilities. They think it’s a criticism of their abilities when in fact it’s a realistic recognition that we simply haven’t had enough time or direct experience with them to form a point of view. No manager (including myself) should delegate responsibilities to people we don’t yet know well enough to have confidence in. And new people shouldn’t be offended if we haven’t yet formed that confidence. + +... 83) Vary your involvement based on your confidence. Management largely consists of scanning and probing everything for which you are responsible to identify suspicious signs. Based on what you see, you should vary your degree of digging, doing more of it for people and areas that look more suspicious, and less of it where probing instills you with confidence. + + + +--- + + +With the right tools in place and performing well, your scanning will include both reviewing the output of these tools (e.g., “issues log,” “metrics,” “daily updates,” and “checklists”) and spot-checking. + +... 84) Avoid the “theoretical should.” The theoretical should occurs when a manager theorizes that people should be able to do something when they can’t or without actually knowing whether they can do it. + +... 85) Care about the people who work for you. If you are not working with people you care about and respect, this whole thing ain’t worth it. If you don’t believe that, you probably shouldn’t work at Bridgewater. While it’s desirable to convey these feelings, having them is more important. It is good to share your lives together, but not required. Be there for weddings, births, and funerals. This is something that I try to do but fail to do enough because of the numbers, so I convey that I will be there for anyone who really needs me. Personal contact at the time of personal difficulty is a must. + +... 86) Logic, reason, and common sense must trump everything else in decision-making. + +... 87) While logic drives our decisions, feelings are very relevant. A feeling is a reality—and a good reality—and it’s up to management to deal with all realities sensibly. Good emotions are important. In fact, they are probably most important since they are the reasons behind the good things we do, e.g., satisfaction with a job wonderfully done and love of others. Emotions are bad only if they cloud judgment and take us away from what we want. + +... 88) Escalate when you can’t adequately handle your responsibilities, and make sure that the people who work for you do the same. Escalating means saying that you don’t believe that you can successfully handle a situation and that you are passing the “responsible party” (RP) job to someone else. The person you are escalating to—the person to whom you report—can then decide whether to coach you through it, take control, have someone else handle it, or do something else. However, the boss should avoid being drawn into doing the job of the person who is failing without exploring why the job has not been done successfully without help. It’s very + + + +--- + + +important to get an accurate assessment of what each person can and can’t do and why. If the boss just does the job for the person, even if it produces good results, we will lack the right attribution of success and failure. Remember that an important goal is to learn about what a person is like from testing, and that we want to get that information without crashing the car. So, the RP must either say that he can handle his job or that he cannot. And it is the responsibility of the boss to make the assessment of whether to remove the RP from the driver’s seat because he might crash. We learn from mistakes by seeing our failures, feeling the pain of them, and reflecting and gaining insight. If the boss and the RP don’t recognize the RP’s failures to fix things, and the RP lacks the ability to do the job, trouble will result. Remember that life is the best teacher—“the proof is in the pudding.” So going through this process is essential to real learning. + +1. Make sure your people know to be proactive. Demand that they speak up when they won’t meet agreed-upon deliverables or deadlines. This communication is essential to getting in synch on both a project level and on a personal level. +2. Tool: An escalation button. Because there is confusion at times about whether responsible parties are conveying to their managers their problems or whether they are escalating, use an escalation button. This is a tool that makes clear to the manager that the managee is escalating. + +Involve the person who is the point of the pyramid when encountering material cross-departmental or cross sub-departmental issues. Imagine an organizational chart as a pyramid that consists of numerous pyramids, so: + +| | A | | | | | | | +| - | - | - | - | - | - | - | - | +| B | | C | | D | | | | +| E | | F | G | | H | | J | + +When issues involve parties that are not in the same part of the pyramid, it is generally desirable to involve the person who is at the point of the pyramid. The individual at the point has the perspective and knowledge to weigh the trade-offs properly and make an informed decision. Not + + + +--- + +involving the person at the point of the pyramid will likely cause problems. + +In the diagram above, if persons G and H are having an issue, who is the point of the pyramid? If persons F and I are having an issue, who is the point of the pyramid?65 + +``` + +--- + + +# 90) PROBE DEEP AND HARD TO LEARN WHAT TO EXPECT FROM YOUR “MACHINE” + +So... + +# 91) Know what your people are like, and make sure they do their jobs excellently. + +This requires constantly challenging them and probing them. That’s true even if your people are doing their jobs well, even though those people can be given more leeway. + +# 92) Constantly probe the people who report to you, and encourage them to probe you. + +Managers are much less able to discover the right things to do than most people assume. I know that’s true for me. The people who work for you should constantly challenge you, in order for you to become as good as you can be. Also, inviting criticism brings to the surface any subterranean discontent and makes the people working for you responsible for helping to find solutions. It’s much easier for people to remain spectators offering unchallenged comments from the stands than to become players on the field. Forcing people onto the field strengthens the whole team. Communication is a two-way responsibility. + +# 92a) Remind the people you are probing that problems and mistakes are fuel for improvement. + +They ought to understand that probing is good for them and everyone else. The main reason Bridgewater has improved at a much faster rate than most other companies over the past 30 years is that we seek out problems and find systematic ways of eliminating them. This approach has given us an unlimited supply of practical ways to improve. + +# 93) Probe to the level below the people who work for you. + +You can’t understand how the person who reports to you manages others unless you know their direct reports and can observe how they behave with them. Also encourage the people who work two levels below you to bring their disagreements with their bosses to you. + +# 94) Remember that few people see themselves objectively, so it’s important to welcome probing and to probe others. + +# 95) Probe so that you have a good enough understanding of whether problems are likely to occur before they actually do. + +If problems take you + + + +--- + + +by surprise, it is probably because you are either too far removed from your people and processes or you haven’t adequately thought through how the people and processes might lead to various outcomes. + +# 95a) + +When a crisis appears to be brewing, contact should be so close that it’s extremely unlikely that there will be any surprises. + +# 95b) + +Investigate and let people know you are going to investigate so there are no surprises and they don’t take it personally. + +# 96) + +Don’t “pick your battles.” Fight them all. If you see something wrong, even something small, deal with it. Because 1) small badnesses can be symptomatic of serious underlying problems; 2) resolving small differences of perception may prevent more serious divergences of views; and 3) in trying to help to train people, constant reinforcement of desired behavior is helpful. The more battles you fight, the more opportunities you will have to get to know each other and the faster the evolutionary process will occur. + +# 97) + +Don’t let people off the hook. Ask the important, difficult questions, and independently audit. + +# 98) + +Don’t assume that people’s answers are correct. They could be erroneous theories or “spin,” so you need to occasionally double check them, especially when they sound questionable. Some managers are reluctant to do this, feeling as though it is the equivalent of saying they don’t trust them. These managers need to understand and convey that trust in the accuracy of people’s statements is gained or lost through this process. People will learn to be much more accurate in what they say to you if they understand this—and increasingly, you will learn who and what you can rely on. + +# 99) + +Make the probing transparent rather than private. That will help to assure the quality of the probing (because others can make their own assessments), and it will reinforce the culture of transparency and freedom to find truth. + + + +--- + + +# 100) EVALUATE PEOPLE ACCURATELY, NOT “KINDLY” + +So... + +# 101) Make accurate assessments. + +Since truth is the foundation of excellence and people are your most important resource, make the most precise personnel evaluations possible. This accuracy takes time and considerable back-and-forth. Your assessment of how responsible parties are performing should be based not on whether they’re doing it your way but on whether they’re doing it in a good way. Speak frankly, listen with an open mind, consider the views of other believable and honest people, and try to get in synch about what’s going on with the person and why. Remember not to be overconfident in your assessments as it’s possible you are wrong. + +# 101a) Use evaluation tools + +such as performance surveys, metrics, and formal reviews to document all aspects of a person’s performance. These will help clarify assessments and communication surrounding them. + +# 101b) Maintain “baseball cards” + +and/or “believability matrixes” for your people. Imagine if you had baseball cards that showed all the performance stats for your people: batting averages, home runs, errors, ERAs, win/loss records. You could see what they did well and poorly and call on the right people to play the right positions in a very transparent way. These would also simplify discussions about compensation, incentives, moving players up to first string, or cutting them from the team. You can and should keep such records of your people. Create your baseball cards to achieve your goals of conveying what the person is like. I use ratings, forced rankings, metrics, results, and credentials. Baseball cards can be passed to potential new managers as they consider candidates for assignments. + +# 102) Evaluate employees with the same rigor + +as you evaluate job candidates. Ask yourself: “Would I hire this person knowing what I now know about them?” I find it odd and silly that interviewers often freely and confidently criticize job candidates despite not knowing them well, yet they won’t criticize employees for similar weaknesses even though they have more evidence. That is because some people view criticism as harmful and feel less protective of an outsider than they do of a fellow employee. If you + + + +--- + + +believe accuracy is best for everyone, then you should see why this is a mistake and why frank evaluations must be ongoing. + +103) Know what makes your people tick, because people are your most important resource. Develop a full profile of each person’s values, abilities, and skills. These qualities are the real drivers of behavior, and knowing them in detail will tell you which jobs a person can and cannot do well, which ones they should avoid, and how the person should be trained. I have often seen people struggling in a job and their manager trying for months to find the right response because the manager overlooked the person’s “package.” These profiles should change as the people change. + +104) Recognize that while most people prefer compliments over criticisms, there is nothing more valuable than accurate criticisms. While it is important to be clear about what people are doing well, there should not be a reluctance to profile people in a way that describes their weaknesses. It is vital that you be accurate. + +105) Make this discovery process open, evolutionary, and iterative. Articulate your theory of a person’s values, abilities, and skills upfront and share this with him; listen to his and others’ response to your description; organize a plan for training and testing; and reassess your theory based on the performance you observe. Do this on an ongoing basis. After several months of discussions and real-world tests, you and he should have a pretty good idea of what he is like. Over time this exercise will crystallize suitable roles and appropriate training, or it will reveal that it’s time for the person to leave Bridgewater. + +106) Provide constant, clear, and honest feedback, and encourage discussion of this feedback. Don’t hesitate to be both critical and complimentary—and be sure to be open-minded. Training and assessing will be better if you frequently explain your observations. Providing this feedback constantly is the most effective way to train.66 + +106a) Put your compliments and criticisms into perspective. I find that many people tend to blow evaluations out of proportion, so it helps to clarify that the weakness or mistake under discussion is not indicative of your total evaluation. Example: One day I told one of the new research + + + +--- + + +people what a good job I thought he was doing and how strong his thinking was. It was a very positive initial evaluation. A few days later I heard him chatting away for hours about stuff that wasn’t related to work, so I spoke to him about the cost to his and our development if he regularly wasted time. Afterward I learned he took away from that encounter the idea that I thought he was doing a horrible job and that he was on the brink of being fired. But my comment about his need for focus had nothing to do with my overall evaluation of him. If I had explained myself when we sat down that second time, he could have better put my comments in perspective. + +# 106b + +Remember that convincing people of their strengths is generally much easier than convincing them of their weaknesses. People don’t like to face their weaknesses. At Bridgewater, because we always seek excellence, more time is spent discussing weaknesses. Similarly, problems require more time than things that are going well. Problems must be figured out and worked on, while things that are running smoothly require less attention. So we spend a lot of time focusing on people’s weaknesses and problems. This is great because we focus on improving, not celebrating how great we are, which is in fact how we get to be great. For people who don’t understand this fact, the environment can be difficult. It’s therefore important to 1) clarify and draw attention to people’s strengths and what’s being done well; and 2) constantly remind them of the healthy motive behind this process of exploring weaknesses. Aim for complete accuracy in your assessments. Don’t feel you have to find an equal number of “good and bad” qualities in a person. Just describe the person or the circumstances as accurately as possible, celebrating what is good and noting what is bad. + +# 106c + +Encourage objective reflection—lots and lots of it. + +# 106d + +Employee reviews: While feedback should be constant, reviews are periodic. The purpose of a review is to review the employee's performance and to state what the person is like as it pertains to their doing their job. A job review should have little surprises in it—this is because throughout the year, if you can’t make sense of how the person is doing their job or if you think it’s being done badly, you should probe them to seek understanding of root causes of their performance. Because it is very difficult for people to identify their own weaknesses, they need the + + + +--- + +appropriate probing (not nitpicking) of specific cases by others to get at the truth of what they are like and how they are fitting into their jobs. From examining these specific cases and getting in synch about them, agreed-upon patterns will emerge. As successes and failures will occur in everyone (every batter strikes out a lot), in reviewing someone the goal is see the patterns and to understand the whole picture rather than to assume that one or a few failures or successes is representative of the person. You have to understand the person’s modus operandi and that to be successful, they can’t be successful in all ways—e.g., to be meticulous they might not be able to be fast (and vice versa). Steve Jobs has been criticized as being autocratic and impersonal, but his modus operandi might require him being that way, so the real choice in assessing his fit for his job is to have him the way he is or not at all: that assessment must be made in the review, not just a theoretical assessment that he should do what he is doing and be less autocratic. + +In some cases it won’t take long to see what a person is like—e.g., it doesn’t take long to hear if a person can sing. In other cases it takes a significant number of samples and time to reflect on them. Over time and with a large sample size you should be able to see what people are like, and their track records (i.e., the level and the steepness up or down in the trajectories that they are responsible for, rather than the wiggles in these) paint a very clear picture of what you can expect from them. + +If there are performance problems, it is either because of design problems (e.g., the person has too many responsibilities) or fit/abilities problems. If the problems are due to the person’s inabilities, these inabilities are either because of the person’s innate weaknesses in doing that job (e.g., with a height of 5-foot-2, the person probably shouldn’t be a center on the basketball team) or because of inadequate training to do the job. A good review, and getting in synch throughout the year, should get at these things. The goal of a review is to be clear about what the person can and can’t be trusted to do based on what the person is like. From there, “what to do about it” (i.e., how these qualities fit into the job requirement) can be determined. + +--- + + +# 107) + +Understand that you and the people you manage will go through a process of personal evolution. Personal evolution occurs first by identifying your strengths and weaknesses, and then by changing your weaknesses (e.g., through training) or changing jobs to play to strengths and preferences. This process, while generally difficult for both managers and their subordinates, has made people happier and Bridgewater more successful. Remember that most people are happiest when they are improving and doing things that help them advance most rapidly, so learning your people’s weaknesses is just as valuable for them and for you as learning their strengths. + +# 108) + +Recognize that your evolution at Bridgewater should be relatively rapid and a natural consequence of discovering your strengths and weaknesses; as a result, your career path is not planned at the outset. Your career path isn’t planned because the evolutionary process is about discovering your likes and dislikes as well as your strengths and weaknesses. The best career path for anyone is based on this information. In other words, each person’s career direction will evolve differently based on what we all learn. This process occurs by putting people into jobs that they are likely to succeed at, but that they have to stretch themselves to do well. They should be given enough freedom to learn and think for themselves while being coached so they can be taught and prevented from making unacceptable mistakes. During this process they should receive constant feedback. They should reflect on whether their problems can be resolved by additional learning or stem from innate qualities that can’t be changed. Typically it takes six to 12 months to get to know a person in a by-and-large sort of way and about 18 months to change behavior (depending on the job and the person). During this time there should be periodic mini-reviews and several major ones. Following each of these assessments, new assignments should be made to continue to train and test them. They should be tailored to what was learned about the person’s likes and dislikes and strengths and weaknesses. This is an iterative process in which these cumulative experiences of training, testing, and adjusting direct the person to ever more suitable roles and responsibilities. It benefits the individual by providing better self-understanding and greater familiarity with various jobs at Bridgewater. This is typically both a challenging and rewarding process. When it results in a parting of ways, it’s usually because people find they + + + +--- + + +cannot be excellent and happy in any job at Bridgewater or they refuse to go through this process. + +... 109) Remember that the only purpose of looking at what people did is to learn what they are like. Knowing what they are like will tell you how you can expect them to handle their responsibilities in the future. Intent matters, and the same actions can stem from different causes. + +109a) Look at patterns of behaviors and don’t read too much into any one event. Since there is no such thing as perfection, even excellent managers, companies, and decisions will have problems. It’s easy, though often not worth much, to identify and dwell on tiny mistakes. In fact, this can be a problem if you get bogged down pinpointing and analyzing an infinite number of imperfections. At the same time, minor mistakes can sometimes be manifestations of serious root causes that could cause major mistakes down the road, so they can be quite valuable to diagnose. When assessing mistakes it is important to 1) ask whether these mistakes are manifestations of something serious or unimportant and 2) reflect on the frequency of them. An excellent decision-maker and a bad decision-maker will both make mistakes. The difference is what causes them to make mistakes and the frequency of their mistakes. + +There is also a difference between “I believe you made a bad decision” and “I believe you are a bad decision-maker,” which can be ascertained only by seeing the pattern. Any one event has many different possible explanations, whereas a pattern of behavior can tell you a lot about root causes. There are many qualities that make up a person. To understand each requires 1) a reliable sample size and 2) getting in synch (i.e., asking the person why and giving feedback). Some qualities don’t require a large sample size—e.g., it takes only one data point to know if a person can sing—and others take multiple observations (five to 10). The number of observations needed to detect a pattern largely depends on how well you get in synch after each observation. A quality discussion of how and why a person behaved a certain way should help you quickly understand the larger picture. + +109b) Don’t believe that being good or bad at some things means that the person is good or bad at everything. Realize that all people have strengths and weaknesses. + + + +--- + + +110) If someone is doing their job poorly, consider whether this is due to inadequate learning (i.e., training/experience) or inadequate ability. A weakness due to a lack of experience or training or due to inadequate time can be fixed. A lack of inherent ability cannot. Failing to distinguish between these causes is a common mistake among managers, because managers are often reluctant to appear unkind or judgmental by saying someone lacks ability. They also know people assessed this way tend to push back hard against accepting a permanent weakness. Managers need to get beyond this reluctance. In our diagram of thinking through the machine that will produce outcomes, think about... + +| GOALS | MACHINE | OUTCOMES | +| ------ | -------- | -------- | +| DESIGN | PEOPLE | | +| | LEARNING | ABILITY | + +111) Remember that when it comes to assessing people, the two biggest mistakes are being overconfident in your assessment and failing to get in synch on that assessment. Don’t make those mistakes. + +111a) Get in synch in a non-hierarchical way regarding assessments. The greatest single discrepancy between a manager and a managee is how well each performs his job. In most organizations, evaluations run in only one direction, with the manager assessing the managee. The managee typically disagrees with the assessment, especially if it is worse than the employee’s self-assessment, because most people believe themselves to be better than they really are. Managees also have opinions of managers that in most companies they wouldn’t dare bring up, so misunderstandings and resentments fester. This perverse behavior undermines the effectiveness of + + + +--- + + +# 111b) Learn about your people + +and have them learn about you with very frank conversations about mistakes and their root causes. You need to be clear in conveying your assessments and be open-minded in listening to people’s replies. This is so they can understand your thinking and you can open-mindedly consider their perspectives. So together you can work on setting their training and career paths. Recognizing and communicating people’s weakness is one of the most difficult things managers have to do. Good managers recognize that while it is difficult in the short term, it actually makes things easier in the long term, because the costs of having people in jobs where they can’t excel are huge. Most managers at other companies dodge being as open with assessments as we insist on; more typically, managers elsewhere tend to be less frank in conveying their views, which is neither fair nor effective. + +# 112) Help people through the pain + +that comes with exploring their weaknesses. Emotions tend to heat up during most disagreements, especially about someone’s possible weaknesses. Speak in a calm, slow, and analytical manner to facilitate communication. If you are calm and open to others’ views, they are less likely to shut down logical exchanges than if you behave emotionally. Put things in perspective by reminding them that their pain is the pain that comes with learning and personal evolution—they’re going to be in a much better place by getting to truth. Consider asking them to go away and reflect when they are calm, and have a follow-up conversation in a few days. + +# 113) Recognize that when you are really in synch + +with people about weaknesses, whether yours or theirs, they are probably true. Getting to this point is a great achievement. When you reach an agreement, it’s a good sign you’re there. This is one of the main reasons why the person being evaluated needs to be an equal participant in the process of finding truth. So when you do agree, write it down on the relevant baseball card. This information will be a critical building block for future success. + +# 114) Remember that you don’t need to get to the point + +of “beyond a shadow of a doubt” when judging people. Instead, work toward developing + + + +--- + +a mutually agreed “by-and-large” understanding of someone that has a high level of confidence behind it. When necessary, take the time to enrich this understanding. That said, you should not aim for perfect understanding. Perfect understanding isn’t possible, and trying to get it will waste time and stall progress. + +# 115) + +Understand that you should be able to learn the most about what a person is like and whether they are a “click” for the job in their first year. You should be able to roughly assess someone’s abilities after six to 12 months of close contact and numerous tests and getting in synch about them. A more confident assessment so that you can make a more confident role assignment will probably take about 18 months. This timeline will of course depend on the job, the person, the amount of contact with that person, and how well you do it. As I explain in the section on design, the ratio of senior managers to junior managers as well as the ratio of managers to the number of people who work two levels below them should be small enough to ensure quality communication and mutual understanding. Generally, that ratio should not be more than 1:10, preferably more like 1:5. + +# 116) + +Continue assessing people throughout their time at Bridgewater. You will get to know them better, it will help you train and direct them, and you won’t be stuck with an obsolete picture. Most importantly, assess what your people’s core values and abilities are and make sure they complement Bridgewater’s. Since core values and abilities are more permanent than skills, they are more important to ascertain, especially at Bridgewater. As mentioned, you should be able to roughly assess people’s abilities after six to 12 months of close contact and confidently assess them after 18 months. Don’t rest with that evaluation, however. Always ask yourself if you would have hired them for that job knowing what you now know. If not, get them out of the job. + + + +--- + + +# 117) TRAIN AND TEST PEOPLE THROUGH EXPERIENCES + +So... + +# 118) Understand that training is really guiding the process of personal evolution. + +It requires the trainee to be open-minded, to suspend ego in order to find out what he is doing well and poorly, and to decide what to do about it. It also requires the trainer to be open-minded (and to do the other things previously mentioned). It would be best if at least two believable trainers work with each trainee in order to triangulate views about what the trainee is like. As previously explained, the training should be through shared experiences like that of a ski instructor skiing with his student—i.e., it should be an apprentice relationship. + +# 119) Know that experience creates internalization. + +A huge difference exists between memory-based “book” learning and hands-on, internalized learning. A medical student who has “learned” to perform an operation in his medical school class has not learned it in the same way as a doctor who has already conducted several operations. In the first case, the learning is stored in the conscious mind, and the medical student draws on his memory bank to remember what he has learned. In the second case, what the doctor has learned through hands-on experience is stored in the subconscious mind and pops up without his consciously recalling it from the memory bank. People who excel at book learning tend to call up from memory what they have learned in order to follow stored instructions. Others who are better at internalized learning use the thoughts that flow from their subconscious. The experienced skier doesn’t recite instructions on how to ski and then execute them; rather, he does it well “without thinking,” in the same way he breathes without thinking. Understanding these differences is essential.67 + +Remember that experience creates internalization. Doing things repeatedly leads to internalization, which produces a quality of understanding that is generally vastly superior to intellectualized learning. + +# 120) Provide constant feedback to put the learning in perspective. + +Most training comes from doing and getting in synch about performance. Feedback should include reviews of what is succeeding and what is not in proportion to the actual situation rather than in an attempt to balance. + + + +--- + + +compliments and criticisms. You are a manager, and you want your machine to function as intended. For it do so, employees must meet expectations, and only you can help them to understand where they are in relation to expectations. As strengths and weaknesses become clearer, responsibilities can be more appropriately tailored to make the machine work better and to facilitate personal evolution. The more intensely this is done, the more rapid the evolutionary process will be. So you must constantly get in synch about employee performance. + +1. Remember that everything is a case study. Think about what it is a case of and what principles apply. +2. Teach your people to fish rather than give them fish. It is a bad sign when you tell people what they should do because that behavior typically reflects micromanagement or inability on the part of the person being managed. Instead, you should be training and testing. So give people your thoughts on how they might approach their decisions or how and why you would operate in their shoes, but don’t dictate to them. Almost all that you will be doing is constantly getting in synch about how they are doing things and exploring why. +3. Recognize that sometimes it is better to let people make mistakes so that they can learn from them rather than tell them the better decision. However, since the connections between cause and effect can be misunderstood, providing feedback for these people is essential to the learning process. +4. 1. When criticizing, try to make helpful suggestions. Your goal is to help your people understand and improve, so your suggestions are important. Offering suggestions also helps those being criticized to understand that your goal is to help them and Bridgewater, not to hurt them. +2. Learn from success as well as from failure. Point out examples of jobs that are well done and the causes of success. This reinforces good behavior and creates role models for those who are learning. + +Know what types of mistakes are acceptable and unacceptable, and don’t allow the people who work for you to make the unacceptable ones. When considering what failures you are willing to allow in order to + + + +--- + + +promote learning through trial-and-error, weigh the potential damage of a mistake against the benefit of incremental learning. In defining what latitude I’m willing to give people, I say, “I’m willing to let you scratch or dent the car, but I won’t put you in a position where I think there’s a significant risk you could total it.” + +... 125) Recognize that behavior modification typically takes about 18 months of constant reinforcement. The first step is intellectualizing the best way of doing things. If you’re out of shape you must understand that you are out of shape, you must want to get in shape, and you must understand the way to get in shape: “I want to be fit by eating well and exercising.” Then the intellect will fight with desires and emotions. With determination, the intellect will overcome the impediments to doing what’s necessary to achieve the goal, and the desired behavior will occur. After doing that consistently for 18 months, the new behavior will be internalized. + +... 126) Train people; don’t rehabilitate them. Training is part of the plan to develop people’s skills and to help them evolve. Rehabilitation is the process of trying to create significant change in people’s values and/or abilities. Since values and abilities are difficult to change, rehabilitation typically takes too long and is too improbable to do at Bridgewater. If attempted, it is generally best directed by professionals over extended periods of time. People with inappropriate values and inadequate abilities to meet their job requirements have devastating impacts on the organization. They should be properly sorted (see the principles section on sorting). + +126a) A common mistake: training and testing a poor performer to see if he or she can acquire the required skills without simultaneously trying to assess their abilities. Skills are readily testable, so they should be easy to determine. Knowing them is less important than knowing people’s abilities. That makes picking people with the right skills relatively easy. Abilities, especially right-brained abilities, are more difficult to assess. When thinking about why someone is a poor performer, openly consider whether it is a problem with their abilities. Values are the toughest and take the longest to assess. + +... 127) After you decide “what’s true” (i.e., after you figure out what your people are like), think carefully about “what to do about it.” As mentioned before, it’s important to separate thinking about “what’s true” and thinking + + + +--- + +about “what to do about it.” Figuring out what’s true takes time—often several months filled with a large sample size. Figuring out what to do about it (i.e., designing) is much faster—typically hours or days—but it isn’t instantaneous. Too often people either jump to decisions or don’t make them. + +--- + + +# 128) SORT PEOPLE INTO OTHER JOBS AT BRIDGEWATER, OR REMOVE THEM FROM BRIDGEWATER + +So... + +# 129) + +When you find that someone is not a good “click” for a job, get them out of it ASAP. If you are expecting/wishing people to be much better in the near future than they have been in the past, you are making a serious mistake—instead, sort the people. People who repeatedly operated in a certain way probably will continue to operate that way because that behavior reflects what they’re like. Since people generally change slowly (at best), you should expect slow improvement (at best), so instead of hoping for improvement, you need to sort the people or change the design to supplement them. Since changing the design to accommodate people’s weaknesses is generally a bad idea, it is generally better to sort the people. Sometimes good people “lose their boxes” because they can’t evolve into responsible parties soon enough. Either there is a problem with their qualities or it will take too long to train them well. Some of these people might be good at another position within Bridgewater. Remember that identifying failure and learning from it are part of the evolutionary process. Make sure you record the reasons on the relevant “baseball card” and think about what a good next step would be for that individual. + +# 130) + +Know that it is much worse to keep someone in a job who is not suited for it than it is to fire someone. Don’t collect people. Firing people is not a big deal—certainly nowhere near as big a deal as keeping badly performing people, because keeping a person in a job they are not suited for is terrible both for the person (because it prevents personal evolution) and our community (because we all bear the consequences and it erodes meritocracy). Consider the enormous costs of not firing someone unsuited for a job: the costs of bad performance over a long time; the negative effect on the environment; the time and effort wasted trying to train the person; and the greater pain of separation involved with someone who’s been here awhile (say, five years or more) compared with someone let go after just a year. + + + +--- + + +131) When people are “without a box,” consider whether there is an open box at Bridgewater that would be a better fit. If not, fire them. Remember that we hire people not to fill their first job at Bridgewater nor primarily for their skills. We are trying to select people with whom we’d like to share our lives. We expect everyone to evolve here. Because managers have a better idea of people’s strengths and weaknesses and their fit within our culture than what emerges from the interview process, you have invaluable information for assessing them for another role at Bridgewater. + +132) Do not lower the bar. If a person can’t operate consistently with our requirements of excellence and radical truth and can’t get to the bar in an acceptable time frame, they have to + + + +--- + + +# TO PERCEIVE, DIAGNOSE, AND SOLVE PROBLEMS... + +# 133) KNOW HOW TO PERCEIVE PROBLEMS EFFECTIVELY + +So... + +# 134) + +Keep in mind the 5-Step Process explained in Part 2. + +# 135) + +Recognize that perceiving problems is the first essential step toward great management. As in nature, if you can’t see what’s happening around you, you will deteriorate and eventually die off. People who can 1) perceive problems; 2) decide what to do about them; and 3) get these things done can be great managers. + +# 136) + +Understand that problems are the fuel for improvement. Problems are like wood thrown into a locomotive engine, because burning them up—i.e., inventing and implementing solutions—propels us forward. Problems are typically manifestations of root causes, so they provide clues for getting better. Most of the movement toward excellence comes from eliminating problems by getting at their root causes and making the changes that pay off repeatedly in the future. So finding problems should get you excited because you have found an opportunity to get better. + +# 137) + +You need to be able to perceive if things are above the bar (i.e., good enough) or below the bar (i.e., not good enough), and you need to make sure your people can as well. That requires the ability to synthesize. + +# 138) + +Don’t tolerate badness. Too often I observe people who observe badness and tolerate it. Sometimes it is because they don’t have the courage to make the needed changes, and sometimes it is because they don’t know how to fix it. Both are very bad. If they’re stuck, they need to seek the advice of believable people to make the needed changes, and if that doesn’t work, they need to escalate. + +# 139) + +“Taste the soup.” A good restaurateur constantly tastes the food that is coming out of his kitchen and judges it against his vision of what is excellent. A good manager needs to do the same. + +# 140) + +Have as many eyes looking for problems as possible. Encourage people to bring problems to you and look into them carefully. If everyone in + + + +--- + + +your area feels responsible for the well-being of that area and feels comfortable speaking up about problems, your risks of overlooking them will be much less than if you are the only one doing this. This will help you perceive problems, gain the best ideas, and keep you and your people in synch. + +# 140a) + +“Pop the cork.” It’s your responsibility to make sure that communications from your people are flowing freely. + +# 140b) + +Hold people accountable for raising their complaints. Ask yourself: + +1. does someone think there’s something wrong; +2. did this lead to a proper discussion; and +3. if they felt raising the issue didn’t lead to the proper response, did they escalate it? That’s how it should be. + +# 140c) + +The leader must encourage disagreement and be either impartial or open-minded. + +# 140d) + +The people closest to certain jobs probably know them best, or at least have perspectives you need to understand, so those people are essential for creating improvement. + +... 141) To perceive problems, compare how the movie is unfolding relative to your script—i.e., compare the actual operating of the machine and the outcomes it is producing to your visualization of how it should operate and the outcomes you expected. As long as you have the visualization of your expectations in mind to compare with the actual results, you will note the deviations so you can deal with them. For example, if you expect improvement to be within a specific range... + + + +--- + + +# SENAE + +# TIME + +... and it ends up looking like this... + +... you will know you need to get at the root cause to deal with it. If you don’t, the trajectory will probably continue. + +... 142) Don’t use the anonymous “we” and “they,” because that masks personal responsibility—use specific names. For example, don’t say “we” or “they” handled it badly. Also avoid: “We should...” or “We are...” Who is “we”? Exactly who should, who made a mistake, or who did a great job? Use specific names. Don’t undermine personal accountability with vagueness. When naming names, it’s also good to remind people of related principles like “mistakes are good if they result in learning.” + + + +--- + + +... 143) Be very specific about problems; don’t start with generalizations. For example, don’t say, “Client advisors aren’t communicating well with the analysts.” Be specific: name which client advisors aren’t doing this well and in which ways. Start with the specifics and then observe patterns. + +... 144) Tool: Use the following tools to catch problems: issues logs, metrics, surveys, checklists, outside consultants, and internal auditors. + +1. Issues log: A problem or “issue” that should be logged is easy to identify: anything that went wrong. The issues log acts like a water filter that catches garbage. By examining the garbage and determining where it came from, you can determine how to eliminate it at the source. You diagnose root causes for the issues log the same way as for a drilldown (explained below) in that the log must include a frank assessment of individual contributions to the problems alongside their strengths and weaknesses. As you come up with the changes that will reduce or eliminate the garbage, the water will become cleaner. In addition to using issues logs to catch problems, you can use them to measure the numbers and types of problems, and they can therefore be effective metrics of performance. A common challenge to getting people to use issues logs is that they are sometimes viewed as vehicles for blaming people. You have to encourage use by making clear how necessary they are, rewarding active usage, and punishing non-use. If, for example, something goes wrong and it’s not in the issues log, the relevant people should be in big trouble. But if something goes wrong and it’s there (and, ideally, properly diagnosed), the relevant people will probably be rewarded or praised. But there must be personal accountability. +2. Metrics: Detailed metrics measure individual, group, and system performance. Make sure these metrics aren’t being “gamed” so that they cease to convey a real picture. If your metrics are good enough, you can gain such a complete and accurate view of what your people are doing and how well they are doing it that you can nearly manage via the metrics. However, don’t even think of taking the use of metrics that far! Instead, use the metrics to ask questions and explore. Remember that any + + + +--- + + + +single metric can mislead. You need enough evidence to establish patterns. Metrics and 360 reviews reveal patterns that make it easier to achieve agreement on employees’ strengths and weaknesses. Of course, the people providing the information for metrics must deliver accurate assessments. There are various ways to facilitate this accuracy. A reluctance to be critical can be detected by looking at the average grade each grader gives; those giving much higher average grades might be the easy graders. Similarly helpful are “forced rankings,” in which people must rank coworker performance from best to worst. Forced rankings are essentially the same thing as “grading on a curve.” Metrics that allow for independent grading across departments and/or groups are especially valuable. + +# 3) Surveys (of workers and of customers). + +... 145) The most common reason problems aren’t perceived is what I call the “frog in the boiling water” problem. Supposedly, if you throw a frog in a pot of boiling water it will immediately jump out. But if you put a frog in room-temperature water and gradually bring the water to a boil, the frog will stay in place and boil to death. There is a strong tendency to get used to and accept very bad things that would be shocking if seen with fresh eyes. + +... 146) In some cases, people accept unacceptable problems because they are perceived as being too difficult to fix. Yet fixing unacceptable problems is actually a lot easier than not fixing them, because not fixing them will make you miserable. They will lead to chronic unacceptable results, stress, more work, and possibly get you fired. So remember one of the first principles of management: you either have to fix problems or escalate them (if need be, over and over again) if you can't fix them. There is no other, or easier, alternative. + +146a) Problems that have good, planned solutions are completely different from those that don’t. The spectrum of badness versus goodness with problems looks like this: + +- a) They’re unidentified (worst); +- b) Identified but without a planned solution (better); + + + +--- + +c) Identified with a good, planned solution (good); and + +d) Solved (best). + +However, the worst situation for morale is the second case: identified but without a planned solution. So it’s really important to identify which of these categories the problem belongs to. + +--- + + +# 147) DIAGNOSE TO UNDERSTAND WHAT THE PROBLEMS ARE SYMPTOMATIC OF + +So... + +# 148) Recognize that all problems are just manifestations of their root causes, so diagnose to understand what the problems are symptomatic of. + +Don’t deal with your problems as one-offs. They are outcomes produced by your machine, which consists of design and people. If the design is excellent and the people are excellent, the outcomes will be excellent (though not perfect). So when you have problems, your diagnosis should look at the design and the people to determine what failed you and why. + +# 149) Understand that diagnosis is foundational both to progress and quality relationships. + +An honest and collaborative exploration of problems with the people around you will give you a better understanding of why these problems occur so that they can be fixed. You will also get to know each other better, be yourself, and see whether the people around you are reasonable and/or enforce their reasonableness. Further, you will help your people grow and vice versa. So, this process is not only what good management is; it is also the basis for personal and organizational evolution and the way to establish deep and meaningful relationships. Because it starts and ends with how you approach mistakes, I hope that I have conveyed why I believe this attitude about and approach to dealing with mistakes is so important. + +# 150) Ask the following questions when diagnosing. + +These questions are intended to look at the problem (i.e., the outcome that was inconsistent with the goal) as a manifestation of your “machine.” It does this first by examining how the responsible parties imagined that the machine would have worked, then examining how it did work, and then examining the inconsistencies. If you get adept at the process, it should take 10 to 20 + + + +--- + + +minutes. As previously mentioned, it should be done constantly so that you have a large sample size and no one case is a big deal. + +1. Ask the person who experienced the problem: What suboptimality did you experience? +2. Ask the manager of the area: Is there a clear responsible party for the machine as a whole who can describe the machine to you and answer your questions about how the machine performed compared with expectations? Who owns this responsibility? +3. - Do not mask personal responsibility—use specific names. + +Ask the responsible party: What is the “mental map” of how it was supposed to work? +4. - A “mental map” is essentially the visualization of what should have happened. +- To be practical, “mental maps” (i.e., the designs that you would have expected would have worked well) should account for the fact that people are imperfect. They should lead to success anyway. + +Ask the owner of the responsibility: What, if anything, broke in this situation? Were there problems with the design (i.e., who is supposed to do what) or with how the people in the design behaved? +5. - Compare the mental map of “what should have happened” to “what did happen” in order to identify the gap. +- If the machine steps were followed, ask, “Is the machine designed well?” If not, what’s wrong with the machine? + +Ask the people involved why they handled the issue the way they did. What are the proximate causes of the problem (e.g., “Did not do XYZ”)? They will be described using verbs—for example, “Harry did XYZ.” What are the root causes? They will be descriptions. For example: inadequate training/experience, lack of vision, lack of ability, lack of judgment, etc. In other words, root cause is not an action or a reaction—it is a reason. + + + +--- + + +# 6) Ask the people involved: + +Is this broadly consistent with prior patterns (yes/no/unsure)? What is the systematic solution? How should the people / machines / responsibilities evolve as a result of this issue? + +- Confirm that the short-term resolution of the issue has been addressed. +- Determine the steps to be taken for long-term solutions and who is responsible for those steps. Specifically: + +... 151) Remember that a root cause is not an action but a reason. It is described by using adjectives rather than verbs. Keep asking “why” to get at root causes, and don’t forget to examine problems with people. In fact, since most things are done or not done because someone decided to do them or not do them a certain way, most root causes can be traced to specific people, especially “the responsible party.” When the problem is attributable to a person, you have to ask why the person made the mistake to get at the real root cause, and you need to be as accurate in diagnosing a fault in a person as you are in diagnosing a fault in a piece of equipment. + +For example, a root cause discovery process might proceed like this: + +- “The problem was due to bad programming.” +- “Why was there bad programming?” +- “Because Harry programmed it badly.” +- “Why did Harry program it badly?” +- “Because he wasn’t well trained and because he was in a rush.” +- “Why wasn’t he well trained? Did his manager know that he wasn’t well trained and let him do the job anyway, or did he not know?” + +Ultimately it will come down to what the people or the design is like. + + + +--- + + +... 152) Identify at which step failure occurred in the 5-Step Process. If a person is chronically failing it is due to either lack of training or lack of ability. Which was it? At which of the five steps did the person fail? Different steps require different abilities. + +1. Setting goals: This requires big-picture thinking, vision, and values that are consistent with those of our community. (It is helpful to ask whether the responsible party lost sight of the goals or whether he or she set goals that are inconsistent with Bridgewater’s.) +2. Perceiving problems: This requires perception, the ability to synthesize, and an intolerance of badness (i.e., some people see badness but aren’t sufficiently bothered by it to push themselves to eliminate it). Of course, having perspective (typically gained via experience) helps at all steps. +3. Diagnosis: This requires logic, assertiveness, and open-mindedness. You must be willing to have open and/or difficult discussions to get at the truth. +4. Design: This requires creativity and practical visualization. +5. Doing the tasks: This requires determination and self-discipline. + +If you 1) identify at which of these steps the chronic failures are occurring and 2) see which, if any, of these abilities the person is short of, you will go a long way toward diagnosing the problem. + +... 153) Remember that a proper diagnosis requires a quality, collaborative, and honest discussion to get at the truth. Don’t just give your verdict without exploring the mistake, because there’s a reasonably high probability that you don’t know the answer. Do not be arrogant. You might have a theory about what happened, and that theory should be explored with relevant others. If you and others are open-minded, you will almost certainly have a quality analysis that will give everyone working theories to explore or you will reach conclusions that can be used for the design phase. And if you do this whenever problems recur, you and others involved will eventually uncover the root causes. + +... 154) Keep in mind that diagnoses should produce outcomes. Otherwise there’s no purpose in them. The outcome might not take the form of an agreement, but at a minimum it should take the form of theories about root + + + +--- + + +causes (which should be written down so you have a collection of synthesized dots to use for identifying patterns) and clarity about what should be done in the future to protect against them, or to gather information to find out. + +... 155) Don’t make too much out of one “dot”—synthesize a richer picture by squeezing lots of “dots” quickly and triangulating with others. A dot is a particular outcome. When you diagnose to understand the reason it occurred, you are “squeezing” the dot. Don’t try to squeeze too much out of a single dot—it can only tell you so much. Rather, try to collect and squeeze a bunch of dots in an 80/20 way, triangulating with the dots of others, so that you can synthesize a pointillist painting of what the person is like. + +... 156) Maintain an emerging synthesis by diagnosing continuously—You must be able to categorize, understand, and observe the evolution of the different parts of your machine/system through time, and synthesize this understanding into a picture of how your machine is working and how it should be modified to improve. But if you don’t look into the significant bad outcomes as they occur, you won’t really understand what they are symptomatic of, nor will you be able to understand how things are changing through time (e.g., if they are improving or worsening). + +... 157) To distinguish between a capacity issue and a capability issue, imagine how the person would perform at that particular function if they had ample capacity. Think back on how they performed in similar functions when they had ample capacity. + +... 158) The most common reasons managers fail to produce excellent results or escalate are: + +- a. They are too removed. +- b. They have problems discerning quality differences. +- c. They have lost sight of how bad things have become because they have gradually gotten used to their badness (the “frog in the boiling water problem”). + + + +--- + + +d. They have such high pride in their work that they can’t bear to admit they are unable to solve their own problems. + +e. They fear adverse consequences from admitting failure. + +... 159) Avoid “Monday morning quarterbacking.” That is, evaluate the merits of a past decision based on what you know now versus what you could have reasonably known at the time of the decision. Do this by asking yourself, “What should a quality person have known and done in that situation?” Also, have a deep understanding of the person who made the decision (how do they think, what type of person are they, did they learn from the situation, etc). + +... 160) Identify the principles that were violated. Identify which of these principles apply to the case at hand, review them, and see if they would have helped. Think for yourself what principles are best for handling cases like this. This will help solve not only this problem but it will also help you solve other problems like it. + +... 161) Remember that if you have the same people doing the same things, you should expect the same results. + +... 162) Use the following “drilldown” technique to gain an 80/20 understanding of a department or sub-department that is having problems. A drilldown is the process by which someone who wants to do so can gain a deep enough understanding of the problems in an area as well as the root causes, so that they can then go on to design a plan to make the department or sub-department excellent. It is not a “diagnosis,” which is done for each problem. A manager doing ongoing diagnosis will naturally understand his areas well and won’t have to do a drilldown. Drilling down is a form of probing, though it is broader and deeper. Done well, it should get you almost all the information needed to turn a department around in about five hours of effort. + +A drilldown takes place in two distinct steps: 1) listing problems and 2) listing causes/diagnosing. It is followed by 3) designing a plan. If done well, getting informed via the first two steps typically takes about four hours (give or take an hour), with the first step of listing the problems. + + + +--- + + +typically taking one to two hours and the second step of diagnosing them typically taking two to four hours, if done efficiently. It’s very important that these steps are done separately and independently. That’s because going into two or three directions at the same time causes confusion and doesn’t allow adequate discussion of each of the possible causes and solutions. + +Having the people from the area under scrutiny actively participate in all three steps is critical. You need to hear their descriptions and allow them to argue with you when they think you are wrong. This way you are much more likely to come up with an accurate diagnosis and a good plan. + +After the drilldown, you will create the plan or design, which typically takes two to three hours. So the whole process, from asking the first question to coming up with the detailed plan, typically takes about five to eight hours spread over three or four meetings. Then there is step four—the executing, monitoring, and modifying of the plan—which typically takes six to 12 months. + +# Here is more detail on each of the steps: + +# Step 1—List the problems. + +Don’t confuse problems with possible solutions. Sometimes problems occur for rare or insignificant reasons because nothing is perfect. Don’t pay much attention to those. But more often than not, they are symptomatic of something malfunctioning in your machine, so it pays to investigate what that is. For example, not having enough capacity is not a “problem”; it might cause problems, but it’s not a problem. Having people work so late that they might quit, getting out reports too late, etc., might be problems that are caused by a lack of capacity. But the lack of capacity itself is not a problem. + +To fix problems, you need to start with the specific problems and address them one by one and come up with very specific solutions. That’s because there are lots of ways to solve problems. The problem of people working late at night might be solved by gaining capacity, or it might be solved by shifting work to another department, or by doing less, etc. To assume that lack of capacity is the problem could lead to inferior problem-solving. So unless you keep in mind the very specific problems, you will not be effective at solving them. In the process of solving problems, you will often see that several problems are due to the + + + +--- + + +same cause (e.g., lack of capacity, a shortage of tech resources, bad management, etc.), but that is not the same thing as starting at the more general level (like saying that bad management or lack of capacity, etc., are problems), which is why I am saying you must start with very specific problems before making generalizations. For example, when you have a “people problem,” be specific. Specify which people you are having what problems with and avoid the tendency of saying things like, “People in operations aren’t...” Avoid the tendency not to name names for fear of offending. + +# Step 2—Identify root causes. + +Root causes are the deep-seated reasons behind the actions that caused the problems. It is important to distinguish between proximate causes, which are superficial reasons for what happened (e.g., “I missed the train because I didn’t check the train schedule”), and root causes (e.g., “I didn’t check the schedule because I am forgetful”). Typically a proximate cause is the action that led to the problem while a root cause is the fundamental reason that action occurred. So, when diagnosing, if you are describing what happened or didn’t happen to cause the problem, you are probably describing proximate causes. When you start describing the qualities that were behind these actions, you are probably getting at the root causes. To get at the root cause, keep asking why. For example, if the problem is that people are working late and the direct cause was that there wasn’t enough capacity, then ask why there wasn’t enough capacity. Then you will get closer to the root cause. + +If your machine is producing outcomes that you don’t want, either the design is flawed or the parts/people that you dropped into the design are malfunctioning. Most, but not all, problems happen because 1) it isn’t clear who the “responsible party” is for making sure things go well or 2) the responsible party isn’t handling his or her responsibilities well (in other words, isn’t operating according to the principles to eliminate the problem). So first ask, “Is it clear who the responsible party is?” If not, specify that. If it is clear, then ask, “Why isn’t he or she doing a good job?” There are two possible reasons for someone doing a poor job: insufficient training or insufficient ability. + +Though it is essential to connect problems to the responsible parties, this can be difficult if the responsible parties don’t acknowledge their mistakes. + + + +--- + +and fail to diagnose why they made the mistakes. Still, clarity about responsibility and the problems’ root causes must be achieved because otherwise there is no hope for improvement. If the responsible parties do not explicitly take responsibility for ensuring that their areas operate smoothly, their areas will not operate smoothly. An important first step toward achieving clarity is to remove the mentality of blame and credit, because it stands in the way of accurately understanding problems, and that’s a prerequisite for producing improvements. Also, it is important not to judge too quickly what the root causes are. Instead, you should observe the patterns of problems using the issues log as a tool and discuss with the responsible parties what the root causes might be each time a problem arises. You probably won’t initially be able to come to conclusions with a high degree of confidence, because there are many possible reasons for any one problem. But over time, the problems’ patterns and causes will become clear to everyone. + +As mentioned, there are two possible reasons why the responsible party handled something badly: + +1. the responsible party didn’t encounter this problem enough times previously to learn from it and prevent it in the future (by using the principles) or +2. the responsible party is unsuited for that job. + +And there are also two possible reasons the person is not suited for that job: + +1. not enough experience or training and +2. lack of values and/or abilities required to do the job well. + +So getting at the root causes is largely a matter of figuring out: + +1. Who is the responsible party for what went wrong? +2. Did that person encounter the problem enough times that he or she should have either learned how not to repeat it or elevated it to someone who could have helped learn how to solve it? + +The conclusions could be the following: + +1. If the person did encounter the problem enough times to have resolved or elevated it, then the person is not suitable for the job69; +2. if the person did not encounter the problems enough times to resolve or elevate it, what are the probable root causes? The most common root causes are: + +1. the person is not suitable for the job in some way (doesn’t learn from mistakes, doesn’t have a high sense of responsibility, is lazy, etc.); +2. the design of the process is flawed (e.g., the person + +--- + +# Step 3—Create a plan (brief notes): + +- Look at each root cause and ask yourself what should be done about it. +- Creating a plan is like writing a movie script in that you visualize who will do what through time in order to achieve the goal. +- Step away from the group to reflect and work on the plan, then bring it back to the group to discuss and modify. +- When developing the plan, iterate through multiple possibilities and play them out in time to help determine the best choice. +- Make sure to assign who is supposed to do what with rough target dates for achieving individual tasks of the plan. Once the plan design is complete, + +--- + +# Step 4—Implement the plan (brief notes): + +- Give each person a monthly to-do list to provide clarity and transparency around responsibilities and expectations for that month. Then plot the progress in open, monthly meetings with all the relevant parties. Explicitly assess how the plan is working and deal with problems that aren’t being resolved. +- Make sure to hold responsible parties accountable for target dates and develop metrics around how they are meeting their commitments. +- Regularly look at that list of assigned tasks to track progress and determine if any adjustments are needed. +- Create transparency around the plan by posting it publicly and reviewing it regularly with the group. This helps people see the ways in which all of the problems are being addressed and reinforces accountability. + +Do not exclude any relevant people from the drilldown: besides losing the benefit of their ideas, you disenfranchise these people from the game plan and reduce their sense of ownership. + +Remember that people tell you things they want and tend not to be self-critical. It is your job as a manager to get at truth and excellence, not to make people happy. For example, the correct path might be to fire some people and replace them with better people, or to put people in jobs they might not want, etc. The brainstorming session must include a discussion of people’s weaknesses and failings to get at truth and excellence. Everyone’s objective must be to get at the best answer, not the answer that will make people happy. This is especially true for managers. In the long run, the best answers will be the ones that make the people we want to be at Bridgewater happiest. + +--- + + +# 163) PUT THINGS IN PERSPECTIVE + +So… + +# 164) Go back before going forward. + +Before moving forward, take the time to reflect on how the machine worked. By diagnosing what went right and what went wrong (especially what went wrong), you can see how the machine is operating and how it should be improved. People who are just focused on what they should do next are overly focused on the tasks at hand and not on how the machine is working; so they don’t make sustainable progress. + +Go back by “telling the story” to help put things in perspective. Sometimes people have problems putting current conditions into perspective or projecting into the future. Sometimes they disagree on cause-effect relationships, or focus on details rather than addressing the big picture. Sometimes they forget who or what caused things to go well or poorly. By asking them to “tell the story” of how we got here, or by “telling the story” yourself, you put where you are in perspective. Doing this highlights important items that were done well or poorly in relation to their consequences, draws attention to the overarching goals, and helps achieve agreement. By telling the story from the past to the present, it will help you continue it into the future (i.e., design a plan). Making a good plan involves sketching out the important events through time and thinking through the specifics in sequence so that when you are done, the final story is vivid and easy to visualize. Then other people can understand the plan, comment on it, and eventually believe in it. It’s also required for specifying who should do what and when. + +# 164a) Tool: + +Have all new employees listen to tapes of “the story” to bring them up to date. Listen to some of the associated tapes about Bridgewater’s story. Imagine how much better informed you would be than a person who just joined Bridgewater and hadn’t listened to these stories. + +# 165) Understand “above the line” and “below the line” thinking + +and how to navigate between the two. There are different levels and themes going on in any one conversation. It is important to know how to navigate them. If you imagine main points and subordinate points organized in + + + +--- + + +In outline form, an above-the-line discussion addresses the main points. That doesn’t mean you shouldn’t reference details, because some details might be necessary to the discussion. But reference details solely for the purpose of understanding major points rather than dissecting minor points. + +For example, suppose your major point is: “Sally can do that job well.” In an above-the-line conversation, the discussion of her qualities would target the question of Sally’s capacity to do her job. As soon as agreement was reached on whether she could perform competently, you would pass to the next major point—such as what qualities are required for that job. In contrast, a below-the-line discussion would focus on Sally’s qualities for their own sake, without relating them to whether she can do her job well. The discussion might cover qualities that are irrelevant to the job. + +While both levels of discussion touch on minor points, “above the line” discourse will always move coherently from one major point to the next in much the same way as you can read an outline in order to fully understand the whole concept and reach a conclusion. You go “below the line” to the minor points only to illustrate something important about the major points and progress in an orderly and accurate way to the conclusion. Your ability to do this is partially innate but can be improved with practice.70 + + + +--- + + + +# A→B→→D→E→F→G= synthesis + +| 1 | 1 | 1 | 1 | 1 | 1 | 1 | +| - | - | - | - | - | - | - | +| 2 | 2 | 2 | 2 | 2 | 2 | 2 | +| 3 | 3 | 3 | 3 | 3 | 3 | 3 | +| 4 | 4 | 4 | 4 | 4 | 4 | 4 | +| 5 | 5 | 5 | 5 | 5 | 5 | 5 | + +# Bigger Picture Sequence + +# A that Works + +| B | C | D | FG= synthesis | | | +| - | - | - | ------------- | - | - | +| 1 | 1 | 1 | | 1 | 1 | +| 2 | 2 | 2 | 2 | 2 | 2 | +| 3 | 3 | 3 | 3 | 3 | 3 | +| 4 | 4 | 4 | 4 | 4 | 4 | +| 5 | 5 | 5 | 5 | 5 | 5 | + +# A Logical Sequence that Explores Specifics and Works + +| A | B | C | D | E | F | G | +| - | -- | - | -- | - | ----------------- | - | +| 1 | 1 | 1 | 1 | 1 | 1 | 1 | +| 2 | >2 | 2 | 2 | 2 | 2 | 2 | +| 3 | 3 | 3 | 73 | 3 | 3 | | +| 4 | 4 | 4 | 4 | 4 | → 4= no synthesis | | +| 5 | 5 | 5 | >5 | | 5 | 5 | + +# A Random Story that Gets Derailed + + + +--- + +# A Detailed Story that Gets Derailed + +| B | C | D | E | F | G | +| - | - | - | - | - | - | +| 1 | 1 | | 1 | 1 | 1 | +| 2 | 2 | 2 | 2 | 2 | 2 | +| 3 | 3 | 3 | 3 | 3 | 3 | +| 4 | 4 | 4 | 4 | 4 | 4 | +| 5 | 5 | 5 | 5 | 5 | 5 | + + +--- + + +# 166) DESIGN YOUR MACHINE TO ACHIEVE YOUR GOALS + +So... + +# 167) Remember: You are designing a “machine” or system that will produce outcomes. This machine will consist of distinct parts (i.e., people and other resources as well as the way they interact with each other). + +| GOALS | MACHINE | OUTCOMES | +| ------ | ------- | ----------------------------- | +| DESIGN | PEOPLE | i.e., the Responsible Parties | + +# Qualities Needed + +# What People Are Like + +# 167a) A short-term goal probably won’t require you to build a machine. But for an ongoing mission, you will need a well-designed and efficient machine. + +# 167b) Beware of paying too much attention to what is coming at you and not enough attention to what your responsibilities are or how your machine should work to achieve your goals. Constantly compare your machine’s outcomes to your goals in order to reflect on how well the machine is operating. Examine both the design and how the individual parts are functioning. + +# ... 168) Don’t act before thinking. Take the time to come up with a game plan. Take at least a few hours to think through your plan. Those hours will be virtually nothing in relation to the amount of time that will be spent doing, and they will make the doing radically more effective. + + + +--- + + +169) The organizational design you draw up should minimize problems and maximize capitalization on opportunities. Make the design an extension of your understanding of your problems and opportunities. + +170) Put yourself in the “position of pain” for a while so that you gain a richer understanding of what you’re designing for. Temporarily insert yourself into the flow to gain a real understanding of what you are dealing with (the process flow, the type of people needed, the potential problems, etc.) and to visualize a clear picture of what will work. You can accomplish this in a number of ways (reviewing work, doing work at different stages in the process, etc.). + +171) Recognize that design is an iterative process; between a bad “now” and a good “then” is a “working through it” period. That “working through it” period involves trying processes and people out, seeing what goes well or poorly, learning from the iterations, and moving toward having the right people in the ideal systematic design. Even with a good future design picture in mind, it will naturally take time, testing, mistakes, and learning to get to a good “then” state. + +172) Visualize alternative machines and their outcomes, and then choose. A good designer is able to visualize the machine and its outcomes accurately, though imperfectly. First visualize the parts and their interactions, and then find the parts to fit the design. Look at all the system’s pieces and their interactions. Imagine how goals 1, 2, and 3 can be achieved. Imagine how Harry, Larry, and Sally can operate in various ways with various tools and different incentives and penalties in place to achieve those goals. Then imagine how the system would work differently if you replaced Harry with George, or if it was configured in an entirely different way. Do this iteratively. Think through what the products and people and finances will look like month by month (or quarter by quarter) over the next year given one system; then change the system and visualize the outcomes again. At the end of this process, your plan should look like a realistic movie script, which describes the parties and their interactions through time. Remember that everything takes longer and costs more than you plan for. Recognize that some people are relatively better or worse at visualization. Accurately assess your own abilities and those of others so you can use the most capable people to create the visualization. + + + +--- + + +# 173 + +Think about second- and third-order consequences as well as first-order consequences. The outcome you get as a first-order consequence might be desirable (or undesirable), while the second- or third-order consequences could be the opposite, so focusing solely on first-order consequences, which people tend to do, could lead to bad decision-making. Though I might not like the first-order consequences of a rainy day, I might love the second-order consequences. So if I were in a position to choose whether or not there should be rainy days, I would need to look at the second- and third-order consequences to make the right decision. For example, for every person you plan to hire, you will have to hire more to support them. I call this “The 1.6 Effect.” + +# 174 + +Most importantly, build the organization around goals rather than tasks. As an example of building the organization around goals rather than tasks, we have traditionally had a marketing department (goal: to market) that is separate from our client service department (goal: to service clients), even though they do similar things and there would be advantages to having them work together. But because marketing and servicing clients are two distinct goals, we have a separate department for each. If they were merged, the department head, salespeople, client advisors, analysts, and others would be giving and receiving conflicting feedback. If asked why clients were receiving relatively poor attention, the answer might be: “We have incentives to raise sales.” Asked why they weren’t making sales, the merged department might explain that they need to take care of their clients. Keeping the two areas separate gives each department a clear focus and the appropriate resources to achieve its goals, makes the diagnosis of resource allocations more straightforward, and reduces “job slip.” Of course, when building departments around goals, your goals have to be the right size to warrant these resources. An organization might not be big enough to warrant having a few salesmen and its own analytical group. Bridgewater has successfully evolved from a one-cell organization, in which most people were involved in everything, to the current multi-cell organization because we retained our ability to efficiently focus as the organization grew. Also, I want to make clear that temporarily sharing or rotating resources is OK, and is not the same thing as a merging of responsibilities. I will discuss merging later in this document, as well the coordination required to maintain focus in large organizations. + + + +--- + + +# 174) Workflow Design and Organization + +First come up with the best workflow design, sketch it out in an organizational chart, visualize how the parts interact, specify what qualities are required for each job, and, only after that is done, choose the right people to fill the jobs (based on how their capabilities and desires match up with the requirements). + +# 174a) Organizing Departments + +Organize departments and sub-departments around the most logical groupings. Some groups naturally gravitate toward one another. Trying to impose your own structure without acknowledging these magnetic pulls is ineffective and likely will result in a bad outcome. + +# 174b) Self-Sufficient Departments + +Make departments as self-sufficient as possible so that they have control over the resources they need to achieve the goals. We do this because we don’t want to create a bureaucracy that forces departments to requisition resources from a pool that lacks the focus to do the job. People sometimes argue that we should have a technology department, but I am against that because building technology is a task, not a goal in and of itself. You build technology to perform valuable tasks. If we kept the tech resources outside the department, we would have people from various departments arguing about whose project is most important in order to garner resources, which isn’t good for efficiency. The tech people would be evaluated and managed by bureaucrats rather than the people they do the work for. + +# 174c) Efficiency and Bureaucracy + +The efficiency of an organization decreases and the bureaucracy of an organization increases in direct relation to the increase in the number of people and/or the complexity of the organization. + +# 175) Building the Organization + +Build your organization from the top down. An organization is the opposite of a building—the foundation is at the top. The head of the organization is responsible for designing the organization and for choosing people to fill its boxes. Therefore, make sure you hire managers before their direct reports. Managers can then help design the machine and choose people who complement the machine. + +# 175a) Oversight and Standards + +Everyone must be overseen by a believable person who has high standards. Without this strong oversight, there is potential for inadequate quality control, inadequate training, and inadequate appreciation of excellent work. Do not “just trust” people to do their jobs well. + + + +--- + + +# 175b + +The people at the top of each pyramid should have the skills and focus to manage their direct reports and a deep understanding of their jobs. Here’s an example of the confusion that can arise when that understanding is absent: It was proposed that the head of technology have the facilities group (the people who take care of facilities like the building, lunches, office supplies, etc.) report to him because both are, in a sense, “facilities” and because they have some things in common, such as the electrical supply. But the head of technology didn’t understand what the facilities people do. Having people who are responsible for the janitorial services and meals reporting to a technology manager is as inappropriate as having the technology people report to the person who is taking care of facilities. These functions, even if they’re considered “facilities” in the broadest sense, are very different, as are the respective skill sets. Similarly, at another time, we talked about combining folks who work on client agreements with those who do counterparty agreements under one manager. That would have been a mistake because the skills required to reach agreements with clients are very different from the ones required to reach agreements with counterparties. It was wrong to conflate both departments under the general heading of “agreements,” because each kind called for specific knowledge and skills. + +# 175c + +The ratio of senior managers to junior managers and to the number of people who work two levels below should be limited, to preserve quality communication and mutual understanding. Generally, the ratio should not be more than 1:10, and preferably closer to 1:5. Of course, the appropriate ratio will vary depending on how many people your direct reports have reporting to them, the complexity of the jobs they’re doing, and the manager’s ability to handle several people or projects at once. + +# 175d + +The number of layers from top to bottom and the ratio of managers to their direct reports will limit the size of an effective organization. + +# 175e + +The larger the organization, the more important are 1) information technology expertise in management and 2) cross-department communication (more on these later). + +# 175f + +Do not build the organization to fit the people. Jobs are created based on the work that needs to be done, not what people want to do or + + + +--- + + +# 176) + +Have the clearest possible delineation of responsibilities and reporting lines. It’s required both within and between departments. Make sure reporting lines and designated responsibilities are clear. To avoid confusion, people should not report to two different departments. Dual reporting (reporting across department lines) causes confusion, complicates prioritization, diminishes focus on clear goals, and muddies the lines of supervision and accountability, especially when a person reports to two people in two different departments. When situations require dual reporting, managers need to be informed. Asking someone from another department to do a task without consulting with his or her manager is strictly prohibited (unless the request will take less than an hour or so). However, appointing co-heads of a department or a sub-department can work well if the managers are in synch and combine complementary and essential strengths to this area; dual reporting in that case can work fine if properly coordinated by the co-heads. + +# 176a) + +Create an organizational chart to look like a pyramid, with straight lines down that don’t cross. A series of descending pyramids make up the whole pyramid, but the number of layers should be limited to minimize hierarchy. + +# 177) + +Constantly think about how to produce leverage. For example, to make training as easy to leverage as possible, document the most common questions and answers through audio, video, or written guidelines and then assign someone to regularly organize them into a manual. Technology can do most tasks, so think creatively about how to design tools that will provide leverage for you and the people who work for you. + +# 177a) + +You should be able to delegate the details away. If you can’t, you either have problems with managing or training or you have the wrong people doing the job. The real sign of a master manager is that he doesn’t have to “do” practically anything. Of course, a great manager has to hire and oversee the people who do things; but a “supreme master” manager can even hire a person or two to do this and has achieved such leverage that things are effortlessly running superbly. Of course, there is a continuum. + + + +--- + + +related to this. The main message I’m trying to convey is that managers should strive to hire, train, and oversee in a way in which others can superbly handle as much as possible on their own. Managers should view the need to get involved in the nitty-gritty themselves as a bad sign. + +177b) It is far better to find a few smart people and give them the best technology than to have a greater number of ordinary and less well-equipped people. First of all, great people and great technology are almost always a great value because their effectiveness in enhancing the organization’s productivity can be enormous. Second, it is desirable to have smart people have the widest possible span of understanding and control because fragmented understanding and control create inefficiencies and undermine organizational cohesion. Usually it is the person’s capacity that limits the scope of his understanding and control. So the mix of really smart people operating with really great technology in a streamlined organization is optimal for organizational efficiency. + +177c) Use “leveragers.” Leveragers are capable of doing a lot to get your concepts implemented. Conceptualizing and managing are most important and take only about 10% of the time needed for implementing; so if you have good leveragers, you can accomplish a lot more with relative ease. + +... 178) Understand the clover-leaf design. Find two or three responsible parties who have overlapping believabilities and responsibilities and who are willing to challenge and check each other. If you do this, and those people are willing to fight for what they believe is best by being open-minded and assertive at the same time, and if they escalate their disagreements and failures to you, this process will have a high probability of sorting issues that they can probably handle well from issues that you should examine and resolve with them. + +... 179) Don’t do work for people in another department or grab people from another department to do work for you unless you speak to the boss. + +... 180) Watch out for “department slip.” This happens when a support department, such as HR or Facilities, mistakes its responsibilities to provide support with a responsibility to determine how the thing they are supporting should be done. An example of this sort of mistake is if those in the Recruiting department think they should determine whom we should hire or + + + +--- + + +If people in HR think they should determine what our employment policies should be. Another example would be if the Facilities group determined what facilities we should have. While support departments should know the goals of the people they’re supporting and provide feedback regarding possible choices, they are not the ones to determine the vision. + +181) Assign responsibilities based on workflow design and people’s abilities, not job titles. What people do should primarily be a function of the job they have, and it should be pretty obvious who should do what (if they’re suited for the job). For example, just because someone is responsible for “human resources,” “recruiting,” “legal,” “programming,” etc., doesn’t necessarily mean they are the appropriate person to do everything associated with those functions. For example, though “Human Resources” people help with hiring, firing, and providing benefits, it would be a mistake to give them the responsibility of determining who gets hired and fired and what benefits are provided to employees. When assigning responsibilities, think about both the workflow design and a person’s abilities, not the job title. + +182) Watch out for consultant addiction. Beware of the chronic use of consultants to do work that should be done by employees. + +183) Tool: Maintain a procedures manual. This is the document in which you describe how all of the pieces of your machine work. There needs to be enough specificity so that operators of the different pieces of the machine can refer to the manual to help them do their job. The manual should be a living document that includes output from the issues log so that mistakes already identified and diagnosed aren’t repeated. It prevents forgetting previous learning and facilitates communication. + +184) Tool: Use checklists. When people are assigned tasks, it is generally desirable to have these captured on checklists so they can check off each item as it is done. If not, there is a risk that people will gradually not do the agreed tasks or there will be lack of clarity. Crossing items off a checklist will serve as a task reminder and confirmation of what has been done. + +184a) Don’t confuse checklists with personal responsibility. People should be expected to do their job well, not just what is on their checklists. + + + +--- + + +184b) Remember that “systematic” doesn’t necessarily mean computerized. It might mean having people do specified tasks and indicate that they have done them with checklists. + +184c) Use “double-do” rather than “double-check” to make sure mission-critical tasks are done correctly. When people double-check someone else’s work, there is a much lower rate of catching errors than when two parties independently do the work and the results are compared. Double-doing is having two different people doing the same task on the same job so that two independent answers are derived. By comparing them you will not only assure better answers but you will see the differences in people’s performances and make much more rapid improvement. I use double-dos in critical areas such as finance, where large amounts of money are involved. + +185) Watch out for “job slip.” Job slip is when a job changes without being explicitly thought through and agreed to, generally because of changing circumstances or a temporary necessity. Job slip will generally cause bad job design. It often leads to the wrong people handling the wrong responsibilities and confusion over who is supposed to do what. + +186) Think clearly how things should go, and when they aren’t going that way, acknowledge it and investigate. First decide which issue to address first: finding the reason the machine isn’t working well or executing the tasks required to get past the problem (in which case you need to come back to the reasons later). Either way, don’t pass the problem by without discussing the reasons. Otherwise, you will end up with job slip. + +187) Have good controls so that you are not exposed to the dishonesty of others and trust is never an issue. A higher percentage of the population than you might imagine will cheat if given an opportunity, and most people who are given the choice of being “fair” with you and taking more for themselves will choose taking more for themselves. Even a tiny amount of cheating is intolerable, so your happiness and success will depend on your controls. Security controls should be viewed as a necessary tool of our profession, not as a personal affront to an individual’s integrity. Just as a bank teller doesn’t view a check on the money in his drawer as an indication that the bank thinks he is dishonest, everyone here should understand the need for our security controls. Explain this to your people so + + + +--- + +they see it in the proper context. Even the best controls will never be foolproof, and trustworthiness is a quality that should be appreciated. + +# 187a) + +People doing auditing should report to people outside the department being audited, and auditing procedures should not be made known to those being audited. + +# 187b) + +Remember: There is no sense in having laws unless you have policemen (auditors). + +--- + + +# 188) DO WHAT YOU SET OUT TO DO + +So… + +# 189) Push through! + +You can make great things happen, but you must MAKE great things happen. Times will come when the choice will be to plod along normally or to push through to achieve the goal. The choice should be obvious.71 + + + +--- + + +# TO MAKE DECISIONS EFFECTIVELY... + +# 190) RECOGNIZE THE POWER OF KNOWING HOW TO DEAL WITH NOT KNOWING + +So... + +# 191) Recognize that your goal is to come up with the best answer, that the probability of your having it is small, and that even if you have it, you can’t be confident that you do have it unless you have other believable people test you. + +# 192) Understand that the ability to deal with not knowing is far more powerful than knowing. That is because there’s way more that we don’t know than what we could possibly ever know. + +# 192a) Embrace the power of asking: “What don’t I know, and what should I do about it?” Generally you should find believable people and ask their advice, remembering that you are looking to understand their reasoning rather than get their conclusions. + +# 192b) Finding the path to success is at least as dependent on coming up with the right questions as coming up with answers. Successful people are great at asking the important questions and then finding the answers. When faced with a problem, they first ask themselves if they know all the important questions about it; they are objective in assessing the probability that they have the answers; and they are good at open-mindedly seeking believable people to ask. + +# 193) Remember that your goal is to find the best answer, not to give the best one you have. The answer doesn’t have to be in your head; you can look outside of you. In life the goal is for you to do the right thing, considering the probability that you might be wrong. So it is invaluable to know what you don’t know so that you can figure out a way to find out and/or to get help from others. + +# 194) While everyone has the right to have questions and theories, only believable people have the right to have opinions. If you can’t successfully ski down a difficult slope, you shouldn’t tell others how to do it, though you can ask questions about it and even express your views about possible ways if you make clear that you are unsure. + + + +--- + +195) Constantly worry about what you are missing. Even if you acknowledge you are a “dumb shit” and are following the principles and are designing around your weaknesses, understand that you still might be missing things. You will get better and be safer this way. + +195a) Successful people ask for the criticism of others and consider its merit. + +195b) Triangulate your view. Never make any important decisions without asking at least three believable people. Don’t ask them for their conclusions or just do what they tell you to do. Understand, visualize, and assess their reasoning to see if it makes sense to you. Ask them to probe your own reasoning. That’s critical to your learning as well as to your successful handling of your responsibilities. + +--- + + +# 196) MAKE ALL DECISIONS LOGICALLY, AS EXPECTED VALUE CALCULATIONS + +So... + +# 197) Considering both the probabilities and the payoffs of the consequences, make sure that the probability of the unacceptable (i.e., the risk of ruin) is nil. + +# 197a) + +The cost of a bad decision is equal to or greater than the reward of a good decision, so knowing what you don’t know is at least as valuable as knowing. + +# 197b) + +Recognize opportunities where there isn’t much to lose and a lot to gain, even if the probability of the gain happening is low. It is a reality that there are always multiple possibilities and nothing is certain. All decisions are therefore risk/reward bets. Know how to pursue fabulous risk/reward ratios that have a huge upside and very little downside, albeit a small probability of happening. My life has been filled with these. + +# 197c) + +Understand how valuable it is to raise the probability that your decision will be right by accurately assessing the probability of your being right. I often observe people giving opinions as soon as they have them, which seems at about the point that they think there’s more than a 50% chance of them being right. Often they don’t pay any attention to the value of raising the probability of being right (e.g., from 51% to 85%) by reflecting harder on whether the answer is right and doing the investigations and double-checking with others to make sure that the answer is right. Remember that, in an expected value sense, raising the probability of being right (e.g., from 51% to 85%) can be worth more than just going from probably wrong (e.g., 45%) to probably being right (e.g., 51%) because we are all playing probabilities. Think about the effects of altering the probabilities of achieving must-dos: if you have a 51% probability of handling a “must-do” correctly, it means that only a bit more than half of your must-dos will be done appropriately, whereas an 85% probability of handling a decision well means that only 15% of the must-dos will be handled badly. + +# 197d) + +Don’t bet too much on anything. Make 15 or more good, uncorrelated bets. + + + +--- + + + +--- + + +# 198) REMEMBER THE 80/20 RULE, AND KNOW WHAT THE KEY 20% IS + +So... + +# 199) Distinguish the important things from the unimportant things and deal with the important things first. + +# 199a) + +Don’t be a perfectionist, because perfectionists often spend too much time on little differences at the margins at the expense of other big, important things. Be an effective imperfectionist. Solutions that broadly work well (e.g., how people should contact each other in the event of crises) are generally better than highly specialized solutions (e.g., how each person should contact each other in the event of every conceivable crisis), especially in the early stages of a plan. There generally isn’t much gained by lots of detail relative to a good broad solution. Complicated procedures are tough to remember, and it takes a lot of time to make such detailed plans (so they might not even be ready when needed). + +# 199b) + +Since 80% of the juice can be gotten with the first 20% of the squeezing, there are relatively few (typically less than five) important things to consider in making a decision. For each of them, the marginal gains of studying them past a certain point are limited. + +# 199c) + +Watch out for “detail anxiety,” i.e., worrying inappropriately about unimportant, small things. + +# 199d) + +Don’t mistake small things for unimportant things, because some small things can be very important (e.g., hugging a loved one). + +# 200) Think about the appropriate time to make a decision in light of the marginal gains made by acquiring additional information versus the marginal costs of postponing the decision. + +There are some decisions that are best made after acquiring more information, and some that are best made sooner rather than later. The later a decision is made, the more informed it can be; however, making it later can also have adverse consequences (e.g., postponing progress). Understanding the trade-off between the marginal gains of acquiring the extra information against the + + + +--- + + +# 201 + +Make sure all the “must do’s” are above the bar before you do anything else. First, distinguish between your “must do’s” and your “like to do’s”. Don’t overlook any “must do’s,” and don’t mistakenly slip the “like to do’s” onto the list. Then, get all the “must do’s” above the bar. Then get all the “must do’s” excellent. If you have time, turn to the “like to do’s” and try to get them above the bar. Only if you have time (though you certainly will not if you are thinking broadly), turn toward making things perfect. Chances are, you won’t have to deal with the unimportant things, which is better than not having time to deal with the important things. I often hear people say, "Wouldn’t it be good to do this or that,” referring to nice-to-do’s rather than must-do’s that have to be above the bar. Chances are, they are being distracted from far more important things that need to be done well. + +# 202 + +Remember that the best choices are the ones with more pros than cons, not those that don’t have any cons. Watch out for people who tend to argue against something because they can find something wrong with it without properly weighing all the pros against the cons. Such people tend to be poor decision-makers. + +# 203 + +Watch out for unproductively identifying possibilities without assigning them probabilities, because it screws up prioritization. You can recognize this with phrases like “It’s possible that...” then going on to say something that’s improbable and/or unimportant, rather than something like, “I think there’s a good chance that...” followed by something that’s important or probable. Almost anything is possible. All possibilities must be looked at in terms of their likelihoods and prioritized. + +# 204 + +Understand the concept and use the phrase “by and large.” Too often I hear discussions fail to progress when a statement is made and the person to whom it is made replies, “Not always,” leading to a discussion of the exceptions rather than the rule. For example, a statement like “The people in the XYZ Department are working too many hours” might lead to a response like “Not all of them are; Sally and Bill are working normal hours,” which could lead to a discussion of whether Sally and Bill are working too long, which derails the discussion. Because nothing is 100%. + + + +--- + +true, conversations can get off track if they turn to whether exceptions exist, which is especially foolish if both parties agree that the statement is by and large true. To avoid this problem, the person making such statements might use the term “by and large,” like “By and large, the people in the XYZ Department are working too many hours.” People hearing that should consider whether it is a “by and large” statement and treat it accordingly. + +204a) When you ask someone whether something is true and they tell you that “It’s not totally true,” it’s probably true enough. + +--- + +# 205) SYNTHESIZE + +So… + +# 206) Understand and connect the dots. + +To do this well, you have to synthesize what is going on. Usually it takes diagnosing a few (e.g., five or so) dots of the same type to get at the true root cause so that you can see how the machine should be modified to produce better outcomes. For example, one type of outcome involves someone, let’s call him Harry, handling a type of responsibility (entering an order). You will need at least a few experiences to learn about Harry doing this. It will pay for you to understand Harry and his handling of orders and have him understand you by looking objectively at the outcomes and by getting in synch, especially about the bad outcomes. The quality of your understanding of your machine and its constituent parts will depend on how well you diagnose and process the important outcomes. If you don’t do this continuously and you don’t synthesize well, you will fail. This isn’t easy. + +See how the dots connect through time. This requires collecting, analyzing, and sorting lots of different types, and it ain’t easy for most folks. Imagine a day in which eight outcomes occur. Some are good, some bad. Let’s represent this day as follows, with each type of event represented by a letter and the quality of the outcome represented by its height. + +| GOODNESS OF OUTCOME | | +| ------------------- | - | +| | | + +In order to see the day this way, you must categorize outcomes by type and quality, which will require synthesizing a “by and large” assessment of each. If you didn’t examine the bad outcomes as they occurred, you couldn’t understand what they are symptomatic of. Keep in mind our + +--- + + +example is a relatively simple one: only eight occurrences over one day. Now let’s look at what a month looks like. + +| 0 | w | T | 7 | | | | | | +| ----------- | - | ---- | - | - | - | - | - | - | +| GOODNESS OF | Y | V | Y | x | x | x | x | | +| OUTCOME | 2 | V | z | x | 2 | X | x | | +| | x | - | x | 1 | A | | | | +| | 0 | x | w | | Z | w | V | | +| | | TIME | | | | | | | + +Confusing, eh? Some people are much better at this than others. In order to understand how your machine is working to achieve your goals, you have to perceive change over time, charting improvement vs. deterioration. The chart below plots just the type X dots, which you can see improving. As mentioned in the section on diagnosis, you must categorize, understand, and observe the evolution of the different parts of your machine through time, and synthesize this understanding into a picture of how your machine is working and how it should be improved. People who do this well are rare and essential. As with most abilities, synthesizing well is partially innate and partially learned through practice. + +| 0 | | | | x | +| ----------- | - | - | - | ---- | +| | x | x | x | x | +| GOODNESS OF | | | | x | +| OUTCOME | A | x | x | x | +| | x | x | | | +| B0 | | | | TIME | + +... 207) Understand what an acceptable rate of improvement is, and that it is the level and not the rate of change that matters most. I often hear people say, “It’s getting better,” as though that is good enough when “it” is both below that bar and improving at an inadequate rate. That isn’t good enough. For example, if someone who has been getting 30s and 40s on tests raised his grade to the 50s, you could say he’s improving but the level is + + + +--- + + +still woefully inadequate. Everything important you manage has to be on a trajectory to be “above the bar” and headed for “excellent” at an acceptable pace. For example, in the chart below, the trajectory of A might be acceptable, but B’s trajectory is not. A gets us above the bar in an acceptable amount of time. + +| EXCELLENT BAR | | | +| ---------------- | - | - | +| "ACCEPTABLE" BAR | | | +| A | B | | + +If your best solution isn’t good enough, think harder or escalate that you can’t produce a solution that is good enough. A common mistake is accepting your own best solution when it isn’t good enough. + +Avoid the temptation to compromise on that which is uncompromisable. You must have and achieve high standards. This is particularly difficult when two uncompromisable things are at odds. At such times, there is a tendency to let one of them go. However, at such times you have to allocate more time to figure out how to best handle this, be more creative, and ask for more input. But don’t compromise on one of the things that shouldn’t be compromised. For example, one of the uncompromisable things I regularly get pressure from people to compromise on is letting great people avoid exploring their mistakes and weaknesses because they find it painful. For reasons articulated throughout these principles, I believe we can’t compromise on this because that process of exploration is healthy for Bridgewater, healthy for them, and key to our culture. I also believe that to allow opt-outs would legitimatize two sets of rules and put our radically honest way of being in jeopardy. But I want great people. + +Don’t try to please everyone. Not everyone is going to be happy about every decision you make, especially the decisions that say they can’t. + + + +--- + + +do something. + +1. Since I learned these principles by encountering reality and reflecting on my encounters, and I am still doing these things, I expect there are more principles to come. So I am still creating this document by throwing various thoughts down when they occur to me, trying to put them in some sensible order and trying to smooth over the bumps. Organizing these principles into a sensible order is a challenge since they relate to each other more like a matrix than as a sequence. To help guide you, I’ve tried to organize them around large themes like building a great culture, managing people well, and creative problem-solving. I will continue these things, so this is an evolving document. +2. While this particular document will always express just what I believe, others will certainly have their own principles, and possibly even their own principles documents, and future managers of Bridgewater will work in their own ways to determine what principles Bridgewater will operate by. At most, this will remain as one reference of principles for people to consider when they are deciding what’s important and how to behave. +3. I wish everyone wrote down their principles. I wish I could read and compare the principles of all the people I’m interested in— Steve Jobs, Albert Einstein, people running for political office, people I share my life with, etc. I'd love to know what they value most and what principles they use to get what they want. Imagine how great that would be—e.g. imagine how much valuable fundamental thinking could be harnessed. I hope that my doing this will encourage others to do the same. +4. Rote memory is memory for things that don’t have an intrinsic logic for being what they are, like a random series of numbers, words in a foreign language and people’s names (all of which I have trouble with). On the other hand, I have a great memory for things that make sense in a context. For example, I can tell you what happened in every year in the economy and markets since the mid-1960s and how many things work. +5. The way I learn is to immerse myself in something, which prompts questions, which I answer, prompting more questions, until I reach a conclusion. + + + +--- + + +[6] This included my retail stockbroker, the people I was caddying for, even my local barber, who was equally engrossed in the stock market. (It wasn’t as precocious as it sounds. At the time, instead of talking about the Yankees, everyone was talking about stocks. That was the world I grew up in.) + +[7] Sometimes when I know that I don’t know which way the coin is going to flip, I try to position myself so that it won’t have an impact on me either way. In other words, I don’t make an inadvertent bet. I try to limit my bets to the limited number of things I am confident in. + +[8] By the way, I still meditate and I still find it helpful. + +[9] It is unethical because a basic principle of justice is that everyone has the right to face his accuser. And it is unproductive because it does not lead to the exploration of “Is it true?” which can lead to understanding and improvement. + +[10] I do not mean that you should say everything you think, just that what you do say matches your thoughts. + +[11] The word “integrity” is from the Latin root “integer,” which means “one” i.e., that you are the same inside and out. Most people would be insulted if you told them that they don't have integrity—but how many people do you know who tell people what they really think? + +[12] I believe that our society's “mistakephobia” is crippling, a problem that begins in most elementary schools, where we learn to learn what we are taught rather than to form our own goals and to figure out how to achieve them. We are fed with facts and tested and those who make the fewest mistakes are considered to be the smart ones, so we learn that it is embarrassing to not know and to make mistakes. Our education system spends virtually no time on how to learn from mistakes, yet this is critical to real learning. As a result, school typically doesn’t prepare young people for real life—unless their lives are spent following instructions and pleasing others. In my opinion, that’s why so many students who succeed in school fail in life. + +[13] After all, isn’t the point of learning to help you get what you want? So don’t you have to start with what you want and figure out what you have to learn in order to get it? + + + +--- + + + +[14] In fact I believe that most people who are quick to come up with answers simply haven’t thought about all the ways that they can be wrong. + +[15] I don’t mean that the more pain the better. I believe that too much pain can break someone and that the absence of pain typically prevents growth so that one should accept the amount of pain that is consistent with achieving one’s objectives. + +[16] I have been very lucky because I have had the opportunity to see what it’s like to have little or no money and what it’s like to have a lot of it. I’m lucky because people make such a big deal of it and, if I didn’t experience both, I wouldn’t be able to know how important it really is for me. I can’t comment on what having a lot of money means to others, but I do know that for me, having a lot more money isn’t a lot better than having enough to cover the basics. That’s because, for me, the best things in life—meaningful work, meaningful relationships, interesting experiences, good food, sleep, music, ideas, sex, and other basic needs and pleasures—are not, past a certain point, materially improved upon by having a lot of money. For me, money has always been very important to the point that I could have these basics covered and never very important beyond that. That doesn’t mean that I don’t think that having more is good–it’s just that I don’t think it’s a big deal. So, while I spend money on some very expensive things that cost multiples relative to the more fundamental things, these expensive things have never brought me much enjoyment relative to the much cheaper, more fundamental things. They were just like cherries on the cake. For my tastes, if I had to choose, I’d rather be a backpacker who is exploring the world with little money than a big income earner who is in a job I don’t enjoy. (Though being in a job that provides me with what I want is best of all, for me). Also, from having come from having next-to-nothing to having a lot, I have developed a strong belief that, all things being equal, offering equal opportunity is fundamental to being good, while handing out money to capable people that weakens their need to get stronger and contribute to society is bad. + +[17] I recognize that sometimes a discovery is made by accident, but the discovery is of some basic underlying principle that creates understanding of a cause-effect relationship that leads to a desired result. + + + +--- + + +[18] In fact, it appears to me that everything other than evolution eventually disintegrates and that we all are, and everything else is, vehicles for evolution. + +[19] Of course, we are often satisfied with the same things – relationships, careers, etc.—but when that is the case, it is typically because we are getting new enjoyments from the new dimensions of these things. + +[20] The marginal benefits of moving from a shortage to an abundance of anything decline. + +[21] When pursuing self-interest is in conflict with evolution, it is typically punished. + +[22] Of course, there are many people who give society what it wants but are paid poorly. This is explained by the law of supply and demand. + +[23] I do know some successful people who are obsessed with making money despite making money having little or no marginal benefit for them. + +[24] Darwin is reported to have said, “It is not the strongest of the species that survives, nor the most intelligent that survives. It is the one that is the most adaptable to change.” + +[25] Your ability to see the changing landscape and adapt is more a function of your perceptive and reasoning abilities than your ability to learn and process quickly. + +[26] Of course it is true that people are born with differences in their various innate abilities. However, judgment is primarily learned. + +[27] As Freud put it, “Love and work are the cornerstones of our humanness.” + +[28] The work doesn’t necessarily have to be a job, though I believe it’s generally better if it is a job. It can be any kind of long-term challenge that leads to personal improvement. As you might have guessed, I believe that the need to have meaningful work is connected to man’s innate desire to improve. And relationships are the natural connections to others that make us relevant to society. + +[29] There are literally two different parts of each person’s brain that influence these reactions: the pre-frontal cortex and the amygdala. They work as though they were two different brains that fight for control of + + + +--- + + +decision-making. The pre-frontal cortex is the logical part of the brain that evaluates choices logically and the amygdala is the “animal instinct” part of the brain that triggers emotional reactions like the instinct to fight or flee. When faced with an obstacle or threat, an emotional reaction (e.g. pain) can be triggered that can lead to a fight or flight reaction that “hijacks” decision making away from the pre-frontal cortex, where the rational choices are being made. This can result in our making decisions that produce consequences that we do not want. This typically causes really big problems. + +[30] Your very unique power of reflectiveness—i.e., your ability to look at yourself, the world around you, and the relationship between you and the world—means that you can think deeply and weigh subtle things to come up with learning and wise choices. Asking other believable people about the root causes of your pain in order to enhance your reflections is also typically very helpful—especially others who have opposing views and who share your interest in finding the truth rather than being proven right. + +[31] If you can reflect deeply about your problems, they almost always shrink or disappear, because you almost always find a better way of dealing with them than if you don’t face them head on. The more difficult the problem, the more important it is that you think hard about it and deal with it. After seeing how effectively facing reality—especially your problems, mistakes and weaknesses—works, I believe you will become comfortable with it and won’t want to operate any other way. + +[32] An example of this is what discussed earlier: wanting to save the wildebeest from the hyenas. When you don’t want to face what’s really happening, you can’t make sound decisions. + +[33] For example, if you are dumb or ugly, you are unlikely to acknowledge it, even though doing so would help you better deal with that reality. Recognizing such “harsh realities” is both very painful and very productive. + +[34] I am not saying that we all have the same potential, just that to get the most of your potential—whatever that is—you must learn and earn. + +[35] As I mentioned in the first chapter, you don’t have to know everything to get what you want. You just have to be honest with yourself about what you don’t know and know who to ask for help. + + + +--- + + +[36] Sometimes it can be difficult to anticipate the 2nd or 3rd order consequences of a decision, such as one that involves using complex technology like X-Rays or DDT, where either things are not what they seem to be or there are too many unknown variables to make a sound decision. For more on the probabilities of personal decision-making, please refer to the “To Make Decisions Effectively” section at the end of Part 3. + +[37] Blaming others is NOT the same thing as holding others accountable, which we will discuss in my Management Principles. + +[38] Luck—both good and bad—is a reality. But it is not a reason for an excuse. In life, we have a large number of choices, and luck can play a dominant role in the outcomes of our choices. But if you have a large enough sample size—if you have large number of decisions (if you are playing a lot of poker hands, for example)—over time, luck will cancel out and skill will have a dominant role in determining outcomes. A superior decision-maker will produce superior outcomes. That does not mean there won’t be certain bad- (or good-) luck events that are life changing: a friend of mine dove into a swimming pool and became a quadriplegic. But he approached his situation well and became as happy as anybody else, because there are many paths to happiness. What happens to a lot of people is that they don’t take personal responsibility for their outcomes, and as a result fail to make the best possible decisions. + +[39] As I mentioned earlier, I believe that nature is symbiotic—and that we must give to it for it to give back. + +[40] The you I am referring to here is the strategic you – the one who is deciding on what you want and how best to get it, previously referred to as you (1). + +[41] Some societies define evil to be the desires that can take you away from your goals, which I think is a good way of seeing the difference between goals and desires. That doesn’t mean I think that there isn’t room for a little “bad”, but I do think that desires that fundamentally divert you from your goals should be avoided at all cost. + +[42] This might sound inconsistent with the previous point that you can’t have everything. It’s not. I am saying that, at this stage of goal-setting, don’t set your goals based on what you think you can achieve. In the process of + + + +--- + +doing the other four steps (especially designing) you will thoroughly think through what is possible. Then you will circle back and enter the goal-setting mode again. As I mentioned, this five-step process is iterative, but it must be pursued one step at a time in order to do each step excellently. + +[43] The more creative I am, the less hard I have to work. + +[44] Though I’ve said it before, it’s worth saying again: I understand that recognizing harsh realities can be extremely painful. But I’ve learned that if you can stare hard at your problems, they almost always shrink or disappear, because you almost always find a better way of dealing with them than if you don’t face them head on. The more difficult the problem, the more important it is that you stare at it and deal with it. After seeing how effectively facing reality – especially your problems, mistakes and weaknesses – works, you will become comfortable with it and won’t want to operate any other way. I also believe that one of the best ways of getting at truth is reflecting with others who have opposing views and who share your interest in finding the truth rather than being proven right. + +[45] This is typically because they let their emotions control their behavior and/or they haven’t learned how to deal with their problems e.g., the amygdala is “hijacking” decision-making away from the pre-frontal cortex. + +[46] There are also other antidotes that we will delve into in the next book. + +[47] Not caring to solve problems often occurs when the expected reward is less than the expected cost. For example, when someone is working toward someone else’s goals without being appropriately supervised, rewarded or punished. + +[48] The organization Outward Bound has a concept that is helpful in thinking about the optimal pace of personal evolution. They speak of a comfort zone, a stretch zone and a panic zone. It’s best to spend most of your time in the stretch zone. + +[49] Thomas Edison said about failure: “I have not failed. I’ve just found 10,000 ways that don’t work.” “I am not discouraged, because every wrong attempt discarded is another step forward.” “Results! Why, man, I have gotten a lot of results. I know several thousand things that won’t work.” “When I have fully decided that a result is worth getting I go ahead of it and + +--- + + +make trial after trial until it comes.” “Many of life’s failures are men who did not realize how close they were to success when they gave up.” + +[50] A good book about this is Einstein’s Mistakes by Hans Ohanian. + +[51] If you recognize short-term failure as a step toward long-term success, which it really is if you learn from it, you won’t be afraid of it or made uncomfortable by it and you will approach all of your experiences as learning experiences, even the most difficult ones. + +[52] Ego often stands in the way of acknowledging your weaknesses (which is the essential first step in overcoming them), like being afraid to ask a question because people might think you’re stupid because you don’t know something. Yet acknowledging those weaknesses (e.g., “I know I‘m a dumb shit, but I’d just like to know...”) helps you move beyond ego toward learning and improving. + +[53] Most people have a tough time disagreeing about the most trivial things, like whether they like the same restaurant, yet are happy to confidently express their opinions, however badly they are formed, if they get them out first. As a result, there is an overabundance of confident bad opinions around and very few thoughtful conclusions arising from learning from each other. It is common for conversations to be exchanges of sentences that begin “I think...” followed by their conclusions, and both parties believing that they had a good conversation and feeling good about each other, even though nothing was accomplished. If most people did the opposite—i.e., if they sought out and open-mindedly explored their disagreements—it would produce a radical increase in learning, and the world would be a much better place. + +[54] In fact, I once toyed with the possibility of developing a voting system based on a believability matrix. Though that might not be possible for practical reasons, it suggests the merit-based decision-making we aspire toward with our current process. The challenging and probing we encourage are not meant to second-guess every decision but to help us assess the quality of our work over time. + +[55] The thing that I like least (or dislike most) about my job is fighting to maintain standards, but it must be done. I know that the only way for me to succeed and to be happy is to have good people do it for me, which means + + + +--- + +that I have to hire, train, and sort out people. It is futile to give responsibilities to people who do not have the qualities required to succeed. It frustrates, and inevitably angers, all parties, which is subversive to the environment. So, hiring, training, and sorting out people so that responsibilities are placed in the hands of people who can be trusted to do an excellent job is the only viable path, and is extremely satisfying. + +[56] I have particularly valued psychologist Bob Eichinger. + +[57] I am convinced that we are just scratching the surface of understanding differences in how people think and how to test for it, so there is great potential for others to follow this path. Unfortunately, most of the world’s experts I have met are more theoretical than practical. + +[58] A good book on this is A Whole New Mind by Daniel H. Pink, and a good article on the science of this is “A Wandering Mind Heads Straight Toward Insight” by Robert Lee Hotz from The Wall Street Journal. + +[59] “Bright” people have high IQs, are highly analytical thinkers, and can solve complex mental problems. + +[60] “Smart” people have common sense, are good at synthesizing, and can imagine what is possible. + +[61] Even the “mistakes” that nature makes have a purpose; they are essential for the evolutionary process. + +[62] The importance of a skill will vary according to the job. The more knowledge-dependent and independent in nature the job is (e.g., a programmer or lawyer whose job isn’t to think about the direction of the company), the more relevant the required skills are. + +[63] Consider how few important decisions you make as a student from first grade through college. Other than deciding which college to attend in the senior year of high school and which major to pursue in the sophomore year of college, most people normally just do what they are told to do. + +[64] You learn principles by experiencing the rewards and punishments of your actions interacting with reality. The clearer the relationship is between cause and effect, the better it is for learning and evolving. So clearly designated responsibilities enhance the feedback and learning process. For example, if you are in the woods and have to survive on your own, the connection between your actions and their results is clearer and is all that + +--- + + +matters. Blame doesn’t enter into it as it gets you nothing. All that you focus on are the interactions between your actions and their results. + +[65] If you answered C and A, you understand the concept. If you didn’t, think again. + +[66] Child psychologists, dog trainers, and other behavior modification specialists will tell you that constant, no-exception feedback is fundamental to good training. + +[67] I believe that school overrates the importance of intellectualized learning. People who were terrific in school and very good at this type of learning tend to overvalue it, or at least fail to distinguish it from the experiential/internalized kind of learning. This lack of differentiation can become a great peril later in life. Many people who have had great academic success need to be mindful of this challenge, especially if their success has been in the “sciences,” such as math and engineering. I also believe this is why hands-on experience is particularly valuable for these types of people. + +[68] Which would be because the manager—the responsible party for making it clear who is responsible for what—is failing to do that well. + +[69] That doesn’t mean that all people have to solve and prevent all repeating problems or they shouldn’t be in their jobs. That might not be possible because smaller, repeating problems might be consciously accepted until they become high enough priorities to be fixed. However, it does mean that repeating problems should be recognized and, if not able to be resolved, they must be elevated. + +[70] Good conceptual thinkers naturally see things in this outline-like form and know how to navigate. They know whether they are having an above-the-line conversation and appropriately delving, and they know how to navigate between both levels. Poor conceptual thinkers tend to get confused because they see things as one big pile of information from which they pick data points almost at random. + +[71] As Lee Ann Womack’s country and western song says, when you have a choice between sitting it out or dancing, I hope you'll dance. + +[72] Everyone is wrestling with some things, but most people don’t talk about them—some people don’t like to probe you about your weaknesses. + + + +--- + +because they think it’s unkind or awkward. And it’s often difficult for us to see and accept our own weaknesses. So when you are really in synch with others about what you’re wrestling with, that is a great step forward, because this feedback is probably true. + +--- + +# HOW COUNTRIES GO BROKE +## THE BIG CYCLE + +# Apps and social media: + +All of Ray’s content, as well as interactive case studies created at the company he founded, Bridgewater Associates, can be found in the Principles In Action app, available in the iOS and Android app stores. Follow Ray on LinkedIn, Facebook, Instagram, X, YouTube, and TikTok. + +# Digital course: + +Ray has partnered with the Wealth Management Institute of Singapore and ADGM Academy of Abu Dhabi to offer a digital course based on his investment and economic principles. Information on the Dalio Market Principles course can be found at principles.com. + +--- + +# WHY I’M SHARING THIS BOOK + +I wrote this book to pass along what I have found to be invaluable timeless and universal understandings and principles that I have learned over my 50‐plus years as a global macro investor. I don’t think that anyone has worked harder for more years and with better resources to acquire these understandings and principles. They have rewarded me and others abundantly, and I don’t want them to die with me. I believe that the concepts I explain can make the world run better when put in the hands of policy makers and investors. Above all else, I hope you will take away from reading this book: + +1. A complete and practical understanding of the Big Debt Cycle. If you want a very brief summary of that, read Part I, and for a more in‐depth understanding, read Part II. +2. A much more practical understanding of how supply and demand really work compared to the conventional economic thinking. This is covered in detail in Chapter 2 but you can see it at play throughout the book. +3. A complete and practical understanding of the Overall Big Cycle, which is driven by the Big Debt Cycle and the other major cycles, including the big political cycle within countries that changes political orders and the big geopolitical cycle that changes world orders. One of my main goals for this book is to help you understand how this Overall Big Cycle brings about these big shifts as I believe that we are now on the brink of such a period of major change. If you read only one chapter in this book, Chapter 8 covers it. + +The material in this book complements and helps complete my explanations of the understandings and principles conveyed in my other books, most importantly Principles for Navigating Big Debt Crises and Principles for Dealing with the Changing World Order. Because that’s a lot of interrelated stuff, I am putting all that and more into an AI avatar of myself that you can easily communicate directly with. If you want to try that out, you can sign up at principles.com. + +--- + +# WITH APPRECIATION + +I am incredibly fortunate to be able to triangulate my thinking with some of the most knowledgeable people in the world. This is particularly important because much of my thinking is unconventional. I am especially grateful to former Treasury Secretaries Larry Summers and Timothy Geithner, former Speaker of the House Paul Ryan, former European Central Bank President Mario Draghi, former Bank of Japan Governor Haruhiko Kuroda, International Monetary Fund Managing Director Kristalina Georgieva, and Committee for a Responsible Federal Budget President Maya MacGuineas. + +The deep historical analysis on which I base my ideas requires a great amount of analytical work. It would not have been accomplished without the help of my excellent research team, including Steven Kryger, Bill LongWeld, Udai Baisiwala, Hemanth Sanjeev, Kaus Bansal, Jonah Garnick, Nick Brown, and Eric Styrcula. + +Converting my big piles of research and writing into book form is also no small feat and would not have been possible without the quick and expert help of Mark Kirby, Chris Edmonds, Julie Farnie, Brian De Los Santos, Martha Merrell, Millissa Henaire, and Zoe Petkanas. + +I am also deeply grateful to my literary agent, Jim Levine, and my editor at Simon & Schuster’s Avid Reader Press, JoWe Ferrari‐Adler. Their help has been indispensable in the publication of all my books. + +--- + +# I N T R O D U C T I O N + +or policy maker, and if you don’t, you ultimately will be hurt by them. Through my research, I discovered that there are big, long-term debt cycles that have unfailingly led to big debt bubbles and busts. I saw that only about 20% of the roughly 750 debt/currency markets that have existed since 1700 remain and that all the remaining ones have been severely devalued through the mechanistic process I am going to describe in this study. I saw how this big, long-term debt cycle was described in the Old Testament, how it repeatedly played out in Chinese dynasties over thousands of years, and how time and again it has foreshadowed the fall of empires, countries, and provinces. + +These Big Debt Cycles have always worked in timeless and universally consistent ways that are not well-understood but should be. In this study, I hope to explain how they work with such clarity that my description will serve as a template that can be used to see what is going on with, and what is likely to happen to, money and debt. While I recognize that my Big Debt Cycle template is unconventional, I am confident that it exists because I’ve made a lot of money using it to bet on how things would go. I am sharing it and other key concepts that have helped me because I am now at a stage of life in which I want to share what I have learned that I have found of value in the hope that it will help others, too. You can do what you like with it. + +Why do I think I understand something that others don’t? I theorize that this is for a few reasons. First, this dynamic is not widely understood because big, long-term debt cycles typically last about one lifetime—roughly 80 years, give or take 25 years—so we don’t get to learn about them through experience. Second, because we focus so much on what is happening to us at the time it is happening, people overlook the big picture. I also think there are biases against being concerned about too much debt because most people like the spending ability that credit gives them, and it is also true that there have been many warnings about pending debt crises that never happened. Memories of big debt crises like the 2008 global financial crisis and + +--- + +# HOW COUNTRIES GO BROKE: THE BIG CYCLE + +The European debt crisis of the PIIGS countries (Portugal, Italy, Ireland, Greece, and Spain) have faded, and since we have gotten past them, many people assume that policy makers learned how to manage them rather than view these cases as early warnings of bigger crises on the horizon. But whatever the reason, it doesn’t matter exactly why these dynamics are overlooked. I am going to paint a picture of what happens and why, and if there is enough interest in what I’m saying, my template will be assessed and will live or die on its merits. + +That leads me to a principle: + +ⓢ If we don’t agree on how things work, we won’t be able to agree on what’s happening or what is likely to happen. + +For that reason, I needed to lay out my picture of how the machine works and triangulate it with other knowledgeable people before moving on to look at what’s happening and what might happen. + +At a time when government debt is large and increasing rapidly, it seems to me dangerously negligent to assume that this time will be different from other times without first studying how other cases transpired. It would be like assuming that we will never have a civil war or world war again because they haven’t happened before in our lifetimes without studying the mechanics that brought them about in the past. (By the way, I believe that both the civil war and world war dynamics are also going on today.) As in my other books, a description of the archetypical dynamic and then look at how and why different cases transpired differently so that one can track current cases relative to the template and put into context what’s happening and what’s likely to happen. In that way, you will both see many cases of this happening and get a peek into the future. Comparing what is happening with that template leads me to believe that we are head- + +1 While debt and currency cycles are comprehensively covered in my book *Principles for Navigating Big Debt Crises (which looked at all of the 48 biggest debt crises in the 100 years between 1918 and 2018, the year I published the book) and in Chapters 3 and 4 of my book Principles for Dealing with the Changing World Order* (which looked at the rises and declines of the world’s reserve currency markets over the last 500 years and 750 currencies since 1700), in this study, I am going to get much more granular in explaining the last and most dramatic breakdown part of the cycle that leads to changes in currency orders. + +--- + + +# I N T R O D U C T I O N + +ing into one of those cases in which central governments and central banks will “go broke” in the ways that have happened hundreds of times before and have had big political and geopolitical consequences. This brings me to an important point. The Big Debt Cycle is just one of several interrelated forces that together make up what I call the “Overall Big Cycle” (or just “Big Cycle”). For example, 1) Big Debt Cycles influence and are affected by largely coinciding 2) big cycles of political and social harmony and conflict within countries that both are affected by and affect 3) big cycles of geopolitical harmony and conflict between countries. These cycles in turn are affected by both 4) big acts of nature (droughts, floods, pandemics, etc.), and 5) developments of big new technologies. Combined, these forces make up the Overall Big Cycle of peace and prosperity and conflict and depression as things progress from one “order” to the next. + +What do I mean by order? Orders are ways of operating that change when systems break down. There are monetary orders that determine how the monetary system works, political orders that determine how governance works within countries, and geopolitical orders that determine how governance works between countries. Big Cycles go from one order (i.e., one system of operating) to the next one. Big Cycles end when these orders break down, usually in a big crisis. + +As I described in my book Principles for Dealing with the Changing World Order, these Big Cycle breakdowns and big changes in orders typically occur about once in a lifetime and are traumatic. The changes from one monetary system to the next, from one system of governance within a country to the next, and from one system of governance between countries to the next typically take about the same amount of time because they have big effects on each other. + +These changes from one set of orders to another have always happened in basically the same ways for the same reasons, but they aren’t well-understood because they come along so infrequently. Yet they happen in highly mechanistic ways that can be measured and monitored. I provide an overview of the forces that drive the Big Cycle in Chapter 8, and I explain what they may mean for the future in + + + +--- + +# HOW COUNTRIES GO BROKE: THE BIG CYCLE + +# Chapter 19 + +which is the concluding chapter. I believe that, once you read about them, they will be obvious to you and will help you understand where we are in the Big Cycle and what is likely to come. If you take nothing else from this book, I hope that you get a much better understanding of the Big Cycle template so that you can apply it to understanding the seemingly improbable events happening today. While these events would have seemed unimaginable just a few years ago, they make perfect sense once you understand the Big Cycle and the mechanics of the five forces that drive it. + +This study consists of four parts and 19 chapters. Part I describes the Big Debt Cycle, at first very simply, then in a more complete and mechanical way, and then with some equations that show the mechanics and help with making projections of what is likely to happen. Part II lays out a detailed template, derived from 35 Big Debt Cycle cases, that shows the typical sequence of events that signifies how a cycle is transpiring and shows symptoms that can help identify how far the cycle has progressed. It also contains a chapter that walks through how the Overall Big Cycle works. Part III reviews the most recent Big Debt Cycle, which started when the new monetary and world orders began at the end of World War II and brings it up to the present. In that part, in addition to looking at the Big Debt Cycle and the Overall Big Cycle with a focus on the US (because it has been the world’s major reserve currency country and the world’s leading power, thus making it the world’s leading shaper of what one might call the American world order since 1945), I also very briefly describe the Big Cycles of both China and Japan, showing them from the 1800s until now. This will give you a more complete picture of what has happened in the world since 1945 and provide two other Big Debt Cycle cases to look at. Finally, in Part IV, I will peek into the future, looking at what my calculations say about what is required for the US to manage its debt burden and how the five big forces might unfold in the years ahead. + +--- + +# Part I: The Big Debt Cycle + +Part I provides a comprehensive picture of the Big Debt Cycle, which has occurred again and again throughout history but isn’t widely recognized because big shifts in it come along so infrequently, only about once in a lifetime. + +The purpose of this part is to describe how the natural mechanics of money, credit, debt, and economic activity, combined with human nature, add up over time to create the Big Debt Cycle. In it I explain the stages of how the Big Debt Cycle progresses and what happens when it unravels. + +In the first chapter, I provide an overview of how the cycle unfolds in a nutshell, and in the following two chapters I dive into more detail, explaining the mechanics that drive the debt cycle both in words and concepts and in numbers and equations. These chapters have a lot for both the general reader and the investor, and I’d encourage you to either read just the bold or explore the details as it suits you. + +--- + + + +# CHAPTER 1 + +# THE BIG DEBT CYCLE + +# IN A TINY NUTSHELL + +My goal for this chapter is to convey a very brief but complete description of the mechanics of a typical Big Debt Cycle. If you read only one chapter to understand how debt works, this is the one to read. + +# HOW THE MACHINE WORKS + +Credit is the primary vehicle for funding spending and it can easily be created. Because one person’s spending is another’s earnings, when there is a lot of credit creation, people spend and earn more, most asset prices go up, and most everyone loves it. As a result, central governments and central banks have a bias toward creating a lot of credit. Credit also creates debt that has to be paid back, which has the opposite effect—i.e., when debts have to be paid back, it creates less spending, lower incomes, and lower asset prices, which people don’t like. + +In other words, when someone (a borrower‐debtor) borrows money (called principal) at a cost (an interest rate), the borrower‐debtor can spend more money than they have in earnings and savings over the near term. But over the long term, this requires them to pay back the + + + +--- + + +# HOW COUNTRIES GO BROKE: THE BIG CYCLE + +principal plus interest, and when they have to pay it back, it requires them to spend less money than they have. This dynamic is why the credit/spending/debt-paying-back dynamic is inherently cyclical. + +# THE SHORT-TERM DEBT CYCLE + +Everyone who has been around long enough to be affected by it several times should be well-acquainted with the short-term debt cycle. It starts with money and credit being provided readily when economic activity and inflation are lower than desired, and when interest rates are low relative to inflation rates and low in relation to the rates of return on other investments. Those conditions encourage borrowing to spend and invest, which causes asset prices, economic activity, and inflation to pick up until they are higher than desired, at which time money and credit are restrained, and interest rates become relatively high in relation to inflation rates and rates of return on other investments. This leads to less borrowing to spend and invest, which leads to lower asset prices, a slowing of economic activity, and lower inflation, which leads interest rates to come down, money and credit to become easier, and the cycle to begin again. These cycles have typically lasted about six years, give or take three years. + +# SHORT-TERM DEBT CYCLES ADD UP TO BIG, LONG-TERM DEBT CYCLES + +What isn’t paid enough attention is the way in which these short-term debt cycles add up to big, long-term debt cycles. Because credit is a stimulant that creates a high, people want more of it, so there is a bias toward creating it. This leads debt to rise over time, which typically leads to most of the short-term cyclical highs and lows in debt to be higher than the ones before. These add up to create the long-term debt cycle, which ends when it becomes + + + +--- + +# T H E B I G D E B T C YC L E I N A T I N Y N U T S H E L L + +unsustainable. The capacity to take on more debt is different early in the Big Debt Cycle when debt burdens are lower and there is more potential for debt/credit to be able to fund highly profitable endeavors than it is later in the Big Debt Cycle when debt burdens are higher, and lenders have fewer productive options. + +In that early stage, it is easy to borrow—even to borrow a lot—and pay it back. These early short-term debt cycles are primarily driven by the previously described availability and economics of borrowing and spending, and also a lingering cautiousness brought about by memories of the pain of the most recent time when money was tight.2 Early in the Big Debt Cycle, when debts and total debt service are relatively low in relation to incomes and other assets, increases and decreases in credit, spending, debt, and debt service are primarily determined by the previously described incentives with less risk. But late in the Big Debt Cycle, when debts and debt service costs get high relative to income and the value of other assets that can be used to meet one’s debt service obligations, the risks of default are higher. Also, late in the Big Debt Cycle, when there are a lot of debt assets and liabilities relative to income, the balancing act of trying to keep interest rates high enough to satisfy lender‐creditors without having them too high for borrower‐debtors becomes more challenging. That’s because one person’s debts are another’s assets and both must be satisfied. So, while short-term debt cycles end because of the previously described economic considerations, long-term debt cycles end because the debt burdens are too great to be sustained. + +Said differently, because it is more enjoyable to borrow and spend, if one isn’t careful, debt and debt service can grow like a cancer, eating up one’s buying power and squeezing out other consumption. This is what makes the long-term Big Debt Cycle. + +Throughout the millennia and across countries, what has driven the Big Debt Cycle and has created the big market and economic + +2 This cautiousness is reflected in market pricing. For example, during the early stages of the cycle, the yields and expected returns of “risky assets” are very high relative to those of “low‐risk assets.” + +--- + + +# HOW COUNTRIES GO BROKE: THE BIG CYCLE + +Problems that go along with it is the creation of unsustainably large amounts of debt assets and debt liabilities relative to the amounts of money, goods, services, and investment assets in existence. Said more simply, a debt is a promise to deliver money. A debt crisis occurs when there have been more promises made than there is money to deliver on them. When that happens, the central bank is forced to choose between a) printing a lot of money, which devalues it, and b) not printing a lot of money and having a big debt default crisis. In the end, the central bank always prints and devalues. But either way—either via default or devaluation—the creation of too much debt eventually causes debt assets (e.g., bonds) to be worth less. + +While there are variations in how each of these cases play out, the most important factor is whether the debt is denominated in a currency that the central bank can “print” and whether it is a reserve currency. But no matter the variation, we almost always see that it becomes relatively undesirable to hold the debt assets (e.g., bonds) relative to holding the productive capacity of the economy (e.g., equities) and/or owning other, more stable forms of money (e.g., gold). + +To me it is interesting and inappropriate that, when credit rating agencies rate the credit of a central government, they don’t rate the riskiness of its debt losing value. They only rate the risk of default on the debt, which gives the misimpression that all higher-rated debt is a safe storehold of value. Said differently, because a central bank can bail out a central government, the riskiness of central government debts is hidden. Creditors would be better served if the rating agencies rated the riskiness of the debt losing value through both default and devaluation. After all, these bonds are supposed to be storeholds of wealth and should be rated as such. As you will see in this study, that is how I look at bonds. For countries with debts denominated in their own currencies (i.e., in a currency they can print), I rate their central governments’ debts separately from their central banks’ debts to show how risky they are, and I rate the risks of central banks’ debts by considering the risk of the devaluation of money to be as, if not more, probable than a default on government debt. + + + +--- + + +# T H E B I G D E B T C YC L E I N A T I N Y N U T S H E L L + +Default or devaluation, I don’t care. What I care about is losing my storehold of wealth, which inevitably will happen one way or another. + +# FOLLOWING THE DEBT CYCLE’S PROGRESSION + +The main difference between a short-term debt cycle and a long-term debt cycle has to do with the central bank’s ability to turn them around. For the short-term debt cycle, its contraction phase can be reversed with a heavy dose of money and credit that brings the economy up from a depressed disinflationary state because the economy has the capacity to produce another phase of non-inflationary growth. But the long-term debt cycle’s contraction phase cannot be reversed by producing more money and credit because existing levels of debt growth and debt assets are unsustainable and holders of debt assets want to get out of them because they believe that, one way or another, they will be poor storeholds of wealth. + +Think of the Big Debt Cycle’s progression like the progression of a disease or a life cycle through stages that exhibit different symptoms. By identifying these symptoms one can identify approximately where the cycle is in its progression with some expectations of how it is likely to progress from there. Described most simply, the Big Debt Cycle moves from sound/hard money and credit to increasingly loose money and credit to a debt bust that leads to a return to sound/hard money and credit brought about by necessity. More specifically, at first there is healthy borrowing by the private sector that can be paid back; then the private sector overborrows, has losses, and has problems paying it back; then the government sector tries to help, overborrows, has losses, and has problems paying it back; then the central bank tries to help by “printing money” and buying the government debt, and has problems paying it back, which leads it to monetize a lot more debt if it can (i.e., if the debt is denominated in a currency that it can print). Though not all cases progress in exactly the same way, most cases progress through the following five stages. + + +--- + + +H O W C O U N T R I E S G O B R O K E : T H E B I G C YC L E + +# The Sound Money Stage + +When net debt levels are low, money is sound, the country is competitive, and debt growth fuels productivity growth, which creates incomes that are more than enough to pay back the debts. This leads to increases in financial wealth and confidence. + +Credit is the promise to deliver money. Unlike credit, which requires a payment of money at a later date, money settles transactions—i.e., if money is given the transaction is complete, whereas if credit is given money is owed. It’s easy to create credit. Anyone can create credit but not anyone can create money. For example, I can create credit by accepting your promise to pay me money even if you don’t have the money. As a result, credit easily grows so there is much more credit than there is money. The most effective money is both a medium of exchange and a storehold of wealth that is widely accepted around the world. At the early stage of the Big Debt Cycle, money is “hard,” which means that it is a medium of exchange that is also a storehold of wealth that can’t easily be increased in supply, such as gold, silver, and more recently Bitcoin. Cryptocurrencies like Bitcoin are now emerging as accepted hard currencies because they are widely accepted around the world and are limited in supply. The biggest, most common risk to money becoming an ineffective storehold of wealth is the risk that a lot of it will be created. Imagine having the ability to create money; who wouldn’t be tempted to do a lot of that? Those who can always are. That creates the Big Debt Cycle. In the early part of the Big Debt Cycle, a) money is typically hard and the paper money that circulates is convertible into the “hard money” at a fixed price and b) there isn’t a lot of paper money and debt (which is the promise to pay money) outstanding. The Big Debt Cycle consists of the building up of + +1 8 + + +--- + +# T H E B I G D E B T C YC L E I N A T I N Y N U T S H E L L + +a) “paper money” and debt assets/liabilities relative to b) “hard money” and real assets (e.g., goods and services) and relative to the income that is required to service the debt. Basically, the Big Debt Cycle works like a Ponzi scheme or musical chairs with investors holding an increasing amount of debt assets in the belief that they can convert them into money that will have buying power to get real things, yet as the amount of the debt assets that are held up by that faith increases relative to the real things, that conversion becomes more obviously impossible until that is realized and the process of selling the debt to get the hard money and real assets begins. + +At the early stage of the debt cycle, private and government debt and debt service ratios are 1) low relative to incomes and/or 2) low relative to liquid assets. For example, government debt and debt service are low relative to government tax revenue and/or low relative to government liquid assets (e.g., reserves and other savings such as sovereign wealth assets) that can easily be converted into money. When the Big Debt Cycle that we are in began in 1945, the ratios of US government debt and US money supply divided by the amount of gold the US government had were equal to 7x and 1.3x, respectively, whereas now these ratios are 37x and 6x, respectively. + +During this early stage in the cycle, debt levels, debt growth, economic growth, and inflation are neither too hot nor too cold and finances are sound. + +At this stage in the cycle, “risky assets” are relatively inexpensive relative to “safe” assets. That is because the memories of the prior period in which there was great damage done affects psychology and pricing. For example, in the late 1940s and early 1950s stock earnings yields were roughly 4x that of bond yields. + +During this stage, there is a healthy economy and good investment returns that lead to the next stage. + +--- + +# HOW COUNTRIES GO BROKE: THE BIG CYCLE + +# The Debt Bubble Stage + +When debt and investment growth are greater than can be serviced from the incomes being produced. + +- In this stage, money is readily available and cheap, and there is a debt-financed economic expansion and an economic boom. Demands for and prices of goods, services, and investment assets are driven up by a lot of debt-financed buying, sentiment is very bullish, and by most conventional measures, the market is overpriced. +- In this stage, there are typically amazing new inventions that are truly transformative that investors invest in without an ability or care to assess whether the present value of their future cash flows will be greater or less than their costs. +- There is always a current most popular meme that just about everyone believes. It is reflected in the price and is bound to be wrong in some way. These memes typically are due to a mix of extrapolating what happened before and emotional considerations. Also, most investors typically don't take into consideration market pricing. In other words, they tend to identify what has been a great investment (e.g., a strongly performing company) as great, and they don't pay enough attention to its pricing, even though its pricing (whether it is cheap or expensive) is the most important thing. At this time, it is typical for almost everyone to be looking to make money by buying assets that they believe will go up (rather betting on them going down), and they quite often use leverage. +- This dynamic eventually produces a bubble that is reflected in the rates of debt and debt service growth to finance speculation being greater than the income growth rates that are needed to service the debts. In this stage, markets and economies seem great, most everyone believes that they will get better, they are financed by a lot of borrowing, and “wealth” is created out of nothing. By wealth being created out of nothing, I mean that there is greater imagined wealth versus actual. + +--- + + +# T H E B I G D E B T C Y C L E I N A T I N Y N U T S H E L L + +existing wealth. For example, bubble periods are identifiable by extensive periods of debt growth (e.g., three years) that is significantly faster than income growth, high asset prices relative to traditional measures of the present values of likely future cash flows, and many other factors that I measure in my bubble indicator. (You can find an article describing the indicator at economicprinciples.org and in the Principles In Action app.) A contemporary example is the unicorn company that is valued at over $1 billion that has made the owner a “billionaire” on paper but has only raised $50 million in capital because speculative venture capitalists put in the money to get option-like chips in case it does well. Bubbles can go on for a while before the top is made, but they inevitably lead to the next stage. + +Then there comes a time when the debt spiral reaches and goes beyond the point of no return, by which I mean the debt and debt service levels go beyond those that can be prevented from accelerating without great losses to debt investors. This self-reinforcing debt “death spiral” occurs when there is a need to borrow in order to service the debt at a time when interest rates are rising because the risks of holding the debt/currency have become apparent to investors, which leads to a debt crisis. + +# The Top Stage + +When the bubble pops and there is a debt/credit/market/economic contraction. + +The popping of the bubble typically occurs due to a combination of a tightening of money and the prior rate of debt growth being unsustainable. It is just that simple. + +When the bubble pops, a self-reinforcing contraction begins so the debt problems spread very quickly, like an aggressive cancer, so it is very important for policy makers to deal with + +2 1 + + + +--- + +# HOW COUNTRIES GO BROKE: THE BIG CYCLE + +it quickly, either to reverse it or to guide the deleveraging to its conclusion. In most cases, the debt contraction can be temporarily reversed by giving the system a heavy dose of what caused the debt problem—i.e., by creating more credit and debt. That continues until it can’t continue anymore, at which time a big deleveraging occurs. + +# The Deleveraging Stage + +When there is a painful bringing down of debt and debt service levels to be in line with income levels so that the debt levels are sustainable. + +- At the beginning of the last stage of the Big Debt Cycle when there is a big debt crisis, debt problems typically spread from the private sector to the central government and then to the central bank. +- Net selling of debt assets, especially net selling of government debt assets, is a big red flag. When that happens, conditions deteriorate quickly unless managed very well and very quickly by central governments and central banks. +- At that time, private holders of debt sell the debt fearing bad returns. That selling takes the form of “runs on banks.” By “runs on banks,” I mean the turning-in of debt assets to get real money, which lenders/banks don’t have enough of. +- When debt problems become apparent and the holders of the debt assets sell their debt assets, that initially drives interest rates on the debt up. This makes the debt more difficult to service, hence more risky, which drives interest rates higher. +- At that point, the central bank typically provides money and credit to fill in for the inadequate demand, which reduces the value of money and credit and reduces credit risk. +- The selling of the government’s debt leads to a) a free-market-driven tightening of money and credit, which leads to b) a weakening of the economy, c) downward pressure on the + +--- + + +# T H E B I G D E B T C Y C L E I N A T I N Y N U T S H E L L + +currency, and d) declining reserves as the central bank attempts to defend the currency. Classically, these runs accelerate and feed on themselves as holders of debt assets see that, one way or another (through default or through the devaluation of their money), they will lose the buying power that they had believed was stored in these debt assets, causing great shifts in market values and wealth until debts are defaulted on, restructured, and/or monetized. Because this tightening proves too harmful for the economy, the central bank eventually simultaneously eases credit and allows a devaluation of the currency. The devaluation of money can itself be the reason to sell the debt asset because it becomes a poor storehold of wealth. So, whether there is a tightening of money that leads to debt defaults and a bad economy or an easing of money that produces a devaluation of money and debt assets, it is not good for the debt asset. This dynamic creates what is called a debt “death spiral” because it is a self-reinforcing, debt-contraction dynamic in which the rising interest rates cause problems that creditors see, leading them to sell the debt assets, which leads to even higher interest rates or the need to print more money, which devalues the money and leads to even more selling of the debt assets and the currency and so on until the spiral runs its course. When this happens to government debt, the realization that too much debt is the problem naturally leads to the inclination to cut spending and borrowing. However, because one person’s spending is another person’s income, cutting spending at such times typically only contributes to increases in debt-to-income ratios. That is typically when policies are shifted to a mix of debt restructurings and debt monetizations, with the mix chosen primarily dependent on how much of the debt is denominated in the country’s currency. This defaulting on, restructuring of, and/or monetizing of debt reduces the debt burdens relative to incomes until a new equilibrium is reached. The movement to a stable equilibrium typically takes place via a few painful adjustment + +2 3 + + + +--- + +# HOW COUNTRIES GO BROKE: THE BIG CYCLE + +spasms because borderline financial soundness is achieved before secure financial soundness. + +Classically, the deleveraging process progresses as follows. Early in this recession/depression phase, central banks bring interest rates down and make credit more available. However, when a) debts are large and a debt contraction is underway, b) interest rates can’t be lowered any more (e.g., when they fall to around 0%), c) there is not enough demand for government debt, and d) the monetary easing is not enough to offset the self-reinforcing depressionary pressures, the central bank is forced to switch to new “tools” to stimulate the economy. Classically, to stimulate the economy the central bank must lower interest rates to below nominal economic growth rates, inflation rates, and bond rates, but that is difficult to do when they approach 0%. At the same time, the central government is typically getting itself into a lot more debt because tax revenues are down and spending is up to support the private sector, yet there is not enough private sector demand to buy that debt. The central government experiences a debt squeeze in which the free-market demand for its debt falls short of the supply of it. If there is net selling of the debt, that creates a much worse problem. + +Often in this deleveraging stage of the cycle, there is a “pushing on a string,” a phrase coined by policy makers in the 1930s. It occurs late in the long-term debt cycle when central bankers struggle to convert their stimulative policies into increased spending because savers, investors, and businesses fear borrowing and spending and/or there is deflation, so the risk-free interest rate that they are getting is relatively attractive to them. At such times, it is difficult to get people to stop saving in “cash”3 even when interest rates go to 0% (or even below 0%). This phase is characterized by the economy entering a deflationary, weak, or negative growth period as people and investors hoard. + +Cash is defined as investor holdings of money earning interest. + +--- + +# T H E B I G D E B T C Y C L E I N A T I N Y N U T S H E L L + +low‐risk, typically government‐guaranteed cash. + +At this stage, central banks must choose between keeping money “hard,” which will lead debtors to default on their debts, which will lead to deXationary depressions, or making money “soft” by printing a lot of it, which will devalue both it and the debt. Because paying oV debt with hard money causes such severe market and economic downturns, when faced with this choice central banks always eventually choose to print and devalue money. Of course, each country’s central bank can only print that country’s money, which brings me to my next big point. + +At this stage, if it has the ability to “print money,” the central bank creates a substantial amount of money and credit and throws it aggressively at the markets. It typically buys government debt and private sector debt of systemically important entities that are at risk of defaulting (in order to make up for the private sector’s inadequate demand for debt and to keep interest rates artiWcially low), and it sometimes buys equities and creates incentives for people to buy goods, services, and Wnancial assets. At this stage, it is also typically desirable to devalue the currency because that is stimulative to the economy and raises inXation rates, thus negating the deXationary pressures. If the currency is linked to gold, silver, or something else, that link is typically bro‐ken and there is a move to a Wat monetary system. If the currency isn’t linked̶i.e., if the currency is already a Wat currency̶devaluing it relative to other storeholds of wealth and other currencies is helpful. In some cases, the central bank’s moves can drive nominal interest rates higher, either because the central bank tightens monetary policy to Wght inXation or because it doesn’t tighten money to Wght inXation and holders of the debt don’t want to buy the newly issued government debt and/or they want to sell it because it doesn’t provide an adequate return. It is important to watch real and nominal interest rates and the supply and demand for debt to understand what is happening. + +At such times, extraordinary policies to get money like + +--- + + +# HOW COUNTRIES GO BROKE: THE BIG CYCLE + +Imposing extraordinary taxes and capital controls become common. It has also often been the case that governments will adopt policies that would have previously seemed unimaginable, such as selectively freezing or seizing the assets of “enemy” countries or creating new forms of money. Note that I am not saying that these extraordinary measures always happen; I’m only saying that it is wise to carefully consider the possibility that they will happen. + +This deleveraging stage is typically a painful time when debt burdens are reduced by defaults, restructurings, and/or devaluations. This is when an aggressive mix of debt restructurings and debt monetizations inevitably takes place to reduce the debt and debt service burdens relative to incomes. In a typical deleveraging, the debt-to-income ratio has to be lowered by roughly 50%, give or take about 20%. It can be done well or poorly. When it is done well, which I call a “beautiful deleveraging,” central governments and central banks simultaneously do both debt restructurings and monetary stimulations in a balanced way. The restructurings reduce debt burdens and are deflationary, while the monetary stimulations also reduce debt burdens (by providing money and credit to make it easier to buy debt) but are inflationary and stimulative to the economy so, if they get the balance right, positive growth occurs with falling debt burdens and acceptable inflation. Whether done well or poorly, this is the stage of the Big Debt Cycle that reduces a lot of the debt burden and establishes the bottom that can be built on to begin the next Big Debt Cycle. + +# The Big Debt Crisis Recedes + +When a new equilibrium is reached, and a new cycle begins. + +In order to have a viable debt/credit/money system, it is + + + +--- + +# T H E B I G D E B T C Y C L E I N A T I N Y N U T S H E L L + +It is imperative that a) debt/money is sound enough to be a viable storehold of wealth, b) debt and debt service burdens are in line with the incomes to service them so that debt growth is sustainable, c) creditors and debtors both believe that those things will exist, and d) the availability of money and credit and real interest rates begin to fall in line with that which is needed by both lender-creditors and borrower-debtors. There is movement toward these things happening in the late phase of the Big Debt Cycle. It requires both psychological and fundamental adjustments. After a big deleveraging, it is typically difficult to convince lender-creditors to lend because the devaluations/restructurings they experienced in the deleveraging make them risk-averse, so it is imperative that the central government and the central bank take credibility-restoring actions. These generally involve bringing their finances in order by a) the central government earning more money than it spends and/or b) the central bank making money hard again by offering high real yields, raising reserves, and/or linking the currency to something hard like gold or a strong currency. Typically, in this stage, interest rates need to be relatively high in relation to inflation rates and more than high enough to compensate for currency weakness, so it pays to be a lender and is costly to be a borrower. This stage of the cycle can be very attractive for lender-creditors. + +The stage that the Big Debt Cycle is in is also reflected in the types of monetary policies being used. As the Big Debt Cycle progresses, central banks have to change how they run monetary policy in order to keep the debt/credit/economic expansion going, so by observing what type of monetary policy they are using, one can surmise what stage the Big Debt Cycle is in. The phases in monetary policy + +--- + + +# HOW COUNTRIES GO BROKE: THE BIG CYCLE + +and the conditions that lead to them are as follows:⁴ + +# Phase 1: A Linked (i.e., Hard) Monetary System (MP0) + +This is the type of monetary policy that existed from 1945 until 1971. This type of monetary policy ends when the debt bubble bursts, and there is the previously described “run on the bank” dynamic, which is a run from credit assets to the hard money, and the limited amount of hard money causes massive defaults. This creates a compelling desire to print money rather than leave the supply of it limited by the supply of the gold or hard money that exists to be exchanged at the promised price. + +# Phase 2: A Fiat Money, Interest-Rate-Driven Monetary Policy (MP1) + +During this phase, interest rates, bank reserves, and capital requirements are also controllers of the amounts of debt/credit growth. This monetary policy phase both allows more flexibility and provides less assurance that money printing won’t be so large that it will devalue money and debt assets. The US was in this phase from 1971 until 2008. It ends when interest rate changes no longer work (e.g., interest rates hit 0% and there is a need to ease monetary policy) and/or the private market demand for the debt being created falls short of the supply being sold so that, if the central bank did not print the money and buy the debt, money and credit would be tighter and interest rates would be higher than desired. + +# Phase 3: A Fiat Monetary System with Debt Monetization (MP2) + +This type of monetary policy is implemented by the central bank using its ability to create money and credit to buy + +⁴ This explanation of the phases differs slightly from how I have described them in my earlier writings, with the main difference being that I have added a designation for linked (i.e., hard money) currency systems, which I had previously lumped in with those governed by interest rate changes. Because I think it is important to draw a distinction between linked and fiat systems, in this book, linked/hard money systems will be known as MP0 and the numbering of the other monetary policies will remain the same as in my other writings. + +2 8 + + + +--- + + +# T H E B I G D E B T C YC L E I N A T I N Y N U T S H E L L + +investment assets. It is the go‐to alternative when interest rates can no longer be lowered and when private market demand for debt assets (mostly bonds and mortgages, though it can also include other financial assets like equities) is not large enough to buy the supply at an acceptable interest rate. It is good for financial asset prices, so it tends to disproportionately benefit those who have financial assets. It doesn’t effectively deliver money into the hands of those who are most stressed financially, and it isn’t very targeted. The US was in this phase from 2008 until 2020. + +# Phase 4: A Fiat Monetary System with a Coordinated Big Fiscal Deficit and Big Debt Monetization Policy (MP3) + +This type of monetary policy is used when, in order to make the system work well, central government fiscal policy and central bank monetary policy have to be coordinated in order to get money and credit into the hands of the people and entities that need it most. While creating money and credit typically temporarily alleviates the debt problem, it does not rectify the problem. + +# Phase 5: A Big Deleveraging + +This is when there must be a big reduction in debt and debt service payments through a debt restructuring and/or a debt monetization. When managed in the best possible way̶what I call a beautiful deleveraging̶the deflationary ways of reducing debt burdens (e.g., through debt restructurings) are balanced with the inflationary ways of reducing debt burdens (e.g., by monetizing them), so that the deleveraging occurs without having unacceptable amounts of either deflation or inflation. The Big Debt Cycle sequence to keep in mind is: first the private sector overborrows, has losses, and has problems paying it back (i.e., a debt crisis); then, to help out, the government overborrows, has losses, and has problems paying it back; then, to help out, the central bank buys the government debt and takes losses. To fund those purchases and to fund other debtors. + +2 9 + + + +--- + +# HOW COUNTRIES GO BROKE: THE BIG CYCLE + +In trouble (because it is the “lender of last resort”), the central bank prints a lot of money and buys a lot of debt. Then, at its worst, the central bank loses a lot of money on the debt it bought. + +While it is said that a modern central bank “prints” money to buy the debt, the central bank doesn’t literally “print money.” Instead, it borrows money (reserves) from commercial banks that it pays a very short-term interest rate on. At this dynamic’s most extreme, the central bank can lose money because the interest earnings it gets on the debt it bought are less than the interest that it has to pay out on the money it borrowed. When these amounts become large it can find itself in a self-reinforcing spiral of having to buy debt, which leads it to have losses and negative cash flows, which leads it to need to print more money to service its debt and to need to buy more debt, which ends up having more losses, which requires it to do more of the same. This is the death spiral I mentioned earlier. When done in large amounts, the “printing” devalues the money and creates inflationary recessions or depressions. If interest rates rise, the central bank loses money on its bond holdings because the interest rate that it has to pay on its liabilities is greater than the interest rate that it receives on the debt assets it bought. This is notable but not a big red flag until the central bank has a very large negative net worth and is forced to “print” more money to cover the negative cash flow that it experiences due to less money coming in on its assets than has to go out to service its liabilities. That is what I mean when I say the central bank goes broke: while the central bank doesn’t default on its debts, it can’t make its debt service payments without printing money. + +Eventually the debt restructurings and debt monetizations reduce the size of the debts relative to incomes and the debt cycle runs its course. + +--- + +# T H E B I G D E B T C YC L E I N A T I N Y N U T S H E L L + +# Phase 6: The Return to Hard Money + +In this phase, the central government takes actions to restore the soundness of its money and debt/credit. This type of monetary policy occurs after the debt has been written down through debt defaults/restructurings and debt monetizations so the debt levels relative to the incomes and amounts of money that are available to service the debts can be brought back into alignment. As previously described, it comes after those who held the debt assets were burned by the defaults and/or inflationary periods, so confidence in holding debt assets has to be rebuilt. At this stage, countries typically go back to MP0 (i.e., a hard-asset-backed monetary policy) or MP1 (an interest rate/money-supply-targeted monetary policy) that is beneficial to lender-creditors via high real interest rates. + +For great countries with great empires, the end of the Big Debt Cycle has typically meant the end of their prominence. + +# A FEW CONCLUDING OBSERVATIONS + +Big debt crises are inevitable. Throughout history only a very few well-disciplined countries have avoided them. They are inevitable because lending is never done perfectly relative to the incomes that are needed to service it. And it is often done badly because people always want more credit and that turns into debt. Debt levels get beyond that which is sustainable, which leads to the need to bring the debt burdens down, which typically leads to a mixture of debt defaults/restructurings and the creating of money and credit, causing a debt crisis to occur. And people’s psychology reinforces the cycle: the bubble period makes people more optimistic, causing them to borrow more, and the bust causes people to be more pessimistic, causing them to cut spending. Even though this progression has happened many times in history, most policy makers and investors think their current. + + + +--- + +HOW COUNTRIES GO BROKE: THE BIG CYCLE + +circumstances and monetary system won’t change. The change is unthinkable—and then it happens suddenly. + +It pays to build up savings in the good times so there are savings to draw on in the bad times. There are costs to having too much savings as well as too little savings, and no one gets the balance exactly right. + +The best way to anticipate a debt crisis happening is not by focusing on a single influence or number like debt as a percent of GDP; it is by understanding and focusing on a number of interrelated dynamics. We will get into, especially in the next two chapters. + +If debts are denominated in a country’s own currency, its central bank can and will “print” the money to alleviate the debt crisis. This allows the central bank to manage the crisis better than if the central bank can’t print the money, but of course it also reduces the value of the money. If the debt is not denominated in a currency that the central bank can print, then it will have debt defaults and deflationary depressions measured in the currency that it owes and can’t print. + +All debt crises, even big ones, can be managed well by economic policymakers restructuring and monetizing the debt so that the deflationary ways of reducing the debt burdens (i.e., writing off and restructuring debt) and the inflationary ways of reducing debt burdens (i.e., creating money and credit and giving it to the debtors to make it easier for them to service their debts) balance each other. The key is to spread the paying back over time. For example, if the debt-to-income ratio needs to fall by about 50% to make it sustainable, a debt restructuring that spreads it out at a rate of 3% or 4% per year would be much less traumatic than one that is about 50% in one year. + +Debt crises provide great risks and opportunities that have been shown to both destroy empires and provide great investment. + + + +--- + +# T H E B I G D E B T C Y C L E I N A T I N Y N U T S H E L L + +opportunities for investors if they understand how they work and have good principles for navigating them well. + +If you try to focus on debt cycles precisely or focus your attention on the short term you won’t see them. It’s like comparing two snowflakes and missing that they are pretty much the same because they’re not exactly the same. + +That’s it in a nutshell. + +In the rest of this study, I will get into the mechanics in greater depth, show the actual sequences that have played out over 35 cases, look at how the Big Debt Cycle and Overall Big Cycle that includes the other big cycles (for instance, cycles of internal and external order) that started in 1945 and that we are currently in the late stages of have transpired relative to this template, and briefly look at the Chinese and Japanese Big Cycles and a number of other cases. The Japanese case is interesting because Japan is further along in its Big Debt Cycle. Notably, its large debt and debt monetizations have led to the depreciation of its currency and debt, which has led holders of its bonds to have losses of 45% relative to holding US dollar debt since 2013 and losses of 60% relative to holding gold since 2013. In the final chapters, I will share how I am processing the US relative to this template, how the US could reduce the risk of an acute debt crisis, and how I see the rough outline of future events unfolding. + +--- + + +# CHAPTER 2 + +# THE MECHANICS IN WORDS AND CONCEPTS + +This chapter is about how the market and the economy work. It provides some unconventional concepts about the mechanics that have helped me a lot and that I believe would be valuable for professionals and aspiring professionals but may be beyond the interests of others. If you don’t have much interest in the mechanics, I suggest just reading the bold material, and if that becomes too much, skipping the rest of this chapter and going to the next one. + +Because everything that happens has reasons that make it happen, it appears to me that everything changes like a perpetual motion machine. To understand this machine, one needs to understand its mechanics, and because everything affects everything else, these mechanics are very complex. + +As a result of breakthroughs in artificial intelligence, I believe that we are on the brink of almost understanding it all, but for now we have to labor along the old-fashioned way, with people studying what happened using contemporary computers to aid them. That’s how I created this description of the mechanics of the debt/credit/money/economic dynamic, which is, of course, only one big part of the greater dynamic. In my feeble attempts to understand and describe the most important mechanics that change the world as we know it, I do these + +--- + +# HOW COUNTRIES GO BROKE: THE BIG CYCLE + +In-depth studies and then try to create more simplified explanations of them. Keep in mind that this is a very simplified picture. + +At the highest level, the five most important drivers of change that are important to understand are: + +- The debt/credit/money/economic cycle +- The internal political order/disorder cycle +- The external geopolitical order/disorder cycle +- Acts of nature (droughts, floods, and pandemics) +- Human inventiveness, most importantly of new technologies + +These are the biggest forces that affect each other to shape the biggest things that happen. I will go into these forces in more detail in Chapter 8, but if you want to understand what I learned from experiencing and studying them in a more complete way than I can cover here, you can read about them in my book Principles for Dealing with the Changing World Order. + +In this study, we are going to examine the first of those—the debt/credit/money/economic dynamic—focusing most intensely on the late part of the long-term debt cycle when central governments and central banks “go broke.” I will start by walking you through some mechanics of how market prices are determined and then look at how the long-term debt cycle works. With that as a background, I will turn to the archetypical sequence that leads to a country hitting the limits of debt and money and central governments and central banks going broke. At the same time, we will explore the other four forces because the interactions of these five forces cannot be overlooked in observing the resulting Overall Big Cycle. From what I can see, we are likely entering the very turbulent stage in the Overall Big Cycle driven by the interactions of these five big forces, and the resulting changes in the world order will be big. I hope this study can... + +For example, in my book Principles for Dealing with the Changing World Order, I looked at and measured at the most important cause/effect relationships that changed the world over the last 500 years and simplified my description of how I see them to consist of the five big forces. + +--- + +# T H E M E C H A N I C S I N W O R D S A N D C O N C E P T S + +contribute to a better understanding of the dynamics and better decision making to produce the best outcomes possible. + +# HOW THE MACHINE WORKS + +To me, money and credit are the lifeblood of the economy. They circulate nutrients (i.e., spending power) from the parts of the system that have excess amounts of the power to the parts of the system that can best use it. The central government is like the brain that directs how the system works while also taking in and using some of the money and credit (typically about 15-30% of it)6 to perform its functions (e.g., providing for social programs, defense, etc.). The central bank is like the heart that produces and pumps money and credit through the system. If the exchanges go well, and those who get capital use it productively, then the providers of capital, the users of it, and the economic system as a whole all prosper. If they don’t, the system will become ill and experience trauma. + +To be clear, viewing the debt dynamic as a cyclical, perpetual motion machine working in essentially the same way through time and across countries doesn’t mean that there are not changes over time and differences between countries. It’s just that these changes are comparatively unimportant in relation to the timeless and universal mechanics and principles that are far less well understood than they should be. To me, it’s invaluable to first see these timeless and universal principles of how the machine works and then focus on the differences and what they are due to because this approach provides a richer understanding of the cause/effect relationships. For that reason, I will start with these most important timeless and universal mechanics and principles. To convey them in brief, I will explain just the major ones in a big-picture, simplified way rather than a detailed and precise way. In this big-picture, + +Typically, 35-55% of all spending in developed countries comes from government spending (if you include state and local governments). + + + +--- + + +# HOW COUNTRIES GO BROKE: THE BIG CYCLE + +# THE FIVE MAJOR PARTS AND HOW THEY WORK + +There are five major parts of the economic system that make up my simplified model of the machine. They are: + +- Goods, services, and investment assets +- Money used to buy these things +- Credit issued to buy these things +- Debt liabilities that are created when purchases are made with credit +- Debt assets (e.g., deposits and bonds), which, since one person’s liabilities are another’s assets, are the other side of the debt liabilities + +If you can understand the transactions that occur as being made up of these five major parts, you can pretty much understand why there are big debt and economic cycles. To start, I will walk through how I think about transactions and some other important baseline mechanics. + +As mentioned, goods, services, and investment assets can be bought with either money or credit. Money, unlike credit, settles transactions. For example, if you buy a car with money, after the transaction, you and the seller are both done. What constitutes money has changed throughout history and across currencies. For long periods of history, money was a promise to deliver a certain amount of gold or other hard asset. In what monetary systems, which we’ve been in since the US left the gold standard in 1971, money is what central banks print and is more like a form of credit in that it is a promise to deliver buying power, not an actual hard asset. But money is different from credit as, at this time, it can + + + +--- + + +# T H E M E C H A N I C S I N W O R D S A N D C O N C E P T S + +only be created by central banks and can be created in whatever amounts the central banks choose. Credit, unlike money, leaves a lingering obligation to pay, and it can be created by mutual agreement of any willing parties. Credit produces buying power that didn’t exist before, without necessarily creating money. It allows borrowers to spend more than they earn, which pushes up the demand and prices for what is being bought over the near term while creating debt that, over the longer term, requires the borrowers, who are now debtors, to spend less than they earn as they pay back their debts. This reduces demand and prices in the future, which contributes to the cyclicality of the system. Because debt is the promise to deliver money and central banks determine the amount of money in existence, central banks have a lot of power. Though not exactly proportional, the more money in existence, the more credit and spending there can be; the less money in existence, the less credit and spending there can be. + +Now let’s look at how prices are set. My approach to supply, demand, and price determination is different from the conventional approach in some simple but important ways that have proven invaluable to me. + +To explain my approach to understanding prices, I start with the most basic building blocks for understanding all markets and economies, which are transactions, and then build up to the price, and I don’t define supply and demand the way conventional economists do. To me, all markets and all economies are simply the aggregates of the transactions that make them up, and a transaction is simply the buyer giving money (or credit) to a seller and the seller giving a good, a service, or a financial asset to the buyer in exchange. The price equals the amount of money/credit the buyer gives divided by the quantity of whatever the seller gives in that transaction, and a market is the aggregate of those transactions. For example, a transaction to buy wheat occurs when a buyer gives a certain amount of money for a specified quantity of wheat. + +7 Bitcoin is an example of an attempt to create a private version of money using blockchain, a distributed ledger technology. + +3 9 + + + +--- + +# HOW COUNTRIES GO BROKE: THE BIG CYCLE + +money to a seller in exchange for a certain quantity of wheat, and a market consists of all the buyers and sellers making exchanges for the same things—i.e., the wheat market consists of different people making different transactions for different reasons over time—and these many exchanges are what determine the price. So... + +ⓢ Price (P) = the amount spent on something ($)/the total quantity of it that is sold (Q) + +Or, more simply + +ⓢ P = $/Q + +In other words, ⓢ since the price of any good, service, or financial asset equals the total amount spent by buyers ($) divided by the total quantity sold by sellers (Q), if you know the total spending (total $) and you know the total quantity sold (total Q), you will know the price and everything else you need to know. + +That is indisputably how it is, so it is indisputable that the best way to estimate the price is to estimate the total spending and divide it by the total quantity sold. That is why I estimate these two numbers—the total amount spent and the total quantity sold—to estimate the price. What is the best way to estimate these things? It is to understand the motivations of the buyers and sellers, most importantly the big ones. This approach is invaluable to understanding what is going on with prices and to making money in the markets. All buyers have their own reasons for spending the amount of money they are spending to get the quantity they are buying, and all sellers have their own reasons for selling the quantity they are selling to get the money they’re getting. What I’m saying is conveyed in the conceptual diagram that follows. + +--- + + +# T H E M E C H A N I C S I N W O R D S A N D C O N C E P T S + +| | | PRICE = TOTAL $ / TOTAL Q | | | | | +| -------- | -------- | ------------------------- | -------- | -------- | -------- | -------- | +| Reason A | Buyer 1 | Money | Seller 1 | Reason B | | | +| Reason C | | | | | | | +| Reason A | Buyer 2 | Money | Total | Total | Seller 2 | Reason A | +| Reason B | Credit | $ | Q | | Reason B | | +| Reason C | Money | | | | Reason C | | +| Reason A | Credit | | | | Reason A | | +| Reason B | etc. . . | etc. . . | | | Reason B | | +| Reason C | | | | | Reason C | | + +While this might look and sound complicated, it’s really not. For each product, the buyers and sellers have their reasons for making those purchases and sales, and it’s pretty easy to determine who the main buyers and sellers are and what motivates them. If you can figure out major buyers’ reasons for spending and the major sellers’ reasons for selling, you can pretty accurately predict their actions, and thus the price. + +This way of looking at price determination is very different from how most economists look at it, and it has proven uniquely helpful. The traditional way measures both demand and supply in terms of quantity (i.e., quantity bought and quantity sold), whereas my approach looks at amount spent to buy instead of quantity bought. This leads to different ways of explaining why prices change. The conventional approach describes price changes as occurring because the quantity demanded and/or the quantity supplied changes. How these changes occur is called price elasticity. The conventional way of looking at the market implies that there is one price elasticity across time and that a change in supply will always have the same effect on price. This is obviously not true. + +If you instead look at it my way, you will see that the conventional approach doesn’t make sense because it assumes that a change in supply will always have the same effect on price (i.e., + + + +--- + + +# HOW COUNTRIES GO BROKE: THE BIG CYCLE + +elasticity), which isn’t true. You will see supply, demand, and price determination in a very different and better way. You will see who the important market participants are and what they are doing and why, and you will be able to connect the market movements to their actions to get a very real understanding of why prices are what they are, why prices change, and what these market participants and the markets are likely to do if certain things happen. You will see why more or less money is spent on an item and more or less quantity is sold and how price movements are explicable for numerous reasons that previously escaped your attention and are escaping most others’ attention. By seeing that prices change because of the total amount spent and the total quantity sold and by working hard to estimate these two numbers, you will be able to make pretty good estimates of price. You will also see that prices change not because of a return to some equilibrium level as most people believe. + +If you pursue this approach, you will see that nowadays, with so much great data and computer power available, you will be able to watch this price determination model move with the price practically in real time, and that is fascinating to watch. I discovered this approach when I estimated livestock, grain, and oilseed and oilseed product prices back in the 1970s and found that it worked for all kinds of asset prices, including financial asset prices, so I have been pursuing and benefiting from it for a long time. I now use this approach to model entire economies, not just how specific markets work, but that’s a subject for another time. + +As for the debt dynamic, an example of how this transaction-based approach has been valuably different from conventional economic thinking is that most people mistakenly think that debt busts and depressions are primarily psychological and that if confidence is built the debt bust and the depression won’t happen, and they overlook the mechanics behind them. I ran into this issue with policy makers prior to both the 2008 debt crisis in the US and the 2010-12 debt crisis in Europe, and I am running into it again now. In the two prior cases, I showed policy makers why the rate of change in buying debt would + + + +--- + +# T H E M E C H A N I C S I N W O R D S A N D C O N C E P T S + +inevitably slow because the buying was being financed by financial institutions (most importantly banks) leveraging up their balance sheets and that would have to slow as they reached their regulatory leverage limits, so the pace of buying would slow at the same time as the supply of debt to be sold was projected to increase, so with less buying and more selling we were headed for a crisis. Until that actually happened, they assured me that they would give the markets confidence so that the buyers would keep buying, so everything would be fine, and refused to look at the supply-and-demand calculations. This is the sort of thinking that is now most popular. For example, I hear policy makers say that if we get control of the budget deficits in out-years investors will see the new calculations and have confidence and the bond market will be fine. That’s naïve because it fails to look at the motivations of the bond buyers to calculate who will buy and sell what amounts of bonds in the way I described. + +If you play with the previously shown formula/model a bit, you will see that prices change when there are changes in the rates of spending and/or quantities sold. For example, if the rate of buying goes from (X) to (X minus 10%), and all else stays the same, the price will fall by 10%. So by identifying rates of unsustainable buying and/or rates of unsustainable selling you can identify unsustainable prices and unsustainable economic conditions. You can also calculate what a return to a more normal level of buying/selling would look like and you can calculate the approximate price change that is needed and likely. I have made a lot of money and have reduced a lot of risk by doing that. + +There are a number of other implications for how this different approach leads to unique perspectives on how economies and markets really work. For example, it shows how these debt/credit/money/market/economic cycles are driven more by the creation of money and credit that leads to changes in spending ($) than by the changes in the quantity sold (Q), and it makes clear that most goods, services, and investment assets are produced to satisfy demand (i.e., in response to increased [$]). One can also see very clearly that: + +--- + +# HOW COUNTRIES GO BROKE: THE BIG CYCLE + +ⓢ When a) more money and credit are created (so there is more spending) and b) producers have the capacity to produce more quantity, then c) there can be more non-inflationary growth because both spending ($) and the quantity sold (Q) increase. + +Whereas + +ⓢ When a) more money and credit are created (so there is more spending), but b) there is little or no capacity so producers can’t produce much more, then c) there is little real growth and a lot more inflation. + +These principles explain why the early stage of the cycle (when there is plenty of excess capacity and central banks are stimulative) is characterized by strong growth and little inflation and the late stage of the cycle typically has weak growth and big price rises. That is what cyclical inflation and growth look like. Later in this study, we will go through this in more detail and explore what monetary inflations and inflationary depressions look like. + +How does productivity fit into this discussion? If productivity growth is high, producers can produce more quantity (Q) as more money and credit are produced, so it allows non-inflationary growth to continue for longer. Of course, productivity can be hard to measure directly, as productivity can also show up as products improving in quality, or the marginal cost of producing something falling all the way to zero (e.g., as has happened for producing photos and electronic books). + +Now let’s look more closely at the reasons buyers spend and sellers sell the quantities they sell. Instead of doing that for all the individual items, I will look at the big categories to convey the principles that affect them all. + +ⓢ People buy goods and services to use and buy investments to make money (i.e., as storeholds of wealth). How much they spend + +--- + + +# T H E M E C H A N I C S I N W O R D S A N D C O N C E P T S + +on goods and services versus investments depends on what the goods and services they want to use cost relative to the amount of money and credit they have to spend, and the relative appeal of spending on goods and services compared to that of spending on financial assets. And of course, they have their own reasons for choosing which goods and services and which financial assets they buy. If you understand these things, you will truly understand the markets. + +ⓢ What people choose to spend their money and credit on is based on the relative appeal of the items. People are constantly making comparisons in two dimensions: 1) one item for another (e.g., stocks versus bonds, beef versus chicken, one currency versus another versus gold) and 2) the same item for delivery at different points in time (e.g., a commodity or a currency for delivery today versus for delivery a year in the future) based on their preferences. As a result, there is an enormous array of relative-appeal assessments and arbitrages to be made. Arbitrages and relatively sure bets are the most powerful types of bets in determining relative pricing. It pays for you to understand them. + +ⓢ Currencies are mediums of exchange and storeholds of wealth (in debt assets). In other words, they facilitate both transactions and investing. + +ⓢ Investments are exchanges of money and credit today for money and credit in the future. + +ⓢ All investment markets derive their value by providing money in two ways: through their yields and through their price changes. Together they make the total return. So, for all investments, total return = yield + price change. + +ⓢ By and large, all investment markets compete with each other on the basis of the total returns they provide. That is because a) most + +4 5 + + + +--- + + +# HOW COUNTRIES GOBROKE: THE BIG CYCLE + +Investors care more about the total returns they get than they care about whether it comes in the form of yield or price appreciation. There is an ability to arbitrage investments based on their total returns. To show how that works, let’s look at how investing in bonds would be compared with investing in gold to determine the price relationship. + +Because gold has no yield and a US Treasury bond has a yield of X% (e.g., 5%), it would be illogical for anyone to buy gold unless the price is expected to go up by more than X% per year (e.g., 5% per year). Said differently, the market is priced for the gold price to rise by 5% relative to the price of Treasuries. Investors form their views about what will determine the price of gold (e.g., one big factor is the amount of inflation based on the amount of money and credit that is produced), and they look at the relative attractiveness of the 5% yield that the bonds are offering and the extent to which the gold price would appreciate due to the depreciation in the value of money. If they think that gold will rise by less than 5%, they can buy bonds and sell gold, and if they think gold will go up more than 5%, they can do the reverse. In either case, they’ll make money if they’re right. + +On top of this simple price analysis, there is a lot of financial engineering (e.g., leveraging and hedging) that turns one thing into the equivalent of another to make relative-value bets and arbitrages that create a whole matrix of market prices. An enormous amount of money is allocated in this way, and it would be easy to make a lot of money if the choices between options were easy. But because we know it’s not easy to make money in the markets, we can assume that the markets do a pretty good job of making these estimates and pricing assets correctly. At the same time, because I and others who have been successful at investing couldn’t have. + +1. While it’s by and large true that all investments compete on a total return basis, it’s not totally true because different investors have different objectives and considerations, so that at some times these different objectives and the differences in the supplies of investments to meet demands can lead to some investments having more attractive returns than others. However, because there is a profit to be made by shorting the asset that has the lower risk-adjusted return to fund the one that has the higher risk-adjusted return, there is a strong tendency for these differences to shrink to be rather small. +2. I can make money by buying an investment that has a higher total return while selling an investment that has a lower total return. + + + +--- + +# T H E M E C H A N I C S I N W O R D S A N D C O N C E P T S + +been successful at investing if the markets were perfect, we can assume that it’s not perfectly done and there are opportunities to make money in the markets if you have a better understanding than other people do. Anyway, my main point is that this is how to determine how markets are priced, which you will soon see is helpful in understanding the debt/credit/money/economic dynamic. + +ⓢ The expected rates of return on investment assets relative to the rate of inflation (i.e., the expected real returns of investments) will influence how much money goes into each of these. By and large, an investment’s inflation-adjusted (“real”) returns are more important than its non-inflation-adjusted (“nominal”) returns because a) investments are made to be storeholds of wealth so buying power matters most and b) there are arbitrages and relative-value bets between real assets and financial assets that drive their relative prices. In other words, the expected returns of putting money into financial investments are compared with the expected returns of putting money into real assets (e.g., real estate, precious metals, commodities, art, etc.), so the returns of all investments, especially the returns of government bonds (because their returns are so well-known since the yield is set and there is virtually no risk of default for bonds denominated in a country’s own currency), are compared with the inflation rate, so when bond yields are low relative to inflation, bonds will be sold and inflation assets will be bought, and vice versa. Also, because the decline in the value of money and credit that arises from central banks creating lots of both causes the prices of goods, services, and most financial assets to rise, when central banks create a lot of money and credit, that tends to lead investors to favor inflation-hedge assets. + +ⓢ Prices are linked by certain determinants that one must understand in order to understand relative pricing. When most non-professional investors think about the price, they usually think about the price for delivery of the item today, which is called the spot price. Most markets also have prices for deliveries sometime in the future, which are called forward (or futures) prices, and there are arbitrages or relative-value bets that one can make that determine the price. + +4 7 + +--- + + +# HOW COUNTRIES GO BROKE: THE BIG CYCLE + +relationship of the same items at different delivery dates. The same sort of analysis of the relative appeal of financial assets (e.g., short-term government debt and long-term government debt) takes place (e.g., a big factor determining that is the projected pace at which the central bank will increase or decrease interest rates). + +# DEBT IS CURRENCY AND CURRENCY IS DEBT + +Since a debt asset is the promise to receive a specified amount of currency at a future date, debt and currency are essentially the same thing. If you don’t like the currency, you must not like the debt asset (e.g., bonds), and if you don’t like the bonds, you must not like the currency, if you take into consideration their relative yields. (In other words, if you don’t like one you must not like the other.) Let’s look again at the gold/bond price comparison process of looking at the relative yields + the expected price changes = the relative total returns. This sets the spot and futures prices for bonds and gold, and it works the same for assessing the value of different currencies and different debt assets of different countries. That assessment drives capital flows in important ways that are very relevant to the debt issue at hand. + +More specifically: Let’s say the government interest rate (which is widely considered default-risk-free because government central banks can print money to make payments) in one country is below that in another country by X% per year. If that’s the case, then the expected appreciation in that currency must be at the same percentage rate. Otherwise, it would be easy to make virtually risk-free profits (by owning the bonds with the higher interest rate). Instead, the difference in the interest rates is + +For example, for items that can be stored, the price premium of the forward (or futures) price over the spot price won’t be more than the cost of storing it (including the interest expense on the money tied up with it in inventory). For items that will be stored (e.g., gold), the spot price will be determined by the expected future price minus the storage cost, rather than the future price being determined by the spot price plus the storage cost. + + + +--- + +# T H E M E C H A N I C S I N W O R D S A N D C O N C E P T S + +expected to be eaten up by the higher‐interest‐rate currency falling compared to the lower‐interest‐rate currency. But what if that currency change is not expected to oVset the interest rate diVerence? For example, if the 10‐year interest rate in Country A is lower (e.g., 3% lower) than that in Country B’s currency‐denom‐inated bond, you’d ordinarily expect Country A’s currency to rise (to eat up the diVerence from the higher interest rate). What if, instead, Country A’s currency is expected to fall (e.g., by 2% per year)? In that case, there is virtually risk‐free proWt to be made. Investors will Xock into the trade, selling the lower‐yielding debt/currency. That will pro‐duce one of two adjustments (or a combination of them): + +1. the spot currency will have to fall (by 40% in this example) +2. the 10‐year interest rate will have to rise by 5%, which will send the bond prices down by about 40%.¹² + +Or if those adjustments can’t happen (say there are capital controls or the like)̶if the interest stays 3% less and the currency falls by 2%̶then the loss relative to holding Country B’s bonds will be 5% per year, which over the 10 years will compound to 40%. Any way you cut it, the bond return in Country A’s currency will be very bad.¹³ If the nominal bond returns are not bad (i.e., the bonds do not depreciate and debt burdens are not reduced in nominal terms) because neither a) the price of the bonds falls in the local currency because the interest rates rise to provide an appropriate return in light + +11 Here’s the math: If a currency is expected to depreciate by 2% per year, that means the forward price is 82% of the current price (2% depreciation compounded for 10 years). The spot needs to be priced to appreciate by 3% each year until it reaches the current 10‐year forward price of 82%. A spot price of 0.61 x 1.03^10 = 0.82. So, the spot must fall from 1 to 0.61 (which is a ~40% move). + +12 Here’s the (somewhat simpler) math: The price impact of an interest rate move on bonds is the change in yield x the duration. The duration of 10‐year government bonds is 7‐8 years, depending on the country: 8 x 5% = 40%. + +13 From a central banker’s perspective, currency weakness and inXation can be good because they reduce the debt burden, which happens when the nominal interest rate is below the nominal growth rate, and especially when the nominal interest rate is below the inXation rate (i.e., when real interest rates are negative). + +--- + + +# HOW COUNTRIES GO BROKE: THE BIG CYCLE + +of the declining value of the currency nor b) the currency declines to a level that makes it cheap enough to provide adequate price appreciation to make up for the interest rates being too low, then the bad return of the bond will come about because c) the annual interest rate and weakness in the currency will not compensate for the inflation.¹⁴ Now that we understand how the mechanics of these major parts work, and how transactions are driven by the motivations of players in dealing with those parts, you can understand how the machine works and what is likely to happen next, so let’s get into that. + +# THE MAJOR TYPES OF PLAYERS AND HOW THEY BEHAVE TO DRIVE WHAT HAPPENS + +There are five major types of players that drive money and debt cycles. They are: + +- Those that borrow and become debtors that I call “borrower-debtors,” which can be private or government entities +- Those that lend and become creditors that I call “lender-creditors,” which can be private or government entities +- Those that intermediate the money and credit transactions between the lender-creditors and the borrower-debtors, which are commonly called banks +- Central governments +- Government-controlled central banks, which can create money and credit in the country’s currency and influence the cost of money and credit + +Debt/credit expansions can only take place when both + +¹⁴ Keep in mind that the different inflation rates in the different countries are typically more due to the differences in the rates of change in the values of their money/currencies (which are more due to the changing supplies of money and credit) than they are due to the changing values of the items being bought and sold when measured in a common currency. + + + +--- + + +# T H E M E C H A N I C S I N W O R D S A N D C O N C E P T S + +borrower-debtors and lender-creditors are willing to borrow and lend, so the deal must be good for both. Said diVerently, because one person’s debts are another’s assets, for the system to work, it takes both borrower‐debtors and lender‐creditors to want to enter into these transactions. However, what is good for one is quite often bad for the other. For example, for borrower‐debtors to do well, interest rates can’t be too high, while for lender‐creditors to do well, interest rates can’t be too low. If interest rates are too high for borrower-debtors, they will have to slash spending or sell assets to service their debts, or they might not be able to pay them back, which will lead markets and the economy to fall. At the same time, if interest rates are too low to compensate lender-creditors, they won’t lend and will sell their debt assets, causing interest rates to rise or central banks to print a lot of money and buy debt in an attempt to hold interest rates down. This printing of money/buying of debt will create inXation, causing a contraction in wealth and economic activity. + +Over time, environments shift between those that are good and bad for lender-creditors and borrower-debtors. To be eVective, it is critical that anyone who is involved in any way in markets and economies knows how to tell the diVerence. This balancing act and the swings between the two environments take place naturally, and sometimes conditions make it impossible to achieve a good balance. That causes big debt, market, and economic risks. Before I describe the conditions that produce these risks, I want to Wrst explain the other players’ motivations and how they try to act on them. + +Private sector banks 15 are the intermediaries between lender-creditors and borrower-debtors, so their motivations and how they work are important, too. In all countries for thousands of years, banks have done essentially the same thing, which is to try to make proWts by borrowing money from some and lending it to others, earning money on the spread. How they do this creates the debt/credit/ + +15 For simplicity, I am using the word “banks” to describe all Wnancial intermediaries that take on Wnancial liabilities to get higher returns on Wnancial assets. + + + +--- + + +# HOW COUNTRIES GO BROKE: THE BIG CYCLE + +money cycles, most importantly the unsustainable bubbles and big debt crises. How are these bubbles and crises created? By the banks lending out a lot more money than they have, which they do by repeatedly borrowing at a cost that is lower than the return they take in from lending. That works well for the society and is profitable for the banks when those who are lent money use it productively enough to pay back their loans—and when those the banks borrowed from don’t want their money back in amounts that are greater than what the banks actually have. But debt crises happen when the loans aren’t adequately paid back or when the banks’ creditors want to get back more of the money they lent to the banks. + +Over the long run, debts can’t rise faster than the incomes that are needed to service them, and interest rates can’t be too high for borrower-debtors or too low for lender-creditors for very long. If debts keep rising faster than incomes and/or interest rates are too high for borrower-debtors or too low for lender-creditors for too long, the imbalance will cause a big market and economic crisis. For that reason, it pays to watch these ratios. + +Big debt crises come about when the amounts of debt assets and debt liabilities become too large relative to the amount of money in existence and/or the amounts of goods and services in existence. Central banks either directly or indirectly create money and credit, which is buying power. Buying power determines the total amount of spending on goods, services, and investment assets. Whatever amount of money and credit is created must be put into goods, services, and financial assets (i.e., investments). So, the total amount of money and credit created determines the total amount of spending on goods, services, and financial assets. As a result, goods, services, and financial assets tend to rise and decline together with the ebb and flow of money and credit, like all boats tend to rise and fall with the ebb and flow of the sea. What this money and credit go into and the quantities of goods, services, and financial assets that are produced are mostly determined by the choices made by + + + +--- + + +# T H E M E C H A N I C S I N W O R D S A N D C O N C E P T S + +thousands or millions of market participants. Central banks came into existence to smooth these cycles, most importantly by handling big debt crises. Until relatively recently (e.g., 1913 in the United States), there weren’t central banks in most countries, and money that was in private banks was typically either physical gold or silver or paper certificates to get gold and silver. Throughout those times, there were boom/bust cycles because borrower-debtors, lender-creditors, and banks went through the debt/credit cycles I just described. These cycles turned into big debt and economic busts when too many debt assets and liabilities led to lender-creditor “runs” to get money from borrower-debtors, most importantly the banks. These runs produced debt/market/economic collapses that eventually led governments to create central banks to lend money to banks and others when these big debt crises happened. Central banks can also smooth the cycles by varying interest rates and the amount of money and credit in the system to change the behaviors of borrower-debtors and lender-creditors. + +Where do central banks get their money from? They “print” it (physically and digitally), which, when done in large amounts, alleviates the debt problems because it provides money and credit to those who desperately need it and wouldn’t have had it otherwise. But doing so also reduces the buying power of money and debt assets and raises inflation from what it would have been. + +Central banks want to keep debt and economic growth and inflation at acceptable levels. In other words, they don’t want debt and demand to grow much faster or slower than is sustainable and they don’t want inflation to be so high or so low that it is harmful. To influence these things, they raise interest rates and tighten the availability of money or they lower interest rates and ease the availability of money, which influences lender-creditors and borrower-debtors who are striving to be profitable. + +Central governments are political organizations with those who run them serving at the pleasure of elected officials who are elected by the people, so they want to give the people what they want. + +5 3 + + + +--- + + +# HOW COUNTRIES GO BROKE: THE BIG CYCLE + +is typically done without paying for it, which typically leads to central government borrowing, which reinforces the cycle of creating greater amounts of credit stimulation early and debt depressants later. When central governments do their jobs well, they tax and spend in ways that provide broad‐based productivity and prosperity, sometimes borrowing more than they are earning and sometimes paying it back, and when central banks do their jobs well, they keep the credit, debt, and capital markets in relative balance, which produces less disruptive big swings. However, for the previously mentioned reasons, the bias to create more ups in economies and markets through credit stimulation leads to long‐term uptrends in debt and debt service relative to incomes until they become too large a percentage of income to be sustainable. + +ⓢ The greater the size of the debt assets and debt liabilities relative to the real incomes being produced, the more difficult is the balancing act of having interest rates high enough to satisfy lender-creditors without having them be so high that they will hurt borrower-debtors, so the greater the likelihood of a debt-caused downturn in the markets and economy. + +Because borrower-debtors, lender-creditors, banks, central governments, and central banks are the biggest players and drivers of these cycles, and because they each have obvious incentives affecting their behaviors, it is pretty easy to anticipate what they are likely to do and what is likely to happen next. When debt growth is slow, economies are weak, and inflation is low, central bankers will lower interest rates and create more money and credit, which will incentivize more borrowing and spending on goods, services, and investment assets, which will drive the markets for these things and the economy up. At such times, it is good to be a borrower-debtor and bad to be a lender-creditor. When debt growth and economic growth are unsustainably fast and inflation is unacceptably high, central bankers will raise interest rates and limit money and credit, which will incentivize more saving and less spending on goods, services, and investment assets. This will drive the markets and economy down because it’s then better to be a lender-creditor-saver than + + + +--- + + +# T H E M E C H A N I C S I N W O R D S A N D C O N C E P T S + +a borrower-debtor-spender. This dynamic leads to two interrelated cycles̶a short‐term one that has averaged about six years in length, give or take three years, and a long‐term one that has averaged about 80 years, give or take 25 years̶which evolve around an upward trend line in productivity that is due to humanity’s inventiveness. I’ll now brieXy review how these cycles transpire. + +# THE SHORT- AND LONG-TERM (BIG) DEBT CYCLES + +By “short-term debt cycle,” I mean the cycle of 1) recessions that lead to 2) central banks providing a lot of credit cheaply, which creates a lot of debt that initially leads to 3) market and economic booms, which lead to 4) bubbles and inXations, which lead to 5) central bankers tightening credit, which leads to 6) market and economic weakening. This cycle typically lasts about six years, give or take about three. As of this writing in March 2025, there have been 12 complete cycles in the US since 1945 and we are about two-thirds through the 13th. Each short-term debt cycle typically ends with higher levels of debt than the previous cycle because policy makers try to end recessions by lowering interest rates enough to get borrowing going again. + +By “long-term (big) debt cycle,” I mean the cycle of building up debt assets and debt liabilities over long periods of time (i.e., successive short-term debt cycles) to amounts that eventually become unmanageable. This leads to a combination of big debt restructur - ings and big debt monetizations that produce a period of big market and economic turbulence. + +ⓢ The short-term debt cycles add up to the long-term (big) debt cycle, which I call the Big Debt Cycle. These cycles move markets and economies around an up - ward-sloping trend line of rising living standards that is due to people’s inventiveness and the increases in productivity that come from it. The incline of its upward slope in productivity is primarily + +--- + + +# HOW COUNTRIES GO BROKE: THE BIG CYCLE + +driven by the inventiveness of practical people (e.g., entrepreneurs) who are given adequate resources (e.g., capital) and work well with others (their coworkers, government officials, lawyers, etc.) to make productivity improvements. + +Over a short period of time (i.e., 1-10 years), the short-term debt cycle is dominant. Over a long period of time (i.e., 10 years and beyond), the long-term debt cycle and the upward-sloping trend line in productivity have much bigger effects. Conceptually, this is how I see the dynamic transpiring: + +Productivity + +Short-term + +The Big Debt Cycle + +debt cycles + +ⓢ What separates a sustainable debt cycle from an unsustainable one is whether the debt creates sufficient income to pay for the debt service. If incomes fail to grow as quickly as debt and debt service, the ratio of debts to incomes will mechanically grow, which will require increased borrowing to service debt as well as to spend. The cycle goes from low to high to unsustainably high debt and debt service relative to incomes. ⓢ A sure sign of moving toward a debt crisis is when there is a large and rising amount of borrowing that is being used to pay for debt service. + +Why don’t central bankers do a better job in smoothing out these debt cycles by better containing debt so it doesn’t reach dangerous levels? There are four reasons: + +5 6 + + + +--- + + +# T H E M E C H A N I C S I N W O R D S A N D C O N C E P T S + +1. Most everyone, including central bankers, wants the markets and economy to go up because that’s rewarding and they don’t worry much about the pain of paying back debts, so they push the limits, including becoming leveraged to long assets until that can’t continue because they have reached the point that the debts are so burdensome that they have to be restructured to be reduced relative to incomes. + +2. It is not clear exactly what risky debt levels are because it’s not clear what will happen that will determine future incomes. + +3. There are opportunity costs and risks to not providing credit that creates debt. + +4. Debt crises, even big ones, can usually be managed to reduce the pain they cause to acceptable levels. + +ⓢ Debt isn’t always bad, even when it’s not economic. Too little debt/credit growth can create economic problems as bad or worse than too much, with the costs coming in the form of unrealized opportunities. That is because 1) credit can be used to create great improvements that aren’t profitable that would have been forgone without it and 2) the losses from the debt problems can be spread out to be not intolerably painful if the government is in control of the debt restructuring process and the debt is in the currency that the central bank can print. However, to avoid a debt crisis, the debt must raise incomes enough to service the debt. + +ⓢ Over time, from one cycle to the next, debt liabilities and debt assets have virtually always increased to produce the long-term debt cycle expansion. In virtually all cases, that has continued until the debt burdens have become unsustainably large or the debt assets have become intolerably low-returning. + +When there are a lot of debt assets and debt liabilities relative to incomes, it is difficult for central bankers to keep interest rates high enough to satisfy lender-creditors without having them so high that they unacceptably hurt borrower-debtors, and it is difficult for + +5 7 + + + +--- + + +# HOW COUNTRIES GO BROKE: THE BIG CYCLE + +Central banks to run monetary policy to balance growth and inflation well. And because holders of debt assets want to sell the debt, one way or another debt is going to have a bad return. That puts central bankers in the position of having to choose between: + +1. Not printing money and buying debt (i.e., not monetizing debt) and letting interest rates rise enough to cut credit demand and economic activity enough to reach the indifference-equilibrium level that will balance the buying and selling of the bonds. This will make cash very valuable, devalue most other assets like stocks and hard assets, cause deflation, lead to debt defaults and restructurings, and depress economic activity. This typically happens first and is intolerable, which leads central banks to start... +2. Printing money and buying debt (i.e., monetizing debt) to make up for the shortfall in demand, which will make money readily available and reduce its value thus raising inflation, raise the value of most other assets like stocks and hard assets, minimize debt defaults, and stimulate economic activity. This typically happens eventually. + +At that part of the Big Debt Cycle, there need to be big reductions in debt liabilities and debt assets. These are the big debt crisis periods. These big debt restructurings and debt monetizations end the prior Big Debt Cycle by reducing debt burdens and eliminating the prior monetary order, leading to the next Big Debt Cycle and monetary order. They take place much like big changes in domestic political orders and big changes in world orders—like seismic shifts due to the old order breaking down. There are four types of levers that policy makers can pull to reduce the debt burdens: + +1. Austerity (i.e., spending less) +2. Debt defaults/restructurings +3. The central bank “printing money” and making purchases + + + +--- + + +# T H E M E C H A N I C S I N W O R D S A N D C O N C E P T S + +4. Transfers of money and credit from those who have more than they need to those who have less + +Policy makers typically try austerity first because that’s the obvious thing to do, and it’s natural to want to let those who got themselves and others into trouble bear the costs. This is a big mistake. Austerity doesn’t bring debt and incomes back into balance. Cutting debts cuts investors’ assets and makes them “poorer,” and because one person’s spending is another person’s income, cutting spending cuts incomes. For that reason, cuts in debts and spending cause a commensurate cut in net worths and incomes, which is very painful. Also, as the economy contracts, government revenues typically fall at the same time as demands on the government increase, which leads deficits to increase. Seeking to be fiscally responsible at this point, governments tend to raise taxes, which is also a mistake because it further squeezes people and companies. More simply said, when there is spending that’s greater than revenues and liquid liabilities that are greater than liquid assets, that produces the need to borrow and sell debt assets, which, if there’s not enough demand, will produce one kind of crisis or another (e.g., either deflationary or inflationary). + +As touched on earlier, the best way for policy makers to reduce debt burdens without causing a big economic crisis is to engineer what I call a beautiful deleveraging, which is when policy makers both 1) restructure the debts so debt service payments are spread out over more time or disposed of (which is deflationary and depressing) and 2) have central banks print money and buy debt (which is inflationary and stimulating). Doing these two things in balanced amounts spreads out and reduces debt burdens and produces nominal economic growth (inflation plus real growth) that is greater than nominal interest rates, so debt burdens fall relative to incomes. If done well, there is a balance between the deflationary and depressing reduction of debt payments and the inflationary and stimulating printing of money and buying of debt by the central banks. + +5 9 + + + +--- + + +# HOW COUNTRIES GO BROKE: THE BIG CYCLE + +In the countries I studied, most big debt crises that occurred with the debts denominated in a country’s own currency were restructured quickly, typically in one to three years. These restructuring periods are times of great risk and opportunity. If you want to learn more about these periods and processes, they are explained more completely in Principles for Navigating Big Debt Crises. + +# THE BIG DEBT CYCLE, ITS RISKS, AND HOW TO DEAL WITH IT NEED TO BE BETTER UNDERSTOOD + +As explained earlier, because the really big debt crises that take the form of debt restructurings and devaluations that come at the ends of Big Debt Cycles happen roughly once in a lifetime, they are not well-understood relative to the short-term cycles. Said differently, what ends long-term debt cycles is different from what ends short-term debt cycles, so most people don’t know about or acknowledge long-term debt cycles or worry about long-term debt cycles ending even though they’re much bigger deals than short-term debt cycles ending. That’s dangerous. It’s like eating fatty foods and having cholesterol accumulate in the arteries and saying that it doesn’t seem to be causing trouble while it is increasing the probability of a heart attack. + +Let’s remember what is healthy, which is 1) having private sector lenders give their credit in exchange for debt that works well for them and creditors because the uses of the funds are profitable and 2) for government borrowings to be used in ways that produce productivity gains (e.g., by investing in better infrastructure, education, etc.) that can be paid for via tax revenue, or for the government to sometimes borrow and spend more than it takes in when the economy needs stimulation and pay it back when conditions are strong. And let’s remember what isn’t healthy, which is 1) the central bank chronically printing money and buying debt to make up for the shortage in demand for the debt and 2) the central government chronically having large deficits that result in debt and debt service levels rising faster. + +6 0 + + + +--- + +# T H E M E C H A N I C S I N W O R D S A N D C O N C E P T S + +than the incomes (in the government’s case, tax revenue) that are required to service them. + +# In summary and to reiterate: + +- Goods, services, and investment assets can be produced, bought, and sold with money and credit. +- Central banks can produce money and can influence the amount of credit in whatever quantities they want. +- Borrower-debtors ultimately require enough money and low enough interest rates for them to be able to borrow and service their debts. +- Lender-creditors require high enough interest rates and low enough default rates from the borrower-debtors in order for them to get adequate returns to lend and be creditors. +- This balancing act becomes progressively more difficult as the sizes of the debt assets and debt liabilities both increase relative to incomes. Eventually they need to be reduced, so a deleveraging happens. +- The best type of deleveraging is what I call a beautiful deleveraging, which can be engineered by central governments and central banks to reduce debt burdens if the debts are in their own currencies. If the debts are denominated in a foreign currency, the deleveraging is quite ugly. I will explain these later. +- Over the long term, being productive and having healthy income statements (i.e., earning more than one is spending) and healthy balance sheets (i.e., having more assets than liabilities) are the markers of financial health. + +--- + + +# HOW COUNTRIES GO BROKE: THE BIG CYCLE + +If you know where in the debt/credit cycle each country is and how the players are likely to behave, you should be able to navigate these cycles well. + +The past is prologue. + +# Important takeaways: + +- Debt crises are inevitable. Throughout history only a very few well-disciplined countries have avoided debt crises. That’s because lending is never done perfectly and is often done poorly due to how the cycle affects people’s psychology to produce bubbles and busts. +- Most debt crises, even big ones, can be managed well if economic policy makers spread out their negative impacts. +- All debt crises provide investment opportunities if investors understand how they work and have good principles for navigating them well. +- Inevitably, at the beginning of the end of the Big Debt Cycle when there is a lot of debt, it is difficult to keep real interest rates high enough to satisfy lender-creditors without them being too high for borrower-debtors, and central banks try to navigate between these choices. Typically during these times, both the tight-money economic contraction and the loose-money inflation occur, and the only question is in what order. In any case, owning the debt/currency of overly indebted governments at such times is a bad investment. +- Central banks have to choose between keeping money “hard,” which will lead debtors to default on their debts, which will lead to deflationary depressions, and making money. + + + +--- + + +# THE MECHANICS IN WORDS AND CONCEPTS + +“soft” by printing a lot of it, which will devalue both it and the debt. Because paying off debt with hard money causes such severe market and economic downturns, when faced with this choice central banks always choose to print and devalue money eventually. For the case studies, see Part II of Principles for Navigating Big Debt Crises. Of course, each country’s central bank can only print that country’s money, which brings me to my next big point. + +ⓢ If debts are denominated in a country’s own currency, its central bank can and will “print” the money to alleviate the debt crisis. This allows them to manage it better than if they couldn’t print the money, but of course it also reduces the value of the money. + +# THE FOUR OTHER BIG FORCES AFFECT HOW THIS DEBT CYCLE TRANSPIRES JUST AS THIS DEBT CYCLE AFFECTS HOW THE FOUR OTHER FORCES TRANSPIRE TOGETHER + +One can’t be a successful global macro investor by just focusing on the markets. One also has to focus on the forces that affect markets. Thus far, I have just spoken about debt cycles because that is the subject of this study. However, many factors interact to determine what happens, so I couldn’t ignore them and do my job well. They were covered extensively in my book Principles for Dealing with the Changing World Order. While I showed 18 measures of the major drivers of conditions in that book, the big five that explain almost everything are: 1) the debt/credit/money/markets/economic cycle, 2) the cycle of social and political order and disorder that takes place within countries, 3) the cycle of order and disorder that is manifest in the peace and war cycle that takes place between countries, 4) acts-of-nature shocks such as droughts, floods, and pandemics, and 5) human inventiveness, especially of new technologies that increase productivity. The interactions between these forces drive + +6 3 + + + +--- + + +# HOW COUNTRIES GO BROKE: THE BIG CYCLE + +how conditions change. They tend to reinforce each other both up ‐wardly and downwardly. For example, periods of Wnancial and economic crisis raise the odds of having periods of internal conXict, and periods of internal conXict worsen Wnancial and economic conditions. Similarly, periods of internal Wnancial problems and internal political conXicts both weaken the country that they are happening in and, if they are global, increase the likelihood of international conXicts. Together these forces create the Big Cycles of ups and downs, peace and wars, that occur in countries and between countries and that lead to big changes in domestic and world orders. + +These big rises and declines are easy to see by monitoring the 18 forces (particularly the big Wve) that I have shared with you. For example, you can see the big evolutionary decline of great powers and their monies reXlected in 1) the unwavering rises of indebtedness accompanied by the steady weakening of the types of monetary systems used to restrain credit‐and‐debt‐growth‐motivated attempts to raise credit and economic growth and 2) the decline of many indicators of health, such as the quality of education, infrastructure, law and order, civility, and government eVectiveness, relative to those of other world powers. + +Chapter 8 provides a more detailed explanation of these Big Cycle forces and how they are interrelated. But before I get to them, I will Wrst delve into a deeper description of the Big Debt Cycle in both numbers and equations, trying to describe it in an easy-to-understand way. + + + +--- + +# CHAPTER 3 + +# THE MECHANICS IN NUMBERS AND EQUATIONS + +This chapter gets into debt mechanics, including some simple equations that are helpful in calculating what is likely to happen related to the limitations of debt. I believe this material will be valuable for professionals and aspiring professionals but will be beyond the interests of others. I suggest that you give it a scan to grab the important concepts and then decide if you want to delve deeper into this material or skip it. + +While in Chapter 2 I described in words how central governments and central banks typically get into financial trouble, in this chapter I will show numbers and equations that can be used to anticipate these financial troubles, including a few formulaic examples to illustrate how high debt burdens compound and create problems. + +I will start by showing you the key drivers of debt sustainability and how they interact. Before I do, I will lay out what an “unsustainable” debt burden is. Ultimately, it’s simple: an “unsustainable” debt burden exists when the amount of money that comes in is less than the money that goes out, either because a) the amount in storage (i.e., savings) goes down and/or b) the amount borrowed goes up until one runs out of savings and/or one can’t borrow more, at which time + +--- + + +# HOW COUNTRIES GO BROKE: THE BIG CYCLE + +A debt failure occurs. Think of this money flow as being like the flow of blood and think of income statements and balance sheets as the reports that show it. A healthy condition is when the amount that comes in from earning is equal to or greater than the amount that goes out from spending and debts don’t build up faster than incomes. This isn’t to say that debt growth is necessarily bad. If debts build up, but the money borrowed leads to incomes rising faster than the rate of debt service rises, that will lead to more money coming in than going out, which will be healthy. When debts grow faster than incomes, think of it like plaque building up in the arteries because it reduces the amount of income flow that can be used for spending or saving. That is because it leads to increased debt service payments that reduce the amount of income that can go toward spending. If the money flow is constrained too much, there is a default, which is the economic equivalent to a heart attack. Interest rates matter a lot because they have a lot of influence on the amounts that have to be paid. They also influence the willingness of lender-creditors to hold and buy the debt assets. As debt service becomes large relative to the amount of income and savings, a squeeze develops, which is when a debt problem occurs. + +We can measure debt burdens in the following ways, and we know that as they become high and/or rise quickly, the risks of defaults and/or devaluations also become high. While there are about 35 indicators that I look at to assess debt risks, the four most important indicators are: + +1. Debts relative to income. As debts get larger relative to incomes, all else equal, the debtor will have higher interest and rollover payments each year. There are two problems with high debts relative to income: 1) there is a greater risk that the large amount of existing debt won’t be rolled over by creditors and 2) it creates higher debt service payments as a percent of income, which reduces the amount of money that can go to spending, all else equal. That brings me to the next measure. + + + +--- + +# T H E M E C H A N I C S I N N U M B E R S A N D E Q UAT I O N S + +# 2. Debt service relative to income. + +Debt service is the amount a debtor must pay in interest and principal payments to not default on their debts each year. As total debt service gets higher and higher relative to income, it leads investors to expect credit problems ahead and choose not to lend more and/or to sell the debt assets they already own, which causes credit problems to come about. To help estimate how debts and debt service will build up, I look at the rate of interest relative to the rate of income growth. + +# 3. Nominal interest rates relative to a) inflation rates and b) nominal income growth rates (i.e., inflation plus real growth). + +I look at these for two reasons: + +- a. They show me how debt and debt service are likely to grow relative to incomes. For example, if someone has debts of 100% of income, the nominal interest rate is 5%, and the nominal income growth rate is 3%, they will owe about 102% of income next year (assuming their spending is equal to their income).¹⁶ +- b. They show me how attractive credit conditions are for lenders relative to borrowers. If nominal interest rates are high relative to nominal growth rates and inflation rates, that is an indicator that conditions are relatively favorable for lenders and unfavorable for borrowers, which will encourage lending and discourage borrowing/spending (i.e., it reflects greater risk of debt problems among more indebted debtors that can’t print money to pay debt). If the reverse is true, conditions are relatively unfavorable for lender-creditors and favorable for borrower-debtors, which will encourage borrowing and discourage lending. + +# 4. Debt and debt service relative to savings (e.g., reserves). + +If the amount earned is greater than the amount spent excluding the interest payments, that is called a primary surplus, and if it is less, that is called a primary deficit. + +6 7 + + + +--- + + +# HOW COUNTRIES GO BROKE: THE BIG CYCLE + +All of the above are not financially healthy but one has large savings to draw down, one won’t have a high risk of default because one can draw on the savings (e.g., reserves) to make debt and spending payments. + +Inevitably, equilibrium levels of 1) debts relative to incomes, 2) debt service relative to incomes, 3) nominal interest rates relative to inflation rates (i.e., real interest rates) and nominal growth rates, and 4) debts and debt service relative to savings will be approached. If you watch these ratios over time, you will see them go to extreme levels and return to more normal levels one way or another. If you understand the cause/effect relationships that drive these changes, you can understand how to navigate them and how they can be best managed. Most importantly, if you understand the painful deleveraging part, you will understand that it can be handled well (to be less painful) or handled poorly (and be very painful). + +These four indicators are not the only ones that matter. In Chapter 4, I’ll show you how a broader set of indicators evolves through the end of the Big Debt Cycle, and in Chapter 17, I’ll show you what my indicators suggest for the US today. However, the previously mentioned four are the most important ones to watch. They give us valuable information about how likely a debt squeeze is and how severe it will be when it happens. However, they cannot tell us exactly when the debt problem will occur because different conditions and different people’s reactions to them lead to different lead times for the selling of debt assets and other actions that precipitate a crisis. Still, we can measure the level of risk because countries with very high debt levels, very large deficits, low savings, and very high and very fast-rising interest rates have a very high risk of a debt default or debt devaluation crisis. + +The rest of this chapter goes through a few formulaic examples to illustrate how high debt burdens compound and create problems. + + + +--- + + +T H E M E C H A N I C S I N N U M B E R S A N D E Q UAT I O N S + +# MEASURING DEBT BURDENS IN NUMBERS + +What follows are the mathematical relationships for measuring these indicators. These are just the commonsense constraints on the amount of debt an entity can have, expressed in equations that are the same constraints that can be expressed in words. To help you understand them, you might relate to them the same way you relate to your own debt constraints. I will explain the rules and include a few helpful guidelines. The pages that follow will explain each of these with examples. Not only can these relationships help one to identify debt problems, but they can be used to help policy makers see how to fix them and help market participants position themselves well. Feel free to skip this and come back if it’s more helpful to see examples first and then the math. + +# 1. Future debts relative to future income. + +The formula to estimate this is: + +Future Debt = + +(Future Expenses Excluding Interest - Future Revenue) + Current Debt * (1 + Interest Rate) + +Current Revenue * (1 + Growth Rate) + +In words: Future debt relative to revenue is a function of 1) spending more or less than one makes in revenue, 2) the “compounding” of one’s existing debts, and 3) revenue growth. As one’s expenses grow relative to one’s revenue, one is forced to borrow more to finance the spending, which increases new borrowing (first numerator term). As interest rates rise, existing debts grow faster (second numerator term). As revenues grow, incomes grow relative to debts, so the ratio of debt + +6 9 + + +--- + +# HOW COUNTRIES GO BROKE: THE BIG CYCLE + +to revenue falls (denominator term).¹⁷ Note that I am looking at debt‐to‐revenue rather than debt‐to‐GDP. That is because GDP doesn’t matter for the government’s—or for that matter, for any entity’s—finances unless it is tapped into because what matters are its actual cash flows. + +Debt‐to‐income is a good indicator of risk because the larger it is, the riskier and the more burdensome the debt is, all else equal. For example, the more debt there is, the more risk there is that the debt won’t be rolled over and the more difficult it is for the central bank to keep interest rates low enough to satisfy the borrower‐debtors without having them too high for the lender‐creditor. You can probably already see that, in addition to the level of debt‐to‐income mattering, the interest rate, income growth rate, and primary deficit (expenses excluding interest versus revenue) matter a lot to how debt burdens evolve. + +This formula can also be configured to solve for ways to keep the debt‐to‐income ratio the same. I will show a few different examples of this at the end of this chapter. + +# 2. Future debt service relative to future income. The formula to estimate this is: + +| Debt | – Debt | = (it – gt) | Debt | + | (Primary Deficit) | +| ------- | --------- | ----------- | ------ | - | ----------------- | +| Incomet | Incomet-1 | | Income | | t | + +One implication of this is that to keep debts constant relative to incomes, primary deficits as a share of income must equal the difference between growth rates and interest rates multiplied by the current ratio of debt to income. + +| Primary Deficit | = (g – i) | Debt | +| --------------- | --------- | ------ | +| Income | | Income | + +17 This relationship is also often represented as follows, where g refers to the income growth rate, i refers to the interest rate, and t is the time or year in question. + +--- + +# T H E M E C H A N I C S I N N U M B E R S A N D E Q U A T I O N S + +| Future Debt Service | = | Future Interest Costs | + Future Principal Payments | +| ------------------------- | - | --------------------- | ------------------------------------------ | +| Future Revenue | = | Current Revenue | \* (1 + Growth Rate) | +| Future Interest Costs | = | Future Debt Level | \* Average Effective Interest Rate on Debt | +| Future Principal Payments | = | Future Debt Level | \* Share of Debts Coming Due | + +In words: Future debt service relative to revenue is a function of future interest costs and principal payments, relative to how much revenue grows. If revenue grows a lot, debt service will fall relative to incomes, all else equal. + +Future interest costs are a function of the debt level and the average interest rate on the debt. If interest rates shoot up, it generally will not make the interest costs for a debtor go up immediately because, on longer-term bonds, the interest rate will be locked at the interest rate at the time of issuance. As the bonds “roll”̶i.e., come due and are reissued at the new interest rate̶the bonds will gradually get to have higher interest rates on them, and interest costs will rise. + +Principal payments are the amount of debt that is coming due each year that must be paid back, typically via issuing new debt to pay back the old debt that comes due. A rough way to estimate principal payments is by calculating the average maturity̶or time until debts must be paid back̶on existing debts. When debtors are stressed, creditors typically will not want to lend to them for as long, so we often see the maturity of debts falling as creditors become more stressed, which means principal payments go up for the same level of debts. + +--- + +# HOW COUNTRIES GO BROKE: THE BIG CYCLE + +# 3. Nominal interest rates relative to a) inflation rates and b) nominal income growth rates (i.e., inflation plus real growth): + +The expected level of nominal interest rates relative to nominal growth rates tells us how debt and debt service are likely to grow or shrink. Here, I show the formula for the interest rate that would keep debt levels and debt service flat relative to revenue. Note that this is based on the first formula, but configured to give us the required interest rate to keep debts flat relative to revenue. + +Interest Rate Required to Keep Debt Flat = + +| Revenue | (Future Expenses Excluding Interest – Growth Rate – Future Revenue) | Starting Debt Level | +| ------- | ------------------------------------------------------------------- | ------------------- | + +In words: If the primary deficit is zero (i.e., current expenses before interest = current revenue), debts will stay flat if the interest rate is equal to the revenue growth rate. If the primary deficit is 5% of the current debt level, interest rates would need to be 5% below the revenue growth rate. + +The intuition here is that if the interest rates are equal to revenue growth, debts will compound at the same rate that income is growing. If the government is also borrowing, debts need to compound slower than income, so interest rates need to be below revenue growth rates. + +As interest rates rise relative to revenue growth rates, debts will grow relative to incomes because existing debts will compound faster than revenue is growing, and debt service costs will grow even faster because both the debt level will grow and the interest rate will rise, and interest costs are the product of these two inputs. Similarly, as interest rates fall, debt levels will grow less quickly and debt service costs will grow even less or shrink. (This is, for instance, what has happened in Japan over the last 20 years. I will show this in more detail in Chapter 16.) + +You can probably see that, just as you can solve for the interest rate + +--- + + +# T H E M E C H A N I C S I N N U M B E R S A N D E Q UAT I O N S + +required to keep debts flat, you can also solve for the deficit or surplus required, revenue growth required, and so on. If you flip to the end of this chapter, I show you what these numbers look like for the US today. + +# 4. Debts and debt service relative to savings (e.g., reserves): + +Just as we can estimate debt burdens relative to income, we can estimate them relative to savings—simply by looking at the level and change in savings rather than the level and change in incomes. The formula to estimate this is as follows:¹⁸ + +| Future Debt | = | Future Savings | +| --------------------------------------------------------------------------------------------- | ---------------------------------- | ---------------------------------- | +| (Current Expenses Excluding Interest - Current Revenue) + Current Debt \* (1 + Interest Rate) | Current Savings + Expected Savings | | +| Future Interest Costs + Future Debt Service | = | Future Principal Payments | +| Future Savings | = | Current Savings + Expected Savings | + +These formulas are very similar to (1) and (2), so I will not fully walk through them in words. The difference is that we are looking at debts and debt service relative to savings. If one has large debts but very large savings, it is less likely that the debt burdens are concerning because one can pay the debt service and pay back part of the debts using the savings. It creates a buffer. + +18 This equation is inexact because a government could use a surplus to either accumulate reserves/savings or to pay down existing debts, which would show up via expenses being lower than revenue. Depending on what choice a government made, the surplus could show up as future debt falling or as future savings increasing. Either way, the ratio would improve but the effect would be slightly different based on the choices of the government. + +73 + + + +--- + +# HOW COUNTRIES GO BROKE: THE BIG CYCLE + +If one is consistently running deficits, and the expected surplus is negative, debts and debt service will quickly grow relative to savings, creating a more concerning setup. + +A few rules of thumb that help to convey how these equations play out: + +- If nominal interest rates are at the same level as nominal income growth and a government is running no primary deficit (i.e., revenue = spending excluding interest), the debts will stay the same relative to the incomes. But if interest rates are higher than income growth, then the debt burdens of existing debts will increase. This is probably the single most important variable in the calculation. For example, a bad but plausible period of nominal interest rates relative to nominal growth would be interest rates being higher than income growth by 2%. This would cause the debt-to-income ratio to increase by around 50% over 20 years, even without primary deficits, leading to more borrowing and debt. This means that if you start with debts of 50% of income, they’ll go to 75%, but if you start with debts of 400%, they’ll go to 600%. +- Debt service expenses accumulating is like plaque in the arteries accumulating in that it squeezes out the desired flow of nutrients to the economy. +- The main effect of high debt levels is making the debtor vulnerable to not being able to roll it forward. + +These mathematical relationships can provide us with good estimates of the magnitudes of debt service squeezes that will occur if the existing levels of debt are rolled over. However, they don’t show the dynamic that happens when holders of debt assets want to sell the debt they are holding. In the following examples, I will explain all these things. + +--- + +# T H E M E C H A N I C S I N N U M B E R S A N D E Q UAT I O N S + +# Example 1: Debts Relative to Incomes (Levels and Changes) + +As starting debt levels grow, and as deficits (i.e., borrowings) grow, future debt levels, debt service, and interest costs all grow. The next set of tables shows a range of outcomes. The debt-to-GDP ratio, which is more commonly quoted, is not as relevant to the government’s debt service picture as its debt-to-income ratio. That is because for any debtor, including central governments, what matters most is the amount of money that goes out (in this case, in debt service) relative to the amount of money that comes in because that is what creates the debt squeeze; the size of GDP is only partially related. 19 Both are only rough indicators of the capacity of the economy to bear the debt burden. + +For reference, the US government’s expenditures excluding interest are projected to average ~112% of income over the next decade, so the primary deficit—the difference between these—is ~12% of income.20 The US is also borrowing ~20% of its income each year to cover interest expenses on the existing debt. + +The US government’s debt to money coming in (mostly tax income) is, as of this writing, about 580%. If we assume that interest rates equal income growth but use the actual projected primary deficit for the US (i.e., the 12% actual gap between non-interest expenses and income), the US government’s debt-to-income is projected to rise by about 120%, from 580% to 700%, over the next 10 years. This would also lead to a proportional increase in the interest expense and debt service burden. + +The first table that follows shows debt levels 10 years forward for + +19 GDP can be an indicator of the size of the economy that can be taxed by governments to make debt payments. + +20 Throughout this study, I am using projections from the Congressional Budget Office (CBO) where possible as a baseline estimate. These projections are based on settled law so they assume that expiring fiscal measures (i.e., the Trump tax cuts) roll off as implemented in current law. If these tax cuts are extended, the CBO estimates they would represent additional annual spending of 1.5% of GDP or 8% of government revenue, which would substantially worsen the fiscal trajectory versus the CBO’s baseline projection. + +--- + +# HOW COUNTRIES GO BROKE: THE BIG CYCLE + +Various starting debt levels and deficits. The second table shows the change relative to the starting debt level. You can see that as the starting debt level rises, and as deficits become larger, the expected debt level at the end gets higher. + +# DEBT-TO-INCOME AFTER 10 YEARS + +| | 0% | 5% | 10% | 15% | 20% | 25% | 30% | +| ---- | ---- | ---- | ---- | ---- | ---- | ---- | ----- | +| 0% | 0% | 50% | 100% | 150% | 200% | 250% | 300% | +| 100% | 100% | 150% | 200% | 250% | 300% | 350% | 400% | +| 200% | 200% | 250% | 300% | 350% | 400% | 450% | 500% | +| 300% | 300% | 350% | 400% | 450% | 500% | 550% | 600% | +| 400% | 400% | 450% | 500% | 550% | 600% | 650% | 700% | +| 500% | 500% | 550% | 600% | 650% | 700% | 750% | 800% | +| 600% | 600% | 650% | 700% | 750% | 800% | 850% | 900% | +| 700% | 700% | 750% | 800% | 850% | 900% | 950% | 1000% | + += US Trajectory Today +Assuming Nominal Interest Rate = Nominal Growth + +# 10YR CHANGE IN DEBT (% INCOME) + +| | 0% | 5% | 10% | 15% | 20% | 25% | 30% | +| ---- | -- | --- | ---- | ---- | ---- | ---- | ---- | +| 0% | 0% | 50% | 100% | 150% | 200% | 250% | 300% | +| 100% | 0% | 50% | 100% | 150% | 200% | 250% | 300% | +| 200% | 0% | 50% | 100% | 150% | 200% | 250% | 300% | +| 300% | 0% | 50% | 100% | 150% | 200% | 250% | 300% | +| 400% | 0% | 50% | 100% | 150% | 200% | 250% | 300% | +| 500% | 0% | 50% | 100% | 150% | 200% | 250% | 300% | +| 600% | 0% | 50% | 100% | 150% | 200% | 250% | 300% | +| 700% | 0% | 50% | 100% | 150% | 200% | 250% | 300% | + +When going through these numbers, you might keep in mind that at the time of this writing, the US, Japanese, Chinese, French, German, and UK numbers are approximately as follows: + +7 6 + +--- + +# T H E M E C H A N I C S I N N U M B E R S A N D E Q U A T I O N S + +| CENTRAL GOVERNMENT DEBT LEVELS | CENTRAL GOVERNMENT DEFICIT | CENTRAL GOVERNMENT REVENUE | | | | +| ------------------------------ | -------------------------- | -------------------------- | ----- | -------------- | ----- | +| | % GDP | % GOVT REVENUE | % GDP | % GOVT REVENUE | % GDP | +| USA | 100% | 583% | 6% | 37% | 17% | +| JPN | 215% | 1376% | 4% | 26% | 16% | +| CHN | 90% | 321% | 5% | 16% | 28% | +| FRA | 86% | 478% | 6% | 31% | 18% | +| DEU | 44% | 340% | 2% | 17% | 13% | +| GBR | 92% | 256% | 6% | 16% | 36% | + +China extensively raises financing at the local level, so I am including revenues, spending, and debt from local governments and related entities in these figures. + +# Example 2: The Effects of Nominal Interest Rates Minus Nominal Income Growth Rates on Debt-to-Income Ratios + +When interest rates are higher than income growth rates, the existing debt grows relative to incomes because the debt compounds faster than incomes grow. The following tables illustrate how this works. Previously, I showed how debt grows for different starting debt levels and deficits. This time, I am assuming a starting deficit of 32% of income (using the Congressional Budget Office’s projected deficit over the next decade). The columns now show the nominal interest rate minus the nominal income growth rate. The CBO projects that, over the next decade, effective interest rates will average 3.45% and the US will have 3.9% nominal growth. The difference is about -0.4%, so this would leave the US around the red-boxed area. + +As noted previously, the CBO projections use settled law so they assume that expiring fiscal measures (i.e., the Trump tax cuts) roll off as implemented in current law. If these tax cuts are extended, the CBO estimates it would represent additional annual spending of 1.5% of GDP or 8% of government revenue. + +--- + + +# HOW COUNTRIES GO BROKE: THE BIG CYCLE + +The first table shows the levels of debt to income 10 years from now based on these assumptions, and the second table shows the change in debt to income over the next 10 years. As interest rates get higher than growth, debt levels grow faster. Also, as debts get higher, the impact of high interest rates gets worse much faster. + +# DEBT-TO-INCOME AFTER 10 YEARS + +| | -3% | -2% | -1% | 0% | 1% | 2% | 3% | | +| -------------- | ---- | ---- | ---- | ---- | ---- | ---- | ----- | ---- | +| 0% | 106% | 110% | 115% | 120% | 125% | 131% | 137% | | +| 100% | 180% | 192% | 206% | 220% | 235% | 252% | 270% | | +| Debt-to-Income | 200% | 255% | 275% | 296% | 320% | 345% | 373% | 403% | +| 300% | 329% | 357% | 387% | 420% | 455% | 494% | 536% | | +| 400% | 404% | 439% | 478% | 520% | 566% | 615% | 669% | | +| 500% | 479% | 522% | 569% | 620% | 676% | 736% | 801% | | +| Starting | 600% | 553% | 604% | 660% | 720% | 786% | 857% | 934% | +| 700% | 628% | 686% | 750% | 820% | 896% | 978% | 1067% | | + += US Trajectory Today Assuming a Constant Primary Deficit of 12% (CBO Projection over the Next 10 Years). + +# 10YR CHANGE IN DEBT (% INCOME) + +| | -3% | -2% | -1% | 0% | 1% | 2% | 3% | | +| -------------- | ---- | ---- | ---- | ---- | ---- | ---- | ---- | ---- | +| 0% | 106% | 110% | 115% | 120% | 125% | 131% | 137% | | +| 100% | 80% | 92% | 106% | 120% | 135% | 152% | 170% | | +| Debt-to-Income | 200% | 55% | 75% | 96% | 120% | 145% | 173% | 203% | +| 300% | 29% | 57% | 87% | 120% | 155% | 194% | 236% | | +| 400% | 4% | 39% | 78% | 120% | 166% | 215% | 269% | | +| 500% | -21% | 22% | 69% | 120% | 176% | 236% | 301% | | +| Starting | 600% | -47% | 4% | 60% | 120% | 186% | 257% | 334% | +| 700% | -72% | -14% | 50% | 120% | 196% | 278% | 367% | | + +Assuming a Constant Primary Deficit of 12% (CBO Projection over the Next 10 Years). + + + +--- + + +# T H E M E C H A N I C S I N N U M B E R S A N D E Q UAT I O N S + +Previously, I forecast that with current debts and deficits, US debt levels will rise from 580% to 700% of income. If I also incorporate projected interest rates relative to nominal growth, I’d expect US debt levels to rise to 650% of income. You get the idea. + +Since interest rates are projected to be slightly below nominal growth, this adjustment doesn’t change our debt outlook much for the US today. But you can see that if the central bank wanted to help the central government keep its debt burdens more manageable, it could push interest rates to further below nominal growth by buying the government bonds, which would cause debt burdens to grow much slower, all else equal. Of course, that wouldn’t be good for the lender-creditors holding the debt assets because they would get a lower nominal interest rate and a lower real interest rate than they would have gotten. I suspect that you are beginning to get the picture of how this dynamic works and has worked in the past—i.e., why central banks created such low nominal rates (near 0%) and such negative real interest rates by printing money and buying government debt—and what is most likely to take place in the future if the current path isn’t altered. More specifically, if debt growth remains as projected, central banks will have to push real interest rates lower, which will make debt assets less attractive for lender-creditors. + +In an economy, there are many interrelated drivers that change interdependently. It’s like a Rubik’s Cube, in which changing one part of the cube—one driver in the grids shown previously—causes changes to the other parts. It gets complicated to understand how these drivers interrelate and to project scenarios. To help illustrate this, I created a simple model to walk through one scenario for the next decade. + +# Example 3: Interest Rates Spiral Upward to Keep Buyers in the Debt Assets + +In this example, I consider a government that has numbers similar to the US government now. Let’s say nominal income is growing at 3.9% a year, interest rates are 3.5%, and debt levels start at 580% of government + + + +--- + + +# HOW COUNTRIES GO BROKE: THE BIG CYCLE + +In this example, we’ll assume that the government spends 32% more than it collects in income, including interest payments. Since this government is running a 12% primary deficit (i.e., excluding interest payments), it collects $5.4 trillion in revenue and spends $6 trillion in Year 1. It must pay $1 trillion in interest because it started with debts at 580% of government income, and interest rates are about 3.5%. Let’s assume that about 35% of the existing debt is coming due this year (which is about how much US government debt matures every year) and will need to be rolled over—so $10.5 trillion of existing debt will come due this year and will need to be paid back. In total, this government needs to sell $12.2 trillion of debt in Year 1. + +What happens if the public is no longer willing to buy this debt, or is a seller at current interest rates? Markets must clear, so this means that interest rates will go up until someone is willing to buy these bonds. But as the interest rates go up, that makes the government’s borrowing even more expensive, meaning the problems get even worse, creating a greater desire to sell the bonds, which creates even more upward pressure on interest rates. A spiral of rising interest rates leading to worsening credit risk, leading to less demand for the debt, leading to higher interest rates is a classic debt “death spiral.” + +In the next table, you can see how this works. In this example, I show interest rates going up by 0.5% a year while nominal growth stays flat. + +If interest rates stayed flat, the government would have ended Year 10 with debts at 650% of income and interest at 22% of income. Here, relative to income, we end with debts at 865%, interest at 67%, and total debt service (including principal payments) of 342%. Of course, if interest rates are going up because the debts are unsustainable, they’ll only go up more as debts rise and become even more unsustainable. And at the same time, the high interest rates are likely constricting income growth, increasing the challenge of debt sustainability. Of course, the worst-case scenario is one where a significant additional amount of debt assets must be sold (e.g., to fund a war or social benefits in a recession), which would drive interest rates up a lot more. + + + +--- + + +# INTEREST RATES RISE BY 50BPS/YEAR + +# THE MECHANICS IN NUMBERS AND EQUATIONS + +# A TOY MODEL: INTEREST RATES SPIRAL HIGHER + +| 25.9 | 20.8 | 26.8 | 65.5 | 865% | 7.6 | 8.5 | 5.1 | 8.5% | 342% | 10 | 67% | | +| ---- | ---- | ---- | ---- | ---- | ---- | ---- | ---- | ---- | ---- | ---- | ---- | --- | +| 23.4 | 19.0 | 24.2 | 59.5 | 817% | 7.3 | 8.2 | 4.3 | 8.0% | 320% | 9 | 60% | | +| 21.1 | 17.4 | 22.0 | 54.3 | 775% | 7.0 | 7.9 | 3.7 | 7.5% | 301% | 8 | 53% | | +| 19.2 | 16.0 | 20.0 | 49.8 | 737% | 6.8 | 7.6 | 3.2 | 7.0% | 285% | 7 | 47% | | +| 17.5 | 14.8 | 18.3 | 45.8 | 704% | 6.5 | 7.3 | 2.7 | 6.5% | 270% | 6 | 42% | | +| 16.0 | 16.8 | 42.2 | 676% | 7.0 | 13.7 | 257% | 5 | 6.3 | 2.3 | 6.0% | 37% | | +| 14.8 | 12.8 | 15.5 | 39.2 | 651% | 6.7 | 2.0 | 5.5% | 245% | 4 | 6.0 | 33% | | +| 13.6 | 11.9 | 14.3 | 36.4 | 629% | 5.8 | 6.5 | 1.7 | 5.0% | 235% | 3 | 29% | | +| 12.6 | 11.2 | 13.3 | 34.0 | 611% | 5.6 | 6.2 | 1.4 | 4.5% | 226% | 2 | 26% | | +| 11.7 | 10.5 | 12.4 | 31.9 | 595% | 6.0 | 1.2 | 4.0% | 217% | 112% | 1 | 5.4 | 22% | +| 3.9% | 3.5% | 30.1 | 35% | 0 | 5.2 | - | - | - | - | 30.1 | 583% | | + + +--- + + +# HOW COUNTRIES GO BROKE: THE BIG CYCLE + +A government can prevent this spiral of rising rates by reducing its debt burdens. I outlined this in the prior chapter and laid it out in more detail in my book *Principles for Navigating Big Debt Crises*, but, to reiterate, there are four ways to reduce debt burdens for a government: + +- Austerity (i.e., spending less), which doesn’t work because one person’s spending is another person’s earnings, so austerity causes a self-reinforcing deflationary contraction. +- Debt defaults/restructurings, which reduce debt burdens and are deflationary because one person’s debts are another’s assets. +- The central bank printing money and making purchases of debt, which reduces debt burdens because it provides the money to pay the debts and is inflationary. +- Transfers of money and credit from private market players who have money to the government via taxes, which is then transferred to other private market players. + +When I looked at historical cases of private debt problems, I typically saw a mix of these levers being pulled, with a strong bias to print money and buy debt (i.e., to monetize debt) when the debt squeeze is big. I also saw the fight over increased taxes as well as big conflicts between those of the political left and those of the political right. That all occurs for logical reasons. When central governments are squeezed, it’s a big deal because central governments are typically the largest part of the economy and the only part of the economy to pay for large amounts of non-economic social expenses, which are critically important when economic conditions are bad. If governments are slow in providing spending and financial support, it’s likely that that will create a larger economic downturn, which counterintuitively worsens debt burdens by reducing income growth and net worths and can lead to social turmoil. As a result, at such times it is self-damagingly painful for overly indebted governments to cut their spending to deal with their debt problems. Then the question is: where does the government get its money from? + +ⓢ The easiest path, though not the best path for the long-term health of the system, is for governments to resolve their debt problems. + + + +--- + + +# T H E M E C H A N I C S I N N U M B E R S A N D E Q U A T I O N S + +and spend as they would like to spend by having the central bank print money and purchase the bonds, thereby holding interest rates down at tolerable levels and putting money into the system. That is what they will unfailingly do when the debts are denominated in their own currencies. Let’s look at an example of how this works. + +# Example 4: The Central Bank Steps In + +# Because Private Players Are Unwilling to Hold the Desired Amount of Government Bonds to Keep Interest Rates at the Desired Level for Acceptable Economic Growth + +Thus far, we looked at how the starting debt‐to‐income ratio, the income growth rate, the spending growth rate, the interest rate, and the maturity of the government debt affects future debt burdens. Also, as mentioned, the demand for the debt matters a lot, and the central bank can, and typically does, print money and buy (i.e., monetize) debt. Let’s now look at how this last piece works. + +There are many factors that determine the private market’s demand for government debt. As previously explained, these include the expected real return of bonds relative to the projected real returns of other assets, the total amount of money and credit in the system, the sense of impending risk of a debt/currency crisis, etc. + +While these factors are measurable, they are much harder to project than the previously described determinants. However, they are observable, most importantly in the form of either a) interest rates going up while the economy and the currency are weak (due to the supply‐and‐demand imbalance worsening) or b) central banks spending reserves and/or printing money and creating debt to buy government debt to try to lower real and nominal interest rates by increasing the demand to eliminate the imbalance. In the next chapter, you will see how this typically happens and the signals for the transition to the debt/currency crisis. + +8 3 + + + +--- + + +# HOW COUNTRIES GO BROKE: THE BIG CYCLE + +Before we move on, I want to show you how it works for the central bank to step in and absorb excess debt supply in order to maintain interest rates and liquidity at a desired level. Let’s start with our previous example and modify it slightly. Let’s assume that in Year 1 the government has $10.5 trillion of debt expiring and is issuing $12.2 trillion of new debt to replace the expiring bonds, pay interest, and cover spending. + +Rather than allowing interest rates to spiral upward to generate sufficient demand for these debt assets, let’s assume the central bank steps in and buys all the excess issuance, so that the private sector continues to hold no more than 600% of government income in debt, and interest rates stay flat at 3.5%. In this example, in Year 2, the central bank will have to buy $0.1 trillion of those debt assets. In subsequent years, these purchases get larger and larger. + +Mechanically, to purchase these debt assets—i.e., to monetize the government debt—the central bank prints money (by creating new reserves/cash) and gives private players that money in exchange for the bonds. This increases the money supply (M0). In this example, let’s assume that the money supply starts at $5.7 trillion—so 110% of the starting government income—roughly where it is today in the United States. In our example, as the central bank prints more and more to cover government shortfalls, the money supply balloons. + + + +--- + +CENTRAL BANK BUYS BONDS + +# THE MECHANICS IN NUMBERS AND EQUATIONS + +# THE CENTRAL BANK STEPS IN + +| Income Growth Rate | 3.9% | +| ------------------------------ | ---- | +| Spending excl Interest (% Inc) | 112% | +| Starting Debt | 30.1 | + +| Year | Purchases | Maturing | Debt | Interest | Sustainability | | | | | | +| -------- | --------- | -------- | ------ | -------------- | -------------- | --------- | ---- | ---- | ---- | ---- | +| Tln)(USD | Stock | Bank | Sector | Service/Income | Debt/Income | Principal | Held | Held | | | +| 18.7 | 17.0 | 19.6 | 51.3 | 677% | 22.4% | 7.6 | 8.5 | 1.7 | 11.8 | 247% | +| 17.8 | 16.2 | 18.7 | 48.7 | 668% | 22.1% | 7.3 | 8.2 | 1.6 | 10.9 | 244% | +| 16.9 | 15.3 | 17.7 | 46.2 | 659% | 21.8% | 7.9 | 1.5 | 10.0 | 241% | | +| 14.6 | 16.8 | 43.8 | 650% | 21.4% | 7 | 6.8 | 7.6 | 16.0 | 1.4 | 0.7 | +| 15.2 | 13.8 | 16.0 | 41.6 | 39.0 | 640% | 21.1% | 6 | 6.5 | 7.3 | 1.4 | +| 13.1 | 14.4 | 15.1 | 39.4 | 37.5 | 631% | 20.8% | 5 | 6.3 | 7.0 | 1.3 | +| 12.4 | 13.6 | 14.4 | 37.4 | 36.1 | 621% | 20.5% | 4 | 6.0 | 6.7 | 1.2 | +| 12.9 | 11.7 | 13.6 | 35.4 | 34.8 | 612% | 20.2% | 3 | 5.8 | 6.5 | 1.2 | +| 12.9 | 33.6 | 602% | 19.9% | 5.6 | 6.2 | 12.2 | 1.1 | | | | +| 11.6 | 10.5 | 12.2 | 31.8 | 31.8 | 593% | 19.5% | 1 | 5.4 | 6.0 | 1.0 | +| 0 | 5.2 | - | - | - | 30.1 | 5.7 | 30.1 | | | | + + + +--- + + +# HOW COUNTRIES GO BROKE: THE BIG CYCLE + +This is a rough example, but you can see the general contours of how this works for real economies. As an economy needs lower and lower interest rates to keep debt burdens manageable, there is less and less private demand for the debt at those lower interest rates, which requires the central bank to step in. The more the central bank steps in, the more it is forced to increase the money supply, which devalues the money and makes holding debt less desirable. + +That is because, all else equal, central bank money and credit creation lowers the value of money, which increases inflation and currency weakness. The relationship is not precise and depends on how exactly the printed money is transmitted through the economy. Lowering interest rates and increasing the supply of money lowers the attractiveness of the currency, which makes holding the debt denominated in that currency unattractive. + +In the following tables, I will give you a sense of how much money gets printed and how it affects the currency. + +In the first table, the rows represent different starting debt-to-income levels for a government, and the columns represent how many bonds private players are willing to purchase at current interest rates. As a government has more of a debt problem, and as private players are willing to hold less of the debt, the money stock increases more. The red box reflects the scenario laid out earlier, where the central bank buys $6 trillion of bonds, increasing the money stock from $5.7 trillion to $11.8 trillion. + +| Debt-to-Income Levels | | Private Demand for Bonds | +| --------------------- | ----------- | ------------------------ | +| Low | Medium | High | +| $5.7 trillion | $6 trillion | $11.8 trillion | + + + +--- + + +T H E M E C H A N I C S I N N U M B E R S A N D E Q UAT I O N S + +# 10YR CHANGE IN MONEY STOCK (M0) (% GOVT INCOME) + +# Max Private Bond Holdings (% Govt Income) + +| | 0% | | | | | | 100% | 200% | 300% | 400% | 500% | 600% | 700% | +| ---- | --- | ---- | ---- | ---- | ---- | ---- | ---- | ---- | ---- | ---- | ---- | ---- | ---- | +| 700% | - | - | - | - | - | - | - | 10% | | | | | | +| 600% | - | - | - | - | - | - | 6% | 79% | | | | | | +| 500% | - | - | - | - | 6% | 75% | 175% | | | | | | | +| 400% | - | - | - | 2% | 71% | 171% | 271% | | | | | | | +| 300% | - | - | - | 67% | 167% | 267% | 367% | | | | | | | +| 200% | - | - | 63% | 163% | 263% | 363% | 463% | | | | | | | +| 100% | - | 59% | 159% | 259% | 359% | 459% | 559% | | | | | | | +| 0% | 55% | 155% | 255% | 355% | 455% | 555% | 655% | | | | | | | + += Range Corresponds to Current Example + +Assuming Primary Deficit = 12%; Starting M0 = 110% of Govt Income + +ⓢ Buying up bonds and increasing the money supply are stimula- + +tive and put downward pressure on the currency. Mechanically, pushing down interest rates usually causes the cur- + +rency to sell off. Why? To spell out the mechanics: + +ⓤ Usually, all else equal, lowering an interest rate won’t change + +investors’ long-term expectations of the value of a currency. + +The 10-year forward currency doesn’t move as much. + +ⓤ If you are getting less interest in the meantime because inter- + +est rates fell, the new deal is strictly worse. + +ⓤ The way to make the new deal fair again is for the spot cur- + +rency to fall. That way, you’ll earn more through currency + +appreciation (as it reaches the same expected 10-year forward + +point) to make up for less in interest. + +My next point will be too technical for some and helpfully tech- + +nical for others, so if you want to skip the technical stuff, skip it. + +Mechanically, pushing down interest rates pushes up the currency + +forward—e.g., a rise in one country’s 10-year risk-free bond yield rel- + +ative to another country’s 10-year risk-free bond yield will raise the + +8 7 + + +--- + + +# HOW COUNTRIES GO BROKE: THE BIG CYCLE + +10-year forward currency̶so if the value to investors of the currency in the 10-year future were to stay the same, the spot currency would have to sell off by the present value of the 10-year interest rate differences to keep the 10-year currency forward flat. Said more precisely and more simply: as explained in Chapter 2, the difference in sovereign interest rates in two countries will be offset by the forward currency premium̶e.g., if the interest rate in Country A is 2% above the interest rate in Country B, then the forward currency of Country A will be at a 2% per year annual discount to Country B, so if interest rates in Country A were lowered by 1% from that level and the forward currency stays the same, the currency would weaken by a corresponding amount. + +Also, the printed money can directly flow out of the currency, creating a selling pressure in the currency. That is, as a central bank buys bonds and gives other players cash, there is a chance that they use that cash to buy other currencies, rather than holding it or buying assets/spending in the same economy. + +In the next table, I show a range of outcomes for how this might work. The columns again reflect different willingness to lend by private players (as you go to the right, private players are less willing to lend to the government). The rows reflect how sensitive the currency is to the money supply. As the market sees a currency as a worse and worse storehold of value, we’d expect the currency to become more sensitive to the money supply because other players will be less willing to hold it. For example, let’s assume that printing 1% of GDP in money led to ~1% currency weakness, then in this example, we’d expect a ~10% currency depreciation. As the currency becomes more sensitive to the amount of money (i.e., M0), and as the private sector becomes less willing to lend, we’d expect to see more and more currency weakness. + + + +--- + + +# T H E M E C H A N I C S I N N U M B E R S A N D E Q UAT I O N S + +# 10YR EXPECTED CHANGE IN FX + +# Max Private Bond Holdings (% Govt Income) + +| | | 700% | 600% | 500% | 400% | 300% | 200% | 100% | +| ------------- | ---- | ---- | ---- | ---- | ---- | ---- | ---- | ---- | +| FX M0 | 0.0% | 0% | 0% | 0% | 0% | 0% | 0% | | +| Move Increase | 0.5% | 0% | -5% | -13% | -21% | -28% | -34% | -40% | +| Expected (%) | 1.0% | 0% | -10% | -25% | -38% | -49% | -58% | -65% | +| 1% | 1.5% | 0% | -15% | -35% | -52% | -64% | -73% | -81% | +| for | 2.0% | 0% | -19% | -44% | -62% | -75% | -84% | -89% | + += Range Corresponds to Current Example + +Assuming Primary Deficit = 12%; Starting M0 = 110% of Govt Income; Starting Debt-to-Income of 5.8x + +# What level of interest rates can make debt burdens affordable for a country? + +In these examples, we looked at how debts can compound to become unsustainable. I also want to show you the numbers around how debts can be managed sustainably. + +In countries that have a lot of debt and high deficits, debts and debt service costs will be a big issue and how much they will increase over time will be determined by the interest rate relative to income growth and inflation, as shown in my calculations. A central bank can prevent debt service costs from rising or cause them to decrease relative to inflation and incomes by pushing down nominal interest rates to below nominal growth rates. What I am referring to are the impacts these things will have on the central government’s and the central bank’s financial conditions. (Of course, they will also have a ripple effect on all parts of the economy, but let’s skip that for now.) + +Given that, we can look at a government’s debt level and projected deficit and calculate what interest rate will be needed to produce any specified level of debt and debt service relative to incomes—e.g., to keep the debt burden the same, to have it decline, etc.—given estimates of future revenue and expenses. + +If I were setting policy for the Fed, I would want to look at what the deficit and debt levels are and likely will be and set an interest rate. + +8 9 + + + +--- + + +# HOW COUNTRIES GO BROKE: THE BIG CYCLE + +so that debt burdens won’t become too great over time. For example, I would probably want to look at what interest rate would keep debt service payments the same. That would affect my interest rate policy. I would also want to calculate what level of interest rate would be needed for the Fed not to have big losses on my balance sheet. Let’s look at these things and also look at how they would have worked in the past. + +# FORMULA FOR DETERMINING FUTURE DEBT BURDENS + +As a reminder, this equation shows the drivers of future levels of debt and debt service relative to incomes. This was more fully explained at the start of the chapter. + +Future Debt = Future Revenue + +(Future Expenses Excluding Interest - Future Revenue) + Current Debt * (1 + Interest Rate) / Current Revenue * (1 + Growth Rate) + +In the following table, I use this formula to estimate what interest rates would stabilize debt burdens relative to incomes for the US today. I also show how each of the other available levers would have to change in order to stabilize debt burdens. You can see that to stabilize government debt burdens, the US would either need to see nominal interest fall to about 1%, see nominal economic growth average about 6.5% (~2.5% additional inflation above the 3.9% nominal growth projected by the CBO), or raise government revenue (i.e., raising taxes) by 11%. Of course, each one of these paths would be intolerably too + + + +--- + + +# T H E M E C H A N I C S I N N U M B E R S A N D E Q U A T I O N S + +large so it would take the right combination of lesser amounts of these to successfully achieve the goal. In Chapter 18, “My 3% 3‐Part Solution,” I show what I believe would be the best combinations to achieve the goal of limiting debt burdens and risks in a very tolerable way. + +# HOW THE US CAN STABILIZE DEBT-TO-INCOME IN THE NEXT 10 YEARS + +| Central Government Debt Today (% GDP) | 100% | +| ------------------------------------------- | ---- | +| Central Government Debt Today (% Revenue) | 583% | +| Proj Debt in 2035 (% GDP, CBO) | 118% | +| Proj Debt in 2035 (% Revenue, CBO) | 648% | +| Proj Nominal Growth Rate (CBO) | 3.9% | +| Proj Real Growth | 1.9% | +| Proj Inflation | 2.0% | +| Proj Effective Nominal Interest Rates (CBO) | 3.5% | +| Current Interest Rate (Avg 3M and 10Yr) | 4.5% | + +# If Lower Interest Rates Were the Only Lever... + +| Interest Rate Required to Stabilize Debt | 1.0% | +| -------------------------------------------------------- | ----- | +| Change in Interest Rates vs Current Interest Rate | -3.5% | +| Change in Interest Rates vs CBO’s Proj Avg Interest Rate | -2.5% | + +# If Higher Inflation Were the Only Lever... + +| Required Inflation Rate to Stabilize Debt | 4.5% | +| ------------------------------------------------------ | ---- | +| Change in Inflation Required (vs Current Proj Inflation) | 2.5% | + +# If Cutting Expenses Were the Only Lever... + +| % Spending Cut Required to Stabilize Debt | 12% | +| ----------------------------------------- | --- | +| % of Discretionary Spending | 47% | + +# If Raising Tax Revenue Were the Only Lever... + +| % Revenue Increase Required to Stabilize Debt | 11% | +| --------------------------------------------- | --- | + +9 1 + + + +--- + +# PART I + +--- + +# THE ARCHETYPICAL SEQUENCE LEADING TO CENTRAL GOVERNMENTS AND CENTRAL BANKS GOING BROKE + +--- + + + +The same basic sequence of events that leads central governments and central banks to go broke has happened repeatedly throughout history and it isn’t well‐understood. The purpose of Part II is to describe it so that it is well‐understood. In it, I provide a template of the typical case and the most important reasons for the two major types of cases: 1) those in which the debt is denominated in currency that the country’s central bank can print and 2) those in which the debt is denominated in currency that the central bank can’t print. Then I devote Chapter 8 to providing an overview of the five forces that make up what I call the Big Cycle, which drives all major changes in monetary systems, domestic political orders, and global geopolitical orders. After I make that clear, in Part III, I will review how this Big Cycle, starting in 1865 and continuing until now, has transpired relative to the archetypical timeless and universal template. + + + +--- + + +# CHAPTER 4 + +# THE ARCHETYPICAL SEQUENCE + +From my experiences in the markets and from examining 35 major debt crises over the last 100 years in which central governments and/or central banks went broke, I have come to understand pretty well how Big Debt Cycles transpire. What follows is the archetypical process, zooming in to the granular mechanics of what typically happens both leading up to central governments and central banks going broke and after. While I think this chapter is valuable for policy makers and investors because it provides a template for dealing with such crises, it is possibly too much for the casual reader. I suggest you read what is in bold and decide if you want to dive into the greater detail or exit and move on. + +There is one important determinant that I’d like to explain that affects how the cases transpire. That is between cases with hard money versus fiat money. + +--- + +# HOW COUNTRIES GO BROKE: THE BIG CYCLE + +# HARD MONEY VERSUS FIAT MONEY + +The cases I am about to describe come in two broad types that typically behave differently in ways that you should understand. The two big types are the hard currency cases and fiat currency cases. In brief, the way the hard currency cases work is that the governments have made promises to deliver money that they can’t print (e.g., gold, silver, or another currency that the parties view as relatively hard, like the dollar). Throughout history, when coming up with these hard currencies that they can’t print to pay debts becomes tough, the governments almost always renege on their promises to pay in the currency that they can’t print, and the value of their money and the debt payments denominated in it tumble at the moment the promise is broken. + +After governments break their promise by not going back to having a hard currency, they have what is called a fiat monetary system. In these cases, the currency’s value is based on the faith and incentives that the central banks provide. The most recent shift of most currencies from being hard to being fiat started on August 15, 1971. I remember it well because I was clerking on the floor of the New York Stock Exchange at the time and was surprised by it; then I studied history and found that the exact same thing happened in April 1933, and I learned how they worked. + +In fiat monetary systems, central banks primarily use interest rates, their ability to monetize debt, and the tightness of money to provide the incentives for lender-creditors to lend and hold debt assets. And throughout history they, like central governments and central bankers operating in hard currency regimes, have created too much debt (which are claims that people believe they can turn in to get money, which they expect they can use to buy things), so there are the same types of debt/credit dynamics at work—i.e., the governments create and allow their private sectors to create too much debt to be paid back, which leads to printing money to make it easier to pay back the debts, which devalues money and makes the prices of things. + +--- + + +# T H E A R C H E T Y P I C A L S E Q U E N C E + +go up̶except in Wat currency cases, the devaluations don’t happen all at once at the moment the government breaks its promise to convert the paper money into the hard money storehold of wealth. They happen more gradually. + +For example, we have seen this clearly in the Bank of Japan’s policies of aggressively monetizing a lot of debt and keeping real and nominal interest rates extremely low, which has resulted in its currency and the debt denominated in its currency being devalued. Since the start of 2013, the holders of Japanese government bonds have lost 60% versus gold, 45% versus US dollar debt, and 6% in domestic purchasing power (as average inflation was 1%). The devaluation came gradually rather than abruptly because the yen is a Wat currency, but it came for the same reasons it would have come if Japan had a hard currency̶i.e., too much debt that needed to be monetized. + +In the charts in this part, you will see three lines—the blue line shows the average of all cases, the red line shows the average of the fixed exchange rate cases, and the green line shows the average of Wat/variable exchange rate cases. For simplicity, I will explain the dynamic by referring to just the aggregate line. + +By the way, the Big Debt Cycles through history have typically included currency regimes going back and forth between being hard and Wat because they each led to extreme consequences and required movements to the opposite̶the hard currency regimes broke down with big devaluations because the governments couldn’t maintain debt growth in line with their monetary constraints, and the Wat monetary systems broke down because of the loss of faith in the debt/money being a safe storehold of wealth. + +# NINE STAGES OF THE FINAL CRISIS + +In the introduction to this book, I summarized the whole archetypical debt cycle. I am now going to focus on the final phase of the Big Debt Cycle, when the central government and the central bank both + + + +--- + + +# HOW COUNTRIES GO BROKE: THE BIG CYCLE + +This final phase typically transpires in nine steps. While this sequence is the archetypical one, there are very big variations in what happens and when it happens, and the stages don’t necessarily transpire in the exact sequence I describe. So, the things I am referring to here can be viewed as the unhealthy things that lead to the crisis and the steps that are classically taken to get out of the crisis. The more of these unhealthy things exist, the greater the risk of a “heart attack” where the central government and the central bank go broke. Said differently, there are many reasons a country goes broke—e.g., chronic overspending and debt accumulations; costly wars; costly shocks like droughts, floods, and pandemics; some mix of these things; etc. Whatever the causes, this checklist adds up to a risk gauge because the more of the unhealthy things that exist, the higher the probability of a debt/currency crisis. Here is the sequence of unhealthy conditions that typifies the last stages of the Big Debt Cycle: + +1. The private sector and government get deep in debt. +2. The private sector suffers a debt crisis, and the central government gets deeper in debt to help the private sector. +3. The central government experiences a debt squeeze in which the free-market demand for its debt falls short of the supply of it. That creates a debt problem. At that time, there is either a) a shift in monetary and fiscal policy that brings the supply and demand for money and credit back into balance or b) a self-reinforcing net selling of the debt, which creates a severe debt liquidation crisis that runs its course and reduces the size of debt and debt service levels relative to incomes. Big net selling of the debt is the big red flag. +4. The selling of government debt leads to a simultaneous a) free-market-driven tightening of money and credit, which leads to b) a weakening of the economy, c) declining reserves, and d) downward pressure on the currency. Because this tightening is too harmful for the economy, the central bank typically also eases credit and experiences a devaluation of the currency. + + + +--- + +# T H E A R C H E T Y P I C A L S E Q U E N C E + +That stage is easy to see in the market action via interest rates rising, led by long‐term rates (bond yields) rising faster than short rates and the currency weakening simultaneously. + +5. When there is a debt crisis and interest rates can’t be lowered (e.g., they hit 0% or long rates limit the decline of short rates), the central bank “prints” (creates) money and buys bonds to try to keep long rates down and to ease credit to make it easier to service debt. It doesn’t literally print money; it essentially borrows reserves from commercial banks that it pays a very short‐term interest rate on. This creates problems for the central bank if this debt selling and interest rate rising continue. + +6. If the selling continues and interest rates continue to rise, the central bank loses money because the interest rate that it has to pay on its liabilities is greater than the interest rate it receives on the debt assets it bought. When that happens, that is notable but not a big red flag until the central bank has a significant negative net worth and is forced to print more money to cover the negative cash flow that it experiences due to less money coming in on its assets than has to go out to service its debt liabilities. That is a big red flag because it signals the central bank’s death spiral (i.e., the dynamic in which the rising interest rates cause problems that creditors see, which lead them not to hold the debt assets, which leads to higher interest rates or the need to print more money, which devalues the money, which leads to more selling of the debt assets and the currency, and so on). That is what I mean when I say the central bank goes broke. I call this “going broke” because the central bank can’t make its debt service payments, though it doesn’t default on its debts because it prints money. When done in large amounts, that devalues the money and creates inflationary recessions or depressions. + +7. Debts are restructured and devalued. When managed in the best possible way, the government controllers of fiscal and monetary policy execute what I call a “beautiful + +1 0 1 + +--- + +# HOW COUNTRIES GO BROKE: THE BIG CYCLE + +deleveraging,” in which the deflationary ways of reducing debt burdens (e.g., through debt restructurings) are balanced with the inflationary ways of reducing debt burdens (e.g., by monetizing them) so that the deleveraging occurs without having unacceptable amounts of either deflation or inflation. + +At such times, extraordinary policies like extraordinary taxes and capital controls are commonly imposed. + +The deleveraging process inevitably reduces the debt burdens and creates the return to equilibrium. One way or another, the debt and debt service levels are brought back in line with the incomes that exist to service the debts. Quite often, there are inflationary depressions so the debt is devalued at the end of the cycle, government reserves are raised through asset sales, and a strictly enforced transition from a rapidly declining currency to a relatively stable currency is simultaneously achieved by the central bank linking the currency to a hard currency or a hard asset (e.g., gold) and central government and private sector finances being brought back in line to a sustainable level. At the early stage of this phase, it is imperative that the rewards of holding the currency and the debt denominated in it, and the penalties of owing money, are great in order to re-establish the creditability of the money and credit by rewarding the lender-creditors and penalizing the borrower-debtors. In this phase of the cycle, there is very tight money and a very high real interest rate, which is very painful but required for a while. If it persists, the supply and demand for money, credit, debt, spending, and savings will inevitably fall back into line. How exactly this happens largely depends on whether the debt is denominated in a currency that the central bank can create and whether the debtors and creditors are primarily domestic so that the central government and the central bank have more flexibility and control over the process. If so, that makes the process less painful, and, if not, it is inevitably much more painful. Also, whether the currency is a widely used reserve currency matters a lot. + +--- + + +T H E A R C H E T Y P I C A L S E Q U E N C E + +because when it is there will be greater marginal inclinations to buy it and the debt that it is stored in. Having said that, it should be noted that throughout history there has been a strong tendency for governments with such currencies to abuse that privilege by doing more than enough borrowing to lose that privilege, which makes their decline more abrupt and painful. + +In the next few chapters, I will show you all this happening in charts. + +1 0 3 + + + +--- + + +# CHAPTER 5 + +# THE PRIVATE SECTOR AND CENTRAL GOVERNMENT DEBT CRISIS (STAGES 1-4) + +In Chapter 4, I laid out the archetypical sequence that you see across crises. This chapter will take you through the first four of the nine stages in much more detail, showing the specific markers and dynamics I saw when I looked at historical cases. I believe that this is probably very helpful for investment professionals, policy makers, and others who care about the typical sequence, timing, and other particulars of the transition into and through a debt crisis. But it is probably too technical for the casual reader. As most of the chapters in Part II are like this one, if you like this chapter, read them all. And if you don’t like it, skip ahead to Chapter 8. + +In the pages that follow, I will show the dynamics of the archetypical debt crisis in charts accompanied by brief explanations. In the charts, the blue line shows the average of all cases, the red line shows the average of the fixed exchange rate cases, and the green line shows the average of floating exchange rate cases. You will note that the timing and the distinctiveness of these events is clearer in the cases where exchange rates are fixed (in which case they more clearly intensify and then break) than in the floating currency cases (in which the adjustments are more fluid). That is because in fixed rate cases you can see the pressures build up until there is a clear break. + +--- + +# HOW COUNTRIES GO BROKE: THE BIG CYCLE + +# Stage 1: The Private Sector and Government Get Deep in Debt + +We see this in classic ways, such as: + +- In the years before the crisis, the government classically has a large and growing stock of debt as a result of chronic deficit spending. Typically, one sees a rising share of spending going to consumption/the social safety net and a declining share going to productivity-enhancing investment, causing debts to increase without a commensurate increase in incomes. Typically, countries become so reliant on a large social safety net that cutting it becomes a political third rail (e.g., today in Brazil or the US). +- The level of debt is typically high relative to the government’s ability to pay it back with tax revenues and the debt service burden is also high relative to the government’s incomes, which starts to crowd out spending on other line items that are considered essential. To cover these costs, more debt needs to be sold than the private sector wants to buy, a source of upward pressure on interest rates (further increasing debt service costs). Note the big differences in what happens in these cases between the floating rate currencies and the fixed rate currencies after the big default/devaluation moment. It reflects the fact that in the fixed exchange rate cases the debt restructuring is more severe and definitive, which sets the stage for a more abrupt and larger rebound. Fiat cases see a gradual increase in debt, as money printing from the central bank allows government spending to continue or even accelerate. In the charts, please note that the numbers in the x-axis represent + +106 + +--- + + +# T H E P R I VAT E S E C T O R A N D C E N T R A L G OV E R N M E N T D E B T C R I S I S ( S TAG E S 1 - 4 ) + +months before and after the peak of the crisis.²² + +| GOVT DEBT LEVEL (% REVENUE) | All Cases | Fixed Cases | Floating Cases | +| --------------------------- | ------------ | ------------ | -------------- | +| (ex-Ongoing) | (ex-Ongoing) | (ex-Ongoing) | | +| | 650% | | 35% | +| | 550% | | 30% | +| | 450% | | 25% | +| | 350% | | 20% | +| | 250% | | 15% | +| | 150% | | 10% | + +-120 -80 -40 0 40 80 120 -120 -80 -40 0 40 80 120 + +| GOVT DEBT SERVICE (% REVENUE) | All Cases | Fixed Cases | Floating Cases | +| ------------------------------------- | ------------ | ------------ | -------------- | +| (ex-Ongoing) | (ex-Ongoing) | (ex-Ongoing) | | +| Rising debt service squeezing incomes | | | 145% | +| | | | 125% | +| | | | 105% | +| | | | 85% | +| | | | 65% | + +-120 -80 -40 0 40 80 45% + +120 + +ⓤ The next charts show the typical amount of government bor‐ +rowing (in total and excluding borrowing to cover interest +payments) that was done in the years leading up to the deval‐ +uation. In 31 of the 35 cases I studied, I saw large, persistent +government deficits going into the crisis. + +22 To show a clearer picture of how the government’s balance sheet evolves in the upswing and +downswing of the cycle, these charts exclude a handful of recent cases that are still playing out +(the US, Europe, the UK, and Japan post‐financial crisis). + +1 0 7 + +--- + + +# HOW COUNTRIES GO BROKE: THE BIG CYCLE + +| | GOVT DEFICIT (% GDP) | | PRIMARY DEFICIT (% GDP) | | +| - | -------------------- | ----------- | ----------------------- | - | +| | All Cases | Fixed Cases | Floating Cases | | +| | | 1% | | | +| | | 0% | | | +| | | -1% | | | +| | | -2% | | | +| | | -3% | | | +| | | -4% | | | +| | | -5% | | | +| | | -6% | | | +| | | -7% | | | +| | | -8% | | | + +-120 -80 -40 0 40 80 120 -120 -80 -40 0 40 80 120 + +It’s worth noting that on its face sometimes the public sector balance sheet looks less problematic. This is true when there is heavy borrowing in the private sector that the public sector has to back up and when there are implicit public sector guarantees to backstop institutions such as banks that the government can’t afford to let fail. Such cases might as well be public sector balance sheet problems. + +| NON-FIN PRIVATE DEBT LEVEL (% GDP) | All Cases | Fixed Cases | Floating Cases | +| ---------------------------------- | --------- | ----------- | -------------- | +| 110% | | | | +| 100% | | | | +| 90% | | | | +| 80% | | | | +| 70% | | | | +| 60% | | | | +| 50% | | | | + +-120 -80 -40 0 40 80 120 + +The buildup of debts requires large lending from foreigners to finance them. That lending can be in borrowing the country’s currency (which increases the risk of devaluation) or a reserve currency (which increases the risk of default). This increases the country’s vulnerability to a pullback in foreign capital. That said, + + + +--- + + +# T H E P R I VAT E S E C T O R A N D C E N T R A L G OV E R N M E N T D E B T C R I S I S ( S TAG E S 1 - 4 ) + +Having a current account deficit doesn’t necessarily signal problems. It reflects capital coming into the country, which could be indicative of the attractiveness of the country’s capital markets. However, in circumstances in which the attractiveness of the country’s capital markets gets impaired by the need to issue a lot of debt and money quickly to deal with a crisis, the potential for foreign selling of the country’s currency and debt represents an added source of vulnerability. As shown in the next set of charts, steadily increasing current account and twin deficits typically lead the crisis by several years. When the crisis occurs, it takes the form of a big devaluation and a constriction of debt-financed demand (including for imports), which has the effect of reducing these deficits. + +# CURRENT ACCOUNT (% GDP) + +| | All Cases | Fixed Cases | Floating Cases | | | | | +| ------------------------------ | --------- | ----------- | -------------- | - | -- | -- | --- | +| | 0% | | | | | | | +| | -1% | | | | | | | +| | | -2% | | | | | | +| Large current account deficits | -3% | | | | | | | +| | -120 | -80 | -40 | 0 | 40 | 80 | 120 | + +# TWIN DEFICIT (% GDP) + +| | All Cases | Fixed Cases | Floating Cases | +| - | --------- | ----------- | -------------- | +| | 0% | | | +| | -2% | | | +| | -4% | | | +| | -6% | | | +| | -8% | | | +| | -10% | | | + +# FOREIGN PURCHASES OF DEBT ASSETS (% GDP) + +| | All Cases | Fixed Cases | Floating Cases | | | | | +| ------------------------------------------ | --------- | ----------- | -------------- | - | -- | -- | --- | +| | | 4% | | | | | | +| | 3% | | | | | | | +| | | 2% | | | | | | +| | 1% | | | | | | | +| | 0% | | | | | | | +| | -1% | | | | | | | +| Large amounts of borrowing from foreigners | | -2% | | | | | | +| | -3% | | | | | | | +| | -120 | -80 | -40 | 0 | 40 | 80 | 120 | + +1 0 9 + + + +--- + + +# HOW COUNTRIES GO BROKE: THE BIG CYCLE + +Years of large-scale borrowing from foreigners results in a substantial accumulated debt to foreigners, which increases the country’s vulnerability to a pullback in foreign capital. The next set of charts shows, on the left, the total net international investment position (assets owned abroad minus liabilities owed to the rest of the world) and an adjusted version on the right that measures the amount of liquid assets the country has available relative to the external debts it must service. By the time of the devaluation, the country is typically very low in liquid assets it can use to cover external debt service obligations. + +| NET IIP (% GDP) | LIQUID IIP ASSETS VS IIP DEBT LIABILITIES (% GDP) | +| --------------------------------------------------------- | ------------------------------------------------- | +| All Cases | 15% | +| Fixed Cases | 10% | +| Floating Cases | 5% | +| Significant accumulated debts to foreigners | 0% | +| | -20% | +| | -40% | +| | -60% | +| Few liquid assets available to cover external obligations | -80% | +| -120 | -120 | +| -80 | -80 | +| -40 | -40 | +| 0 | 0 | +| 40 | 40 | +| 80 | 80 | +| 120 | 120 | + +| | DEBT HELD BY FOREIGNERS (% GDP) | | | | +| --------- | ------------------------------- | -------------- | --- | --- | +| All Cases | 25% | | | | +| | Fixed Cases | 20% | | | +| | | Floating Cases | 15% | | +| | 10% | | | | +| | 5% | | | | +| -120 | -120 | | | | +| | | | -80 | -80 | +| | | | -40 | -40 | +| | | | 0 | 0 | +| | | | 40 | 40 | +| | | | 80 | 80 | +| 120 | 120 | | | | + + + +--- + + +# T H E P R I VAT E S E C T O R A N D C E N T R A L G OV E R N M E N T D E B T C R I S I S ( S TAG E S 1 - 4 ) + +# Stage 2: The Private Sector Suffers a Debt Crisis, and the Central Government Gets Deeper in Debt to Help the Private Sector + +Typically, this occurs at the stage of the cycle when the government’s balance sheet goes from being moderately stretched in the years ahead of the devaluation to extremely stretched when the government is forced to step in to address debt problems that emerge in the private sector. When the private sector has financial problems, the government typically plays an increased role because it can get money and credit much more easily than the private sector can. During these difficult times, it is easier for governments to borrow because there is much more willingness to lend to them because everyone knows that their central banks can print money and get it to governments to repay the debt and because governments have the power to tax. Having this greater ability to borrow is especially true for those governments that have the most established reserve currencies because there is high demand to hold that debt/currency. + +As a result, when debt conditions deteriorate and governments need to save the day, government debt increases faster than private sector debt. As shown in the following charts, it is typical for the government debt level to soar while the private sector’s debt level plunges about a year before the crisis, and for the government debt level to rise a lot relative to the private debt level. In 15 of the 21 cases where I had data on both the government and the private sector balance sheets, I saw this pattern happen. When private debt is falling sharply and government debt is rising sharply, it is a short leading indicator of trouble. + +1 1 1 + + + +--- + + +H O W C O U N T R I E S G O B R O K E : T H E B I G C YC L E + +# PUBLIC AND PRIVATE DEBTS (% GDP) + +| | Government Debt Level | Non-Fin Private Debt Level | +| ---- | ------------------------ | -------------------------- | +| 100% | | | +| 95% | Private sector at limits | of ability to support | +| 90% | | | +| 85% | | | +| 80% | | | +| 75% | | | +| 70% | | | +| 65% | | | +| 60% | | | +| 55% | | | +| 50% | | | + +# GOVERNMENT DEBT/PRIVATE DEBT + +| | All Cases | Fixed Cases | Floating Cases | +| ---- | --------- | ----------- | -------------- | +| 150% | | | | +| 140% | | | | +| 130% | | | | +| 120% | | | | +| 110% | | | | +| 100% | | | | +| 90% | | | | +| 80% | | | | +| 70% | | | | + +At this time, government debt problems tend to intensify. I will show a few more measures in the following pages. + +The stock of government debt grows in relation to 1) its revenues, 2) the hard assets it has available to repay its debts (usually in the form of reserves), and 3) the quantity of money in the economy that is available to finance the debt (until the central bank eventually steps in to provide more money and credit to the government). + +1 1 2 + + +--- + + +T H E P R I VAT E S E C T O R A N D C E N T R A L G OV E R N M E N T D E B T C R I S I S ( S TAG E S 1 - 4 ) + +| RESERVES/ GOVERNMENT DEBT | GOVERNMENT DEBT | | | +| ------------------------------------------------- | --------------- | -------------- | -- | +| All Cases | Fixed Cases | Floating Cases | | +| Falling reserve coverage. . . until CB lets FX go | 13% | 11% | 9% | +| Surge in debt, first without monetization. . . | 7% | 5% | 3% | + +-120 -80 -40 0 40 80 120 -120 -80 -40 0 40 80 120 + +# Stage 3: The Central Government Experiences a Debt Squeeze in Which the Free-Market Demand for Its Debt Falls Short of the Supply of It + +This squeeze creates a debt problem. If there is net selling of the debt, that creates a much worse problem, so net selling of the debt is a big red flag. The central government gets into financial trouble when 1) its finances are squeezed by debt and debt service expenses that limit its ability to spend on what is essential and 2) the holders of the debt assets created to finance government spending want to sell those assets. This puts upward pressure on interest rates, further increasing the government’s financing costs and requiring either painful spending cuts or even more borrowing to cover those costs. More specifically, when debt service becomes a very high percentage of income (e.g., 100%), it is a red flag because it means that it is a) + +1 1 3 + + +--- + + +# HOW COUNTRIES GO BROKE: THE BIG CYCLE + +squeezing out a lot of spending and/or b) requiring a lot of borrowing and debt rollovers that might not happen because lender‐creditors see this situation and worry about it, leading them to not lend or to sell their debt assets. There comes a time in the long‐term debt cycle when the debt service becomes so large relative to the incomes that it either squeezes out other spending or it leads to a big demand shortage. In 25 of the 35 cases I studied, I saw government debt service as a percent of government revenues accelerate going into the crisis. + +| GOVT DEBT SERVICE (% REVENUE) | All Cases | Fixed Cases | Floating Cases | +| ----------------------------- | ------------ | ------------ | -------------- | +| (ex-Ongoing) | (ex-Ongoing) | (ex-Ongoing) | | +| Rising debt service | 145% | | | +| squeezing incomes | 125% | 105% | 85% | +| | | | 65% | + +-120 -80 -40 0 40 80 45% 120 + +Given the debts the government has built up (and the ongoing deficits it is running to compensate for a weak private sector), its debt and debt service burdens are on a path to continue climbing. The following charts show the average projected path of government debt and interest expense at the time of devaluation across the historical cases. At the time of the eventual devaluation, we can see that the government was typically on a path toward indefinitely increasing debts and debt service absent a devaluation of those debts. + + + +--- + + +# T H E P R I VAT E S E C T O R A N D C E N T R A L G OV E R N M E N T D E B T C R I S I S ( S TAG E S 1 - 4 ) + +PROJ PATH OF DEBT AT TIME OF MAJOR DEVALUATION + +| Govt Debt (% GDP) | Projected at Time of Devaluation | +| ----------------- | ------------------------------------------------------------------------------------------- | +| 110% | At the time of devaluation, government is on a path toward indefinitely increasing debts... | +| 100% | | +| 90% | | +| 80% | | +| 70% | ...along with growing debt service burdens relative to tax revenues | +| 60% | | +| 50% | | + +PROJ PATH OF INTEREST AT TIME OF MAJOR DEVALUATION + +| Interest Costs (% Revenue) | Projected at Time of Devaluation | +| -------------------------- | -------------------------------- | +| 35% | | +| 30% | | +| 25% | | +| 20% | | +| 15% | | + +This hasn’t happened yet in the US, but it is moving toward happening. As far as Europe, Japan, and China go, government interest service in those places is around half that of the US as a percent of GDP—Europe and China because their government debts are lower (though the debts of other sectors are higher), and Japan because its interest rates have been much lower for a long time. But that can change quickly, especially in Japan, where very high government debts (around 215% of GDP) could become a problem if refinanced at higher rates. As we will see in Chapter 16, the very large government debts, Bank of Japan bond purchases, and the BoJ artificially holding interest rates at extremely low levels led to terrible returns for government debt assets because of both the low yields on the debt and the depreciated value of the currency. + +Faced with a large and growing debt burden and financing need, the classic next step is the pursuit of measures to paper over issues and creative ways to source financing, including accounting tricks: + +1 1 5 + +--- + +# HOW COUNTRIES GO BROKE: THE BIG CYCLE + +1. Use of policy and development banks to create off-balance-sheet financing (frequently part of the playbook in Asian crises, e.g., Japan and Asian financial crises). +2. Use of debt guarantees instead of direct spending (Peru 1980s, Turkey recently). The government will say that it guarantees losses for a certain type of debt, which encourages borrowing—effectively a subsidy. But it doesn’t show up in government spending until losses start to appear, so it can misleadingly seem “free” to the government. For example in 2017, the Turkish government rolled out a loan guarantee program for businesses in the midst of balance of payments pressure. +3. Requiring or heavily incentivizing domestic players, especially banks, pensions, and insurers, to finance the government (Turkey and Brazil recently). Sometimes this takes the form of extremely beneficial regulatory treatment of government debt (making a risky instrument seem risk-free), and sometimes manipulation of the yield curve and financing rates to make it attractive (the US during World War II), which is effectively backdoor monetary financing (because it incentivizes banks to lever up at short-term interest rates to lend to the government). +4. Patriotic campaigns to get people to fund the government (Turkey recently appealing for people to sell their dollars for lira, World War II appeals for people to buy government bonds, Korea in the 1990s relatively successfully creating a campaign asking people to use their gold to pay back the IMF). +5. “Paying” for increased spending with future cuts and tax increases that might never come (Brazil recently, creating a constitutional amendment to limit spending, but creating plenty of outs when needed). +6. Calling in favors from international creditors and/or making geopolitical deals for financing (Turkey recently, the UK setting up the Sterling Area after World War II). +7. Shortening maturities of debt, since usually borrowers are more willing to lend for short periods than for long periods. + +--- + + +# T H E P R I VAT E S E C T O R A N D C E N T R A L G OV E R N M E N T D E B T C R I S I S ( S TAG E S 1 - 4 ) + +(described further later). + +# 8. Capital controls + +to keep money from leaving the country are common in relatively severe situations. + +# Stage 4: The Selling of the Government’s Debt Leads to + +- a) a Free-Market-Driven Tightening of Money and Credit, +- b) a Weakening of the Economy, +- c) Downward Pressure on the Currency, and +- d) Declining Reserves as the Central Bank Attempts to Defend the Currency + +Because this tightening is too harmful for the economy, the central bank eventually eases credit and simultaneously allows a devaluation of the currency. These events typically accelerate investors’ and savers’ flight from the country’s assets, bringing the run on the currency and the debt to a breaking point. Typically, the central bank attempts to defend the currency with monetary tightening and reserve sales but is ultimately forced to change course due to the painful economic effects of tightening and the inadequacy of its reserves. + +A relatively large red flag for me is when debts rise relative to the incomes that are necessary to service them to such an extent that smart investors recognize losses are inevitable (i.e., because there must be either a default or a lot of printing of money, currency weakness, and inflation to depreciate the debts in order to avoid a default). When the lender‐creditor loses faith that they will be adequately paid (because the debtor won’t be able to afford to pay debt service or because the amount of debt service isn’t sufficient—e.g., won’t adequately compensate the lender‐creditor for inflation), there will be inadequate buying relative to the selling of debt, so the price of debt will have to go down (so the interest rate will have to go up) until there is either less borrowing or more saving. + +During times of risks of war or actual war, this is worsened because + + + +--- + + +# HOW COUNTRIES GO BROKE: THE BIG CYCLE + +risks of sanctions (e.g., confiscating debt assets), excessive borrowing, debt default, and devaluation increase. War or not, that is when the doom loop can kick in̶i.e., when the upward pressure on interest rates weakens the economy and increases the government’s future borrowing needs (or requires big tax increases or spending cuts that would be excessively painful at this juncture), which then creates an even bigger supply‐and‐demand mismatch in the bond market and puts even more upward pressure on interest rates. That is when central banks have to come in to save the day by “printing money” and buying the debt and we have what is called quantitative easing (QE). + +As you will see in the following charts, in these times there is a simultaneous plunge in foreign inflows to buy local government and corporate bonds (left chart), and a spike in real rates (right chart) as there is a classic failed attempt to support the currency via rising interest rates and tightening credit. + +| FOREIGN PURCHASES OF DEBT ASSETS (% GDP) | | | | +| ----------------------------------------------------------- | --------- | ----------- | -------------- | +| | All Cases | Fixed Cases | Floating Cases | +| | | 4% | 6% | +| | | 3% | 4% | +| | | 2% | 2% | +| | | 1% | 0% | +| | | 0% | -2% | +| Price-sensitive investors (e.g., foreigners) go from buying | | -1% | | +| to selling | | | -2% | +| | | -3% | | +| | | | -4% | +| | | | -6% | +| | | | -8% | + +In these periods, we often see the government shorten the maturity of its issuance in order to make the bonds more palatable to the market. + + + +--- + + +# T H E P R I VAT E S E C T O R A N D C E N T R A L G OV E R N M E N T D E B T C R I S I S ( S TAG E S 1 - 4 ) + +# SHARE OF DEBTS MATURING IN <1YR + +| All Cases | Fixed Cases | Floating Cases | +| --------- | ----------- | -------------- | +| | | | + +When market participants see that these limitations are being reached, there is selling, which worsens the supply‐and‐demand balance. When that becomes large, the central bank is faced with the choice of a) allowing interest rates to rise to a level that will curtail borrowing and lead to a greater desire to lend to the government by redirecting money and credit that would have gone to other things (e.g., the purchase of other investments) or b) printing money and buying the debt to make up for the demand shortfall. History shows and logic dictates that the central bank will always choose b) over a), and that the best path is to balance a) and b). When that produces enough selling so that inflation rises when the economy is weak, the central bank is damned if it does print money and buy a lot of debt because it contributes to terrible currency weakness and inflation, and it’s damned if it doesn’t because it causes extremely tight money, extremely high interest rates, and a very bad economy. + +That happens when the debt service squeeze becomes intolerable for the borrower‐debtor and/or the lender‐creditor doesn’t want to hold the debt (typically because it is not providing a high enough real return, the risk of default is perceived as high, and/or the risk of the central bank printing a lot of money, thus devaluing it, is high). When those things happen, a doom loop downward spiral in the value of the government debt occurs until a new equilibrium level is reached when + +1 1 9 + + + +--- + + +# HOW COUNTRIES GO BROKE: THE BIG CYCLE + +the debt is sufficiently destroyed or devalued so that the debt burdens are no longer excessive. This hasn’t yet happened in the US, Europe, Japan, or China. Now, we will walk through these dynamics in more detail. + +- There is a tightening and/or currency intervention to defend the currency, but the tightening is abandoned because it’s too harmful for the economy and the currency intervention is abandoned because it doesn’t work and is too costly, so the debt/currency devalues. This situation becomes untenable when investors and savers see what’s going on and make the logical decision to abandon the country’s assets and currency because there is a high risk that in one way or another they won’t get their buying power back. This brings the crisis to a head because it puts more pressure on the central bank to tighten at a time when doing so would likely produce unacceptably bad economic outcomes. A few of the red flags of this more advanced stage are: + +- Interest rates rise because there is selling of the country’s debt assets and because the central bank typically attempts to tighten to defend the currency. In the face of such depressed conditions, such an increase in real interest rates is unsustainable as it puts too much pressure on an economy that is already weak and on a government that is facing a debt spiral absent lower interest rates. + +| NOMINAL SHORT RATE | | REAL SHORT RATE | | +| ------------------ | ----------- | --------------- | --- | +| All Cases | Fixed Cases | Floating Cases | | +| | 19% | | 6% | +| | 17% | | | +| | 17% | | 4% | +| | 15% | | 2% | +| | 13% | | | +| | 13% | | 0% | +| | 11% | | | +| | 9% | | -2% | +| | 9% | | | +| | 7% | | -4% | +| | 5% | | -6% | +| | 5% | | | +| | 3% | | -8% | + +-120 -80 -40 0 40 80 120 -120 -80 -40 0 40 80 120 + +| NOMINAL BOND YIELD | All Cases | Fixed Cases | Floating Cases | +| ------------------ | --------- | ----------- | -------------- | +| | 19% | | | +| | 17% | | | + + + +--- + + + +# T H E P R I VAT E S E C T O R A N D C E N T R A L G O V E R N M E N T D E B T C R I S I S ( S TAG E S 1 - 4 ) + +| NOMINAL BOND YIELD | | | +| ------------------ | ----------- | -------------- | +| All Cases | Fixed Cases | Floating Cases | +| 19% | 17% | 15% | +| 13% | 11% | 9% | +| 7% | 5% | | + +The tightening worsens a weak economy, which ultimately requires the tightening to be abandoned and the devaluation to occur. + +| GROWTH VS POTENTIAL SLACK | | | +| ------------------------- | ------------ | -------------- | +| All Cases | Fixed Cases | Floating Cases | +| 3% | Low = weaker | 4% | +| 2% | 2% | | +| 1% | 0% | | +| 0% | -2% | -1% | +| -2% | -4% | | +| -3% | -6% | | +| -4% | -8% | | + +| UNEMPLOYMENT | | | +| ------------ | ----------- | -------------- | +| All Cases | Fixed Cases | Floating Cases | +| 11% | 10% | 9% | +| 8% | 7% | 6% | +| 5% | | | + + + +--- + + +H O W C O U N T R I E S G O B R O K E : T H E B I G C YC L E + +While not always the case, inflation tends to rise and become higher than desirable going into the crisis, constraining the central bank’s ability to ease without risking undesirable high inflation. + +# INFLATION + +| | All Cases | Fixed Cases | Floating Cases | | | | | +| - | --------- | ----------- | -------------- | - | -- | -- | --- | +| | | 30% | | | | | | +| | | 25% | | | | | | +| | | 20% | | | | | | +| | | 15% | | | | | | +| | | 10% | | | | | | +| | | 5% | | | | | | +| | | 0% | | | | | | +| | -120 | -80 | -40 | 0 | 40 | 80 | 120 | + +Due to the weak economy and the rising inflation, there is substantial pressure for the currency to fall. At this stage, there is a big divergence between the floating rate and fixed rate cases. The policy makers in fixed rate cases are fighting against currency depreciation. In fact, with high inflation the currency is getting more expensive right when they need a devaluation. In the floating rate cases, the currency is gradually selling off into the economic weakness. + +# GOLD RETURN VS LOCAL CURRENCY CASH (INDEXED) + +| | All Cases | Fixed Cases | Floating Cases | | | | | +| - | --------- | ----------- | -------------- | - | -- | -- | --- | +| | 80% | | | | | | | +| | 60% | | | | | | | +| | 40% | | | | | | | +| | 20% | | | | | | | +| | 0% | | | | | | | +| | -20% | | | | | | | +| | -40% | | | | | | | +| | -60% | | | | | | | +| | -80% | | | | | | | +| | -120 | -80 | -40 | 0 | 40 | 80 | 120 | + +# REAL FX VS TWI + +| | All Cases | Fixed Cases | Floating Cases | | | | +| ---- | --------- | ----------- | -------------- | -- | -- | --- | +| | 15% | | | | | | +| | 10% | | | | | | +| | 5% | | | | | | +| | 0% | | | | | | +| | -5% | | | | | | +| | -10% | | | | | | +| | -15% | | | | | | +| -120 | -80 | -40 | 0 | 40 | 80 | 120 | + +1 2 2 + + +--- + +# T H E P R I VAT E S E C T O R A N D C E N T R A L G OV E R N M E N T D E B T C R I S I S ( S TAG E S 1 - 4 ) + +For countries with hard currency debts, credit spreads rise as markets price in a greater likelihood of default. + +# SOVEREIGN SPREAD + +| All Cases | Fixed Cases | Floating Cases | +| ----------------------------------------------------- | ----------- | -------------- | +| ![Sovereign Spread Chart](sovereign_spread_chart.png) | | | + +Risky assets price in higher risk premiums (i.e., sell off), adding to the downward pressure on the economy. + +# CORPORATE SPREADS + +# EQUITY CUMUL EXCESS RETURNS (INDEXED) + +| All Cases | Fixed Cases | Floating Cases | | +| --------- | ----------- | -------------- | ---- | +| | 5% | 100% | | +| | 4% | 80% | | +| 3% | | 60% | | +| 2% | | 40% | | +| | 1% | 20% | | +| | 0% | 0% | | +| | | - | -20% | +| | | - | -40% | + +At this stage, the central bank typically sells reserves. Remember that debt works for governments pretty much the same way it works for people and companies except that governments that have the debt denominated in their own currency and have the ability to print their own currency can do so to pay off their debt. Also, as for people and companies, governments can build up savings to help them prevent. + +--- + + +# HOW COUNTRIES GO BROKE: THE BIG CYCLE + +Financial problems when their incomes fall short of their expenses. For that reason, when looking at the riskiness of any debtor, including governments, one should also see what amount of liquid savings they have. Reserves are one of the main forms of liquid savings for governments. So are sovereign wealth funds. Watching their size, how fast they are being drawn down, and how close they are to running out is important to identifying the timing of debt problems. In the process, it pays to watch for the selling of foreign currency and buying of local currency, which is typically done. Because this reduces the money supply, it is a form of tightening. As shown in the next chart, the selling of reserves is typical at this stage of the cycle. + +| | | RESERVE FLOW (% GDP) | | | | | | +| - | --------- | -------------------- | -------------- | - | -- | -- | --- | +| | All Cases | Fixed Cases | Floating Cases | | | | | +| | | | 10% | | | | | +| | | | 5% | | | | | +| | | | 0% | | | | | +| | | | -5% | | | | | +| | | | -10% | | | | | +| | | | -15% | | | | | +| | -120 | -80 | -40 | 0 | 40 | 80 | 120 | + +Note that in the most severe cases, reserves are typically already low relative to the central bank’s liabilities (e.g., the stock of money that savers hold), which gives the central bank little firepower to fight the run on the currency. When that is the case, it becomes apparent that their currency defense will fail, which increases the betting against the currency and the fleeing of debt denominated in it. + + + +--- + + +# T H E P R I VAT E S E C T O R A N D C E N T R A L G OV E R N M E N T D E B T C R I S I S ( S TAG E S 1 - 4 ) + +# RESERVES/MONEY (M0) VS 20YR AVG + +| | All Cases | Fixed Cases | Floating Cases | +| ---- | --------- | ----------- | -------------- | +| 30% | | | | +| 20% | | | | +| 10% | | | | +| 0% | | | | +| -10% | | | | + +The following table details past interventions of central banks via their reserves across all the cases with meaningful intervention. What you can see is that: + +- Before the central bank intervenes by selling reserves, the country has a modest war chest of reserves (in the typical case, around 5% of GDP, covering around a tenth of the money supply and government debt outstanding). +- To stem capital flight and currency weakness, during the intervention phase, the central bank typically spends over half of its reserves in total to defend the currency. Typically, a lot of this selling is concentrated in a relatively short period of time—for example, in the worst six-month period of intervention, reserves decline by 49% in the median case. Then, the central bank stops spending reserves on trying to hold the currency up because it sees that it will fail at that and the prospect of having no reserves is scarier than the prospect of the currency falling. +- The currency generally falls during the currency defense. + + + +--- + +# HOW COUNTRIES GO BROKE: THE BIG CYCLE + +phase (gold rallies by 42% in the median case)—though in some cases the central bank’s intervention is able to temporarily prop up the currency. + +After a roughly two-year defense (though it of course varies by case)—the central bank gives up. At this point, the reserves back only about 6% of the money stock and 3% of the government debt. After the central bank stops intervening, the currency sells off (gold rallies another 51% in the median case). + +--- + + +# SUMMARY OF CENTRAL BANK INTERVENTIONS VIA SELLING RESERVES + +# T H E P R I VAT E S E C T O R A N D C E N T R A L G OV E R N M E N T D E B T C R I S I S ( S TAG E S 1 - 4 ) + +| vs | Excess FX | Bottoms | where | +| ------------ | --------- | ------- | ----- | +| Local Return | 51% | 133% | >500% | +| Gold FX | Until | 66% | 3% | +| | 5% | 56% | | + +| Phase | Govt Post-Intervention Debt | 3% | 2% | 3% | 2% | 6% | 10% | +| ------------------- | --------------------------- | -- | -- | -- | --- | -- | ----------- | +| Post-Intervention % | 0% | 2% | 3% | 2% | 1% | 6% | 1% in <100% | +| Money Stock (M2) | 27% | 6% | 6% | 5% | 21% | % | -- | +| | 0% | 2% | 7% | 6% | 2% | 6% | 1% | + +show Levels USD, 1.661.661.652.569.4232.72 Bln 0.020.480.771.660.440.160.07We + +Reserve reserves). + +| GDP | 1.9% | 2.0% | 1.7% | 2.0% | 7.9% | 5.2% | 0.1% | +| --- | ---- | ---- | ---- | ---- | ---- | ---- | ---- | +| | 1.1% | 5.2% | 4.7% | 1.5% | 2.7% | 0.6% | | + +# ACROSS CASES WITH MEANINGFUL INTERVENTION (1 OF 3) + +| % vs | Intrven additional | Excess During | intervention | +| ------------ | ------------------ | ------------- | ------------ | +| Local Return | 330% | 107% | 107% | +| 42% | 192% | 42% | | +| 36% | 52% | 40% | 54% | +| 19% | 35% | Gold FX | 10% | + +| Reserve | Initial Level | -62% | -65% | -58% | -50% | -65% | -56% | +| ------- | ------------- | ---- | ---- | ---- | ---- | ---- | ---- | +| -90% | -84% | -43% | -38% | -89% | -67% | FX | -81% | + +| borrow | Defend | reserve | Phase | Spend % GDP | +| ------ | ------ | ------- | ----- | ----------- | +| -14.1% | -12.8% | Total | -3.3% | -3.3% | +| -3.8% | -2.6% | -6.7% | -0.6% | -7.0% | +| -3.3% | -2.4% | -5.1% | -2.4% | to the | + +Intervention % line before Start swap 6-Month Rsvs Period 6m -49% -48% -57% -50% -47% -49% -46% -48% -36% -21% -66% -55% Intervention -58% % at of a bottomed Peak GDP -2.6% via -2.7% -1.9% -2.6% -6.8% -5.2% -0.2% -8.2% -2.7% -1.0% -3.7% -3.0% % -2.5% instance, Defense Months) Length currency FX (in 23 19 29 6 19 11 64 92 15 36 37 26 38 of (for + +| Govt reserves | Pre-Intervention Debt | 11% | 13% | 11% | 25% | 21% | 29% | +| ------------- | --------------------- | --- | --- | --- | --- | --- | ------- | +| 11% | 15% | 3% | 0% | 4% | 3% | 13% | % where | + +| Firepower | Money of Stock (M2) | 10% | 10% | 14% | 43% | 34% | 26% | +| --------- | ------------------- | --- | --- | --- | --- | --- | --- | +| 2% | 10% | 22% | 10% | % | -- | 7% | 9% | + +Starting Levels USD, 26.85 war 6.444.989.035.16 73.62 for Bln 0.252.961.342.664.070.490.37 entire Reserve out GDP 5.1% 30.9% 14.7% dashed 6.1% 4.4% 1.3% 8.7% 8.5% 0.8% 6.1% 6.2% 4.0% 5.1% its % than vs Floating are Fixed more Fixed Fixed Fixed Fixed Fixed Fixed Fixed Fixed Fixed Fixed figures + +Break Deval spent HyperInfl Cases) Break return Depr Depr bank Peg Post-WWII Post-WWII (All 1990s Peg Great excess 2001 Great central Median 1999 WWII WWII WWII + +Floating ARG: Case Fixed ARG: GBR: Gold GBR: DEU: GBR: FRA: JPN: BRZ: JPN: the + + + +--- + + +SUMMARY OF CENTRAL BANK INTERVENTIONS VIA SELLING RESERVES +ACROSS CASES WITH MEANINGFUL INTERVENTION (2 OF 3) + +# Starting Firepower + +# Intervention Phase + +# Post-Intervention Phase + +| Reserve Levels Pre-Intervention | Length of FX Intervention | Peak Spend | Total Reserve FX | Local Reserve Levels Post-Intervention | +| ------------------------------- | ------------------------- | ---------- | ------------------ | -------------------------------------- | +| Excess FX Return | 150% | 133% | 23% | -42% | +| 110% | 28% | 16% | 55% | Until 43% | +| -- | 10% | 94% | -- | cases | +| Govt Debt | -7% | 14% | 12% | 25% | +| % | 3% | 2% | -4% | 3% | +| -6% | 2% | 3% | 6% | 5% | +| "<100%" | Money Stock (M2) | -11% | -16% | -9% | +| 19% | 10% | 44% | % | 9% | +| 2% | 9% | 4% | 6% | 7% | +| 3% | show | -12.93 | 255.62 | USD, | +| 1.76-5.75 | 14.42 | -20.63 | Bln | 9.24 | +| 4.25 | 3.18 | 0.12 | 0.83 | 6.21 | +| 5.25 | We reserves). | GDP | -1.7% | -3.2% | +| 16.2% | stopped. | 1.7% | 4.4% | -3.5% | +| 1.2% | 6.1% | 1.4% | 1.9% | 6.3% | +| 2.4% | 2.4% | % | Intrven additional | Excess During | +| >500% | intervention Phase | 227% | 163% | -26% | +| 42% | 27% | 42% | 10% | -6% | +| -1% | 16% | 48% | -4% | Reserve | +| Initial Level | -128% | -135% | -159% | -65% | +| -50% | -23% | -18% | -55% | -31% | +| -73% | -28% | -43% | FX | -21% | +| borrow | Defend | reserve | % | GDP | +| -2.7% | -12.6% | -6.4% | -4.4% | -0.4% | +| -1.3% | -1.9% | -9.5% | -7.1% | -4.8% | +| -2.8% | -1.9% | -0.7% | to the | % | +| line | before | Start | swap | Rsvs | +| Period | <-100% | <-100% | <-100% | 6m | +| -57% | -44% | -14% | -15% | -55% | +| -18% | -39% | -19% | -29% | -28% | +| % at of a | bottomed | GDP | -1.8% | via | +| -3.2% | -3.3% | -0.2% | -1.0% | -5.0% | +| -1.9% | -5.5% | -2.9% | -1.6% | -0.7% | +| -1.0% | % | -0.8% | instance, | currency | +| Defense | Months) | 12 | 11 | 5 | +| 23 | 14 | 68 | 6 | 20 | +| 33 | 63 | 77 | 25 | 15 | +| (for | Govt reserves | Debt | 25% | the | +| 19% | 15% | 11% | 11% | 5% | +| 3% | 5% | 28% | 11% | 5% | +| 4% | 7% | % | where | Money | +| of Stock | (M2) | 18% | 26% | 18% | +| 18% | 31% | 7% | 3% | 9% | +| 44% | 11% | chest | % | 7% | +| 7% | 4% | cases | USD, | 20.89 | +| 371.27 | war | 18.44 | 4.98 | 18.61 | +| 36.47 | 34.88 | 10.94 | for | Bln | +| 5.15 | 7.13 | 0.59 | 1.15 | 6.67 | +| entire | out | GDP | 1.6% | 15.9% | +| 3.9% | 6.1% | 1.8% | 6.6% | 5.9% | +| 2.5% | 6.9% | 6.6% | 4.0% | 4.7% | +| 2.9% | % | than | vs Floating | Floating | +| are | Floating | Floating | Floating | Floating | +| Floating | Floating | Fixed | more | Fixed | +| Fixed | Fixed | Fixed | Fixed | Fixed | +| figures | spent | Deval | Crisis | Deval | +| return | HyperInfl | Crisis | Deval | Crisis | +| Default | Default | Depr | Deval | bank | +| Deval | BoP | Tequila | BoP | 20s | +| 70s | excess | Great | Weimar | 70s | +| central | 1982 | 2020 | 1971 | 1980s | +| Early | 2002 | Late | 2001 | 2014 | +| Late | MEX: | ARG: | Case | MEX: | +| USA: | GBR: | Gold | USA: | DEU: | +| BRZ: | FRA: | BRZ: | TUR: | BRZ: | +| ITA: | the | | | | + +1 2 8 + + +--- + + +# T H E P R I VAT E S E C T O R A N D C E N T R A L G OV E R N M E N T D E B T C R I S I S ( S TAG E S 1 - 4 ) + +vs Excess FXBottoms where + +| Local Return | 47% | +| ----------------- | ----------- | +| FX | 84% | +| Gold | Until cases | +| Phase | Govt | +| Post-Intervention | -30% | + +% Debt 5% in + +Post-Intervention "<100%" + +Money Stock -15% (M2) + +% 14% show Levels USD, -58.67 + +# SUMMARY OF CENTRAL BANK INTERVENTIONS VIA SELLING RESERVES + +| Bln | 2.47 | +| ------- | ---------- | +| Reserve | reserves). | +| GDP | -6.8% | +| 1.4% | | + +# ACROSS CASES WITH MEANINGFUL INTERVENTION (3 OF 3) + +| % | vs additional | Excess | Intrven intervention | During | +| ------------ | ------------- | ------ | -------------------- | ------ | +| Local Return | Phase | 108% | | | +| FX | 31% | | | | +| Gold | | | | | + +Reserve + +| Reserve InitialLevel | -293% | | +| -------------------- | -------- | ------ | +| FX | -62% | | +| borrow | Defend | | +| reserve Phase | Spend | | +| % GDP | -10.2% | | +| Total | -2.1% | | +| to the Intervention | % line | | +| before Start | swap | | +| 6-Month Rsvs | Period | <-100% | +| Intervention 6m | -60% | | +| % at of a | bottomed | | +| Peak GDP | -1.9% | | +| % | -6.5% | | +| instance, Defense | Months) | | +| Length | currency | | +| FX | (in 4 41 | | + +of (for Govt reserves + +| Pre-Intervention | the Debt | +| ---------------- | --------- | +| 11% | 14% | +| % where | Firepower | +| Money Stock | (M2) | +| 22% | 8% | +| cases | | + +Starting Levels USD, 30.34 + +| Bln | 6.44 | +| ---------- | ----------- | +| for entire | Reserve out | +| GDP | 2.6% | +| 3.8% | | + +% than vs Floating are Floating Floating Fixed more figures spent Crisis return Crisis bank + +BoP BoP excess 1994 central 2018 + +Case TUR: Gold TUR: the + +--- + + +# HOW COUNTRIES GO BROKE: THE BIG CYCLE + +At this stage, it becomes relatively clear that the currency is at best highly risky and at worst a very bad deal. This leads to not just investors leaving the debt/currency, but in many cases participants in the economy—most importantly banks, corporations, and households—making prudent/de-risking moves out of the debt and currency. Here are many of the dynamics I saw in the cases I studied that I consider classic signs of being in the late stages of the debt cycle: + +# Corporate Treasury Actions + +1. Domestic companies decide to keep international revenue offshore principally in foreign FX (i.e., dollars), not converting it back to local currency like they used to. Seeing their revenues swing in local currency terms even as dollar prices stay more stable, they begin to think of their local currency as the currency to hedge, even though in traditional investing they should hedge the foreign currency. +2. Domestic corporations decide to increase their amount of hedging of the local currency, especially those with hard currency debts. Hedging involves a forward contract to sell the local currency and buy foreign currency, which lowers the forward exchange rate and drags down the spot exchange rate. +3. Similarly, foreign corporations with domestic subsidiaries ensure cash is promptly swept out of the country. +4. Companies decide their foreign subsidiaries aren’t worth the hassle—navigating the currency risk, political chaos, and sometimes career risk, for a small expansion opportunity doesn’t make a lot of sense. New FDI projects are put on hold. + + + +--- + + +# T H E P R I VAT E S E C T O R A N D C E N T R A L G OV E R N M E N T D E B T C R I S I S ( S TAG E S 1 - 4 ) + +# Domestic Bank Actions + +5. The banks that were forced to buy the debts under government policies have to sell them when liquidity dries up ̶ accelerating the debt sell‐off in the worst of the crisis. + +6. Some of the central bank tactics to keep conditions stimulative (multiple interest rates, capital controls) make it more attractive to keep money offshore than onshore. Domestic banks and corporations are often the ones best placed to make that market. Even if kept in the same currency, money leaving the domestic banking system often means selling government debt. + +# International Bank Actions + +7. International lenders close lines of business that are too much of a headache̶trade financing, working capital lines of credit, etc. + +8. Often, they literally sell or give away their bank subsidiaries when it is not worth the exposure to losses that a small subsidiary has on the broader corporation (let alone the headache of paying attention to this corner of the business). + +# Large International Investor Actions + +9. Ironically, even as borrowing grows, more of it is held by players who can’t sell (e.g., banks), and the dollar value of the assets falls. Liquidity dries up, pushing out large foreign investors who don’t like illiquid assets. + +10. There are moves out of the currency by large government + +1 3 1 + + + +--- + +# HOW COUNTRIES GO BROKE: THE BIG CYCLE + +reserve holders, often with geopolitical considerations a big part of the decision. + +11. Often, big international reserve allocators can’t really sell their assets—it would be too disruptive to the market. Instead, reserve managers start accumulating all new reserves in a different currency—causing demand to dry up. + +12. Relatedly, international investors can’t sell their assets (too little liquidity), but they don’t roll the exposures. + +The outflows from foreigners are classic and tend to lead the devaluation. + +| FOREIGN PURCHASES OF DEBT ASSETS (% GDP) | | FOREIGN INFLOWS INTO LOANS AND DEPOSITS (% GDP) | | +| ---------------------------------------- | ----------- | ----------------------------------------------- | - | +| All Cases | Fixed Cases | Floating Cases | | +| 4% | 5% | | | +| 3% | 4% | | | +| 2% | 3% | | | +| 1% | 2% | | | +| 0% | 1% | | | +| -1% | 0% | | | +| -2% | -1% | | | +| -3% | -2% | | | + +Domestic Saver Actions + +13. Domestic savers decide they want diversification, and to some degree begin betting on inflation-hedge assets, which drives flows in that direction. They convert bank deposits to hard currency, requiring banks to sell local currency to buy foreign currency. + +14. People buy real goods to get ahead of inflation. Since imports are a share of these real goods, it creates a currency sale. This of course also fuels inflation and makes matters worse. + +--- + + +# T H E P R I VAT E S E C T O R A N D C E N T R A L G OV E R N M E N T D E B T C R I S I S ( S TAG E S 1 - 4 ) + +15. High-net-worth individuals, mostly concerned about wealth preservation and rising taxes and wealth confiscation, move money abroad. + +16. Domestic savers see holding foreign stocks as the more reliable bet. More products pop up to make that possible. + +17. Opening foreign bank accounts, since domestic banks look troubled, looks like the prudent move. Those banks make it easy to exchange to other currencies (assuming the government hasn’t imposed capital controls; in many cases, the government makes opening foreign bank accounts quite difficult). + +# More Traditional Speculative Trading + +18. Bond vigilante market action emerges and becomes self-reinforcing. + +19. Equity investors pull out of the country as the environment deteriorates, which creates a negative currency impact. + + + +--- + + +# CHAPTER 6 + +# THE CRISIS SPILLS OVER + +# TO THE CENTRAL BANK + +# (STAGES 5-6) + +This chapter continues to go through the dynamics I laid out in my archetype of a big debt crisis. Here, we will focus on Stages 5-6, when problems spill over to the central bank. + +# Stage 5: When There Is a Debt Crisis and Interest Rates Can’t Be Lowered (e.g., They Hit 0%), the Central Bank “Prints” (Creates) Money and Buys Bonds to Ease Credit and Make It Easier to Service Debt + +The central bank doesn’t literally “print money.” In doing this, it essentially borrows reserves from commercial banks that it pays a very short-term interest rate on. Ultimately, the government can’t escape the fact that it needs to find much more financing for its spending priorities. But at this stage, it typically experiences financing rates higher than it can afford—often because of the mechanical selling of the currency and debt. Needing financing, the government turns to the central bank. This puts the problem in the central bank’s court. + +History shows that during such times, central banks typically + +--- + + +# HOW COUNTRIES GO BROKE: THE BIG CYCLE + +produce a lot of money and credit to buy the bonds. I view this as a red Xag, but not yet a big red Xag because of the power of central banks to control the production of money and credit. In the case of central governments and their debts, it will be diYcult to avoid the squeeze if the deWcits continue because the high debt burdens cause increasing amounts of government spending to be directed to debt service. We will get into an examination of the US government’s Wnances later. + +More speciWcally, the central bank steps in to relieve the pressure on the government’s Wnances (or the Wnances of other systemically important entities) either through the direct purchase of assets or indirectly through guarantees and backstops. The central bank often takes losses on these assets if they were bought at uneconomical prices in the form of defaults, inXation, and/or rising interest rates. At this stage, the balance sheet hit is transferred from the government to the central bank and the holders of the currency. + +As previously explained, when there isn’t enough demand for government debt, the central bank will be faced with the choice between a) having interest rates rise enough to bring supply and demand into balance, which will reduce both the demand for credit and spending and b) printing money and buying debt assets, which will expand the central bank’s balance sheet via quantitative easing, which means acquiring a lot of debt assets. If these things continue for a long time, they should be viewed as early-stage red Xags. + +Also, when governments shorten the maturities of their debt, which typically happens when there isn’t enough demand for their long-term debt, that should be viewed as an early-stage red Xag, too. And, when both a) the total debt and b) the government debt that is held by the central bank rise because there isn’t enough free-market demand to buy the debt, that should be viewed as an early-stage red Xag as well. + +As shown in the following charts, these trends toward greater central bank holdings of bonds and shortening of maturities typically start nearly a decade before the crisis and reverse after it. Notice the ac‐ celeration of central bank bond buying and how the maturity of the government debt is rapidly shortening. + + + +--- + + +THE CRISIS SPILLS OVER TO THE CENTRAL BANK (STAGES 5 - 6) + +# CENTRAL BANK BOND HOLDINGS (% GDP) + +# SHARE OF DEBTS MATURING IN <1YR + +| | All Cases | Fixed Cases | Floating Cases | +| ------- | --------- | ----------- | -------------- | +| QE/debt | 13% | | | +| | 11% | | | +| | 9% | | | +| | 7% | | | +| | 5% | | | +| | 3% | | | + +As discussed earlier, when the system is working well, the demand to borrow from borrower-debtors and the willingness to lend by lender-creditors balance. However, when the free-market demand for the debt that is being sold is not adequate, the central government and the central bank take on more of the debt when the private sector can’t. The government can do this when the private sector can’t because lender-creditors will more readily lend to the government during times of stress as they believe that the central government will pay it back since the central bank has the power to print money to pay debts so there is virtually no risk that it will default. The risk becomes that the central bank will produce too much money and credit in order to prevent defaults, which will produce a lot of inflation that will make being paid back in devalued money a big risk for the lender-creditor. When this happens, I view it as a red flag, but not a big red flag because history shows that it can happen a lot before the supply-and-demand imbalance becomes a problem. In the most recent example, this started in 2008. It was previously called debt monetization and has this time around been called quantitative easing. In the United States, it came in four waves that added up to 18% of potential GDP, 5% of total debt, and 16% of government debt. In Europe, it also came in four waves that added up to 30% of potential GDP, 10% of total debt, and 36% of government debt. In Japan, it came in three waves that added up to 95%. + +1 3 7 + + +--- + + +# HOW COUNTRIES GO BROKE: THE BIG CYCLE + +of potential GDP, 22% of total debt, and 46% of government debt. When central banks buy bonds, they take on the same set of risks that commercial banks and investors do. The only difference is that central banks have the power to print money to monetize the debts and to account for their losses in ways that make them less apparent. More specifically, when the central bank buys the bond (say, from a bank), it pays for it by telling the bank it has a new deposit at the central bank. The central bank pays interest on that deposit (not that different from money you or I keep at a bank). Just like commercial banks can get into trouble if the interest they earn on their assets is below the interest they pay on deposits, it’s the same for central banks. If the interest rates the central banks pay on deposits rise above the interest that they are getting on the bonds they own, they will lose money and will have a negative cash flow. If they used mark-to-market accounting, they would have losses on the bonds, and as with banks and investors, if their losses become greater than their capital, they have a negative net worth. In reality, at this stage no one cares much, but for reasons that I will explain, they should. + +# Stage 6: If Interest Rates Rise, the Central Bank Loses Money Because the Interest Rate That It Has to Pay on Its Liabilities Is Greater than the Interest Rate It Receives on the Debt Assets It Bought + +When that happens, that is notable but not a big red flag until the central bank has a significant negative net worth and is forced to print more money to cover the negative cash flow that it experiences due to less money coming in on its assets than has to go out to service its debt liabilities. That is a big red flag because it signals the central bank’s death spiral (i.e., the dynamic in which rising interest rates cause problems that creditors see, which leads them not to hold the debt assets, which leads to higher interest rates or the need to print more money, which devalues the money, which leads to more selling. + + + +--- + + +# T H E C R I S I S S P I L L S OV E R T O T H E C E N T R A L B A N K ( S TAG E S 5 - 6 ) + +of the debt assets and the currency, and so on). That is what I mean when I say the central bank goes broke: it can’t make its debt service payments, though it doesn’t default on its debts because it prints money. When done in large amounts, that devalues the money and creates inflationary recessions or depressions. + +At this stage, the central bank typically ends up in a difficult situation, caught between the need to maintain policy that is at once easy enough to support a weak economy and a fiscally weak government but also tight enough to discourage savers and investors from fleeing the currency. This is a hallmark of an unsustainable situation, and it typically manifests in the following ways: + +1. Central banks have losses and negative net worths. + +After the central bank has bought a lot of debt and interest rates have risen so debt prices have fallen and the central bank’s short-term costs of funds are greater than the returns on the debt they bought, central banks have losses that are so big that they lead the central banks to have negative net worths. That is another red flag. Still, all these red flags don’t signal the end of the Big Debt Cycle—they just show signs of the fading financial health of the system. It is not the end because central banks can still print plenty of money to provide ample money and credit and to fund their losses. Having said that, it is noteworthy that in some cases where the governments don’t want to have flimflam finances, the central government is required to put capital in the central bank to recapitalize it. When that happens, the central government has to get more capital to provide it, which it will do by taxing, cutting spending, and/or borrowing, which adds to the squeeze. + +When central banks buy a lot of debt, that lowers the value of the debt because it lowers the value of the money that the debt asset is promised to get. And when the short-term interest rates that they have to pay are high relative to the long-term interest that they get from the debt assets that they own, central banks have losses and + + + +--- + + +# HOW COUNTRIES GO BROKE: THE BIG CYCLE + +can have a negative net worth. This is a moderate red flag at first̶ several central banks have negative net equity (or equivalent) today, and it doesn’t hinder them much in the way of their operations. But at larger degrees of losses, it could begin a spiral that creates much bigger problems. + +The advantage of the central banks doing such buying is that 1) it provides credit that wouldn’t have existed to keep interest rates lower than they would have been and 2) when interest rates rise and the bonds have losses, it will be the central bank that has the losses. This raises the question of whether central bank losses matter, and if so why. The answer is that central banks having losses certainly matters less than private sector investors having losses and having to appear to lender‐creditors as creditworthy. When central banks have big losses on their debt, that signifies a step toward a more advanced stage near the end of the Big Debt Cycle so I view it as a flag. There is typically still no reason for a crisis at this stage because, as stated, small or moderate losses don’t matter much for the central bank. However, as these losses move from being small to being very large, they can create cash flow needs for the central bank that can only be met with a lot of money printing, which puts a significant downward pressure on the currency, as the central bank runs up a large interest bill on its liabilities (in an effort to keep savers in the currency) but earns little on its assets (in an effort to support the government) and ends up printing the difference. + +The following table describes historical cases where these cash flow losses became very large and necessitated a big monetization that contributed to a currency spiral. + +1 4 0 + +--- + + +# HISTORICAL CASES WHERE CENTRAL BANKS TOOK LARGE CASH FLOW LOSSES + +| Average over Period | | Outcomes of Case | | | | | +| --------------------------- | ------------------------------------- | ---------------- | --------- | ---------------- | ------- | -------- | +| Cumulative Move | -97% | -86% | -100%-80% | -42% | | | +| FX | contributor were massive devaluations | | | | | | +| Inflation (Ann) | 4927% | 49% | 246% | 22% | 84% | Losses | +| Growth | Money (Ann) | 107% | 50% | 214% | 27% | 20% | +| Propensity to Spend | Printed Money | | | | | | +| | | | High | High | High | High | +| Paid | rather | monetized | through | recapitalization | | | +| | | | | Money Losses | By | Reserves | +| Net CB Losses (% of GDP) | 4.7% | 1.4% | 2.5% | 1.8% | -2.5% | | +| Cash Flow (% of GDP) | -3.3% | -3.5% | -2.6% | -3.3% | -2.6% | | +| CB Balance Sheet (% of GDP) | 31.5% | 34.0% | 6.9% | 5.8% | 17.2% | | +| Date End | Dec-90 | Dec-22 | Dec-88 | 1796 | Early | | +| Date Start | Jan-88 | Jan-19 | Jan-85 | Jan-23 | 1780 | | +| Case | ARG: | ARG: | Late 80s | Dutch | Turkey: | | + + + +--- + + + +# HOW COUNTRIES GO BROKE: THE BIG CYCLE + +The central bank is forced to print money to monetize losses on its debt and other debts even though it worsens the pressure on the currency. + +Faced with these circumstances, the central bank is ultimately forced to print money to monetize its losses and the losses of others. This can happen explicitly through the direct purchase of assets by the central bank or indirectly through guarantees and backstops. The central bank typically takes losses on these assets (often bought at uneconomical prices) through defaults, inflation, and/or rising interest rates—transferring the balance sheet hit from the government to the central bank and the holders of the currency. Some of the hallmarks of this stage are: + +- An expanding central bank balance sheet as money is printed to finance the government or to roll the debts of other stressed entities. The next chart shows the central bank’s purchases of government bonds, but it’s worth noting that central bank actions can be much broader than this (up to and including the purchase of private assets like corporate bonds or equities). They can also include measures to guarantee and backstop stressed borrowers that don’t always show up on the balance sheet but still represent some transfer of purchasing power to stressed debtors as the central bank and government are on the hook for covering losses (e.g., the Emergency Banking Act of 1933 and the Bank of Amsterdam’s backstop of the Dutch East India Company—both of which ultimately required monetization). + + + +--- + + +# T H E C R I S I S S P I L L S OV E R T O T H E C E N T R A L B A N K ( S TAG E S 5 - 6 ) + +# CENTRAL BANK BOND HOLDINGS (% GDP) + +| | All Cases | Fixed Cases | Floating Cases | +| -------------------- | --------- | ----------- | -------------- | +| QE/debt monetization | 13% | | | +| | 11% | | | +| | 9% | | | +| | 7% | | | +| | 5% | | | +| | 3% | | | + +The sale of reserves as the central bank tries to defend the currency while simultaneously providing money and credit to those that need it. The result is that the composition of the central bank’s asset holdings shifts from hard assets (gold and FX reserves) to soft assets (claims on the government or financials). This contributes to the run on the currency (particularly when the currency is pegged) as investors see the central bank’s resources to defend the currency rapidly decreasing, forcing the central bank to sell reserves even faster until it reaches the point where a defense is no longer feasible. This dynamic is far more pronounced in the fixed rate cases than it is in the floating cases. + +The monetization of debts combined with the sale of reserves causes the ratio of the central bank’s hard assets (reserves) to its liabilities (money) to decline, weakening. + + + +--- + +# HOW COUNTRIES GO BROKE: THE BIG CYCLE + +the central bank’s ability to defend the currency. This is an‐other case where having a Wxed versus a Xoating rate currency is important. Pegged currency countries tend to have a more backed money supply but run into problems sooner when the ratio of reserves to money declines. They also tend to expend more reserves in the currency defense stage of the cycle. + +| RESERVES/MONEY (M0) VS 20YR AVG | | LEVEL | +| ------------------------------- | ----------- | -------------- | +| All Cases | Fixed Cases | Floating Cases | +| 30% | 70% | | +| 20% | 60% | | +| 10% | 50% | | +| 0% | | 40% | +| -10% | | 30% | + +In fixed rate cases, the level of hard assets tends to be higher (closer to 50% backed on average), but begins to decline and is only around a third backed at the time of devaluation. + +--- + +# CHAPTER 7 + +# THE PRIOR BIG DEBT CRISIS RECEDES, A NEW EQUILIBRIUM IS REACHED, AND A NEW CYCLE CAN BEGIN (STAGES 7-9) + +The cycle ends when a mix of market forces and policy‐maker actions create a bottom and an upswing from there. This chapter lays out the dynamics and markers I look for in these times (Stages 7‐9 of the archetype I showed in Chapter 4). + +# Stage 7: Debts Are Restructured and Devalued + +When managed in the best possible way (what I call a beautiful deleveraging), the deflationary ways of reducing debt burdens (e.g., through debt restructurings) are balanced with the inflationary ways of reducing debt burdens (e.g., by monetizing them) so that the deleveraging occurs without having unacceptable amounts of either deflation or inflation. When the debt burdens become too great, a big restructuring and/or devaluation that substantially reduces their size and value will happen, either by itself or with the help of good management. + +The currency devalues and the remaining holders of the currency and the debt take big losses in real terms. The loss of purchasing power continues until a new monetary system is established with + +--- + + +# HOW COUNTRIES GO BROKE: THE BIG CYCLE + +enough credibility to entice investors and savers to hold the currency again. Typically, this involves a substantial write‐down and restructuring of the debt. + +| REAL FX VS TWI | | INFLATION | | | | +| -------------- | ----------- | -------------- | -- | - | - | +| All Cases | Fixed Cases | Floating Cases | | | | +| | 15% | | | | | +| | 10% | | | | | +| | 5% | | | | | +| | | | 0% | | | +| | -5% | | | | | +| | -10% | | | | | +| | -15% | | | | | + +Government debts devalue relative to real assets like gold, stocks, and commodities. Perhaps this time, digital currencies like Bitcoin will benefit. The following charts show the average devaluation of currency and debts across the cases relative to 1) gold, 2) commodities, and 3) equities. On average, gold outperforms holding the local currency in these cases by roughly 60% from the start of the devaluation until the currency bottoms. Notice the big difference in what happens in the fixed exchange rate and the variable (floating) exchange rate cases. + + + +--- + +# T H E P R I O R B I G D E B T C R I S I S R E C E D E S , A N E W E Q U I L I B R I U M + +# I S R E AC H E D , A N D A N E W C YC L E C A N B E G I N ( S TAG E S 7 - 9 ) + +# GOLD RETURN VS LOCAL CURRENCY CASH (INDEXED) + +| All Cases | Fixed Cases | Floating Cases | +| ------------------------------------------- | ----------- | -------------- | +| ![Gold Return Chart](gold_return_chart.png) | | | + +# COMMODITY INDEX RETURN (CUMUL EXCESS, INDEXED) + +| All Cases | Fixed Cases | Floating Cases | +| ----------------------------------------------------------------- | ----------- | -------------- | +| ![Commodity Index Return Chart](commodity_index_return_chart.png) | | | + +# EQUITY RETURN (CUMUL EXCESS, INDEXED) + +| All Cases | Fixed Cases | Floating Cases | +| ----------------------------------------------- | ----------- | -------------- | +| ![Equity Return Chart](equity_return_chart.png) | | | + +You can see the individual returns of the various assets by case in the following table. + +--- + + +H O W C O U N T R I E S G O B R O K E : T H E B I G C YC L E + +# ASSET RETURNS DURING CURRENCY DEVALUATIONS AND DEBT WRITE-DOWNS (EXCESS RETURN) (1 OF 2) + +| | | Individual Assets (at 15% Vol) | | | Assets vs Debt/FX | | +| ---------------------------- | --------------------------- | ------------------------------ | ---- | ----- | --------------------------- | ------------------------------------ | +| Equities, Gold (in Local FX) | Gold vs Bonds (Vol-Matched) | | | | | | +| Gold (in Local FX) | Nominal Equities | | | Bonds | Gold vs Bonds (Vol-Matched) | Gold, and Cmd vs Bonds (Vol-Matched) | +| Average Return | 81% | 55% | 34% | -5% | 94% | 71% | +| Median Return | 66% | 49% | 3% | -2% | 71% | 38% | +| JPN: WWII | 282% | 203% | 100% | -53% | 335% | 260% | +| DEU: Weimar HyperInfl | 245% | 241% | 754% | -99% | 501% | 516% | +| USA: 1971 Deval | 185% | 162% | -44% | -6% | 191% | 141% | +| ITA: WWII | 173% | 156% | 92% | -28% | 201% | 154% | +| USA: Great Depression | 149% | 70% | 33% | 19% | 130% | 68% | +| JPN: Great Depression | 146% | 73% | 60% | 30% | 116% | 72% | +| ITA: Early 20s Deval | 126% | 105% | -22% | -15% | 141% | 71% | +| USA: Late 70s Deval | 109% | 56% | 3% | -33% | 143% | 104% | +| GBR: Late 70s Deval | 88% | 23% | 22% | 19% | 69% | 37% | +| GBR: Great Depression | 81% | -4% | -8% | 26% | 56% | 2% | +| GBR: Post-WWII Deval | 75% | 57% | 11% | 19% | 57% | 38% | +| ITA: Late 70s Deval | 73% | 20% | -16% | -42% | 114% | 79% | +| FRA: Early 20s Deval | 73% | 87% | 43% | -11% | 84% | 59% | +| FRA: WWII | 71% | 90% | 11% | -14% | 86% | 66% | +| GBR: 08 Fin Crisis | 71% | 11% | 24% | 52% | 19% | -4% | +| GBR: WWII | 66% | 52% | 8% | 18% | 49% | 31% | +| TUR: 2018 BoP Crisis | 66% | 40% | 63% | -27% | 144% | 165% | + +These tables show returns from the moment of devaluation through to the period when the currency has settled at a new equilibrium (e.g., in the US Great Depression, returns are shown from the month of the peg break to shortly after; in cases where the devaluation was more drawn out, returns are shown for the full period of devaluation). We would consider the returns figures in individual cases to be more indicative than exact, because getting returns and volatility adjusting are imprecise in cases with market closures, defaults, and in cases where we have lower-quality data. + +1 4 8 + + +--- + + +T H E P R I O R B I G D E B T C R I S I S R E C E D E S , A N E W E Q U I L I B R I U M +I S R E AC H E D , A N D A N E W C YC L E C A N B E G I N ( S TAG E S 7 - 9 ) + +# ASSET RETURNS DURING CURRENCY DEVALUATIONS AND DEBT WRITE-DOWNS (EXCESS RETURN) (2 OF 2) + +| | | Individual Assets (at 15% Vol) | | | Assets vs Debt/FX | | | | | +| -------------------------- | ----------------------------- | ------------------------------ | ---- | ---- | ----------------- | -------- | ------------- | --------------------------- | ------------------------------------ | +| Gold (in Local FX) | Commodity Index (in Local FX) | | | | | Equities | Nominal Bonds | Gold vs Bonds (Vol-Matched) | Gold, and Cmd vs Bonds (Vol-Matched) | +| USA: 08 Fin Crisis | 63% | 2% | 16% | 55% | 7% | -27% | | | | +| MEX: 1982 Default | 53% | 73% | -27% | -81% | 134% | 131% | | | | +| ARG: 1990s HyperInfl | 47% | 54% | - | - | - | - | | | | +| TUR: 1994 BoP Crisis | 46% | 51% | -1% | -50% | 97% | 99% | | | | +| MEX: Tequila Crisis | 40% | 47% | -18% | -42% | 82% | 77% | | | | +| JPN: 08 Crisis + Abenomics | 38% | -21% | 61% | 49% | -11% | -22% | | | | +| BRZ: 2002 BoP Crisis | 31% | 33% | -11% | 1% | 25% | 15% | | | | +| ITA: Euro Debt Crisis | 28% | -2% | -16% | 11% | 17% | -6% | | | | +| ESP: Euro Debt Crisis | 28% | -2% | -15% | 39% | -11% | -34% | | | | +| BRZ: 1999 Peg Break | 27% | 16% | -3% | -6% | 33% | 26% | | | | +| BRZ: 2014 BoP Crisis | 25% | -11% | -14% | -2% | 49% | 24% | | | | +| JPN: Post-Bubble Deval | 23% | 64% | 6% | 48% | -25% | 0% | | | | +| GRC: Euro Debt Crisis | 23% | -13% | -50% | -49% | 71% | 30% | | | | +| ARG: 2001 Peg Break | 20% | 14% | -4% | 0% | 21% | 16% | | | | +| TUR: 2001 HyperInfl | 13% | 1% | -13% | 22% | -9% | -22% | | | | + +1 4 9 + + +--- + + +# HOW COUNTRIES GO BROKE: THE BIG CYCLE + +When debts are restructured and/or devalued, it is typically a terrible time in markets and economies, but this terrible time reduces the debt burdens and establishes the foundation for the improvement. In the archetypical case, debt levels rise significantly relative to the monetary base in the run-up to the crisis, requiring the private sector to absorb a much greater amount of government debt with the same quantity of base money in circulation (which is likely a part of why we see upward pressure on interest rates at first in many of our cases). Eventually, when the pressure becomes too great, the central bank steps in and monetizes the debt, resulting in an expansion of the monetary base and a decline in the debt-to-money ratio. + +The ratio of reserves to debt typically falls at first, then rises. Typically, at this stage, we see reserves fall relative to debts—at first because debt levels are increasing quickly, then additionally because reserves are being sold in an attempt to defend the currency. After policy makers give up and let the currency go, we see this ratio improve as the devaluation of the currency mechanically reduces the value of local currency debts relative to hard currency assets and improves the country’s competitiveness, helping it to earn more in hard currency terms. + +| RESERVES/ | GOVERNMENT DEBT/ | | MONEY (M0) | | | +| --------- | ---------------- | ----------- | -------------- | - | - | +| | All Cases | Fixed Cases | Floating Cases | | | +| | 13% | | 1200% | | | +| | 11% | | | | | +| | 9% | | 1000% | | | +| | 7% | | | | | +| | 5% | | | | | +| | 3% | | 600% | | | + +-120 -80 -40 0 40 80 120 -120 -80 -40 0 40 80 120 + +1 5 0 + + + +--- + + +# T H E P R I O R B I G D E B T C R I S I S R E C E D E S , A N E W E Q U I L I B R I U M + +# I S R E AC H E D , A N D A N E W C YC L E C A N B E G I N ( S TAG E S 7 - 9 ) + +The next charts show how the paths of government debts and the monetary base typically line up. Typically, we see government debt rise first (usually in response to some crisis) while money growth is by and large unchanged (and, in fact, slows at the point of the cycle where the central bank tries to mount a currency defense). The government typically tries to control things through various techniques like foreign exchange controls or managing the currency (e.g., sometimes having an official foreign exchange rate that is different from the market rate). These controls create market distortions and do more harm than good. After the central bank gives up and lets the currency go, the pace of money printing picks up and helps to produce inflation that improves the government’s nominal incomes relative to its debts. This dynamic is by and large similar across pegged and non‐pegged cases. + +| GOVERNMENT DEBT/ | MONEY (M0) | | +| ------------------------------- | ------------------------ | -------------- | +| All Cases | Fixed Cases | Floating Cases | +| Surge in government spending, | 1200% | | +| first without monetization. . . | 110% | | +| | 100% | | +| | 90% | | +| | 80% | | +| | 70% | | +| | 800% | | +| . . .then monetization | 60% | | +| inevitably needed | 50% | | +| | 40% | | +| | -120 -80 -40 0 40 80 120 | | + +The next three charts show government debt against reserves; the fall in reserves relative to debts is driven mostly by the rise in government debt but also by the selling of reserves late in the cycle to try to fight off the collapse of the currency. After the selling stops and the currency devalues, we typically see an improvement in the ratio as the devaluation lowers the value of local currency government debts relative to any remaining hard currency assets. + +1 5 1 + + + +--- + + +H O W C O U N T R I E S G O B R O K E : T H E B I G C YC L E + +# RESERVES/GOVERNMENT DEBT + +| | All Cases | Fixed Cases | Floating Cases | +| --------------------------------------------------------------------------------- | --------- | ----------- | -------------- | +| Fall in reserve coverage due to currency defense and rising debts. | 13% | 11% | | +| | 9% | 7% | | +| ...improvement after the central bank lets the currency go and devalues the debts | 5% | 3% | | + +# GOVERNMENT DEBT + +| | LEVEL (% GDP) | FX RESERVES | (% GDP, IDX TO START) | +| --------- | ------------- | ----------- | --------------------- | +| All Cases | 110% | | 5% | +| | 100% | | 4% | +| | 90% | | | +| | 80% | | 3% | +| | 70% | | 2% | +| | 60% | 1% | | +| | 50% | 0% | | + +# Stage 8: At Such Times, Extraordinary Policies Like Extraordinary Taxes and Capital Controls Are Commonly Imposed + +At this point, the government is cash‐strapped and typically raises taxes to try to meet its financing need. The prospect of greater taxation + +1 5 2 + + +--- + + +THE PRIOR BIG DEBT CRISIS RECEDES, A NEW EQUILIBRIUM IS REACHED, AND A NEW CYCLE CAN BEGIN (STAGES 7 - 9) + +puts additional pressure on households and businesses to move what they can out of the country. In response, governments often enact capital controls to try to stem these outflows, though by now the economic pressure to leave the country and the currency is too great for governments to stop the bleeding. + +The following charts show a few different perspectives on tax rates across cases. You can see, for example, that both marginal income tax rates for top earners and inheritance tax rates rise by about 10% in the years going into the devaluation.23 + +| MARGINAL INCOME TAX RATE | | INHERITANCE TAX RATE | | | | +| ------------------------ | ----------- | -------------------- | --- | - | --- | +| All Cases | Fixed Cases | Floating Cases | | | | +| | 90% | | 65% | | | +| | 80% | | 60% | | | +| | 70% | | 55% | | | +| | | | 50% | | | +| | | | 60% | | 45% | +| | 50% | | 40% | | | +| | 40% | | 35% | | | +| | 30% | | 30% | | | + +Higher tax rates typically go hand in hand with capital controls in order to try to prohibit money from fleeing the country in response. You can see just how common this is in the following table: + +Note that tax rate data only covers the US, the UK, Japan, Germany, and France. + +1 5 3 + + +--- + + +H O W C O U N T R I E S G O B R O K E : T H E B I G C YC L E + +# 20YR PERIODS OF STRICT/RISING CAPITAL CONTROLS + +| | 1900 | 1920 | 1940 | 1960 | 1980 | 2000 | +| --------------- | ---- | ---- | ---- | ---- | ---- | ---- | +| UK | Yes | Yes | Yes | Yes | | | +| US | Yes | Yes | | | | | +| China | | Yes | | Yes | Yes | | +| Germany | Yes | Yes | Yes | Yes | | | +| France | Yes | | | Yes | | | +| Russia | Yes | Yes | Yes | Yes | Yes | Yes | +| Austria-Hungary | Yes | | | | | | +| Italy | | Yes | | | | | +| Netherlands | | | | | Yes | | +| Japan | | Yes | | | Yes | | + +# Stage 9: The Deleveraging Process Inevitably Creates a Reduction in the Debt Burdens That Creates the Return to Equilibrium + +Quite often, when there are inflationary depressions so the debt is devalued, at the end of the cycle, government reserves are raised through asset sales, and a strictly enforced transition from a rapidly declining currency to a relatively stable currency is achieved by the central bank linking the currency to a hard currency or a hard asset (e.g., gold) while having very tight money and a very high real interest rate, which severely penalizes the borrower-debtors and rewards the lender-creditors, which leads to the buying of the debt/currency, which stabilizes the debt/currency. + +At this stage, the currency has been devalued and the remaining holders of the currency and the debt have taken big losses in real terms, which has relieved a lot of the debt burdens of the debtors. + +While this diagram is not exhaustive, I include instances where I could find clear evidence of each occurring in the 20-year period shown. Relevant capital controls are defined as meaningful restrictions on investors moving their money to and from other countries and assets (although this does not include targeted measures directed only at single countries, such as sanctions). + +24 + + +--- + + +# T H E P R I O R B I G D E B T C R I S I S R E C E D E S , A N E W E Q U I L I B R I U M + +Now, it doesn’t take much to back up the debt, stabilizing it and the currency. When managed well, the government raises reserves, sometimes by selling government‐owned assets, sometimes by getting IMF or other loans requiring sound financial policies including austerity. At this stage, the interest rate is still high—in fact, very high in relation to the prospective inflation rate and the prospective rate of depreciation in the currency, which means that the central bank can make the debt/money an attractive investment again, and debt in that currency very expensive, if they manage the situation well. This is when a new and more stable monetary system is established with enough credibility to entice investors and savers to hold the currency again. Typically, this follows a substantial write‐down and restructuring of the debt along with a return to some form of hard money. And this typically requires a set of fundamental adjustments that improve the country’s balance sheet and income statement. + +# The Five Classic Steps + +Typically necessary to make the transition are: + +1. A restructuring of the country’s debts to manageable levels where reserve assets can cover a substantial portion of liabilities and the government’s debt service no longer exceeds its revenue growth. Typically, defaulting and restructuring foreign currency debts and some local currency debts are required, too. + +1 5 5 + + + +--- + + +H O W C O U N T R I E S G O B R O K E : T H E B I G C YC L E + +# RESERVES/GOVERNMENT DEBT + +| | All Cases | Fixed Cases | Floating Cases | +| --- | --------- | ----------- | -------------- | +| 13% | | | | +| 11% | | | | +| 9% | | | | +| 7% | | | | +| 5% | | | | +| 3% | | | | + +# RESERVES/INTEREST EXPENSE + +| | All Cases | Fixed Cases | Floating Cases | +| ---- | --------- | ----------- | -------------- | +| 190% | | | | +| 170% | | | | +| 150% | | | | +| 130% | | | | +| 110% | | | | +| 90% | | | | +| 70% | | | | +| 50% | | | | + +# GOVT INTEREST EXPENSE (% REVENUE) + +| | All Cases | Fixed Cases | Floating Cases | +| ------------ | ------------ | ------------ | -------------- | +| (ex-Ongoing) | (ex-Ongoing) | (ex-Ongoing) | | +| 35% | | | | +| 30% | | | | +| 25% | | | | +| 20% | | | | +| 15% | | | | +| 10% | | | | + +The next two charts show an attribution of what happens to government debt-to-GDP following the devaluation, on average across the case set. You can see that in the average case, central government debt is at 89% of GDP around the time of the devaluation. The green bars show the factors that work to bring the debt-to-GDP ratio down—on average, 7% comes from central bank purchases, 38% is due to inflation, 26% is due to positive growth in real GDP, 16% is due to primary surpluses, and 8% is due to defaults or restructuring of the debt; the red bar shows what led it to rise—76% driven by. + +25 To show a clearer picture of how the government’s balance sheet evolves in the upswing and downswing of the cycle, these charts exclude a handful of recent cases (the US, Europe, the UK, and Japan post-financial crisis) that are still playing out. + +1 5 6 + + +--- + + +# T H E P R I O R B I G D E B T C R I S I S R E C E D E S , A N E W E Q U I L I B R I U M + +# I S R E AC H E D , A N D A N E W C YC L E + +# ( S TAG E S 7 - 9 ) + +continued interest payments. The net of these is that in the average case, debt falls from 89% to 70% of GDP and that rising inflation and rising real growth arising from aggressive stimulations are the big forces behind the debt burden reduction. Said differently, governments that have debt in their own currencies 1) make their interest and principal payments by having their central banks create money and credit, raise inflation, and stimulate real growth, and by restructuring debts, which raises nominal income growth relative to debt service payments, and 2) restructure defaulted debts in the amounts shown. While this chart shows all cases, this is especially true in the cases when the currencies are denominated in monies that the central banks can produce. In most such cases, the debt problems never go away as much as they remain a manageable burden handled in the way described. Of course, these are average numbers and the ranges around them are large, though the patterns are pretty consistent. + +# ATTRIBUTION OF ARCHETYPICAL DECLINE IN GOVERNMENT DEBT-TO-GDP + +| Starting Debt | Due to | Ending Cost | | | | | +| ------------- | --------- | ----------- | --------------- | ------------------ | ------------- | --- | +| CB Purchases | Inflation | Real Growth | Primary Surplus | Debt Restructuring | Interest Cost | | +| 89% | -7% | -38% | -26% | -16% | -8% | 70% | + + + +--- + + +H O W C O U N T R I E S G O B R O K E : T H E B I G C YC L E + +# IN ATTRIBUTION OF ARCHETYPICAL DECLINE + +# GOVERNMENT DEBT-TO-GDP (EX-ONGOING CASES) + +| 90% | -2% | -49% | 100% | | +| ------------------------- | -------------------- | ---------------- | ------------------ | ---------------------- | +| 80% | 92% | 59% | 60% | | +| -35% | 40% | 20% | 0% | | +| -28% | -8% | -20% | | | +| Starting Debt | Due to CB Purchases | Due to Inflation | Due to Real Growth | Due to Primary Surplus | +| Due to Debt Restructuring | Due to Interest Cost | Ending Cost | -40% | | + +# 2. + +A deep, painful fiscal policy adjustment to make the country’s finances sustainable without requiring the printing of money to monetize the debt. Deep, painful fiscal policy adjustments from the central government and healthy balance of payments adjustments are usually required. It is typical to see a bigger improvement in the primary deficit before the government is able to reduce interest costs by rolling into lower rates. + +# GOVT DEFICIT (% GDP) + +# PRIMARY DEFICIT (% GDP) + +| All Cases | Fixed Cases | Floating Cases | +| --------- | ----------- | -------------- | +| 2% | 1% | | +| 0% | -1% | | +| -2% | -2% | | +| -4% | -3% | | +| -6% | -4% | | +| -8% | | | + +# 3. + +Obtaining sufficient quantities of reserves to defend the currency (or back the new currency if the old, collapsed currency) + +1 5 8 + + +--- + +# T H E P R I O R B I G D E B T C R I S I S R E C E D E S , A N E W E Q U I L I B R I U M + +# I S R E AC H E D , A N D A N E W C YC L E C A N B E G I N ( S TAG E S 7 - 9 ) + +is being replaced) is typically part of the process. The deval ‐ uation of the currency typically helps with this both because the fall in the exchange rate increases the value of the country’s reserves relative to its nominal liabilities and because it improves the country’s competitiveness, helping to increase export incomes relative to import costs. In addition, we see a combination of asset sales to build up reserves further and occasional borrowing from official creditors (which at this point are among the few parties still willing to lend). Also, government‐owned companies and other assets are typically sold off, which brings in money for reserves and improves efficiencies of these businesses. + +| FX RESERVES | | RESERVES/MONEY (M0) | | +| ---------------- | --------- | ------------------- | -------------- | +| (% GDP, INDEXED) | | | | +| | All Cases | Fixed Cases | Floating Cases | +| | 5% | | 70% | +| | 4% | | 60% | +| | 3% | | 50% | +| | 2% | | | +| | 1% | | 40% | +| | 0% | | 30% | + +-120 -80 -40 0 40 80 120 -120 -80 -40 0 40 80 120 + +| CURRENT ACCOUNT (% GDP) | | | | | +| ----------------------- | --------- | ----------- | -------------- | ---- | +| | All Cases | Fixed Cases | Floating Cases | | +| | | | | 15% | +| | | 0% | | 10% | +| | | 5% | | | +| -1% | | | | 0% | +| | | -2% | | -5% | +| | | -3% | | -15% | + +-120 -80 -40 0 40 80 120 -120 -80 -40 0 40 80 120 + +--- + + +# HOW COUNTRIES GO BROKE: THE BIG CYCLE + +4. High real interest rates that more than adequately compensate investors for the risks of holding the currency. These charts show the nominal interest rates on local currency and hard currency debts. + +| NOMINAL SHORT RATE | | | SOVEREIGN HARD FX SPREAD | | +| ------------------ | --------- | ----------- | ------------------------ | --- | +| | All Cases | Fixed Cases | Floating Cases | | +| | | 19% | | 25% | +| | | 15% | | 20% | +| | | 15% | | | +| | | 11% | | | +| | | 7% | | 5% | +| | | 3% | | 0% | + +-120 -80 -40 0 40 80 120 -120 -80 -40 0 40 80 120 + +| REAL SHORT RATE | | | +| --------------- | ----------- | -------------- | +| All Cases | Fixed Cases | Floating Cases | +| 4% | | | +| 0% | | | +| -4% | | | +| -8% | | | + +-120 -80 -40 0 40 80 120 + +5. Placing limits on what the central bank can do that would undermine sustainable finances of the new stable money. + + + +--- + + +T H E P R I O R B I G D E B T C R I S I S R E C E D E S , A N E W E Q U I L I B R I U M +I S R E AC H E D , A N D A N E W C YC L E C A N B E G I N ( S TAG E S 7 - 9 ) + +# CENTRAL BANK BOND HOLDINGS (% GDP) + +| All Cases | Fixed Cases | Floating Cases | | +| --------- | ----------- | -------------- | - | +| | 13% | | | +| | 11% | | | +| | 9% | | | +| | 7% | | | +| | 5% | | | +| 3% | | | | + +When these conditions are met, these are among the best times to hold the country’s currency and debt. + +# REAL CASH RETURN (INDEXED TO FX BOTTOM) + +# GOLD RETURN VS LOCAL CURRENCY CASH (INDEXED TO FX BOTTOM) + +| All Cases | Fixed Cases | Floating Cases | | +| --------- | ----------- | -------------- | - | +| | 180% | | | +| | 160% | | | +| | 140% | | | +| | 120% | | | +| | 100% | | | +| 80% | | | | +| 60% | | | | +| 40% | | | | +| 20% | | | | +| 0% | | | | + +That is what the end stages of the typical Big Debt Cycle look like to me. Let’s now return to the very big‐picture level and look at how the current Big Debt Cycle has played out over the last 80 years. + +1 6 1 + + +--- + + +# CHAPTER 8 + +# THE OVERALL BIG CYCLE + +If I had to pick the most important chapter in the book, this would be it. That is because it deals with the biggest and most important forces that are dramatically changing the world order, and it shows how and why these forces have repeatedly driven history through its big cycles. Having seen so many of these cycles, watching what is happening is like watching a movie that I have seen many times before—just a contemporary version in which the clothes that the people are wearing and the technologies that they are using are more modern. I hope to show you what I see. Also, by showing what happened in the past and why it happened, we can understand how previously unimaginable developments are now happening and could happen in the future. + +While this book is mostly focused on understanding what’s going on with debt/credit/money/economic cycles, we can’t look at this dynamic in isolation and make sense of it because how these cycles transpire is influenced by other big forces. Similarly, to understand what is happening in other areas, we need to understand the debt/credit/money/economic force as it has big effects on developments in most areas. Together, five big forces produce the Overall Big Cycle that + +--- + + +# HOW COUNTRIES GO BROKE: THE BIG CYCLE + +leads to radical changes in monetary, domestic, and/or world orders. I comprehensively explained how this Overall Big Cycle works and how it was manifest over the last 500 years in *Principles for Dealing with the Changing World Order*, but I won’t cram that 600-page book in here. Instead, I am going to give you a brief summary. That way, when we turn to Part III about what has happened in our current Big Cycle, and Part IV, in which I will try to look into the future, you will be able to see how what actually happened compares with my templates of both the Big Debt Cycle and the Overall Big Cycle. + +# HOW THE MACHINE WORKS + +Because everything that happens has reasons that make it happen, it appears to me that everything changes like a perpetual motion machine. To understand this machine, one needs to understand its mechanics. Because everything affects everything else directly or indirectly, these mechanics are very complex. Sometimes I try to explain what I know about them with enough of their complexity to show them in useful detail, such as I did previously in this book to explain how countries go broke. And sometimes I try to explain them simply. As the saying goes, “Any fool can make something complicated. It takes a genius to make it simple.” In this chapter, I will try to explain the Big Cycle simply. I will begin by explaining my approach. + +As a global macro investor for most of my life, I have tried to understand and model the cause/effect relationships and use my models to bet on what will happen in the markets. To do that, for about the last 35 years, I have created computerized expert systems that enable the computer to make decisions like I make them. These systems are based on the following principle: + +ⓢ Decision-making systems should be based on timeless and universal relationships, meaning that they should explain all the big, important developments in all time frames and in all countries, though + +1 6 4 + + + +--- + +# T H E OV E R A L L B I G C YC L E + +not necessarily precisely or in detail. If they fail to explain all the big developments in all time frames and in all countries, that indicates that an important influence is missing and needs to be added to the template/model. + +The expert systems I have built are previously developed forms of artificial intelligence. Now, with various breakthroughs in artificial intelligence, I am—and I believe we all are—on the brink of being able to understand all of the cause/effect relationships that drive everything, though for now we still have to labor along the old-fashioned way, with people studying what happened using the computing and AI tools available today. That is why, in my own feeble attempts to understand and describe the most important mechanics that change the world as we know it, I do these in-depth studies and create explanations of them. What I am about to describe is a result of this process. However, because the forces that drive the Big Cycle are so big, it is easy to see and understand them without worrying about the details and the complexities. + +Zooming out to the highest level, the five most important drivers of change are:²⁶ + +1. The debt/credit/money/economic cycle +2. The internal order and disorder cycle +3. The external geopolitical order and disorder cycle (i.e., the changing world order) +4. Acts of nature (droughts, floods, and pandemics) +5. Human inventiveness, most importantly of new technologies + +These forces affect each other to shape the biggest things that happen, creating cycles that move markets and economies around an upward-sloping trend line. The incline of its upward slope is primarily + +Additionally, there is the demographic force that will certainly lead to a lot of old people who don’t work and will be expensive to support (because at that stage in their lives, their healthcare costs will be high), a shrinking workforce in developed countries, large increases in population in less developed countries, and only a small percentage of the people being truly productive. + +1 6 5 + +--- + + +# HOW COUNTRIES GO BROKE: THE BIG CYCLE + +driven by the inventiveness of practical people (e.g., entrepreneurs) who are given adequate resources (e.g., capital) and work well with others (their coworkers, government officials, lawyers, etc.) to make the inventions and products that create productivity improvements. + +Over a short period of time (i.e., 1-10 years), the short-term cycles, especially the debt and political cycles, are dominant. Over a long period of time (i.e., 10 years and beyond), the long-term cycles and the upward-sloping trend line in productivity have much bigger effects. + +As I explained earlier, conceptually the way this dynamic transpires looks like this to me: + +Productivity + +Short-term + +The Big Debt Cycle + +debt cycles + +I will now delve into these five forces. While reading about them, please think about how these forces have worked and how they are working now. That will help you see how and why “history rhymes” and better understand what is now happening and what is likely to happen. + +# HOW THE OVERALL BIG CYCLE WORKS: THE FIVE BIG FORCES + +We are now 80 years into the Overall Big Cycle that began at the end of World War II, which is by and large unfolding in the classic ways that will produce dramatic changes that one can only + +--- + + +# T H E OV E R A L L B I G C YC L E + +imagine by visualizing these five forces interacting simultaneously in a historical context. More specifically: + +# 1. The Debt/Credit/Money/Economic Cycle + +Throughout this book, I have described the most important things that influence the Big Debt Cycle (like debt service payments relative to income, the amount of new debt sold relative to the demand for it, the desirability and willingness of debt asset holders to hold their existing debt assets, and other factors explained earlier, etc.). Because I have already covered this Big Debt Cycle so completely that you are probably sick of hearing about it, I won’t say much more. I will just reiterate the main points I want to get across, which are: + +- There has always been, and I expect that there will always be, short-term cycles that over time add up to Big Debt Cycles. +- The average short-term debt cycle has typically taken about six years, give or take about three (with the duration of that cycle dependent on a number of influences that we can monitor and use to come up with rough estimates of how long each one will last). +- The average long-term Big Debt Cycle has typically taken about 80 years, give or take 25 years (with the duration of that cycle also driven by a number of influences that we can monitor and use to come up with rough estimates of how long each one will last). +- These debt cycles are influenced by and influence other things, most importantly what I have identified as the four other big forces. + +To summarize the dynamic in a few sentences, what has timelessly and universally (i.e., throughout the millennia and across + + + +--- + + +# HOW COUNTRIES GO BROKE: THE BIG CYCLE + +Countries driven the Big Debt Cycle changes and has created the big debt and economic problems is the creation of unsustainably large amounts of debt assets and debt liabilities relative to the amounts of money, goods, services, and investment assets in existence. This always has led to big debt crises and runs on banks. By a run, I mean a turning-in of debt assets (that have no intrinsic value—i.e., their only value is to buy things) to banks in order to get real money, which the bank doesn’t have enough of to meet the demand. Classically, when the holders of those financial assets actually try to convert them back into money and buy things and see that they can’t get the buying power they believe they have stored in their debt assets, the run accelerates and feeds on itself, which causes great shifts in markets’ values and wealth until debts are defaulted on, restructured, and/or monetized, reducing the debt burdens relative to incomes, and a new equilibrium is reached. The debts are almost always monetized, by which I mean that it is almost always the case that the central bank creates a lot of money and credit to make it easier to pay back the debt, which devalues the money and debt. + +It’s worth noting that at times when the debt/money force, the internal order force, and the external order force are late in their cycles (i.e., when there is a lot of debt and a lot of internal and external conflict), it is typically just before big conflicts and revolutionary changes to monetary orders, internal orders, and world orders. Like a life cycle, the Big Cycle goes through stages. This late-cycle stage, which I call Stage 5, comes just before the depression and war stage that brings about the end of the Big Cycle. For reasons I will explain later, I believe that we are now in this late-cycle stage. It is a time of radical, typically unexpected changes that haven’t happened in one’s own lifetime but have happened many times throughout history. At such times, it is extremely valuable to understand these past cases of big changes and consider whether they could happen again. In Principles for Dealing with the Changing World Order, I examined a number of such cases. Since history can be an effective guide for understanding cause/effect relationships and bringing perspective on + + + +--- + + +# T H E OV E R A L L B I G C YC L E + +what is now happening and might happen, we can use these historical cases to think about what’s logically likely to happen under the existing circumstances. + +So, what are the existing circumstances? At this time, there is great overindebtedness in the US and in all other major countries at the same time as there are increasingly nationalistic and fragmented internal orders in these countries, increasingly contentious relationships between countries, adverse and expensive acts of nature, and amazing new technologies. + +Looking at past cases with similar configurations of conditions can help us imagine otherwise unimaginable possible developments. For example, I repeatedly saw, and will show you in the next part of this book, that, when faced with similar conditions of excessive debt, countries (including the US) took the following extraordinary actions: + +- Exerting great pressure on countries to buy the country’s debt (as the British did in the past) +- Selectively freezing debt and/or taking the assets of “enemy” countries (the way the US did to Japan in 1941 and Russia more recently) +- Defaulting on/restructuring debts by extending maturities and/or monetizing them to cut debt burdens (the way Germany did after Hitler came to power) +- Imposing confiscatory taxes and capital/foreign exchange controls to prevent assets from leaving the country +- Revaluing/managing government assets +- Creating new types of money + +To be clear, I am not saying that these sorts of things will happen, and I am hesitant to raise them as possibilities because my doing so could engender exaggerated fears, which could prompt inappropriate and exaggerated actions. However, like a good doctor speaking to a patient suffering from serious conditions, I feel that it would be an + +1 6 9 + + + +--- + + +# HOW COUNTRIES GO BROKE: THE BIG CYCLE + +irresponsible omission of mine not to convey what past cases tell us about the possibilities that sometimes accompany these conditions. + +# 2. The Internal Order and Disorder Cycle + +Within countries, there are both short-term political swings lasting about six years on average, give or take three years, that over time add up to big shifts in domestic orders that last about 80 years, give or take 25 years. To reiterate, I don’t mean that these time frames are fixed because they are highly variable in duration, but I do mean that they have always happened and I believe always will happen, with the durations driven by influences that we can monitor and use to come up with rough estimates of how long each one will last. 27 These are the cycles that exist within countries and lead to conflicts and changes in the system of governance, or what I’m calling “orders.” These fights for power work basically the same way in all systems of government, all types of organizations, and even within families because the approaches to fighting them are embedded in human nature. + +So, how do they work? It’s simple: nothing lasts forever. That includes the orders built around established leaders and governance systems. Changes in orders are driven by those who have the greatest power getting to determine what is done. Orders change when those who don’t run the existing order acquire more power than those who do and want to change it. Fights occur when both a) a powerful group wants to change the order and b) it is not clear which side has more power, so only a fight can determine it. Fights don’t occur if a) there isn’t a powerful group that wants to change the order and/or b) there is a powerful group that wants to change it and is so much stronger than the existing. + +27 I explained these more completely in Chapter 5, “The Big Cycle of Internal Order and Disorder,” of Principles for Dealing with the Changing World Order. + + + +--- + + +# T H E OV E R A L L B I G C YC L E + +group that the changes will take place with little or no Wghting. In democracies, there is an election cycle that roughly coincides with the economic cycle because bad economic conditions typically lead to political changes. 1 At the beginning of a new popularly chosen leader coming to power—e.g., in the first 100 days of a new presidency—there is a honeymoon period and great optimism. That is when dreams of great changes and great improvements exist and before realities and criticisms of how the new leader has shaped and handled them set in. As time passes, typically the big promises the leader made to get elected become difficult to deliver and bad things happen so disappointment sets in, critics and enemies become bolder, and support wanes. All this makes fighting to stay in power harder, which often leads to more extreme actions to make that happen. + +These dynamics are at play in the US at my time of writing this book in March 2025. How things go typically depends mostly on the economy, which depends mostly on where the market‐ and economy‐shaping short‐term and long‐term debt/credit/money/economic cycles are, though exogenous events (like droughts, floods, and pandemics, and big international or domestic conflicts) can also matter. + +All governance orders within countries change from one type to another—e.g., from democracies to autocracies and from autocracies to democracies—and each major type of order comes in varying flavors with some managed well and some managed poorly. I will now focus on what happens when democracies fail. + +2 When democracies fail, autocracies come in. + +In my studies of how orders have changed throughout history, I have seen how changes from republic‐style representative democracies to autocracies typically happen. These changes are exemplified in how Julius Caesar in ancient Rome (from 49 to 44 BCE), Napoleon Bonaparte in France (from 1799 to 1815), Benito Mussolini in Italy (from 1922 to 1943), Adolf Hitler in Germany (from 1933 to 1945), a consortium of leaders in Japan (from 1931 to 1945), Francisco Franco in Spain (from 1936 to 1975), Recep Tayyip Erdogan in Turkey (from 2016 until now), and many other countries’ leaders have shifted to + + + +--- + + +# HOW COUNTRIES GO BROKE: THE BIG CYCLE + +become autocratic leaders. I also read about it in Plato’s Republic, writ‐ ten around 375 BCE, which is still a valuable description of how de ‐ mocracies become autocracies. + +In almost all cases, there are large gaps in wealth and values, bad and worsening conditions, and weak, fragmented leadership in the republic-style representative democracies. These democracies can’t fix their problems because democracies intrinsically rely on compromise between opposing factions, and compromise breaks down during such times. So, instead of following the laws and the system of compromise, the opposing sides become willing to fight to win at all costs. Typically, this leads to intensifying populist conflicts between those of the hard right, those of the weak middle, and those of the hard left. Conflicts increase, especially during times of economic stress, which leads to fights for the power to control. How these fights for power take place are largely similar for logical reasons that I will explain. + +Plato pointed out, and my study of history showed me, that leaders in democracies typically appeal to their constituents’ desires for immediate benefits and temporary relief rather than doing the hard things that address deeper, systemic issues and make their nation strong over the long term. I have seen and read historical accounts of how leadership also typically becomes weak, decadent, and corrupt, especially after periods of great prosperity and few challenges. Plato argued that when democracies become weak and decadent and lose sight of justice and virtue, they pass their peaks and begin their declines. These periods are typically marked by growing corruption, inequality, and a failure of institutions to function effectively. When the system no longer satisfies the needs of a large percentage of the people, it loses legitimacy. Independently, and long before Plato observed this, this dynamic was recognized in China (as far back as 1046 BCE), where it is called “losing the mandate of heaven.” It is when and why orders fail. + +In times of disorder, financial, political, and military power matter more than laws, and authoritarianism works better than weak, disorganized collectivism. + + + +--- + + +# T H E OV E R A L L B I G C YC L E + +Plato called the person who typically leads the revolutionary changes from democracy to autocracy a “demagogue.” Demagogues manipulate public opinion, stir up emotions, and use extraordinary means to gain power. They typically rile up populist sentiment, promise easy solutions to complex problems (often at the expense of truth or rational discourse), and use propaganda and bullying to gain and increase power. They are generally of the well-educated class and gather around them others who are powerful. When they are of the political hard right, they and those who support them are typically rich and powerful nobles (in the old days) or capitalists (since the Industrial Revolution) who are allied in their belief and their self-interest that great leadership requires strong leadership and strong partnerships from the top, like strong companies that have to work well together to do great things. When demagogues are of the left, they typically get their support from the unprivileged masses. As these populist leaders, whether they are from the right or the left, gain power, they typically employ tactics such as propaganda, coercion, and the consolidation of power to undermine their enemies and the democratic institutions that support their enemies and/or that support the inefficient bureaucracies that are enabling the problems rather than fixing them. This typically leads to the eventual replacement of democracy with a more centralized, dictatorial form of government. + +The approach a strong CEO uses in running a company can be difficult to distinguish from a demagogue’s approach. In fact, it can be said that some strong CEOs govern as demagogues, so it should be expected that if they were running governments, they would run them the same way. In both cases, they are people who take control and make radical changes to make radical improvements, and the big questions are what will the controls on them be and how far will they take the autocracy. If looking at a company, one should see if there is strong oversight and a controlling force like a strong board and controls from effective regulators; for governments, such controls come from oversight functions and the separation of powers. The more uncontrolled they are, the more dictatorial the leaders are likely to be. + + + +--- + + +# HOW COUNTRIES GO BROKE: THE BIG CYCLE + +become. A relevant good principle is ⓢ power corrupts and absolute power corrupts absolutely, a phrase attributed to historian and politician Lord Acton in 1887. + +In the new order that emerges, financial and political power matters more than laws, and authoritarianism works better than weak, disorganized collectivism. + +In most of these cases, the transfers from the democracies to autocracies take place within the rules of the democracy and become increasingly extreme over a few years, usually around three to five. These leaders typically make radical changes to the monetary, political, and geopolitical orders, and they typically become very nationalistic, militaristic, expansionist, and autocratic. As mentioned, examples include Caesar in Rome, Napoleon in France, Hitler in Germany, and Mussolini in Italy. + +In ways that were more thoroughly explained in Principles for Dealing with the Changing World Order and that should be apparent to observers who are watching what is happening today, this is now taking place with big political shifts (mostly toward the hard right) for the same reasons that they happened in the past. + +# 3. The International Order and Disorder Cycle (i.e., the Changing World Order) + +How countries deal with each other is of paramount importance and it, too, is cyclical. + +For the same reason that there are periods of order (i.e., periods of harmony, productivity, and prosperity) and periods of disorder (periods of great conflict, destruction, and depression), and big cyclical swings between these periods within countries, there are periods of order (periods of harmony, productivity, and prosperity) and periods of disorder (periods of great conflict, destruction, and depression) between countries. The periods of disorder take place when there are fights to determine which country or countries will + + + +--- + + +# T H E OV E R A L L B I G C YC L E + +have the power to set what type of order exists. However, because there has never been an effective global governance system, the world order is more prone to disorder and conflict. + +As part of the Big Cycle, there have also been big swings between + +- a) unilateralism in which there is fighting for one’s self-interest, the strong winning over the weak, and the law of the jungle/the survival of the fittest +- b) multilateralism in which there is striving for global harmony, peaceful coexistence, and egalitarianism. + +Historically, the only times that multilateralism worked were after wars when people were sick of fighting and there was a dominant power to enforce how things should go. In fact, throughout most of history, brutal and destructive unilateralism was the norm and periods in which there was multilateralism in pursuit of harmony, peaceful coexistence, and the common good were extremely rare and never sustained. Consider that it wasn’t until 1648, after the terrible Thirty Years’ War, that there was an agreement in Europe (the Peace of Westphalia) establishing that countries have borders and that all countries would pledge to enforce those borders rather than to simply fight one another to get what the other had, which up until then was the norm (though these pledges not to fight have only worked sporadically). + +Also consider that it wasn’t until after World War I, when Woodrow Wilson, the idealistic academic president of Princeton University who became president of the newly powerful United States in 1913, naïvely aspired to have a world governance system that imitated the US governance system, the League of Nations. It didn’t last and failed to prevent World War II, which was followed by the new American world order, which created multilateral organizations like the UN, the IMF, the World Bank, the World Health Organization, the World Trade Organization, the International Court of Justice, the World Intellectual Property Organization, etc. These organizations aimed to foster global cooperation, economic stability, and collective problem-solving. The US, leveraging its unparalleled economic and military power, became the linchpin of this liberal international order, promoting democracy, free markets, and human rights. + + + +--- + + +# HOW COUNTRIES GO BROKE: THE BIG CYCLE + +While not without its flaws, this system maintained a relative stability that has so far prevented another world war. While we all have lived through a time when multilateralism’s striving for harmony, peaceful coexistence, and egalitarianism was of course what we all wanted, multilateralism is now fading into irrelevance and unilateralism is rising for reasons that are understandable in the context of history. As a result, the powers of multilateral organizations are declining rapidly and transitioning into the hands of the major powers. I believe that realists must accept the fact that both the aspiration for and the existence of global cooperation are eroding as the pendulum is swinging toward self-interested unilateralism and survival of the fittest. It increasingly becomes the case that the strong prey on the weak. These developments are all typical of the stage of the Big Cycle that we are now in. + +While this transition from multilateralism to unilateralism is at first shocking, it quickly becomes normalized. For example, it was only months before this writing that Donald Trump’s statements concerning Greenland, Canada, and the Panama Canal would have been considered unimaginable (much like Russia’s use of military force to defend what it saw as its interests by invading Ukraine if its interests weren’t guaranteed peacefully). + +At such times, alliances often change fast as circumstances change quickly and winning is more important than loyalties. To help us imagine the future, we should pay close attention to the lessons from history. Through most of history, without the existence of countries with borders, collections of people with common interests (i.e., tribes) fought to seize wealth from other tribes or defend their own. As those who won got richer and more civilized, they typically got more decadent and weaker and were eventually taken down by stronger barbarians, who were in turn brought down by subsequent generations learning to be stronger. For example, that is the story of the rise of the Roman Empire and its defeat by the Gauls as well as the rises and falls of most dynasties, and with them, the rises and declines of leadership approaches. These alternating ages of barbarianism and + + + +--- + + +# T H E OV E R A L L B I G C YC L E + +Civility contributed to periods of war that took down the more advanced civilizations when the barbarians were strong and civilizations were weak. + +History has repeatedly shown us that civility when taken too far creates weak decadence that eventually loses to strong barbarism. The peaceful and productive, modern-day version of this is the “Wghting” that happens in business with the invention of new and effective business ideas/weapons that fuel creative destruction. We love to watch these Wghts, which are like watching Wghts in the Roman Colosseum, or better yet we love being in them. Frankly, I love being in them, and I detest impractical idealism (while I love practical idealism above all else). But the destructive version of this same impulse leads to a lack of cooperation and to Wghting in politics, geopolitics, dealing with acts of nature (particularly climate change), and new technologies, and I worry a lot about it. + +# 4. Acts of Nature (Droughts, Floods, and Pandemics) + +Throughout history, acts of nature have killed more people than wars and toppled more orders than the previously mentioned forces, and an objective view of the data shows that droughts, Xoods, and pandemics are increasing and increasingly costly. While why this is happening is debated, that it is happening is not debatable. Nor is it debatable that humanity’s polluting and disrupting of nature, higher human population density, closer contact across the world (brought about by more international travel), and closer contact with other species due to land development (leading to animal-human disease transmissions) are all causes. We regularly see these happening in the news, most recently with the Los Angeles wildWres. It is also almost certain that these problems will get worse. + +As with the other forces, this force is intertwined with the other big forces to shape what is happening. For example, the migration issues in developed countries (with immigration pressures resulting from + + + +--- + + +# HOW COUNTRIES GO BROKE: THE BIG CYCLE + +Changes in climate and the living conditions issues in underdeveloped countries (where people are struggling to adapt to droughts, floods, and other changes) are obviously worsening due to damaging acts of nature increasing, and given that nearly all nations are facing debt issues, there isn’t enough money to be spent on climate mitigation or adaptation. + +# 5. Human Inventiveness, Most Importantly of New Technologies + +There are great advances in technology, particularly in artificial intelligence, that will dramatically affect all thinking in all areas for good or for bad. Throughout history, technological advances have raised living standards and life expectancies, have been used to generate economic and military power, and have been used in wars to create great destructions. They are closely tied to the other four forces. When technological advances are supported by good financial, economic, and social conditions, they advance more quickly than when those conditions are bad. But when their developments are supported by unsustainable credit growth, they tend to cause financial bubbles and busts. + +For example, the South Sea Bubble in 1720 when the Dutch Empire was beginning to decline, the Railway Mania in the 1830s and 1840s, the electricity and utilities bubbles (the “War of the Currents”) in the 1870s and 1890s, and the dot-com bubble and telecoms crash of 1990-2001 are all relevant examples of cases where great advances in major life- and productivity-improving technologies led to debt bubbles and busts, as well as big beneficial changes. + +That’s enough of the Big Cycle for now—enough to help you better understand the dynamics you’ll read about in Part III as you look at the events that have unfolded since our current Big Cycle began in 1945 with the end of World War II. It will also help you understand the perspective I take when I attempt to look into the future in Part IV. But before we move on, it is worth sharing one final principle, + +1 7 8 + + + +--- + + +# T H E OV E R A L L B I G C YC L E + +which has the biggest impact on how the challenges that arise during the Big Cycle are handled, namely: + +ⓢ The biggest and most important force is how people deal with each other. + +If people deal with their problems and opportunities together rather than fight each other, they can get the best possible results. Unfortunately, while technology has evolved a lot, human nature hasn’t changed much, so this is still probably beyond the capabilities of humankind. + +1 7 9 + + + +--- + +# PART III + +--- + +# LOOKING BACK + +--- + + +As explained, watching what is now happening is like watching a movie that I have seen many times before but set in different countries at different times because all of these Big Cycles transpire in analogous ways. In the previous chapters, I described how that classic movie typically transpires. In this part of the book, I will show you the most important cases of it transpiring over the last 180 years, which covers two Big Cycles in the US, China, Japan, and the wider world. That way, in just about 100 pages you will be able to get a comprehensive review of roughly the last two centuries, see these Big Cycles transpire, and compare them with the Big Cycle template I previously described in Parts I and II. + +# Chapter 9 + +I will very briefly take you through the 80-year Big Cycle before 1945. Then, in the following chapters, I will show you more completely what has happened from the end of World War II until my writing of this book in March 2025. I conclude Part III with single chapters that cover the same periods and the Big Cycles for China and Japan. After you see all these cases and the Big Cycle changes to monetary, internal governance, and external governance orders, you will have seen the Big Cycle template play out repeatedly so you can join me in using that template to look at what we are now seeing happen and what may be ahead, which we will do in Part IV. + +--- + + +# THE PAST IS PROLOGUE + +Before I begin my descriptions of history, I will pass along two principles that I think will help you if you keep them in mind: + +- If you want to see how and why big events have unfolded, be careful not to focus precisely on small events. People who try to see things up close and precisely typically miss the most important big things because they are preoccupied with looking for precision. So, when looking for the big things, pay attention to the big things. +- Everything that happens does so for reasons that make it happen, so we should strive to understand and explain the cause/effect relationships that drive changes and create from them a logical template/model that both explains past changes and aligns with what is actually happening, and if there are discrepancies, we should work to understand and resolve them. + +What I am saying is that in the most fundamental ways, the previously described processes and cycles have happened in all countries over all of time, though none of them have been exactly the same. So, to see the processes and cycles and the template they provide us, you need to pay attention to the biggest and most important changes that have happened, keeping in mind the reasons for the big changes and the big differences. + +To emphasize the importance of the big things, I describe them in a simplified way, so it’s easy for some people to say, “That’s not exactly right!” and be correct. I am intentionally conveying this template in a non-exact way in order to draw attention to the most important things. + +As you read these descriptions of history, please remember that this timeless and universal template has been working in essentially the same way for thousands of years in all countries, driven by the same basic and logical cause/effect relationships that will be clear to you if you don’t get too focused on the details. + +--- + + +# CHAPTER 9 + +# FROM 1865 TO 1945 + +This very brief, eight-page chapter begins a series of chapters that explain how the Big Cycle has played out in the past. It describes the 80 years from 1865 to 1945. By reading it, you will gain a great perspective on what happened and how well my template explains it. In this chapter and those that follow, you will see the classic Big Debt Cycles and the classic domestic and international cycles that changed the monetary, internal political, and international geopolitical orders, starting and ending with wars. You will see how the wars were followed by periods of great inventiveness and productivity early in the post-war periods, leading to great debt-financed speculations, big increases in wealth differences, and then bubbles and busts that created new fights over wealth and power that led to new internal and international wars, produced new winners and losers, and created new orders and the next Big Cycles. + +Starting in the US, 80 years before 1945 brings us back to the end of the US Civil War. That is a good time to begin this review of what happened, given that Big Cycles typically start after a war. + +--- + + +# HOW COUNTRIES GO BROKE: THE BIG CYCLE + +# FROM 1865 TO 1918 + +The US Civil War was over the usual issues—i.e., who got to say what would happen related to economic, political, and social issues—e.g., slavery in this case. As is typical of such conflicts, it was very costly and financed by debt that grew too great to be paid back. The US government’s debt went from 2% of GDP to 40% of GDP and interest payments alone ate up over half of the budget, not including the debts of the losing Confederate states, which defaulted after the war. At the start of the war, the dollar was linked to gold at a price of $20.67 per ounce. During the war, the US government defaulted on its promise to pay its debts by not letting holders of dollars turn them in for gold. It printed paper money that wasn’t backed by gold (called greenbacks), so the value of money plunged, the value of gold in this new printed currency soared to roughly $250 per ounce, and the inflation rate in this new currency rose to 80% in 1865. + +A timeless and universal principle to keep in mind is: + +ⓢ During times when there is too much debt relative to the quantity of money that is needed to service debts, the need to either increase the amount of money that exists and/or cut the amount of debt there is leads governments to break their promises and do some combination of a) raising the amount of money and credit, b) reducing the amount of debt (e.g., by restructuring it), and/or c) preventing the free-market ownership and movement of the hard money (e.g., gold). At such times, there is a run away from bad money to good money that the government wants to stop. This often leads to prohibiting good money from being freely held and freely moved. + +That devaluation of money, defaults, and monetary stimulations reduced the debt burdens relative to incomes, and when the civil war ended, it was followed by a period of great productivity and leveraging up that created the next bubble and bust, which I will soon describe. It was all classic. + +From 1870 to 1914, with the war over and debt burdens reduced, the Second Industrial Revolution productivity miracle began. + +188 + + + +--- + + +# FROM 1865 TO 1945 IN A TINY NUTSHELL + +Classically, debt- and equity-financed great technological investment booms led to great economic advances, big wealth and values gaps, and then bubbles and busts that led to great internal conflicts. At the same time, similar conditions around the world led to newly powerful countries challenging both the established powers and the established world order, which eventually led to war. + +The technological advances that accompanied this great productivity boom were in railroads that opened up and linked the Western and Eastern US; steel production that was used to build bridges, skyscrapers, and railroads; electricity (e.g., Thomas Edison’s invention of the light bulb and revolutionary improvements in electricity distribution); Alexander Graham Bell’s invention of the telephone; oil production that fueled these advances; and the invention and broad distribution of the automobile. As always, big wealth gaps appeared as the great new inventions that were turned into great new products made those who came up with them and commercialized them very rich. + +The rich were increasingly resented (they were then called “robber barons”) for their business tactics and their lavishness (this era was called the Gilded Age), which led to classic left/right class conflicts developing in the early 20th century. + +During this time, there was no central bank, and the dollar was fixed to gold by commercial banks. As a result, when there were debt busts, there was no printing of money to ease them, so some of the busts were very big and long-lasting. For example, a big debt bust led to the Panic of 1873, which marked the start of the Long Depression and several national and regional panics that lasted until 1896. There were similar debt-bust panics in 1893 and 1907. Sticking to the gold standard became a major political issue that led presidential candidate William Jennings Bryan to famously declare, “You shall not crucify mankind upon a cross of gold.” Eventually, the severity of these booms and busts, especially the Panic of 1907, prompted the government to create the Federal Reserve central banking system in 1913 in order to better manage monetary policy for dealing with these boom/bust cycles. + + + +--- + +# HOW COUNTRIES GO BROKE: THE BIG CYCLE + +In the 1900 to 1914 period, all the classic late Big Cycle symptoms emerged. There was overindebtedness and internal political conflicts between rich business elites/capitalists of the right and the low-earning workers and socialist/anarchists on the left. Capitalism versus Marxism was the economic/ideological conflict in both the US and Europe, and many extremist followers on both sides were willing to fight to the death rather than compromise. + +In the US, there was a move toward the left with progressive Theodore Roosevelt becoming president after President William McKinley was assassinated by an anarchist. Anarchists assassinated several world leaders around this time. In Europe, the rising power of Germany and its allies challenged the more established power of the UK and its allies (most importantly, France). In Asia, Japan went to war with and defeated Russia, making Japan the leading imperial power in the region. The world was much less connected in this era and foreign countries seemed much farther away, so what happened in one’s own region was much more important than what happened on the other side of the world. But by the early 20th century, the world was starting to come closer together, and the United States increasingly became a world power. + +Then in 1914, Archduke Franz Ferdinand from Austria-Hungary was assassinated and World War I began. I won’t go into the blow-by-blow of it, but I will say that it led to the world order changing in the classic big and important ways previously described, including the emergence of the United States as the world’s richest and largest creditor nation. The US became the world’s leading financial power because it played a big role in financing the war and manufacturing and selling things for the war, and it didn’t have major spending or war destruction costs because it entered the war late. While the US profited from the war, the other winners—the UK and France—were weakened and indebted by it, and the war’s losers were devastated by it. Germany became terribly indebted, and both Austria-Hungary and the Ottoman Empire were completely destroyed and broken up. Germany was in debt both to + +--- + + +# FROM 1865 TO 1945 IN A TINY NUTSHELL + +those who lent it money to Wnance the war (which it immediately defaulted on) and to the winners of the war through the imposition of reparations. Germany’s economy was burdened by these obligations until Hitler defaulted on them in 1933. + +In Russia, the World War I period brought conXict between the rich monarchy (who wanted to keep its wealth and privileges) and the poor masses (who were angry and wanted more). This led to civil war and the dramatic change in the domestic order to become Marxist‐communist. Russia then created the Soviet Union in 1922 by taking over Ukraine, Belarus, and parts of central Asia. Japan, which had allied itself with the winners of the war, became the leading power in Asia. + +At the end of the war in 1918, a big pandemic happened. + +After all that, the winners got together to determine what the new world order would look like. In this case, it was clear that the world was becoming more interconnected due to advances in transportation and communications. World War I was the Wrst truly global versus regional war, so naturally the question of how world governance should work arose for the Wrst time. As described in the last chapter, President Wilson aspired to create an orderly world that would in some ways replicate a US style of representative governance. That led to the formation of the League of Nations, which failed at preventing the next major war. We still haven’t Wgured out how world governance could advance beyond Wghting to determine who gets what they want. + +# FROM 1918 TO 1945 + +Then, from 1918 until around 1930, in the West, there was an - other classic period of peace, great inventiveness, and productivity due to entrepreneurs coming up with great new products that were Wnanced by debt and equity investments/speculations that produced big increases in wealth diVerences and bubbles. + +More speciWcally, the 1920s became known as the Roaring ’20s because of the rapid economic growth and technological + + + +--- + + +# HOW COUNTRIES GO BROKE: THE BIG CYCLE + +innovations that, early on, produced great productivity and productive lending in which incomes were more than large enough to fuel advances and provide good returns. The great inventions that were converted into mass production and greatly advanced the world included automobiles, airplanes, radios, televisions, talking movies, refrigerators, drugs and medications, and many other items. As always, what started as productive lending and investment grew into a big bubble. When it burst in 1929 with debt defaults and a stock market crash, it was followed by a depression. When the crash happened, the debt/money/economic force greatly impacted the domestic political and international geopolitical forces and changed the monetary, political, and geopolitical orders. + +Seeing this debt/stock market/economic bust, what principle should jump to mind? The same one I mentioned a few pages ago: + +ⓢ During times when there is too much debt relative to the quantity of money that is needed to service debts, the need to either increase the amount of money that exists and/or cut the amount of debt there is leads governments to break their promises and do some combination of a) raising the amount of money and credit, b) reducing the amount of debt (e.g., by restructuring it), and/or c) preventing the free-market ownership and movement of the hard money (e.g., gold). At such times, there is a run away from bad money to good money that the government wants to stop. This often leads to prohibiting good money from being freely held and freely moved. + +Through a series of actions, President Franklin D. Roosevelt outlawed the private ownership of gold, defaulted on the promise to allow holders of paper money to turn it in for gold, and changed the official exchange rate of $1 for 1/20.67th of an ounce of gold to $1 for 1/35th of an ounce—devaluing money by about 40%. He also imposed strict foreign exchange controls that prevented Americans from taking their money abroad and restricted Americans’ abilities to have foreign bank accounts. This wasn’t the only significant change in monetary policy or radical approach to a debt issue that occurred during the period covered in this chapter. Many more countries went broke (i.e., defaulted on or + + + +--- + + +# FROM 1865 TO 1945 IN A TINY NUTSHELL + +signiWcantly devalued their debts in the ways I’ve reviewed) between 1865 and 1945 than I can describe here, but I can give you a partial list: + +- The US leaving the gold standard during and devaluing money after the civil war +- Several countries, in addition to the US, leaving the gold standard and devaluing money in the Great Depression +- Weimar Germany restructuring its Treaty of Versailles debts +- China and Russia repudiating past debts +- China abandoning the silver standard in favor of paper currency in 1935 +- Greece debasing its coinage, causing it to be expelled from an early European currency union (1908) + +As is classic, in the 1930s there were those of the hard right (fascists) and those of the hard left (communists) who fought in their own ways for control within their countries. In the 1920s and 1930s, several ineYciently run, conXict‐ridden representative governments (Spain, Italy, Japan, and Germany) turned to demagogic leaders and autocracies of the right (fascism) to bring order to the chaos. Just as we are now seeing in the US and several other countries, this turn toward more rightist governments led to a squaring‐oV against leftists, and there was a marked move away from attempts at multilateralism, a breaking of agreements, and the rise of strongman unilateralism. + +For example, Hitler broke out of the Treaty of Versailles by choosing to default on the debt that Germany had agreed to pay. Germany and Japan both became more nationalistic and expansionistic, seizing territories in Europe, Africa, and Asia (more detail on Japan during this time can be found in Chapter 16). These ascending powers largely rose at the expense of the prior leading world powers—the UK, France, and the Netherlands—that had all become overextended and unable to defend their colonies around the world. As a principle, when countries are weak, opposing countries take advantage of their weaknesses to obtain gains. All these dynamics set the stage for + +193 + + + +--- + + +# HOW COUNTRIES GO BROKE: THE BIG CYCLE + +increased conflict between nations, eventually leading to World War II, after which there was the beginning of the next world order, which is the one we are now in the late stages of. + +As previously explained and covered much more completely in Principles for Dealing with the Changing World Order and elsewhere in my writings, in the period leading up to World War II, nations around the world employed all the classic maneuvers and developments that precede military wars. These include economic warfare, freezing of financial assets, and military buildups. Once the war began (with Germany’s attack on Poland in 1939 and Japan’s attack on Pearl Harbor in 1941), all the usual war developments unfolded, such as using conventional weapons and the secret development and then usage of powerful new weapons that won the war. Then the unconditional surrenders of the losers led to meetings of the winners and new monetary, internal political, and external geopolitical orders. The spoils of war went to the winning Allies and the penalties of losing were handed out to the Axis powers as laid out in the Treaty of Versailles. As always, these decisions reshaped the world order and had implications for decades to come. + +We will next look in greater detail at what happened after the end of World War II until my writing of this book in March 2025. While I will frame the evolution of the cycle in the context of the Big Debt Cycle, showing how the Big Debt Cycle went through its various monetary regimes, I will also show how it combined with the other four forces to shape the Overall Big Cycle. + + + +--- + +# CHAPTER 10 + +# A BRIEF REVIEW OF THE BIG DEBT CYCLE FROM 1945 TO NOW + +This chapter is a very brief overview of the Big Debt Cycle that began in 1945. In it, I explain how the cycle has transpired as a function of the earlier‐described template based on mechanical cause/effect relationships. If you are interested in the relationships that drive the markets and the economy and how they have moved in the post‐1945 period, this chapter will probably interest you. If you’re not interested in such things, you may want to skip it and move on to Chapters 11‐14, in which I walk through the monetary policy phases of our current Big Debt Cycle. + +Because I was born in 1949 and have been a global macro investor for most of my life, I have both experienced and studied most of what I am going to describe, so I am going to share some personal descriptions to help enrich the picture and pass along some lessons that I learned from going through these experiences, especially through my painful mistakes, which stick in my mind much more than my winning decisions. As you watch the story of the last 80 years unfold, observe the almost in‐unison swings in the five forces from one extreme to the other. Note that they were so extreme that each decade was more likely to be more opposite than similar to the decade before it, yet at the end of each, markets and investor. + +--- + + +# HOW COUNTRIES GO BROKE: THE BIG CYCLE + +Psychology expected more of the same, so those were the key times to understand the fundamentals well and bet against the crowd on the unexpected developments that were logically probable. + +Let’s now look at what has happened since the end of World War II when the new world order began. While I will be putting what happened in the context of the Big Debt Cycle, you will see that the other four forces also swung greatly and interacted with the debt cycles to shape what happened. You will see all five forces flow like waves, sometimes small ones and sometimes big ones, sometimes reinforcing each other and sometimes negating each other, and sometimes with big ones coming together to create perfect storms. As for the debt cycle force, to repeat, the main thing to keep in mind is: + +ⓢ Normally, when central banks want to be stimulative, they lower interest rates and/or create a lot more money and credit, which creates a lot more spending and debt. This stimulation both extends the expansion phase of the cycle and raises debt assets and liabilities relative to incomes, which makes the debt asset and debt liability balance more precarious. History shows us that when central banks can’t lower interest rates anymore and want to be stimulative, they print money and buy debt, especially government debt. That gives debtors, most importantly governments, money and credit to prevent them from defaulting and allows them to continue to borrow in order to spend more than they are earning until the debt assets and liabilities become too great to balance, which is when a debt restructuring and/or debt monetization must occur. + +# THE CURRENT BIG DEBT CYCLE IN BRIEF + +Before I get into what happened, I’d like to show you the Big Debt Cycle in a few charts, starting in 1900 with the United States. Showing the whole period from then to the present will give you a greater perspective. I have focused on the US dollar debt charts because the world money/debt market has been a US dollar debt market during + + + +--- + + +A B R I E F R E V I E W O F T H E B I G D E B T C YC L E F R O M 1 9 4 5 T O N O W + +This Big Cycle, even though it is the case that other countries have also had their own Big Cycles. In the US, between 1945 and 2024 there have been 12 complete short-term debt cycles and we are about two-thirds through the 13th. They averaged about six years in length and added up to one Big Debt Cycle that brought the central government’s debt-to-income ratio up and worsened the central bank’s balance sheet in the ways shown in the charts that follow. Said differently, the US and its credit markets have been in the leveraging-up phase of the long-term debt cycle, and they haven’t yet entered the deleveraging part of the long-term debt cycle, though there have been some brief deleveragings along the way. These charts show the big picture. Most people overlook this big-picture arc because they are focused on the short-term wiggles, which don’t even show up in these charts. + +# 1. USA PRIVATE DEBT LEVEL (% GDP) + +| 200% | | | | | | | +| ---- | ---- | ---- | ---- | ---- | ---- | ---- | +| 160% | | | | | | | +| 120% | | | | | | | +| 80% | | | | | | | +| 40% | | | | | | | +| 1900 | 1920 | 1940 | 1960 | 1980 | 2000 | 2020 | + +The next chart shows US government debt relative to GDP, with the dots signifying projections by the CBO in 10 and 20 years. + +1 9 7 + + +--- + + +# HOW COUNTRIES GO BROKE: THE BIG CYCLE + +shown, it is evolving in a Big Cycle way, is now at the highest level since 1946 (around the end of World War II), and is projected to be much higher in the future. + +# USA CENTRAL GOVT DEBT LEVEL (% GDP) + +| Projected | Government Debt | +| --------- | --------------- | +| 160% | | +| 120% | | +| 80% | | +| 40% | | +| 0% | | + +Now I will combine the last two charts into one chart so you can see how they relate to each other. You can see how private and public sector debt levels have been related: most importantly, how the government has tended to acquire more debt when the private sector is acquiring less. For example, you can see how the government’s debt as a share of GDP has increased dramatically since 2008, while the private sector’s debt-to-GDP has gone down. That is because in order to provide the private sector with more support, the central government has gone deeper into debt. + +# USA DEBT LEVEL (% GDP) + +| Projected | Government Debt | Private Debt | +| --------- | --------------- | ------------ | +| 180% | | | +| 160% | | | +| 140% | | | +| 120% | | | +| 100% | | | +| 80% | | | +| 60% | | | +| 40% | | | +| 20% | | | +| 0% | | | + + + +--- + +# A BRIEF REVIEW OF THE BIG DEBT CYCLE FROM 1945 TO NOW + +The next chart shows central government debt service as a percentage of government revenue. As shown, it is now at about 100% and it is projected to rise to about 150% in 15 years. To visualize what that means, imagine that the amount of money you had to pay in debt service each year was 50% greater than what you earned each year. It’s unthinkable. So, what would one have to believe to think this would work? One would need to believe that the government will be able to 1) roll over the debt that is coming due, 2) sell the new debt that it needs to borrow to fund the deficit, and 3) have holders of the existing debt not sell it (i.e., that those who are lending to the government decide that they want to continue lending to the government because it’s not too risky). + +# USA CENTRAL GOVT DEBT SERVICE (% REVENUE) + +| Total | o/w Interest | o/w Principal | +| ------------------------------------------------------------------- | ------------ | ------------- | +| ![Debt Service Chart](chart_placeholder.png) | | | +| Rising principal payments; interest still low but projected to rise | | | + +Because everything that happens does so because of reasons that make it happen, if one looks at and thinks about them, one can see indicators of the cause/effect relationships, watch them unfolding, and use them as indicators of what is likely to happen. To help paint the picture, I will pass along a few more of these indicators. + +The next chart shows the 10-year Treasury bond rate and a three-year moving average of the inflation rate. The relationship between interest rates and the inflation rate is important because when interest rates are high relative to the inflation rate there is an incentive to save and earn the interest rate, and when interest rates are low relative to the inflation rate there is an incentive to borrow and hold assets that. + +--- + + +# HOW COUNTRIES GO BROKE: THE BIG CYCLE + +benefit from inflation and the growth that low interest rates foster. The bond yield consists of two parts—the expected inflation rate and the expected real bond yield. Both are important in affecting the value of money and debt as a storehold of wealth and as a cost of funds. Note that on the upswing of this Big Cycle, all short-term cyclical swings in bond yields (i.e., those that took place in the cycles of recessions, stimulations, strong growth, and rising inflation periods that led to tightening money and credit that then led to recessions and falling bond yields) and all the cyclical declines in bond yields were higher than the ones before them until 1981. Also note that each of the short-term cyclical swings in bond yields from 1981 until 2020 was lower than the ones before until nominal interest rates nearly hit 0% and real interest rates were significantly negative. That reflects the big cycle in inflation expectations and the real interest rates’ movements around these expectations. While nominal interest rates are important, real interest rates are even more important because they are an indicator of the attractiveness of Treasury bonds as a storehold of wealth. + +| USA 10Yr Bond Yield | Inflation (3Yr Moving Average) | +| ------------------- | ------------------------------ | +| | 18% | +| | 16% | +| | 14% | +| | 12% | +| | 10% | +| | 8% | +| | 6% | +| | 4% | +| | 2% | +| 1945 | | +| 1965 | | +| 1985 | | +| 2005 | 0% | +| 2025 | | + +In the next chart, you can see the real 10-year bond yield. In the years after 1997, I am using the real yield on a 10-year Treasury inflation-protected bond. In my opinion, the real bond yield is the most important number to watch in the financial world. That is because it shows what real return you can certainly get on your wealth (i.e., free + + + +--- + +# A Brief Review of the Big Debt Cycle from 1945 to Now + +of inflation risk and default risk), 28 which is the most foundational rate for all capital markets. To earn more than that rate, one has to do so through cleverness. Even more importantly, it is the single best indicator of whether it is better to be a borrower-debtor or a lender-creditor—e.g., when real interest rates are low, it is much easier to borrow money and convert it into profits than when real interest rates are high. As such, it is a great tool for central banks to use to modulate credit and economic activity. As shown, the real bond yield has averaged about 2% over the last 100 years, which is a rate that is neither too low for borrower-debtors nor too high for lender-creditors. Periods of great differences from this 2% were times of excessively cheap or excessively expensive credit/debt that contributed greatly to the big swings in the Big Debt Cycle. + +# USA Real Yield + +| Real Yield (Actual) | Real Yield (Estimated) | 2% | +| ------------------- | ---------------------- | --- | +| 7% | | | +| 6% | | | +| 5% | | | +| 4% | | | +| 3% | | | +| 2% | | | +| 1% | | | +| 0% | | | +| -1% | | | +| | | -2% | + +When looking at nominal bond yields relative to inflation-indexed bonds’ real yields, I can also see the breakeven inflation rate, which is the inflation rate that the market is betting on. Since one can make money betting against that rate if one thinks inflation will be higher or lower than the market believes, and the markets are pretty tough to beat, one can use that inflation rate as a naïve but pretty good estimate. + +28 If it were free of tax risk, it would be a perfect estimation of the real return you can certainly get. + +29 We show rough estimates of the real yield and breakeven inflation rate (using surveyed inflation expectations and recent inflation) for periods when those were unobservable because inflation-linked bond markets did not exist. + +--- + + +# HOW COUNTRIES GO BROKE: THE BIG CYCLE + +If one doesn’t have a market‐beating way to make a better estimate. Because I can see in the market pricing both the “discounted” (i.e., market‐expected) inflation rate and the discounted real interest rate that I can lock in, I see the bond yield and price as consisting of these two important drivers. I am always watching them rather than just the Treasury bond interest rate, and I often think of and trade the two pieces—i.e., the inflation rate and the real interest rate—separately. Their historical estimated pricing is shown in the next chart. + +# USA ESTIMATED AND ACTUAL RATES + +| Nominal Rate | RY Estimated and Actual | BEI Estimated and Actual | +| ------------ | ----------------------- | ------------------------ | +| 2% | | | +| 18% | | | +| 16% | | | +| 14% | | | +| 12% | | | +| 10% | | | +| 8% | | | +| 6% | | | +| 4% | | | +| 2% | | | +| 0% | | | +| -2% | | | + +1900 1910 1920 1940 1950 1960 1980 1990 2010 2020 -2% 1930 1970 2000 2030 + +I always think about the 10-year interest rate and its two parts because it is the most important governor of all capital markets. I have been intimately involved with it for a long time. For several years, when there wasn’t an inflation‐indexed bond market in the US, I invested in non‐US inflation‐indexed bonds that I currency‐hedged to create a synthetic equivalent of a US inflation‐indexed bond. That came about because a great investor, David White of the Rockefeller Foundation, explained that he had to give away 5% a year and asked me what I thought was the surest way of investing to fund that, which prompted me to think about leveraging and hedging non‐US inflation‐indexed bonds. That led Bridgewater to become the largest global inflation‐indexed bond manager in the world, and I was invited. + +30 We show rough estimates of the real yield and breakeven inflation rate (using surveyed inflation expectations and recent inflation) for periods when those were unobservable because inflation‐linked bond markets did not exist. + + + +--- + +A BRIEF REVIEW OF THE BIG DEBT CYCLE FROM 1945 TO NOW + +to work on the design of the Treasury InXation ‐Protected Security (TIPS) market with Larry Summers when he ran the US Treasury. Since then, we have had a real market showing real bond yields both to look at for guidance and to invest in, which has been foundational to all my investment thinking. I believe that the inXation ‐indexed bond markets that exist around the world are much underappreciated and underused relative to their potential. I watch them as indicators and use them as storeholds of wealth. + +ⓢ The relationship between short-term rates and long-term rates (i.e., the yield curve) is very important because when short-term interest rates are high relative to long-term rates that indicates money is tight and encourages the holding and lending of cash, which becomes more attractive than borrowing and investing in other assets. Movements in the attractiveness of different assets affect the nominal interest rate yield curve̶i.e., the difference between the 10‐year nominal bond yield and the nominal short rate³¹̶reflecting the changing tightness of money and the changing incentives to hold cash relative to bonds.³² That is because a higher interest rate is normally required by lender ‐creditors to hold longer ‐term debt and because long ‐term interest rates higher than cash rates provide a reward/inducement for lending. When the central bank wants to slow credit growth and economic demand, it raises short ‐term rates relative to long ‐term rates, and when it wants to stimulate, it does the opposite. When both 1) real yields are high and 2) the yield curve is nearly flat or inverted, money and credit are tight, which is typically a good environment for lender‐creditors and a bad environment for borrower‐debtors, and when 3) real yields are low and 4) the yield curve is relatively positive, that is typically a good environment for borrower ‐debtors and a bad environment for lender‐creditors. When central banks shift these things extremely, that leads to extremely good or extremely bad environments. + +31 I look at both the short rate minus the long rate and the short rate divided by the long rate as measures of the yield curve. + +32 The yield curve is typically upward‐sloping, with short rates about 1% below long rates and about 70% of long rates. + +203 + +--- + +# HOW COUNTRIES GO BROKE: THE BIG CYCLE + +ronments and a lot of volatility for both borrower-debtors and lender-creditors, which is also disruptive to economies and causes pain and inefficiencies. + +I think the Fed should not be as extreme and volatile as it has been in its use of interest rates to influence monetary policy. If I were running monetary policy, my goal would be to keep the long-term real interest rate relatively stable at a rate that balances the needs of both borrower-debtors and lender-creditors and doesn’t contribute to the making of debt bubbles and busts. That would mean seeking to have the real Treasury bond yield around 2%, varying that target by something like 1%, and targeting the yield curve slope so that a) the short-term rate is about 1% below the long-term rate and b) the short-term rate divided by the long-term rate is about 70%, give or take about 2% and about 50%, respectively. + +# YIELD CURVE + +| 3M Minus 10Yr Rate | 3M Divided by 10Yr Rate | +| ------------------ | ----------------------- | +| 4% | 200% | +| 2% | 160% | +| 0% | 120% | +| -2% | 80% | +| -4% | 40% | + +Setting policy in a way that produces fewer big and volatile swings in real interest rates and yield curves would lead to less volatility. In turn, that would lead to less harm to borrower-debtors and lender-creditors (and everything else they affect in the economy), and it would allow them to plan better. In other words, with a more consistent policy, borrower-debtors and lender-creditors would know that they could expect a reasonable real rate, which should be acceptable to both of them so they could plan their activities accordingly. With that relatively certain borrowing rate, lending and economic + +204 + +--- + +A BRIEF REVIEW OF THE BIG DEBT CYCLE FROM 1945 TO NOW + +Conditions would adapt to that reasonable interest rate. Also, setting that rate would help provide both borrower-debtors and lender-creditors more stable cost of funds and real returns, which would make for more stable capital markets and yield more stable economic conditions, which would improve efficiencies that would enhance the running of capital markets and the economy. But let’s get back to exploring rates and how they impact the economy. + +Thus far I have just shown you the big picture of the Treasury interest rate, but that isn’t the rate that people, companies, and local governments borrow at. For that reason, watching credit spreads is helpful. Next is a chart that shows an average credit spread (for Baa corporate bonds) since 1920. + +| USA BAA CORPORATE SPREAD | | | | | | | | | +| -------------------------------- | -- | -- | -- | -- | -- | -- | -- | -- | +| | 8% | 7% | 6% | 5% | 4% | 3% | 2% | 1% | +| 1920 1940 1960 1980 2000 2020 0% | | | | | | | | | + +The amount of interest owed on a debt is determined by the amount borrowed and the interest rate, which, together with the amount of principal to be paid back, is the amount of debt service. Let’s revisit the chart shared earlier that shows total debt service (principal payments plus interest payments) for the US central government relative to its revenues and how much of that comes from principal payments and how much comes from interest payments. Note that debt service was roughly flat from 1950 to 2000; that is because government debt levels were roughly flat or falling slightly relative to revenue over that period, so principal payments were also roughly flat to slightly falling. Interest payments rose slightly from + +205 + +--- + +# HOW COUNTRIES GO BROKE: THE BIG CYCLE + +1950 to 1990, as the average interest rate on government debt slowly rose, then fell from 1990 to roughly 2022, as the average interest rate on government debt slowly fell. + +I am using dots to show how this is projected to grow, based on the CBO’s estimates, for the next 10 and 20 years. The projected picture is very different from the recent past because the central government’s debt levels are high and projected to rise fast and the interest rate on these high debts is also projected to rise, which will cause a big increase in government debt service relative to government revenue, which will produce a significant squeeze on spending unless there is a lot more borrowing, most likely financed by the central bank. Therein lies the problem. + +# USA CENTRAL GOVT DEBT SERVICE (% REVENUE) + +| Total | o/w Interest | o/w Principal | +| ------------------------------------------------------------------------------------- | ------------ | ------------- | +| ![Chart showing USA Central Government Debt Service over time](chart_placeholder.png) | | | +| Rising principal payments; interest still low but projected to rise | | | + +Who did the central government borrow the money from? It borrowed a lot of it from the central bank. It also borrowed a lot from commercial banks and, for about a third of it, from foreign investors. These commercial and foreign buyers/holders of US debt have had losses in it as interest rates have risen, they have more US debt as a percentage of their holdings than makes sense on a financial basis alone, and some of them are worried that the US government won’t pay them the way it didn’t pay Japan in the years before World War II. + +--- + +A BRIEF REVIEW OF THE BIG DEBT CYCLE FROM 1945 TO NOW + +so they have become sellers. In the case of the biggest foreign holders of US government bonds, they acquired so much because they wanted to store buying power in the most widely used and accepted currency of the greatest and most credible world power̶said diVerently, because the dollar is the leading reserve currency of the leading world power. Looking ahead, given the increased supply of US government dollar debt that is coming (as shown in the last chart) relative to the desired demand for it, it is hard to imagine that these big buyers/holders are likely in the future to buy the huge amounts of US Treasuries that they did in the past, especially if any of the key underpinnings of that demand weaken̶e.g., a) if the US government irresponsibly handles its debt and its domestic and foreign policy issues, b) if the US government threatens to sanction them by withholding payments on the debt, c) if the returns from holding the debt are bad, and/or d) if the US loses its economic and geopolitical prominence. + +From 1980 until 2008, lowering interest rates was more than enough to keep debt service affordable even as debt levels kept rising. But when rates nearly hit zero in 2008, as they did in the post-1933 period, private market demand for the bonds was inadequate to meet the supply so the central bank stepped in to print money and buy the bonds, which put downward pressure on longer-term rates. It happened in two major waves—one in response to the 1929-33 debt-crisis-induced Great Depression when interest rates hit 0% in the post-1933 period, and again in response to the 2008 debt-crisis-induced Great Recession when interest rates hit 0%. (You can see this in the following chart where the small circles indicate the beginning of money printing and interest rates hitting zero.) I wouldn’t have known that, and Bridgewater wouldn’t have been successful in this period, if we hadn’t studied the time frame shown in this chart. This is also what led to my first discovery of how the Big Debt Cycle works. + +207 + +--- + + +# HOW COUNTRIES GO BROKE: THE BIG CYCLE + +| | USA Short-Term Interest Rate | USA Monetary Base (% GDP) | | | | | +| ---- | ---------------------------- | ------------------------- | ---- | ---- | ---- | ---- | +| 18% | | Big money | 30% | | | | +| | Big money | printing | | | | | +| 13% | printing | | 20% | | | | +| 8% | | | 15% | | | | +| 3% | | 10% | | | | | +| -2% | | | 5% | | | | +| | | | 0% | | | | +| 1900 | 1920 | 1940 | 1960 | 1980 | 2000 | 2020 | + +As for the central bank, the Federal Reserve and other central banks’ debt assets provide lower returns than the costs required to service their liabilities, so the modest rise in the interest rate that has occurred in this most recent tightening has caused the Fed to take modest operating losses (blue line in the next chart). If the bonds on the Fed balance sheet were marked to market, the Fed’s losses would be around $700 billion, or 2.5% of GDP (red line). This sounds significant but it is relatively minor compared to the central bank’s capacity to obtain funding. However, it is a red flag and would become a major problem if there was a big selling of US debt, which is what typically happens when that debt is perceived to be a risky asset. As previously explained, for countries like the United States that have the ability to print their own money, that would lead to either a) a big and intolerable rise in nominal and real interest rates, which would contract credit and lead to a severe economic contraction, or b) a big central bank printing of money and buying of debt and providing of + + + +--- + +A B R I E F R E V I E W O F T H E B I G D E B T C YC L E F R O M 1 9 4 5 T O N O W + +credit, which would lead to the devaluation of debt and money. The big central bank losses and bad conditions would also increase the likelihood that the central bank’s independence would be called into question. For those countries that have debt denominated in a reserve currency that is not their own, conditions would be much worse. + +| | Reported | If Bonds Marked to Market | +| ----- | -------- | ------------------------- | +| 0.8% | | 5% | +| 0.6% | | 4% | +| 0.4% | | 3% | +| 0.2% | | 1% | +| 0.0% | | 0% | +| -0.2% | | -1% | +| -0.4% | | -3% | +| -0.6% | | -4% | + +1920 1940 1960 1980 2000 2020 + +# DEBT BURDENS WILL INCREASE GLOBALLY + +In this overview chapter, I have focused on the debt picture for the US. You can see in the charts that follow that this is not only a US issue. Debt burdens are projected to grow substantially across the developed world over the coming decades. It is crucial to understand how these dynamics will play out in order to understand how to make policy and how to trade in markets in the years ahead. + +2 0 9 + +--- + + +# HOW COUNTRIES GO BROKE: THE BIG CYCLE + +| | | GOVT DEBT LEVEL (% GDP) | | | | | | | +| -------- | ---- | ----------------------- | -------- | ---- | -------- | ---- | ---- | ---- | +| World | | G7 | | US | | | | | +| | 140% | | | 200% | 200% | | | | +| | 120% | | | | | 150% | | | +| | 100% | | 100% | | | | | | +| Forecast | 80% | Forecast | | 100% | Forecast | 50% | | | +| | 60% | | | 50% | 0% | | | | +| 2000 | 2025 | 2050 | 2000 | 2025 | 2050 | 2000 | 2025 | 2050 | +| China | | | Germany | | Japan | | | | +| | 150% | | | 100% | | 400% | | | +| | 100% | | | 80% | | 300% | | | +| Forecast | 50% | Forecast | | 60% | Forecast | 200% | | | +| | 0% | | | 40% | | 100% | | | +| 2000 | 2025 | 2050 | 2000 | 2025 | 2050 | 2000 | 2025 | 2050 | +| UK | | | France | | Italy | | | | +| | 150% | | | 200% | | 180% | | | +| | 100% | | | 150% | | 160% | | | +| Forecast | | 140% | | | | | | | +| | 50% | | Forecast | 100% | Forecast | 120% | | | +| | 0% | | | | | 50% | 100% | | +| 2000 | 2025 | 2050 | 2000 | 2025 | 2050 | 2000 | 2025 | 2050 | + +In the rest of Part III, I am going to take you through the complete Big Debt Cycle for the US since 1945 because the US dollar was and + +Source: Bloomberg Economics. Note: Debt is shown as a proportion of gross domestic product. + + + +--- + +A B R I E F R E V I E W O F T H E B I G D E B T C YC L E F R O M 1 9 4 5 T O N O W + +still is the dominant reserve currency that most transactions were and still are denominated in and most savings are in, before diving into China’s and Japan’s Big Debt Cycles in Chapters 15 and 16. To me, the US over the last 80 years, Japan after its bubble bursting, and the other cases I have looked at are all classic Big Debt Cycles that are operating in the previously described ways that are important for investors and policy makers in all countries to understand. This is especially true now that some of them are encountering the late stages of Big Debt Cycles in their own countries and they will likely experience serious consequences from their own Big Debt Cycles, as well as the US’s Big Debt Cycle and its implications for US dollar assets and liabilities. + +We will now look at what has happened through the phases of the long-term debt cycle. To make clear how events have transpired relative to the previously explained debt/credit template, I will divide the post-1945 period into four phases signifying the four main monetary regimes that have driven the debt/credit dynamic since 1945. We will begin in 1945 because that is when the new monetary, geopolitical, and, in many cases, domestic political orders began. + +# 2 1 1 + +--- + + +# CHAPTER 11 + +# 1945 TO 1971— + +# A LINKED (I.E., HARD) MONETARY SYSTEM + +I urge you to read this and the following three chapters, which will take you from the beginning of the current monetary, domestic, and international orders in 1945 up to now. I believe we are near the end of these orders and our current Big Cycle. I would be surprised if, after reading these chapters, the rhymes of history don’t ring loudly in your ears and you don’t feel that you have a good sense of the rhythms of the Big Cycle. With that, we will then be prepared to look ahead. + +As explained, World War II ended the prior world order and caused the transition to the world order that we are now in. As always, the biggest winners of the war—in this case, the US, the UK, and their allies, as well as the Soviet Union and its allies—determined the rules of the new world order including the new world monetary system, though right from the start there was a split between the US and its allies and the Soviet Union and its allies. In 1944, the US, the UK, and their allies created what is called the Bretton Woods system (because it was created in Bretton Woods, New Hampshire). This type of system was a gold-linked (i.e., hard) monetary system. I call this type of monetary system Monetary Policy 0 to signify that it is the first type in a sequence of monetary systems. + +--- + +# HOW COUNTRIES GO BROKE: THE BIG CYCLE + +approaches to deal with the Big Debt Cycle’s evolving conditions. + +A Monetary Policy 0 system looks like most prior monetary systems that existed throughout the millennia with “paper” money being linked to the real money (gold), which was held in banks (in this case, central banks). In an MP0 system, currency can be used to buy a designated hard asset (most often gold) at a set price, and because of that ability, the supply of the currency is supposedly limited. That is because if the supply of the currency becomes too large, its price should fall. This is because if there is too much currency relative to the item the currency is backed by (e.g., gold), people will exchange their money for that item, worsening the imbalance between the amount of money and the amount of the hard asset the money is backed by. The fear of this doom loop is intended to limit money creation and therefore support the value of the money. The problem with this system is that it has never worked in the long term because, even with the link to a hard asset, governments still create more money and allow more debt growth than they should, which leads to many more claims on the asset (e.g., gold) than there is money that can be converted into it at the specified price. The consequences of this are almost always a “run on the bank,” with people rushing to make the conversion, and the breaking of the promise to deliver the hard asset. + +The gold-linked MP0 system set up at Bretton Woods lasted until 1971, during which time dollars, which were then considered like checks with no intrinsic value, were exchangeable for gold, which was considered the real money, at a fixed exchange rate. Other currencies were exchangeable for dollars at agreed-upon and changeable rates. During this 27-year period, there were five short-term debt/economic cycles, which were wiggles around an uptrend in debt relative to incomes during this period. I will now describe how this period unfolded, including what happened with all five of the big forces. + +Like all prior monetary systems, the system set up at Bretton Woods had its own particular characteristics. In this case, because the US had about two-thirds of the world’s gold, which was held by the + +--- + +1 9 4 5 T O 1 9 7 1 — A L I N K E D ( I . E . , H A R D ) M O N E TA RY SY S T E M +US Treasury, the dollar became the world’s reserve currency. Other countries had their own currencies, so to get gold from the US central bank, they had to buy dollars and then use those dollars to buy the gold. Only countries’ central banks were allowed to buy gold; individuals were prohibited from buying gold with their paper money. In fact, in the US and most other countries, it was illegal for citizens to own gold because governments wanted people to save in debt assets in order to build the credit system and they didn’t want debt assets to have to compete with gold. + +This system was created for the United States and the countries that wanted to join it, and the US wanted to let others in. The UK became a subordinate power in this new world order because its financial and other powers were weakened by the war, while the United States became much richer because it entered the war late. The Soviet Union opted out of Bretton Woods agreement and had its own monetary system and ways of doing things that were independent of the US-dominated system. + +The main geopolitical competition was between the US (which was a capitalist democracy) and the Soviet Union (which was a communist autocracy). The United States was much stronger economically and militarily than the Soviet Union, so it was able to provide financial support programs like the Marshall Plan to help rebuild its allies, especially in Europe. These programs were done to enhance alliances, which was especially important at the time of the Cold War. Because the US was rich, had the world’s reserve currency, and accounted for about half of world GDP, it could easily afford to provide this support to allies. Having the world’s reserve currency, which other countries wanted to save in, gave it great buying power that it eventually abused. + +At that time, China, which was allied with the winning powers against the Japanese in the war, was a destroyed and powerless country having suffered what it calls the “Century of Humiliation,” in which foreign powers took over different parts of China, conditions deteriorated terribly, and the whole system of government + +2 1 5 + +--- + + +# HOW COUNTRIES GO BROKE: THE BIG CYCLE + +collapsed. This roughly 100‐year period began in 1839 and ended with the end of World War II. During this period, Japan took over Taiwan in 1895, which was given back to China by the winning powers at the end of the war. Between 1945 and 1949, China had its version of a classic civil war between the hard-right Kuomintang party and the hard-left Chinese Communist Party. That led to the communists driving the Kuomintang out to Taiwan, Chinese communists siding with Russian communists, and the United States alienating China. At that time, both parties to the civil war agreed that there was only one China and that Taiwan was a part of it, and the argument was over who would control both. Arguments about this issue have festered for a long time and are intensifying, which is especially important because of the powers the US and China possess and because Taiwan is the center of chip production, which today is even more important than oil production was in the last cycle. + +In that early post-war period, inventive people, especially American scientists and entrepreneurs who were financed by the capitalists with government support, continued to come up with great new technologies that would eventually have huge effects. For example, in 1956 “artificial intelligence” was invented, and in 1957 the first satellite was launched. In the mid‐1950s the technical foundations of the internet were developed. Of course, there were too many inventions that had big economic, political, geopolitical, and environmental effects for me to delve into here. + +Because the UK was heavily indebted and in fast relative decline economically and militarily, it rapidly and persistently had its bonds and money devalued in the classic ways that were described earlier and that are important to keep in mind when looking at the US now. Immediately after the war, the UK had a lot of debt, and it had colonies and military bases in over 40 countries that it couldn’t afford to maintain. I won’t repeat all the steps, but I will point out that this overextended British Empire had debt problems that led to a managed 30% devaluation of its currency in 1949, which was followed by a series of devaluations in the years that followed, all to relieve + + + +--- + + +1 9 4 5 T O 1 9 7 1 — A L I N K E D ( I . E . , H A R D ) M O N E TA RY SY S T E M + +its debt burdens at great cost to its debt holders. The decline in the value of the currency and debt was classic. There were debt payment problems and the inevitable losses of the controlled foreign territories that made it obvious to the world that the UK was declining, which reinforced the desire not to hold its debt and currency and led to their further declines. Most obviously, when Egypt took over the Suez Canal in 1956, loyal holders of UK bonds sold them. In 1967, another financial crisis led to another major devaluation and abandonment of its debt/money being held as a storehold of wealth, and in 1976 the UK’s financial condition got so bad that it had to go to the IMF for financial help. The decline of the British pound and the British Empire is the most recent classic case study of the decline of a reserve currency and is described at length in my book Principles for Dealing with the Changing World Order. + +In the early 1960s, the US short-term money and credit cycle was expansionary, which was great for the US markets and economy until 1965-66 when inflation rose to 3.8% and the Fed tightened monetary policy, inverting the yield curve for the first time since 1929. These events produced, in 1968, what would be the peak inflation-adjusted price in the S&P 500 for the next 25 years, with that long period of bad performance due to the Big Cycle influences I described earlier in this study. It also led to a recession in 1969-70. That long period of terrible stock and bond market performance and terrific gold and other inflation-hedge asset performance was primarily due to the needed creation and devaluation of money to deal with the debts (i.e., the debtors’ obligations to deliver money) being too large relative to the actual amount of real money in existence. That paradigm taught me a lot about the need to be able to make money in all types of market environments and the skills required to do it. It also puts me today in a very different mindset from most investors who haven’t been through something like that and have views based just on their experiences and so think that being long only in equity-like assets and ignoring the Big Cycles is the best way to invest. + +In the 1960s, there were also some nail-biting political and + + + +--- + + +# HOW COUNTRIES GO BROKE: THE BIG CYCLE + +Geopolitical conflicts that made a big impression on me, most notably when the Cuban Missile Crisis in 1962 brought the world’s two most powerful countries to the brink of nuclear war. I was 13 at the time and vividly remember watching John F. Kennedy’s address to the country explaining the situation and wondering if there would be nuclear war or which country would back down. I was sure the potential for geopolitical catastrophe would have a big impact on the markets, but over the next few days the stock market didn’t behave nearly as badly as I thought it would have. What happened was that the Soviet Union pulled its missiles that were aimed at the US out of Cuba, and the United States pulled its missiles that were aimed at the Soviet Union out of Turkey. This allowed both countries to claim victory without telling their people about the concessions they made. + +This episode also gave me my first lesson about how brinkmanship diplomacy really works and how markets behave during such dramas (when the damages that would result from the conflict are unacceptably high). In November 1963, JFK was assassinated, which also had only a brief passing effect on the markets and economy; then came the civil rights movement, and big spending on “guns” (the Vietnam War) and “butter” (US domestic social programs). The fact that these and numerous other seemingly earthshaking events didn’t have much effect on markets helped me to realize why they didn’t affect the markets more and to sort out what really matters and doesn’t matter to market prices and the economy. + +While I won’t delve into all that matters, I will tell you that what matters to markets is the money that investments earn, so big political events like threats of war don’t matter much until they start to affect those cash flows. That is why, from an investment perspective, I don’t worry about the headline-grabbing events of today, and I suggest that you do the same. Also, I learned that most of these global threats turn out to sound more threatening than they actually are because most countries’ leaders will step back from the brink rather than choose to go over it. However, to be clear, there are times when international conflicts have impacts, such as on supply chains and the value of currencies, and there are rare occasions. + + + +--- + + +# 1 9 4 5 T O 1 9 7 1 — A L I N K E D ( I . E . , H A R D ) M O N E TA RY SY S T E M + +when leaders don’t step back and things do blow up, so that these conflicts become very consequential. Because I view protecting myself against these events as being like buying insurance to be protected against an improbable, unacceptable loss, I look for ways to be insured against them even though I don’t expect them to happen. + +In the 1960s, there was also a big geopolitical swing in the relationship between China and the Soviet Union. They changed from being “friendly” countries to becoming “enemy” countries, which led to a corresponding big geopolitical swing between China and the United States from being “enemies” to being “friends.” That led to Henry Kissinger’s secret visit to China in 1971 and then President Nixon’s visit in early 1972, which set the stage for China’s opening up after Mao Zedong died in 1976. These developments, like the earlier‐mentioned technology developments, were like small seeds of change being planted that grew into enormous changes that would affect all five forces everywhere. They mattered a lot even though they didn’t seem to matter much at the time. + +During this 1945-71 period, the US overspent and financed that overspending by borrowing, especially in the 1960s on the Vietnam War and the “war on poverty,” so its paper-money promises to give real money (gold) far exceeded what it had in its central bank. That mattered a lot, though it didn’t seem to at the time because the bad finances grew slowly until they led to the blowup. You see, early in the 1950s and 1960s, most countries were happy to accept these “paper” dollars in return for their goods and services because they wanted to accumulate dollars as savings. As a result, the US could overspend liberally. Also over those years, other countries, especially Germany and Japan, gradually recovered from their big losses from the war and became competitive economically, which led the US balance of payments to worsen. In the late 1960s, one could see the US and the UK having runs on their central banks because holders of paper money turned it in to get the real money (gold), so the US central bank’s reserves of gold steadily declined. + +You might recall the following principle: + +ⓢ During times when + + + +--- + + +# HOW COUNTRIES GO BROKE: THE BIG CYCLE + +there is too much debt relative to the quantity of money that is needed to service debts, the need to either increase the amount of money that exists and/or cut the amount of debt there is leads governments to break their promises and do some combination of a) raising the amount of money and credit, b) reducing the amount of debt (e.g., by restructuring it), and/or c) preventing the free-market ownership and movement of the hard money (e.g., gold). At such times, there is a run away from bad money to good money that the government wants to stop. This often leads to prohibiting good money from being freely held and freely move. + +Seeing the US central bank running out of real money (gold), Charles de Gaulle, the French president at the time, openly called for a reform of the monetary system in 1965. Other holders of paper dollars caught on and the run accelerated and the US spending and deficits didn’t slow down, so the run on the US central bank ended like most such central bank runs end. For previously described reasons, the selling of the debt drove interest rates up and the currency down at the same time as the economy weakened. The US central bank did not have enough real money (gold) in the bank to meet its obligations to exchange it for the paper money at the promised price. + +On the night of Sunday, August 15, 1971, President Nixon went on television and announced that the United States was no longer going to allow dollar holders to turn their dollars in for gold. That ended the monetary system, and money, as we knew it. It immediately devalued money, raised inflation, and made it much easier to pay debts for the reasons I previously explained. I was clerking on the floor of the New York Stock Exchange at the time. It was a summer job between college and business school. I figured that ending the monetary system as we knew it and preventing people from getting the real money was a big, bad deal, so I expected the stock market to be down a lot. Instead, that Monday was the best day for the market that year—stocks were up more than 3%. + +Because I had never experienced a currency devaluation before, I was ignorant about how they work. That led me to study history, + + + +--- + + +# 1945 TO 1971 — A LINKED (I.E., HARD) MONETARY SYSTEM + +which led me to find out that, in 1933, President Roosevelt had done the exact same thing (default on the promise to allow people with dollars to exchange them for gold at the promised exchange rate) for the exact same reason (the US had created more promises for gold than it had in gold, and it was running out of gold and money during a bank run), which had the exact same effect (the devaluation, big market rallies in stocks and gold). The only real difference from Nixon was that Roosevelt made the announcement on the radio, not television, which wasn’t common yet. + +In both cases, de-linking the currency meant the central government didn’t have to deliver the real money, and it freed central bankers to create a lot of money and credit. This made it easier to handle the debts and stimulate the economy, leading equity, gold, and commodity prices to rise and the economy to pick up. That’s when I learned that when central banks create a lot of money and credit, the value of money and credit goes down and the price of most things goes up. I realized that these moves were classic cases of “hard” currency (gold-linked) exchange rate systems breaking down, leading to the devaluations of the money and debt. Once I saw this happen in these two cases, I saw that it happened throughout history in almost all such cases, and I learned the principle that when there is a big debt problem that is intolerably painful, central banks will “print money” and distribute it to make it easier for debtors to pay their debts, which will devalue the money and debt relative to other assets. That helped me make a lot of money and avoid a lot of painful losses. + + + +--- + + +# CHAPTER 12 + +# 1971 TO 2008 — A FIAT MONEY, INTEREST-RATE-DRIVEN MONETARY POLICY + +The August 1971 breakdown of the monetary system changed the value of money and how the system worked—i.e., the gold-linked system was replaced by a fiat monetary system in which central banks stimulated and restrained debt/credit/money growth by changing interest rates. I call this type of monetary system (i.e., one in which fiat currencies are managed via interest rate changes) Monetary Policy 1 (MP1).34 I make these distinctions between types of monetary policy because they work very differently, and it is important to understand these differences. The most important differences between MP0 and MP1 are that in an MP1 monetary system a) the amount of money and credit provided by lender-creditors to borrower-debtors is primarily driven by the cost of money (i.e., interest rates) and b) it is not restrained by the link to hard currency (e.g., to gold). Because the amount of money and credit was unrestrained and because the world’s central banker (the Fed) wanted to accommodate + +34 There are two other types of monetary policy that take place at the later stages of the long-term debt cycle, which I call Monetary Policy 2 (MP2) and Monetary Policy 3 (MP3). I will touch on them later in this study. If you are interested in learning more about them, I describe them in my book Principles for Navigating Big Debt Crises, which you can buy in print or find in PDF form at economicprinciples.org. + +--- + + +# HOW COUNTRIES GO BROKE: THE BIG CYCLE + +what happened, this change in policy led to a very classic combination of economic stagnation and inflation, which was called stagflation. + +# FROM 1971 TO 1982: STAGFLATION AND TIGHTENING AND THE MOVE FROM THE POLITICAL LEFT TO THE POLITICAL RIGHT + +The decade from 1971 to 1982 provides a good example of how cycles in the five big forces interrelate to create the Overall Big Cycle. In this period, the Big Debt Cycle was influenced by, and helped drive, big cycles in politics and global conflict. + +We’ll start by looking at the debt/money/economic cycle. When President Nixon ended the MP0 monetary system and transitioned to the MP1 system, the central bank and the central government took advantage of having fewer constraints and printed money. From 1971 until the end of 1981, the Federal Reserve increased the supply of money by 100%, and the broader measures of money supply that included some bank accounts and cash instruments (called M2) increased by 180%. The prices of goods and services (measured in CPI) went up by about 140%; stocks went up by around 30%, and the price of gold increased about 10x. Stock prices fell by 45% in real terms. Of course, debtors benefited because they could pay their debts with much more available and much cheaper dollars and creditors suffered because the value of the money they were promised dwindled. In that 10-year period, a holder of 10-year Treasury bonds lost around 40% in inflation-adjusted terms, and holders of Baa corporate bonds had slightly negative returns in inflation-adjusted terms. + +In other words, starting in 1971 and through the next few years, the Fed dealt with the debt crisis by creating a lot more money and credit, which created great debt relief for debtors and great losses of buying power for creditors, which encouraged borrowing and discouraged lending. This decade of debt monetization developments made a big impression on me and taught me some invaluable lessons. + +224 + + + +--- + + +# 1971 TO 2008 — A FIAT MONEY, INTEREST-RATE-DRIVEN MONETARY POLICY + +about the need and ability to make money in all kinds of markets. I think that current investors who have only lived in an environment in which equity‐like assets have had positive real returns approach investing by only looking to buy equity‐like investments to provide great real returns, and that is a mistake. + +The most important diVerence between today’s dollars and dollars in the 1945-71 period is that today’s money is and has been Wat money since 1971. That means that the Fed (which is essentially the world’s central banker because the US dollar is the world’s dominant medium of exchange and storehold of wealth) can more freely create money and credit than in the past. Other central banks can do the same, so this aVects all mediums of exchange and storeholds of wealth. For previously explained reasons, doing that is the easiest and subtlest way for governments to alleviate debt burdens and conWscate wealth. By the way, Wat monetary systems have existed throughout history, so studying those from the past provides invaluable lessons on how they work that can provide clues for how the one we are in will go as the debt cycle progresses. + +While the gold‐dollar‐based system broke down in 1971, the US remained the dominant world power economically, militarily, and in most other respects, and most world trade and capital transactions were done in dollars, so the dollar remained the world’s leading currency that governments, companies, and people wanted to save in, despite the fact that it was such a terrible storehold of wealth in the 1970s. + +In the 1971-82 period, it paid to be a borrower-debtor because the big devaluation that started in August 1971 had immediate inflationary eVects. At the same time, geopolitical conflicts played a role in shaping the environment. + +More specifically, the big easing of monetary policy in 1971 after the de-linking from gold got inflation going. Simultaneously, in 1973, the British Empire and colonialism were breaking down, so there was a big geopolitical shift in the Middle East. With more money chasing limited supply—in this case, of oil—Middle Eastern countries took advantage to create the first “oil shock” that caused + + + +--- + + +# HOW COUNTRIES GO BROKE: THE BIG CYCLE + +It was mostly a fight about money, as it normally is. More specifically, at that time, the colonized countries of the Middle East (and elsewhere) were overthrowing the colonialists that controlled them and nationalizing the colonialist claims on the assets of the colonized. Saudi Arabia, Iran, Iraq, and Libya nationalized most of the oil properties that were owned by the “Seven Sisters” (the seven major oil companies), and in October 1973, war broke out between the Arabs and Israelis. These events led to oil prices rising a lot. + +The debt/credit/money/economic cycle played out differently for different countries depending on whether they benefited or suffered from this change in prices. Commodity producers, especially in emerging countries, boomed and experienced debt-financed bubbles while the US created more money and credit to finance its debts. Naturally, dollars from Europe, the US, and elsewhere began to be lent to commodity-producing emerging economies, creating their debt bubbles. In the early 1970s, a lot of dollars were held in other countries, especially in European countries, so there was the growth of what was called the Eurodollar market. Those dollars had to be lent out. Because there was high inflation in the world due to the previously described currency devaluations, commodity prices were high, so it seemed good to lend to commodity-producing emerging countries. That fueled a boom that created a bubble in those countries, with the lender-creditors to them being US, European, and some Japanese banks. All this investment into commodity extraction eventually contributed to price declines, especially when money became tight in the 1980s. + +Early in this period, in 1971-74, money was easy, inflation and economic activity rose, and the oil-exporting countries embargoed oil, which sent oil prices and inflation higher. So, from the end of 1973 to 1974, the Fed tightened money and credit, raising interest rates and inverting the yield curve, which sent the markets and the economy into severe declines. That led to a recession. That completed that short-term debt cycle, and as always, a new cycle began. + + + +--- + +1 9 7 1 T O 2 0 0 8 — A F I AT M O N E Y , I N T E R E S T - R AT E - D R I V E N M O N E TA RY P O L I C Y + +This next cycle played out in the same way. The easy money and credit that followed the recession caused economic activity and inflation to pick up, and there was a second oil price shock that was caused by internal political and international geopolitical conflicts. In Iran, the shah’s domestic order was overthrown, which led to the US embassy being seized and American hostages being held by those who took power. That began the conflict with Iran that remains with us. This development was both inflationary and humiliating for the United States. + +The following chart shows the average interest rate (the average of the 90‐day Treasury bill rate and the 10‐year Treasury bond rate) and the CPI inflation rate from 1971 through 1981. As you can see, in the 1970s interest rates rose more slowly than inflation rates, so real interest rates were low until they were negative (as low as ‐4% at certain points, compared to the average up to that point of 2%). These artificially low interest rates relative to inflation rates were great for borrower‐debtors and terrible for lender‐creditors, which encouraged borrowing and buying, which drove inflation rates up and interest rates followed, until inflation became so bad that changes had to be made, which led to the reverse. You can clearly see the two short‐term debt cycles reflected in this chart. The vertical lines in these charts represent January 1980. + +| USA INTEREST RATES AND INFLATION | Headline CPI | USA Avg Interest Rate (Avg of 3M, 10Yr Rates) | +| -------------------------------- | ------------ | --------------------------------------------- | +| | 20% | | +| 18% | | | +| 16% | | | +| 14% | | | +| 12% | | | +| 10% | | | +| 8% | | | +| 6% | | | +| 4% | | | +| 2% | | | + +2 2 7 + +--- + + +# HOW COUNTRIES GO BROKE: THE BIG CYCLE + +# YIELD CURVE + +| 3M Minus 10Yr Rate | 3M Divided by 10Yr Rate | +| ------------------ | ----------------------- | +| 6% | 160% | +| 4% | 140% | +| 2% | 120% | +| 0% | 100% | +| -2% | 80% | +| -4% | 60% | +| -6% | 40% | + +# USA ESTIMATED REAL BOND YIELD + +| Estimated | Very high | real | interest rates | Very low real | interest rates | +| --------- | --------- | ---- | -------------- | ------------- | -------------- | +| 2% | 6% | 5% | 4% | 3% | 2% | +| 1% | | | | | | +| 0% | | | | | -1% | + +In the next chart, you can see a few other flavors of real interest rates. + +35 We show rough estimates of the real yield and breakeven inflation rate (using surveyed inflation expectations and recent inflation) for periods when those were unobservable because inflation-linked bond markets did not exist. + + + +--- + + +1971 TO 2008 — A FIAT MONEY, INTEREST-RATE-DRIVEN MONETARY POLICY + +# MEASURES OF REAL INTEREST RATES + +| USA Avg Interest Rate Minus Headline Inflation | USA Avg Interest Rate Minus GDP Deflator | +| ---------------------------------------------- | ---------------------------------------- | +| ![Interest Rate Chart](chart_placeholder.png) | | + +# LABOR SHARE OF PRIVATE EARNINGS + +75% +70% +65% +60% + +At the same time, workers and labor unions had become stronger, which raised wage inflation and squeezed company profits. As shown in the next chart, labor’s share of revenue increased from 68% in 1965 to the US historical high of 74% in 1980. That both reflected and influenced the political cycle that accompanied the debt cycle. + +Enough was enough. The combination of high inflation, a weak dollar, bad economic conditions, bad conditions for businesses, and geopolitical crises was intolerable for voters. The debt/money/economic, domestic-political, and international-geopolitical pendulums/orders had swung to their extremes, so + +229 + + +--- + + +# HOW COUNTRIES GO BROKE: THE BIG CYCLE + +Big changes were made and conditions were reversed. Pretty much everything moved in the opposite direction. More specifically, in reaction to the uncontrolled inflation, in 1979 Paul Volcker was appointed chair of the Federal Reserve to shift monetary policy from very easy to the tightest money and the highest level of interest rates “since the birth of Jesus Christ” (according to German Chancellor Helmut Schmidt), and in reaction to the generally terrible conditions that occurred under left-leaning governments, Ronald Reagan, Margaret Thatcher, Helmut Kohl, and other right-leaning leaders gained control. In other words, there was one of those classic roughly synchronized debt/economic and political swings that typically occurs because the people’s discontentment with their conditions causes discontentment with the country’s leaders and the party in power. + +The following chart shows the CPI inflation rate (as a simple proxy for inflation), the average of the three-month and the 10-year interest rate (as a simple proxy for interest rates), and the yield curve (the three-month rate minus the 10-year rate—as a simple proxy for the tightness of monetary policy). From this chart, you can see the two short-term credit cycles in the 1970s and you can see the next one emerging in the early 1980s. You can see that money was made very tight to fight inflation around 1980. + +| USA INTEREST RATES AND INFLATION | Headline CPI | 3M Minus 10Yr Rate | USA Avg Interest Rate (Avg of 3M, 10Yr Rates) | +| ------------------------------------ | ------------ | ------------------ | --------------------------------------------- | +| 4% | | | | +| 3% | | | | +| 2% | | | | +| 1% | | | | +| 0% | | | | +| -1% | | | | +| -2% | | | | +| -3% | | | | +| -4% Paul Volcker Appointed Fed Chair | | | | +| -5% | | | | +| 1970 1972 1974 1976 1978 1980 1982 | | | | + + + +--- + +1 9 7 1 T O 2 0 0 8 — A F I AT M O N E Y , I N T E R E S T - R AT E - D R I V E N M O N E TA RY P O L I C Y + +In addition to the monetary tightening, high real rates, and falling inflation, there was a shift from liberal to conservative labor policies. Thatcher in the UK, Reagan in the US, and Kohl in Germany (all moderate conservatives) led strong fights against labor inflation and labor unions that cut labor’s share of the revenue pie, which reduced inflation and raised corporate profits. These conservative leaders also cut taxes on income and corporate profits and pursued tougher geopolitical policies. + +The new Iranian leadership released the hostages exactly as Reagan took office in response to his threat of severe consequences if they didn’t. Thatcher went to war with Argentina and won; the war was over Argentina’s attempt to take the Falkland Islands, a group of small, nothing-special, British-controlled colonial islands. And Reagan accelerated the Cold War with the Soviet Union, which eventually ended the Soviet Union. + +The strong moves by the American central government and central bank changed the flow of money and power and the direction of most everything. The markets respected strength and loved the combination of falling interest rates, falling inflation rates, high real interest rates, improving profit margins, and falling tax rates. It was a capitalist’s delight. I remember the changes in policies and the changes in mood very well, especially the willingness of these leaders to have the fights to do the difficult things, even when doing these difficult things was painful. + +As a result of all of these things, the 1980s were more opposite from than similar to the 1970s—i.e., it was a decade of disinflationary growth, strong stock and bond prices in developed countries, and debt bubbles popping, leading to classic inflationary depressions in emerging countries. + +Throughout this period, I was deeply involved with these markets and the circumstances that drove them, which gave me the perspective that allowed me to identify great investment opportunities and to + +2 3 1 + +--- + + +# HOW COUNTRIES GO BROKE: THE BIG CYCLE + +describe the mechanics of the process. But that’s not to say that I fully understood all the mechanics behind these big moves from the start. In 1982, I was dead wrong because I expected the big debt crisis to cause big debt problems for American banks, the stock market, and the American and world economies. I was wrong because I failed to anticipate how forceful the change in global financial flows away from emerging markets and into American markets would be and how well the Federal Reserve and the regulators would protect the American banks. That failure provided me with great but painful lessons about the need to watch capital flows and how to do it, about how to diversify to reduce my risks without reducing my returns, and about how to be humble. That painful experience, like many others, turned out to be great because it educated me, which radically improved my and Bridgewater’s performance over the next 30-plus years. + +As you can see, all these big movements in markets and economies that had big effects on politics, geopolitics, and technology development were driven by debt/money/capital flows. For that reason, I decided to become an expert on capital flows. + +The decade from 1971-72 to 1981-82 was a very painful and very classic decade of debt restructurings and debt monetizations that played out following the archetypical template previously described. As is quite typical, the decade that followed it was more opposite from than similar to the decade that came before it. + +# FROM 1982 TO 1990: FALLING INFLATION, STRONG GROWTH, AND LEVERING UP; FROM ONE DEBT CRISIS TO ANOTHER; STILL OPERATING WITH AN MP1 MONETARY SYSTEM + +The 1979-82 monetary policy changes shifted the environment from benefiting borrower-debtors, as it had in the early 1970s, to + + + +--- + + +# 1971 TO 2008 — A FIAT MONEY, INTEREST-RATE-DRIVEN MONETARY POLICY + +benefiting lender-creditors, as it did in the 1980s. As shown in the following charts, it lowered the inflation rate, which lowered nominal interest rates while keeping real interest rates relatively high in the 1980s. The following charts update the previous chart, showing interest rates and inflation rates through 1990 so you can see how different the 1980s were from the 1970s. The monetary policy moves that ended the 1970s’ decade-long period of rising inflation, rising nominal interest rates, and low real interest rates created the 1980s’ period of falling inflation and a relatively high real interest rate environment, which began a long period of falling interest rates. With those things happening and profit margins widening, the 1980s were more opposite from than similar to the 1970s. They were almost ideal for the markets and the economy because strong growth was accompanied by falling inflation, falling interest rates, and big stock and bond market gains in the US and most developed countries. From the early 1980s to the early 1990s, inflation fell a lot and interest rates and the tightness of credit fell even more, thus shifting the environment from one that was great for lender-creditors and terrible for borrower-debtors to one that was slightly good for borrower-debtors and slightly bad for lender-creditors. + +# USA INTEREST RATES AND INFLATION + +| Headline CPI | USA Avg Interest Rate (Avg of 3M, 10Yr Rates) | +| ------------ | --------------------------------------------- | +| 20% | | +| 16% | | +| 12% | | +| 8% | | +| 4% | | +| 0% | | + +1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 + +--- + +# HOW COUNTRIES GO BROKE: THE BIG CYCLE + +# YIELD CURVE + +| 3M Minus 10Yr Rate | 3M Divided by 10Yr Rate | +| ------------------ | ----------------------- | +| 6% | 160% | +| 4% | 140% | +| 2% | 120% | +| 0% | 100% | +| -2% | 80% | +| -4% | 60% | +| -6% | 40% | + +# USA INTEREST RATES, INFLATION, AND BOND YIELD + +| USA Avg Interest Rate Minus Headline Inflation | 3M Minus 10Yr Rate | USA Real Bond Yield | +| ---------------------------------------------- | ------------------ | ------------------- | +| 10% | | | +| 8% | | | +| 6% | | | +| 4% | | | +| 2% | | | +| 0% | | | +| -2% | | | +| -4% | | | + +We show rough estimates of the real yield and breakeven inflation rate (using surveyed inflation expectations and recent inflation) for periods when those were unobservable because inflation-linked bond markets did not exist. + +--- + + +1971 TO 2008 — A FIAT MONEY, INTEREST-RATE-DRIVEN MONETARY POLICY + +# USA REAL BOND YIELD + +7% +6% +5% +4% +3% +2% +1% +0% +-1% +-2% + +# USA ESTIMATED REAL RATES + +| USA Avg Interest Rate Minus Headline Inflation | | | Long-Term Average (2%) | USA Avg Interest Rate Minus GDP Deflator | +| ---------------------------------------------- | - | --- | ---------------------- | ---------------------------------------- | +| 10% | | | | | +| 8% | | | | | +| 6% | | | | | +| 4% | | | | | +| 2% | | | | | +| 0% | | | | | +| | | -2% | | | +| -4% | | | | | +| | | | -6% | | + +In the 1980s, the previously described tight money and short dollar (debt) conditions drove the dollar higher until 1985 when there was the Plaza Accord, which was an agreement to get the dollar to fall, which it would have done anyway because the large current account deficit and the large demand for dollars were unsustainable. Throughout these years, there were big swings in interest rates and inflation that felt massive as you lived through them. But the overall dynamic is clear (as seen in the prior chart): in the 1980s, inflation rates fell as a result of the tightness of money in the 1980‐82 period. + +37 We show rough estimates of the real yield and breakeven inflation rate (using surveyed inflation expectations and recent inflation) for periods when those were unobservable because inflation-linked bond markets did not exist. + +235 + + +--- + + +# HOW COUNTRIES GO BROKE: THE BIG CYCLE + +Then nominal interest rates also fell, following inflation down but keeping real interest rates relatively high. Those high real rates were great for lender-creditors and terrible for borrower-debtors. And then when nominal interest rates fell after inflation began to fall, it was great for bond and stock prices because the discount rate used to value future cash flows fell, and the lower rates made borrowing easier. All of this was good for economic activity. And along with declining inflation, it created an ideal set of circumstances for US markets and the economy. + +But where was this transfer of wealth from? It came from the borrower-debtors who held high-interest debt liabilities and debt assets, especially emerging market borrower-debtors who had borrowed in dollars and had their earnings in local currency, and those that lent to them (especially US multinational banks). The cycle that they experienced was classic. The high interest rates not only made dollar debt more expensive to service, but they also helped drive a rally in the dollar. Those countries that had debt liabilities and debt assets denominated in the tight foreign currency that they couldn’t print (US dollars) faced debt default problems, while those countries that had debts in currencies that they could print had their currencies plunge in value due to the money printing. In other words, that produced monetary inflation (i.e., inflation in the currencies they could print) and monetary deflations in the currencies that they owed and couldn’t print. + +The debt bubbles of the late 1970s turned into classic debt busts when there was a big tightening that tortured both sides with an ugly deleveraging in the 1980s. Those countries facing debt busts, including many emerging countries, experienced a classic full debt cycle over these 20-plus years that included inflationary depressions because there were great debt monetizations that depreciated the value of the money and debt denominated in their local currencies while they had deflationary debt default problems in the foreign currency debt that they couldn’t monetize. That cycle transpired in accordance with the template laid out in Part II. The debt busts for these countries. + + + +--- + +1 9 7 1 T O 2 0 0 8 — A F I AT M O N E Y , I N T E R E S T - R AT E - D R I V E N M O N E TA RY P O L I C Y + +created a classic “lost decade” with inflationary depressions in these countries and classic debt workouts for the banks that had lent to them. Eventually, in 1991, there was a classic end to the debt bust that occurred in the way described in Part II̶i.e., the local currency debt was devalued and the foreign currency debt was restructured. Also, near the end of the cycle, most overly indebted governments sold their government assets to build foreign exchange reserves, and they linked their domestic currencies to the dollar, completing their Big Debt Cycles. + +Of course, each country experienced its own cycle and we will explore a few of these cases, notably China and Japan in Chapters 15 and 16, respectively. But there were also important geopolitical shifts during this time that impacted the Big Cycle for all nations in important ways. + +During the 1980s, the geopolitical landscape changed as the Soviet Union declined, China rose, and wealth gaps increased. These changes were mostly driven by the Soviet Union’s inadequate financial and economic system. More specifically, the United States had much more money and productivity than the Soviet Union and so it outcompeted the Soviet Union in most everything; notably on the military. That led to the Soviet Union’s debt, economic, currency, political, and geopolitical collapses, which were manifest in the fall of the Berlin Wall in late 1989 and the official collapse of the Soviet Union in December 1991. + +Deng Xiaoping coming to power in China in 1978 brought about big changes in the 1980s that have had big impacts on shaping the changing world order up until now. Deng’s ascension ushered in the beginning of China’s capitalist-like era and the start of its big debt/credit/money/economic cycle. Before then, there was little debt/credit/savings/economic activity. Deng changed that by creating China’s “open door” and “reform” policies, which brought in foreign capitalists with their money and their talent. This swing from pure and extreme communism to market-oriented, capitalism-infused “communism” had a huge impact on China and the rest of the world. That shift unleashed a wave of productivity that led China + +2 3 7 + +--- + + +# HOW COUNTRIES GO BROKE: THE BIG CYCLE + +to become the greatest trading and manufacturing power ever be - cause it was able to produce many tradable goods at much lower costs than could be produced elsewhere. This also had a huge impact on China and other countries, as we will explore later. Because of my relationships in China and my knowledge of financial markets, I was able to contribute to and watch up close China’s big transformation during this period. I will explain China’s Big Cycle evolution in much more detail in Chapter 15. Suffice it to say for now that China became extremely productive, to the degree that it swamped the world with attractively priced items, earned a ton of money, and lent a ton of money to Americans and others so they could buy Chinese goods. So, Americans got the goods and the Chinese got Americans’ debt and I’m still trying to work out who got the better deal. + +In the 1980s, the most important big inventions were laptop computers, lithium-ion batteries, the internet, the digitization of thinking, apps, and DNA profiling, and big advancements were made in GPS, video game consoles, microprocessors, and satellite television. Americans remained the leading inventors and investors while other countries were the leading producers. Most importantly, in the 1980s, the technology development force, in which entrepreneurs were supported by capitalists, led to the internet being developed, which led to the launching of the World Wide Web in 1991 and the dot-com bubble emerging in the 1990s. This led to the dot-com bubble bursting in 2000, when the Fed tightened money to rein in the rapid debt-financed speculation on the dot-com miracle. + +# FROM 1990 TO 2000: MORE DISINFLATION AND LEVERAGING UP, WHICH LED TO A BUBBLE + +In brief, as with all decades, the 1990s brought many developments that seemed giant at the time and are barely memorable in retrospect. I wonder if I am giving you too much detail or not enough. To me, at the time these events were unfolding, every minute seemed + + + +--- + +1 9 7 1 T O 2 0 0 8 — A F I AT M O N E Y , I N T E R E S T - R AT E - D R I V E N M O N E TA RY P O L I C Y + +like an eternity; now I struggle to remember them, which led to my principle that ⓢ everything seems bigger up close. This has helped me keep things in perspective and navigate changes. + +Looking back, I am happy to see that I did well navigating them, which I know is because of what I learned and am trying to convey in this study. I hope to show you these events in the context of the Big Cycle so you can put things in perspective and see how the five big forces work and are interrelated. In brief, the changes I’d highlight are described here. + +In the mid‐1980s and early 1990s, tight money and abundant commodity supplies led commodity producers to sell at low prices. More specifically, the investment into commodity production in the 1970s/early 1980s led to a lot more supply at the same time as money was tight and producers that had dollar‐denominated debt were squeezed. These factors caused the prices of key commodities to collapse in the mid‐1980s and stay relatively low through the 1990s. That caused the flow of money and credit to commodity producers to dry up. As is typical, these big financial/economic changes that came from the debt/credit/money turning down led to big changes in domestic and international orders. + +For instance, these tight money and strong dollar conditions led to oil prices averaging only around $20 per barrel from 1986 to 1991, and these very low oil prices had a big negative impact on the Soviet Union and contributed to its fall, which greatly changed the world order. + +The collapse of the Soviet Union ushered in an era of globalization. Amazing new technologies were developed during this period, most importantly, Wi‐Fi, smartphones, and e‐commerce, and further big advancements were made in GPS, video games, and perhaps most significantly artificial intelligence. As in all Big Cycles, these big inventions were financed and accompanied by debt and equity cycles (e.g., the steam engine and the railroads come to mind). In this case, the early development led to excitement that turned into a bubble (in 1995-99), which contributed to an overheating economy and rising inflation, which led the central bank (in this case, the Fed) to tighten monetary policy, which burst the bubble (in this case, in March 2000). + +2 3 9 + +--- + + +# HOW COUNTRIES GO BROKE: THE BIG CYCLE + +which produced a short‐term cyclical downturn in the markets and the economy, which ended when the tighter credit and the downturn reduced inflation, which led the Fed to ease monetary policy in the classic way. + +For highly competitive, low-labor-cost countries, especially those in Asia, this era of globalization, combined with the decline in commodity prices, created a boom lasting from the mid-1980s to the mid-1990s. China started the process of joining the World Trade Organization in the 1990s, which would later bring about an era of its inexpensive goods flooding world markets and China becoming very rich and financially and economically powerful. As is classic, the boom produced debt bubbles. In 1997‐98, that bubble popped, and there was the Asian Financial crisis, which, while concentrated in Thailand, Indonesia, Malaysia, and South Korea, affected all countries in the region in the “Asian Contagion.” As is typical, these debt/economic crises led to internal social and political conflicts in all those countries to varying degrees. These crises were all very classic in following the previously described process and exhibiting all the classic leading indicators. + +In Europe, the need for countries to operate as an economic unit and to be of a scale that allowed it to compete with other economic blocs—and the need for the European economic bloc to have a coordinated currency policy—led to the major European countries linking their currencies in the Exchange Rate Mechanism (ERM). Because a system of separate currencies held together with separate monetary policies doesn’t work, this ERM broke up, which was one of the great trades of the 1990s for those who understood how currencies work, and eventually led to the abandonment of individual currencies and central banks and the making of one currency (the euro) and one central bank (the European Central Bank) in 1999. The major European countries made these choices to unify despite the unimaginable challenge of bringing together such different and independent people who had a long history of fighting because in this globalized world they were not viable economic or geopolitical powers if operating separately as individual nations. + + + +--- + + +# 1971 TO 2008 — A FIAT MONEY, INTEREST-RATE-DRIVEN MONETARY POLICY + +remains a highly fragmented union that is declining in competitiveness. Also in this period, in the US, President Clinton succeeded in transforming a large budget deficit into a budget surplus, so it’s one of a number of cases worth remembering to help us think about how to handle things well. + +# FROM 2000 TO 2008: FROM THE BUBBLE BURSTING TO DELEVERAGING TO RELEVERAGING TO CREATING A NEW BUBBLE THAT POPPED AND LED TO THE GLOBAL FINANCIAL CRISIS AND DEBT MONETIZATION + +Investors typically make the mistake of thinking that great companies in great industries are great investments because they don’t pay enough attention to the prices that they have to pay to invest in them. Bubbles are made when there is a lot of thinking in that way and a lot of borrowing to lever up those purchases. Bubbles are most typically burst when central banks tighten monetary policies and interest rates rise. That’s what happened in 2000. The debt/asset bubble burst in March 2000, with the tech-heavy Nasdaq falling by around 80%. To make things worse, on September 11, 2001, the World Trade Center and the Pentagon were attacked, which began the “war on terror” and wars in Afghanistan and Iraq. Both of these events (though primarily the first) contributed to a contraction in the short-term debt cycle. + +The next charts show this dynamic well. In the bubble (1), unemployment rates fell to quite low levels, and stock prices rose to bubble levels. Both reversed in the early 2000s (2). These things led to a recession, which reduced inflation and led to the next short-term debt cycle easing of credit, which then led to a recovery (3). From 2006 to 2007, another classic bubble developed; while it was most prominent in real estate mortgages, it was also in banks and companies. + + + +--- + + +# HOW COUNTRIES GO BROKE: THE BIG CYCLE + +# EQUITY PRICES + +| | UNEMPLOYMENT RATE | S\&P 500 | MSCI ACWI (USD) | | +| ------------------ | ----------------- | -------- | --------------- | ---- | +| Short Rates Hit 0% | | | | | +| | 10% | | 3 | 125% | +| 9% | 1 | 2 | 100% | | +| | 8% | | | | +| | 7% | | | | +| | 6% | | | | +| | | | 5% | | +| | 4% | | | | +| | | | 25% | | +| 0% | | | | | + +1995 2000 2005 2010 1995 2000 2005 2010 + +These were the last two short-term debt cycles in the MP1 era. In the 27 years from 1981 (when interest rates hit “the highest levels since the birth of Jesus Christ”) to 2008 (when interest rates hit 0%), the Big Cycle consisted of four short-term debt/credit/economic cycles. From 1981 until 2008, every cyclical high and every cyclical low in interest rates was lower than the one before it, until interest rates hit 0%. That ended the MP1 monetary era (in which central banks’ monetary policies were implemented with interest rate changes) as it was replaced by quantitative-easing-driven monetary policy (MP2). + +Having studied the big cycles from 1918 to 1945, from the end of World War I to the start of the new monetary system that began when World War II ended, we at Bridgewater put into our investment system rules that if there was a debt contraction crisis and short-term Treasury and fed funds interest rates nearly hit 0%, we would bet on a bad contraction until the central government and the central banks became very stimulative in the ways they became stimulative in March 1933. That served us well in 2008 because we understood it, so we were able to navigate the crisis well for our clients. I also saw from my study of history that the declines of real and nominal interest rates shifted conditions from those that benefited lender-creditors back to those that favored borrower-debtors, which allowed debt/income levels to rise. This downward trend in interest rates and increase in + + + +--- + + +# 1971 TO 2008 — A FIAT MONEY, INTEREST-RATE-DRIVEN MONETARY POLICY + +debt burdens set the stage for the next major shift in monetary policy, which we will explore in the next chapter. + +| USA NOMINAL INTEREST RATE | USA REAL YIELD | +| --------------------------------------------------------------------------------------------------------------------------- | -------------- | +| 10Yr Bond Yield | Short Rate | +| Actual | Estimated | +| 20% 15% 10% 5% 0% -1% 1970 1980 1990 2000 2010 0% 1% 2% 3% 4% 5% -2% | | + +Before I describe the MP2 era in depth, I will touch on the other big forces at play in the 2000s. + +Despite the tech stock bubble bursting in 2000, the internet tech industry and its effects on the world continued to grow and improve rapidly. Social media began in the middle of the 2000s (e.g., Facebook in 2004, YouTube in 2005). The iPhone was released in 2007, which created the “everything device” because of all the things it has on it (phone, camera, and many tools in apps). It was a period in which the internet and computing impacted just about every aspect of life. The US system led these developments far more than others, though around this time China began to copy and compete effectively. China and other emerging market producers became more competitive in producing most everything, from everyday goods (apparel, toys, appliances, etc.) in the 1990s and 2000s to electric vehicles and high-tech goods now. This was wonderful for the Chinese sellers who earned a lot of money and for the American and other buyers who benefited from good-value purchases, though it put a lot of manufacturing workers in the US and Europe out of work. The US was also + +We show rough estimates of the real yield and breakeven inflation rate (using surveyed inflation expectations and recent inflation) for periods when those were unobservable because inflation-linked bond markets did not exist. + + + +--- + + +# HOW COUNTRIES GO BROKE: THE BIG CYCLE + +helped by the fact that Chinese sellers were lending the money they were making back to the US to fund its deficits. This dynamic worked essentially the same way for the Chinese as it had worked previously for Japanese goods manufacturers and their customers. In this case, it was the Chinese who were earning money by selling to Americans and lending money they earned back to Americans by buying US debt assets. China, like Japan before it, put a sizable amount of its earnings into its foreign exchange reserves, which led it to buy a lot of US Treasuries because the dollar was the world’s leading reserve currency. That enabled the US government to ramp up deficits and debts without too much consequence (at least so far) while also helping to keep global goods inflation down, which allowed central banks to keep monetary policy easier and contributed to bull markets in stocks. This dynamic was good for the capitalists who owned the means of production and not good for the workers who were displaced. + +While there were wars in Iraq and Afghanistan, there weren’t big wars between big world powers. But the seeds were being sown for conflict. The European Union and NATO continued to take in more Eastern European countries and move closer to the Russian border. And as China got much richer, it began to rival the US as a geopolitical power, increasing tensions. + +Risks from acts of nature increased. Climate change, which had first received significant attention as an area for global policy action in the 1990s, began to bring about destructive weather events, like Hurricane Katrina hitting New Orleans in 2005. These impacts grew more and more costly with time. During this period, global health authorities monitored novel virus outbreaks including SARS in 2002-03 and H1N1 in 2009. Neither turned out to be as disruptive as feared, but they were symptomatic of challenges to come. + +Politically in the US during this period, the president was a moderate rightist, George W. Bush. The House and Senate were narrowly controlled by Republicans. Republicans, and members of Congress voted across party lines more often and government was much more bipartisan than it is at the time of this writing. + + + +--- + +# CHAPTER 13 + +# 2008 TO 2020 — FIAT MONEY AND DEBT MONETIZATION + +In 2008, there was a big deleveraging̶the global financial crisis. It was led by the mortgage/real estate sector being financed by a lot of debt, which led to big debt problems that spread quickly to affect almost everyone in all countries, like the Great Depression in the 1930s. The debt crisis that started with the mortgage/real estate sector spread to take down overleveraged banks, companies, and individuals and to knock down financial assets and the real economy. Unemployment hit 10% in late 2009 and major stock indices were down over 50% from their peak in 2007. + +In late 2008, the interest-rate-driven monetary system (Monetary Policy 1) could no longer be used to create money and credit anymore because interest rates hit 0%, and because that could not continue, central banks had to make up for inadequate free-market demand to buy these debt assets by printing money and buying the assets themselves. As a result, a new monetary system (MP2)—where central banks buy large quantities of debt and provide credit funded with their balance sheets, which is essentially printing. + +--- + + +# HOW COUNTRIES GO BROKE: THE BIG CYCLE + +money, debt monetization, and quantitative easing 39 —replaced + +MP1. In MP2, the central bank creates and provides money and credit to the government and marketplace to make up for an inadequate amount of private market lending. That began in 2008 and was the first time this monetary policy had been used since 1933 (i.e., 75 years earlier). Such moves to monetize debt have occurred throughout history and are symptomatic of being in the late phase of the long-term debt cycle. + +During this part of the Big Debt Cycle, the central bank becomes the big buyer and big owner of debt (i.e., the big creditor) rather than private investors. Because the central bank doesn’t mind having losses from holding the debt that has reduced in value and because it doesn’t worry about getting squeezed, it can continue to prevent a debt crisis by printing money and buying debt. It is willing and able to lose lots of money and have a negative net worth to protect the spending ability of both the government and the private sector even when their finances are bad. One can see this occur via changes in central bank balance sheets by looking at their holdings of debt assets that were acquired by providing those who sold the debt assets to central banks with cash and credit. The central banks of the US, Europe, and Japan own roughly 15%, 30%, and 40% of central government debt, respectively, and roughly 5%, 10%, and 20% of the total debt, respectively. In the charts that follow, you can see how this process unfolded in the US. Note the timing of the hitting of the 0% interest rate bottom and the printing-of-money expansion of the Fed’s balance sheet. Because the Fed responded quickly to the problem—much more so than during the Great Depression—the markets and economy rebounded quickly. + +39 Debt monetization and quantitative easing are essentially the same thing, though slightly different. Both are intended to reduce debt problems and stimulate economic activity via the central bank buying government bonds. In the case of quantitative easing (QE) the central bank buys the bonds or other securities from private investors, whereas in the case of debt monetization the central bank buys the bonds directly from the government. That normally doesn’t make much of a difference, though it can when the banking system is impaired. + + + +--- + +# 2008 TO 2020 — FIAT MONEY AND DEBT MONETIZATION + +# USA INTEREST RATES AND INFLATION + +| Headline CPI | USA Avg Interest Rate (Avg of 3M, 10Yr Rates) | +| ------------------ | --------------------------------------------- | +| 20% | | +| 18% | | +| Short Rates Hit 0% | 16% | +| | 14% | +| | 12% | +| | 10% | +| | 8% | +| | 6% | +| | 4% | +| | 2% | +| | 0% | +| | -2% | + +# FED BALANCE SHEET (% GDP) + +| Total Assets | | +| -------------------------------- | --- | +| 20% | | +| Short Rates Hit 0% | 16% | +| “Money printing” and buying debt | 12% | +| by the Federal Reserve begins | 8% | +| | 4% | + +# YIELD CURVE + +| 3M Minus 10Yr Rate | 3M Divided by 10Yr Rate | +| ------------------ | ----------------------- | +| 6% | Short Rates Hit 0% | +| 4% | 200% | +| 2% | 160% | +| 0% | 120% | +| -2% | 80% | +| -4% | 40% | +| -6% | Very easy money | +| 0% | | + +The real bond yield has averaged about 2% over the last 100 years (indicated in the following charts by the dashed line), which is neither + +2 4 7 + +--- + + +# HOW COUNTRIES GO BROKE: THE BIG CYCLE + +too low for borrower‐debtors nor too high for lender‐creditors. Periods of great differences from this 2% were times of excessively cheap or excessively expensive credit/debt that contributed greatly to the big swings in the Big Debt Cycle. + +# USA REAL YIELD + +| Real Yield (Actual) | Real Yield (Estimated) | 2% | +| --------------------- | ---------------------- | --- | +| Short rates hit zero; | liquidity squeeze | 7% | +| causes real yields | to briefly spike | 6% | +| | | 5% | +| | | 4% | +| | | 3% | +| | | 2% | +| Very easy money | | 1% | +| | | 0% | +| | | -1% | + +1970 1975 1980 1985 1990 1995 2000 2005 2010 + +# USA Avg Interest Rate Minus Headline Inflation + +# USA Avg Interest Rate Minus GDP Deflator + +| | 2% | | | +| - | -- | - | --- | +| | | | 10% | +| | | | 8% | +| | | | 6% | +| | | | 4% | +| | 2% | | | +| | | | 0% | +| | | | -2% | +| | | | -4% | +| | | | -6% | +| | | | -8% | + +1970 1980 1990 2000 2010 + +In this new MP2 era (2008-20), there were two short-term debt/credit/economic cycles. In each, the amount of debt creation and the amount of debt monetization was greater than the one before it. + +40 We show rough estimates of the real yield and breakeven inflation rate (using surveyed inflation expectations and recent inflation) for periods when those were unobservable because inflation‐linked bond markets did not exist. + +2 4 8 + + + +--- + + +# 2008 TO 2020 — FIAT MONEY AND DEBT MONETIZATION + +# USA MONETARY BASE (% GDP) + +| | 2008 | 2012 | 2016 | 2020 | +| --- | ---- | ---- | ---- | ---- | +| 30% | | | | | +| 25% | | | | | +| 20% | | | | | +| 15% | | | | | +| 10% | | | | | +| 5% | | | | | +| 0% | | | | | + +While the 2008 crisis began in the US, it spilled over into a global crisis, and virtually all developed world central banks followed the US and transitioned from MP1 to MP2 (and many emerging market central banks did, too). These actions pushed up the prices of financial assets and pushed down the yields for lender-creditors and created cheap money for borrower-debtors. The stimulative monetary policies that flowed through the system further benefited the rich, who had financial assets. The government bailing out the banks contributed to the perception that the system favored the rich, which heightened animosity toward the rich capitalists, especially those who seemed to cause the problems and got away free and made a lot of money. Ultimately, the US was able to manage its private sector debt problems and engineer an economic recovery, even as public debt kept rising (effectively kicking the can down the road; more on that in Chapter 18). + +The continuing increases in imports of Chinese- and other foreign-produced goods took away American jobs at the same time that new technology was taking away jobs. These forces contributed to the hollowing out of the middle class, which increased tensions between the “elites/capitalists” and the “proletariat.” China came to hold a lot of US debt assets and the US lost lots of jobs in uncompetitive businesses, which in the US contributed to the creation of large wealth and values differences, anti-China sentiment, and great political and social polarization. People who were hurting + + + +--- + + +# HOW COUNTRIES GOBROKE: THE BIG CYCLE + +Economically believed that the “elites” running things and the system they controlled were maximizing their profits at the expense of American workers. That, along with the 2008 debt/economic crisis and the fact that the government bailed out financial institutions and benefited those who held financial assets more than it was perceived to have helped the common man, also had a big impact on domestic conflict. As a result, the financial crisis led to a shift toward populism of the right (e.g., the Tea Party movement) and populism of the left (e.g., Occupy Wall Street). + +Conflict between the politically and socially right and the politically and socially left became greater in response to growing wealth and values differences in most countries, especially in the United States. In the US, the rise of populism of the right, especially among the non-college-educated, non-urban white population, led to Donald Trump’s election in 2016. That changed the American approach to its domestic order and the world order in profound ways that wouldn’t be understood for many years (and, at the time of my writing in March 2025, still are not fully understood). I will describe these changes more extensively at the end of Chapter 14. However, said succinctly, President Trump produced a shift in the domestic, international, economic, political, and geopolitical orders to be much more aggressive, top-down/autocratic, rightist, nationalistic, protectionist, and militaristic. + +These shifts in policies to ones that are characterized by increased confrontation and reduced levels of cooperation (and that are also reflected in the breakdown of multilateral organizations and increased unilateralism) are analogous to those that occurred many times throughout history, most recently in the periods before World War I and World War II. + +Trump’s election led to rightist policies of big tax cuts for companies and individuals, the appointment of three conservative justices to the Supreme Court, big cuts in government regulations, the renegotiation of trade and military support deals with other countries, big tariffs, and immigration restrictions. Cutting income and corporate taxes and reducing regulations helped stock prices rise and the + + + +--- + + +# 2008 TO 2020 — FIAT MONEY AND DEBT MONETIZATION + +Economy grow, so the unemployment rate fell to a 50‐year low of 3.5% by the end of 2019. Then COVID, the first major global pandemic since the 1918‐20 H1N1 pandemic, came along in early 2020. For those who are interested, these developments and their outcomes are explained in more detail in *Principles for Dealing with the Changing World Order* and are analogous to those in the early 1930s. They are not unexpected if one understands the Big Cycle. + +The big debt, political, and geopolitical cycles and the relationships between them have been unfolding in pretty classic ways so they have been contributors to the Overall Big Cycle transpiring in pretty classic ways. What we saw and are now seeing are these three big cycles transpiring along with big disruptions coming from nature (i.e., the pandemic and climate change) and with big advances in technology, especially artificial intelligence (which should greatly improve productivity and be disruptive in other ways, too). + +In Europe, events closely followed the template that I laid out previously, though Europe in 2012 consisted of 17 countries in the Eurozone, some debtors, and some creditors, which made the process more difficult. The overly indebted countries that had their debts denominated in a currency they couldn’t print (the euro) suffered in the way I described, and the European Central Bank handled the situation in the typical way. I will use Greece as an example of how the cycle transpired and what happened to the heavily indebted countries that couldn’t print their own currency because they were tied to the euro. To show how the cycle tracked the template, I will restate what typically happens and then show what actually happened. + +# 1. The private sector and central government get deep in debt. + +In the 10 years prior to the 2008 financial crisis, Greece’s total debt as a percent of GDP increased by around 90%, from 160% to 250%. The impetus was Greece joining the euro, making the country’s debt assets seem much safer (no devaluation risk, backstop from the ECB). Capital flowed in from across the Eurozone, and debt increased in every sector. + + + +--- + +# HOW COUNTRIES GO BROKE: THE BIG CYCLE + +2. The private sector suffers a debt crisis, and the central government gets deeper in debt to help. When the 2008 financial crisis hit, the Greek government responded with stimulus and bigger deficits that added to its debt. Because they couldn’t monetize debt, this worsened rather than alleviated the debt crisis, so Greece entered a deep depression. + +3. The central government experiences a debt squeeze in which the free-market demand for its debt falls short of the supply of it. That creates a government debt problem. The debt crisis became an acute public sector debt crisis in late 2009 and the Greek government revealed that it had been substantially underreporting its own debt and deficits. + +4. The selling of the government’s debt leads to a) a free-market-driven tightening of money and credit, which leads to b) a weakening of the economy, c) downward pressure on the currency, and d) declining reserves as the central bank attempts to defend the currency. The obviously crushing debt burdens and the reporting fraud made Greek debt much less desirable to foreign investors, so they became sellers of Greek debt and Greece needed more stimulus to offset its depression-like conditions. Unavoidably, Greece pursued austerity, which caused the depression to get deeper and made government finances worse as tax receipts dried up. The result was a massive sell-off in Greek debt, which raised interest rates even higher and worsened the debt problem. By 2012, short-term interest rates in Greece had spiked to over 70%. Greek debt increased another roughly 70% of GDP, a combination of austerity not working and GDP declining (a dynamic I call an “ugly deleveraging”). + +5. When there is a debt crisis and interest rates can’t be lowered (e.g., they hit 0%), the central bank “prints” (creates) money and buys bonds to ease credit and make it easier to service debt. Actually, it doesn’t literally print money; it essentially borrows reserves from commercial banks that it pays a very short-term interest rate on. The ECB stepped in with + +--- + +# 2008 TO 2020 — FIAT MONEY AND DEBT MONETIZATION + +huge amounts of crisis money printing and buying of debt, and expanded its balance sheet just as the Fed had. But that wasn’t nearly enough, and it became politically toxic as the more financially stable European countries decried this bail-out of Greece, worrying that one way or another they would have to pay for it. + +# 6. + +If interest rates rise, the central bank loses money because the interest rate that it has to pay on its liabilities is greater than the interest rate it receives on the debt assets it bought. We did not see this dynamic in this case. This typically happens when the central bank has purchased significant government debt at a fixed rate, financed via creating bank reserves that pay floating short rates, and then is forced to raise short rates because of flight from the currency or an inflation problem creating a negative net interest margin for the central bank and forcing the central bank to continue printing money to cover those losses. In the case of the European debt crisis, we saw the central bank purchase significant government debt and finance it via creating bank reserves, but in that period, Europe as a whole did not see an inflation problem or currency flight, so the ECB was not forced to raise interest rates and never had a negative net interest margin problem. + +# 7. + +Debts are restructured and devalued, reducing debt burdens. It became clear that Greece needed a debt restructuring, and the money the ECB was spending on Greece was likely to lead to losses. There was even a chance Greece would leave the euro. Meanwhile, the exceedingly tight credit in Greece was crushing the economy. Ultimately, what was called “the Troika” (the ECB, the IMF, and the European Commission) engineered a debt restructuring paired with a bailout. In 2012, that restructuring reduced debt burdens by about 50% of GDP. + +# 8. + +Extraordinary taxes are raised, and capital flees the country and/or capital controls are imposed. There was a bank run as smart citizens pulled money out of Greek banks. Needing + +--- + +# HOW COUNTRIES GO BROKE: THE BIG CYCLE + +money, new taxes were introduced, and capital controls were eventually imposed in 2015. + +There is a transition from a severely devalued currency to a stable currency. This restructuring was enough to end the most acute phase of the crisis, and Greece stayed in the euro. Reducing debt through an explicit restructuring is usually the more painful, drawn‐out path. Greece took years to recover, but it did recover as all countries eventually do. If Greece and other overly indebted countries could have printed the currencies they owed, they would have gone down the classic path that was previously described for countries in that position. + +# Here are some other key developments that I’ll note briefly but not digress into: + +- Regarding international relations, there were big resets economically and geopolitically that led to more allied and enemy geopolitical relationships that were analogous to those that occurred in the 1933‐38 period (and numerous prior analogous periods). If you want to get into them, they are covered in Principles for Dealing with the Changing World Order. +- Climate change started to get a lot of attention. In 2015, there was the Paris Agreement, which initiated an attempt to keep global temperatures from rising by more than 2 degrees Celsius. Climate change is a big force that is very costly and will reshape what the human and natural worlds look like. +- Regarding new technologies, computer chips rapidly advanced, cryptocurrencies were launched, self‐driving‐car features started rolling out, movie streaming became more widespread, 4G (and then 5G) wireless began, reusable rocket ships began to be used, and many more advances were made. + +--- + +# CHAPTER 14 + +# SINCE 2020 — + +# PANDEMIC AND BIG FISCAL DEFICITS MONETIZED + +In 2020, the world was hit with the COVID pandemic. While there is a government financial management principle in the US and in many other countries that monetary policy should be independent of fiscal policy and be targeted to pursue inflation and, in the US case, economic growth goals, because without that independence and that independent mandate there would be the politicization and degradation of the supply and value of money, the truth is that nearly every sacrosanct rule is inevitably tested by reality and starts to break down later in the Big Cycle. + +I call that economic-impact-necessitated change in monetary policy Monetary Policy 3 (MP3). MP3 is when there are coordinated moves between the central government and the central bank, where the government runs large deficits and the bank monetizes them. The dynamic inevitably arises when interest rate changes (MP1) and quantitative easing (MP2) are no longer effective at helping conditions for most people and when the free-market capitalist system doesn’t get the job done. Naturally, the capitalist system provides capital to those who are financially well-off, hold financial assets, and are able to borrow, and it doesn’t provide capital to those who have the least and suffer the most. That is what happened starting in 2008. But, because of the + +--- + + +# HOW COUNTRIES GO BROKE: THE BIG CYCLE + +COVID pandemic, there was a need not just to make money and credit, but also to get it into the hands of specific people and organizations. Throughout history, MP3 has been used in similar cases when there were very bad economic conditions and big wealth gaps so interest rate changes or quantitative easing alone could not do what was needed. MP3 typically occurred late in the long-term debt cycle. In this case, it came in two big rounds. + +What follows are a few of the previously shown key charts brought up to the time of my writing. They do a good job of painting the big picture both in terms of what has happened since 2020 and in putting what has happened into perspective within the Big Debt Cycle. As you can see, in the context of the big picture shown in the long-term charts going back to 1945, the weekly, monthly, and even annual changes seem trivial. I hope these charts help you to see the more important bigger pictures. + +# DEBT LEVELS AND DEBT SERVICE + +The central government spends a lot and hands out lots of money, getting itself into much more debt while relieving the private sector’s debt burdens. In the following charts, the gray vertical lines represent transitions from one type of monetary policy to another. + +# USA DEBT LEVELS (% GDP) + +# USA CENTRAL GOVT DEBT SERVICE (% REVENUE) + +| Central Govt Debt | Total | o/w Interest | +| ----------------- | ------------- | ------------ | +| Private Debt | o/w Principal | | + +| | 180% | 120% | +| - | ---- | ---- | +| | 160% | 100% | +| | 140% | | +| | 120% | 80% | +| | 100% | 60% | +| | 80% | | +| | 60% | 40% | +| | 40% | 20% | +| | 20% | 0% | + +1965 1985 2005 0% 0% +1945 2025 1945 1965 1985 2005 2025 + + + +--- + + +# SINCE 2020 — PANDEMIC AND BIG FISCAL DEFICITS MONETIZED + +# MONETARY POLICY AND CENTRAL BANK HEALTH + +The Fed’s printing of money and buying of the government’s debt increased a lot from 2008 until late 2021, after which the Fed began tightening to fight inflation. That was a pretty classic tightening in response to accelerated inflation. The tightening and higher interest rates led the Fed to lose money on all the bonds it had acquired, as shown in the chart on the right. + +# INTEREST RATES AND CENTRAL BANK PROFIT + +# MONETARY BASE + +| | USA Short-Term Interest Rate | USA Monetary Base (% GDP) | | | | | | +| --- | ---------------------------- | ------------------------- | ----- | -------- | ------------------------- | ----- | ---- | +| | | | | Reported | If Bonds Marked to Market | | | +| 20% | | 30% | 0.8% | | | | | +| 16% | | 25% | 0.6% | | | | | +| 12% | | 20% | 0.4% | | | | | +| 8% | | 15% | 0.2% | | | | | +| | | | | | 4% | 10% | 0.0% | +| 0% | | | | | 5% | -0.2% | | +| | 0% | -0.4% | | | | | | +| | 0% | | -0.6% | | | | | + +# INTEREST RATES + +The rise in interest rates, while significant, was less significant than the rise in inflation (the chart on the left), though it brought the real bond yield up to its long-term average of ~2% (the charts on the right and at the bottom). + + + +--- + + +H O W C O U N T R I E S G O B R O K E : T H E B I G C YC L E + +# USA INTEREST RATES + +# AND INFLATION + +| USA Avg Interest Rate | USA 10Yr Bond Yield | (Avg of 3M, 10Yr Rates) | USA Short Rate | +| --------------------- | ------------------- | ----------------------- | -------------- | +| 20% | 20% | | | +| 18% | | | | +| 15% | 16% | | | +| 14% | | | | +| 10% | 12% | | | +| 10% | | | | +| 5% | 8% | | | +| 6% | | | | +| 4% | | | | +| 0% | 2% | | | +| 0% | | | | + +# REAL BOND YIELD + +| Actual | Estimated | +| ------ | --------- | +| 2% | | +| 7% | | +| 6% | | +| 5% | | +| 4% | | +| 3% | | +| 2% | | +| 1% | | +| 0% | | +| -1% | | +| -2% | | + +We draw a line at 2% because, as a rule of thumb, when real rates are much above that, money is quite expensive, and cheap if it's much below. 41 + +# BREAKDOWN OF INTEREST RATES + +The yield curve inverted; the discounted 10‐year inflation rate stayed steady at around 2% as the real yield rose to about 2%. These moves reflected the tightening. + +41 We show rough estimates of the real yield and breakeven inflation rate (using surveyed inflation expectations and recent inflation) for periods when those were unobservable because inflation‐linked bond markets did not exist. + +2 5 8 + + +--- + + + +# SINCE 2020 — PANDEMIC AND BIG FISCAL DEFICITS MONETIZED + +# YIELD CURVE + +| | | | USA 10Yr Bond Yield | USA Inflation Rate in Bonds | USA Real Bond Yield | +| --- | - | ---- | ------------------- | --------------------------- | ------------------- | +| 4% | | 200% | 16% | | | +| 2% | | 160% | | 12% | | +| 0% | | 120% | | 8% | | +| -2% | | 80% | | 4% | | +| -4% | | 40% | 0% | | | + +# THE WEALTH AND INCOME SHIFTS + +Labor’s share of earnings continued to trend down to the lowest level since the 1950s, and the wealth and income shares of non-college-educated Americans continued to fall, so the wealth and values gap issue grew worse. + +# USA LABOR SHARE OF PRIVATE EARNINGS + +# USA INCOME SHARE + +| | Bottom 60% | Top 40% | +| --- | ---------- | ------- | +| 76% | 47% | 57% | +| 74% | 46% | 56% | +| 72% | 45% | 55% | +| 70% | 44% | 54% | +| 68% | 43% | 53% | +| 66% | | | +| 64% | | | +| 62% | | | +| 60% | | | + +42 We show rough estimates of the real yield and breakeven inflation rate (using surveyed inflation expectations and recent inflation) for periods when those were unobservable because inflation-linked bond markets did not exist. + + + +--- + + +H O W C O U N T R I E S G O B R O K E : T H E B I G C YC L E + +# USA WEALTH SHARE + +# USA INCOME SHARE + +| College-Educated | Non-College-Educated | +| ---------------- | -------------------- | +| 75% | 65% | +| 70% | 60% | +| 65% | 55% | +| 60% | 50% | +| 55% | 45% | +| 50% | 40% | +| | 35% | + +1990 2000 2010 2020 1990 2000 2010 2020 + +During this period, the US population and political parties became much more divided and more extreme, and there was a change in 2020 in leadership from the Trump-led rightist Republicans to the Biden-led leftist Democrats. + +I am now going to look in more detail at what happened between 2020 and the present (i.e., March 2025), shifting from my Big Cycle perspective down to the short-term cycle that is transpiring within the long-term Big Cycle. That shift from the macro of several decades to the relative micro of years and months can seem disorienting. It can seem like shifting from big, important forces to small, unimportant forces, but that is not true as the small short term affects the big long term as much as the big long term affects the small short term. + +Most importantly, between 2020 and now there was a pandemic, which led to a big economic contraction, which led to a huge coordinated fiscal and monetary stimulation (MP3), which raised inflation and markets and redistributed wealth, which produced a big surge in inflation, which led to a tightening that helped to bring down inflation, which led to a relatively modest easing. It was a time of continued movement to greater political polarization and the political shift to the right and back to a Trump presidency, which were also accompanied by big changes in climate and technologies. + +2 6 0 + + +--- + + +# SINCE 2020 — PANDEMIC AND BIG FISCAL DEFICITS MONETIZED + +More specifically: + +- This short-term debt cycle easing began in 2020 in response to the combination of a) a COVID-induced economic crisis, b) large wealth gaps, and c) political moves to the left via the elections of a Democratic president, a Democratic-controlled House of Representatives, and a Democratic-controlled Senate. The easing took the form of huge government spending increases that led to huge government fiscal deficits and government debt sales that were much greater than free-market lender-creditors would buy, which required central banks, most importantly the Fed, to buy/monetize the debt. Other entities like banks and Japanese institutional investors also bought a lot of US Treasury debt. That stimulation increased the amount of debt/credit/money/spending by a lot. This massive MP3-type of coordination of fiscal and monetary policies that allows the government to borrow and direct money as it chooses because the central bank buys its debt with printed money is explained more completely in Principles for Navigating Big Debt Crises, if you’re interested in knowing more and seeing past cases, which you can download at economicprinciples.org. That is what happened in 2020-21; as mentioned, it has happened repeatedly for similar reasons throughout history though not in our lifetime. +- The 2020-21 debt monetization was the fourth43 and the largest big debt monetization since the original big debt monetization/QE in 2008 (which was the first since 1933). From the start of the easing cycle of 2008, the nominal Treasury bond yield was pushed down from 3.7% to only 0.5%, the real Treasury bond yield was pushed from 1.4% to -1%, and the non-government nominal and real bond yields fell a lot more (because credit spreads narrowed). Money and + +43 Counting QE1, QE2, QE3, and then this QE during COVID lockdowns. + + + +--- + + +# HOW COUNTRIES GO BROKE: THE BIG CYCLE + +Credit became essentially free and plentiful, so the environment became great for borrower-debtors and terrible for lender-creditors and led to an orgy of borrowing and new bubbles forming. My bubble indicator, which was at only 18% in 2010, rose to 75% at the end of 2020, showing the bubbles in companies and assets that had little or no profits and were funded by selling equity and/or borrowing money based on promises of doing well in the future and speculative buying fever. It was analogous to the Nifty Fifty bubble in the 1970-72 period, the Japan bubble of 1989-90, and the dot-com bubble of 1999-2000. The decline in interest rates in the years following 2008 took them so low that they couldn’t continue to fall and it benefited stocks a lot. I estimate that the interest rate decline raised stock prices about 75% more than they would have risen without that decline (compared to the pre-financial-crisis peak). In addition, profit margins roughly doubled on average as a result of advances in technology and globalization, which also boosted profits and profit margins. Corporate and personal taxes declined, which also helped asset prices. From the post-crisis lows of 2009 through the second quarter of 2024, the nominal value of US household wealth in financial assets (i.e., “paper wealth”) rose from $32 trillion to $99 trillion, so there was a tripling of paper wealth.44 + +That debt/credit/money surge in 2020 produced a big increase in inflation, which was exacerbated by supply chain problems and external conflicts (the third of the five major forces that I will touch on at the end of this chapter). + +That big increase in inflation led to the short-term debt cycle tightening by the Fed and the contraction in the balance sheet by having maturing debt roll off rather than buying more of it. As a result of the Fed (and other central banks) + +Household wealth here is the difference between total household financial assets and total household liabilities (using data from the Federal Reserve). + + + +--- + + +S I N C E 2 0 2 0 — PA N D E M I C A N D B I G F I S C A L D E F I C I T S M O N E T I Z E D + +changing their short-term debt cycle mode from easing to tightening, nominal and real interest rates went from levels that were overwhelmingly favorable to borrower-debtors and detrimental to lender-creditors to levels that were more normal (e.g., a 2% real bond yield). Once the tightening began, US Treasury bond nominal yields rose from 0.5% to over 4% and real yields rose from about ‐1.1% to about 2.5%, which hurt most asset prices, particularly those with weak or negative profits and/or needs for new equity funding. Naturally, that shift especially hurt the prices of assets that were in bubbles. My bubble indicator fell from 75% (in a significant bubble) to 35% (not in a bubble) and the bubble stocks in the index fell an average of 75%. As a result, the nominal value of wealth in stocks and bonds fell by ~12% in the US and the real value of wealth fell by nearly 18%, which were the largest declines since 2009. As cash (i.e., investing in short-term cash instruments like T-Bills) went from “trash” to “attractive,” and both short-term nominal and real interest rates were brought to levels that were more attractive than they were for lender-creditors and more unattractive than they were for borrower-debtors, and the yield curve inverted, these changes had the very classic effect of lowering the present values of most investment assets’ future cash flows and strengthening the dollar relative to the currencies of other countries whose central bankers were slower to tighten. In other words, the Fed’s quick movement brought US dollar-denominated cash to relatively attractive levels in relation to most assets, cash denominated in other currencies, and gold. This, as usual, hurt interest-rate-sensitive sectors like commercial and residential real estate, as well as low or negative cash flow bubble companies, both public and private, though public more so. For example, the then-hot “FAANG” stocks and the tech-heavy Nasdaq fell from their peaks by around 45% and 33%, respectively. Non-public-market assets—private equity, venture capital, + + + +--- + + +# HOW COUNTRIES GO BROKE: THE BIG CYCLE + +and real estate assets̶were not marked down commensurately as there was a great reluctance to accept the markdowns. Write‐downs and having down fundraising rounds became too painful for both the companies and the venture capital and private equity managers in these markets, so there has been, to this day, a stand‐oV in which sellers and buyers can’t agree on prices and transaction volumes have plunged. It did not, however, weaken the economy as much as it typically would have because it was the central government that got into more debt rather than the private sector and it was the central bank that bought the debt and had the losses from holding it rather than the private sector. Also, the inXation was in wages and other compensation being earned as well as in goods and services being bought. + +Then inXation fell but prices stayed high, and the Fed and other central banks eased their monetary policies, which supported asset prices generally. ArtiWcial intelligence and artiWcial intelligence companies became the new hot things and are expected to improve the economy and life hugely like the new hot things that produced the industrial and digital revolutions and led to Wnancial bubbles. With these changes came great diVerences in which stocks, companies, and countries did well. Also, the world capital markets changed with new types of investment products, though in the same sort of ways we saw before. For example, we are seeing new types of lending, like the development of the private credit market, which is the modern‐day version of the junk bond market of the late 1970s and early 1980s (though more customized, not securitized, more illiquid, and inclusive of early‐stage companies). The large amount of money entering this type of lending helped to keep credit spreads down and fund more speculative activities. + +Regarding the internal conXlicts over wealth and values between the populists of the right and the populists of the left, + +264 + + + +--- + + +SINCE 2020 — PANDEMIC AND BIG FISCAL DEFICITS MONETIZED + +The intensity increased in most democracies, most importantly in the US. In the US, the divide between the political right and the political left became more extreme and the big rises in prices that came from the earlier-described big fiscal and monetary stimulations by the US central government and central bank led to big price increases in goods, services, and financial assets. In the 2024 election, this inflation and other factors, such as President Biden’s impaired acuity, helped a) the rightist/capitalist/social conservative Donald Trump and the Republican Party to a decisive win over b) the leftist/socialist/social liberal Kamala Harris and the Democratic Party, giving Trump a mandate to undertake a big renovation of the central government and the country as a whole and prepare for some type of war with China and its allies. The potential great conflict that would have likely occurred if there was a close Trump loss was averted and huge changes to the US domestic order began. + +- Climate changes continued unabated. +- Technological advances, most notably in artificial intelligence but in several other areas as well, led to big shifts in wealth and power. + +That brings us up to where we now are. + +# THE FIVE BIG FORCES: DEBT, CIVIL WAR, INTERNATIONAL WAR, ACTS OF NATURE, AND TECHNOLOGY + +Every day we see news about these five forces. If you connect the dots from the past to the present, you can see them evolving along the lines of the Big Cycle template that was comprehensively explained in my book as well as my 40-minute and five-minute videos about the changing world order, on economicprinciples.org. Government debt is obviously a big and growing issue. The thus-far + + + +--- + + +# HOW COUNTRIES GO BROKE: THE BIG CYCLE + +Nonviolent civil war between the rightists/capitalists/MAGAs and the leftists/socialists/communists/woke is continuing to intensify, though in the last US election the rightists clearly beat the leftists. This shift has brought the big domestic order/disorder cycle to the same stage it last was in the 1930s. Simultaneously and relatedly, the international great power conflict, particularly between the United States and its allies and China and its allies, is intensifying. Similarly, the acts of nature force, most importantly climate change, is intensifying, while technology, especially AI, will have a big impact, both good and bad, that we won’t be able to imagine. As always, these five big, interrelated forces are moving the Big Cycle forward. Most importantly, the internal fight within the US and the external fight between the US and China is and increasingly will be affected by the technology war and the economic war (e.g., the need to raise military spending). For previously explained reasons, this looks quite like the 1930s period. Because of the importance of China, I will now briefly review its whole Big Cycle starting in 1945 (when the new world order began) and 1949 (when its new domestic order began). Then I will look at Japan’s Big Cycle, focusing most on how its Big Debt Cycle unfolded because it provides another good case study for gaining the valuable lessons it offers. + + + +--- + +# CHAPTER 15 + +# CHINA’S BIG CYCLE FROM 1945-49 UNTIL NOW IN A TINY NUTSHELL + +This chapter explains how the Big Cycle has played out in China, bringing you right up to the present. It will take you about 15 minutes to read. Having spent a lot of time in China and having had very close relationships there for over 40 years, including with some of its leaders, I have seen much of it unfold from up close, so China’s Big Cycle is as vivid to me as the US’s Big Cycle. I think this chapter is well worth your time to read. + +To put China’s history in the context of its Big Cycle, I will summarize what has happened since the start of the new world order and China’s domestic order in the 1945-49 period with a very brief look at what happened before then. + +# BEFORE 1945 + +I will start by directing your attention to the following chart that shows the Big Cycles of China back to the year 600. This measure shows the estimated relative strength of China using many measures of strength as described in Principles for Dealing with the Changing World Order. It shows the biggest Big Cycle waves in Chinese history. + +--- + + +# HOW COUNTRIES GO BROKE: THE BIG CYCLE + +Having studied these cycles, I have found them to be consistent with the Big Cycle template that I am touching on in this study and that I comprehensively explained in that book and the animation of the same title. + +# Major Wars Rough Estimate of China’s Relative Standing vs Great Powers + +| Dynasty | Tang | Song | Yuan | Ming | Qing | RC PRC | +| ------- | -------------------------------------------- | ---- | ---- | ---- | ---- | ------ | +| Level | (1 Relative = All-Time to Other Max Empires) | | | | | | + +(1 Relative = All-Time to Other Max Empires) + +0 + +600 800 1000 1200 1400 1600 1800 2000 + +In the next chart, you can see China’s Big Debt Cycles since 1865, which is 26 years after the Century of Humiliation began, until now. This 110-year period of humiliation (as the Chinese call it) was the period in which foreign powers “humiliated” and exploited China, starting in 1839 with the First Opium War and ending in 1949 with Mao and the Chinese Communist Party coming to power and the founding of the People’s Republic of China. As you can see, big debts were built up, wiped out, and built up again. As is typical, the debt wipeout corresponded with internal and external wars (in 1945‐49), then there was a new order, and debts were built up again. Through most of these years, Chinese money and debt were not considered a good storehold of wealth so it was difficult to build credit and other capital markets. Then in 1989, with the development of the stock market and the beginnings of the bond market, they started building their capital markets. Because I was closely involved with this, I can tell you all about it. + + + +--- + +CHINA’S BIG CYCLE FROM 1945-49 UNTIL NOW IN A TINY NUTSHELL + +# CHINA TOTAL DEBT (% GDP) + +| Total CHN Debt | Rough Estimate of Debt 1950-80 | Estimate of Debt Pre-1937 | +| ------------------------------------------ | ------------------------------ | ------------------------- | +| 300% | | | +| 250% | | | +| 200% | | | +| 150% | | | +| PRC repudiates previous debts | | | +| 100% | | | +| 50% | | | +| 1865 1885 1905 1925 1945 1965 1985 2005 0% | | | +| 2025 | | | + +While I will not delve into a detailed discussion of China’s prior Big Cycle, which encompassed the Century of Humiliation, I will touch on it because it profoundly affected Chinese leaders’ perspectives about foreign powers and what is now going on domestically and internationally. That part of China’s history is deeply embedded in the Chinese leadership’s psyche, leading them to vow that nothing like it will happen again because China will be strong enough to fight it. More specifically, China’s leaders see the US as self-interested and trying to contain China in an area of the world that the US is not part of. I am not saying that the Chinese perspective is more true than the American one. I am simply describing what happened and touching on both perspectives. + +China’s leaders now see America’s handling of Taiwan as being even more intrusive than Americans saw Russia’s influence in Cuba in the 1960s because from their perspective Taiwan has been “indisputably and consistently” recognized as part of China by all the world’s powers since the end of World War II and is 90 miles away from mainland China. Chinese leaders see Taiwan as a part of China that has not been incorporated back into China, because it was given back to China after World War II but the Chinese civil war led to the + +269 + +--- + + +# HOW COUNTRIES GO BROKE: THE BIG CYCLE + +Kuomintang and its leader Chiang Kai-shek taking control of it. In 1971, the UN General Assembly recognized the mainland People’s Republic of China as “the only legitimate representative of China to the United Nations” and reinforced the “One China” policy. That policy asserts that there is only one China and Taiwan is part of China. So, there is no question that Chinese leaders expect to eventually take control of Taiwan and parts of the South China Sea. In contrast, most Americans see China as a big and growing threat to the United States and the existing US-led world order, and see the Chinese as being ideologically threatening communists who autocratically control their people and who are in a great ideological war with its capitalist/democratic/Abrahamic (i.e., Jewish/Christian/Islamic) approach. + +Some in both Washington and Beijing see this conflict as being the last and biggest great cultural/religious/economic and possibly military war. Of course, this relationship is complicated and there are at least two sides to this story, which I won’t go into because it would be too large of a digression. I just wanted to make clear Chinese leaders’ perspective, which has a big effect on how they think and what they do. Additionally, I want to point out that because of the very long history of the Chinese civilization, which the leaders know very well, they are very aware of the Big Cycle. + +The most important things to know are that China has had a strengthening over the last 50 years that has been greater in magnitude than any other country’s in history. This has led to it becoming a great power that is approaching the power of the United States, and as a result, the United States and China have entered into a classic period of great power conflict. + +The next two charts show my aggregate readings of relative powers since 1825 and my US-China conflict gauge since 1963. As you can see in the first chart, China’s relative power fell a lot during the Century of Humiliation and then rose a lot thereafter, so that it is now close to rivaling the US. This is + + + +--- + + +# CHINA’S BIG CYCLE FROM 1945-49 UNTIL NOW IN A TINY NUTSHELL + +leading to a classic great power conflict between the US, China, and their respective allies.45 + +| COUNTRY POWER INDICES | US-CHINA CONFLICT GAUGE | +| --------------------- | ----------------------- | +| China | United States | +| | | +| 1800 | 1.2 | +| 1850 | 1.0 | +| 1900 | 0.8 | +| 1950 | 0.6 | +| 2000 | 0.4 | +| 1960 | 0.2 | +| 1975 | 0.0 | +| 1990 | -0.2 | +| 2005 | | +| 2020 | | + +SINCE 1945 + +Here is my very brief description of what has happened in China since 1945. The end of World War II led to the creation of the new and current world order, and in 1949, China’s civil war ended, which led to the creation of the new and current domestic order. From 1949 until the 1970s, China was a strictly isolated communist country run by the revolutionary leader Mao Zedong and his chief administrator, Zhou Enlai. During those years, China recovered slowly from World War II and its civil war because it was encumbered by rigid and unproductive communist economic policies that didn’t reward hard work and didn’t allow savings and wealth creation, and imposed draconian controls that ensured that Mao and the Chinese Communist Party remained in power, and created isolation from the rest of the world that prevented China from benefiting from what the world had to offer. In Big Cycles, it is typical for those who + +45 On my website economicprinciples.org, you can see much more detail on the measures that led to this reading for China. + +271 + + + +--- + + +# HOW COUNTRIES GO BROKE: THE BIG CYCLE + +win political power in a civil war to suppress the opposition in order to consolidate and solidify their power over the opposition due to fears that they will be overthrown. In Chinese dynasties, secret and violent overthrows of leaders have been frequent so they are viewed as a constant threat. That went on throughout Mao’s life. Mao had many enemies, most importantly capitalists from within China and the Soviet Union (starting in the late 1950s) from outside of China. Marxist-Leninist communist principles and isolation from “foreign devils” shaped what China did and didn’t do during the 1949-76 period. During Mao’s reign, China’s development fell behind the rest of the world’s and there was a lot of suffering, especially in the Great Leap Forward and the Cultural Revolution. + +There was a classic confluence of economic, domestic political, and geopolitical turbulence. + +As far as dealing with foreign powers was concerned, Mao’s greatest fear in the early 1970s was the Soviet Union, which became increasingly threatening, starting in the 1960s. As has typically been the case throughout history and is conveyed in the adage “the enemy of my enemy is my friend,” the common enemy brings countries together, which was true in this case, with the common enemy of the United States and China being the Soviet Union. That is what led to the visits to China first by Henry Kissinger and soon after by President Nixon. + +Because I knew Henry Kissinger and Ji Chaozhu, who were both participants in those discussions, I heard firsthand about the thinking and the discussions that took place and can assure you that the common enemy perspective was top of mind for both sides in motivating the initiating of their “friendship” in 1972. + +Mao and Zhou died in 1976. That led to big shifts in China’s economic, political, and geopolitical policies. + +As described in Chapter 12, Deng Xiaoping came to power in 1978 and changed just about everything with his “reform” and + +272 + + + +--- + +CHINA’S BIG CYCLE FROM 1945-49 UNTIL NOW IN A TINY NUTSHELL + +“open door” policies, which introduced a much freer, market-based economic system that brought in foreign talent and foreign capital to enable the Chinese to seize new opportunities. He distinguished the new way with statements like “to get rich is glorious” and when asked about his move to a more market‐capitalist direction, he said, “It doesn’t matter whether a cat is black or white as long as it catches mice.” This was the recognition that the market‐capitalist systems can “catch mice” (i.e., make riches) and that it is best to get rich and powerful first and then work toward “common prosperity.” These policies led to China having huge economic advances that changed not just China but the whole world. China went from being a poor, weak country to being a very strong one that was more capitalist. + +I saw all this up close from 1984 until now and, through my contact with China, got to see things through Chinese leaders’ eyes as we became friends working on the development of markets and the economy in China. + +I started going to China in 1984 as a guest of CITIC, which was the only “window company” (so‐called because it could deal with the outside world in a capitalist way). They asked me to teach them about the world’s capital markets. China hardly had any money at the time so I didn’t go there to make money or be involved with their markets; I went at first because I was curious, and I’ve kept going until now because I love the people and culture, and I could have a good impact on the country’s markets and economic development. That has given me an invaluable education as well as lots of enjoyment, so much so that I don’t dare describe it entirely because it would be too great a digression. What I am now going to describe is through the lens of my experiences. I watched that combination of powerful economic reform and opening up to the outside world take China from: + +1. a classic unproductive communist country to +2. an effective “socialist market economy” to +3. the development of its capital markets and its version of capitalism to + + + +--- + + +# H O W C O U N T R I E S G O B R O K E : T H E B I G C YC L E + +4. the forming of a classic debt bubble that led to + +5. a classic debt bust of the type that those who have their debt denominated in their own currency and have most of the debtors and creditors as their own citizens have to + +6. a classic great power conflict. + +More specifically, China experienced a classic upward swing in the Big Cycle productivity that took China’s people from terrible poverty to much-improved living standards, with many people and the country as a whole gaining great riches and powers. At the same time, there were big increases in indebtedness and developments in the capital markets that created big wealth gaps and a bubble. I witnessed up close China go from grappling with its poverty and its geopolitical weaknesses to creating its market/debt reform and “open door” policies, which created great increases in its riches and geopolitical power, to grappling with these greater wealth and geopolitical powers because with them came big wealth and opportunity gaps and big domestic and international conflicts. + +In the Deng era, I saw the Big Cycle unfold up close as follows: + +- China’s inexpensive labor and high productivity gains provided the world with very attractively priced manufactured goods. +- The US and most of the world liked getting attractively priced manufactured goods on good terms, especially because China used a lot of the money it earned to lend money to Americans who bought the merchandise. As a result, large trade and capital imbalances developed and US manufacturers suffered, which became an unsustainable economic/capital, political, and geopolitical issue for the US. +- China’s income, wealth, and power increased greatly. At the same time, the US overborrowed and started to decline. In 2008, the US had a big debt crisis that put China in the + + + +--- + +CHINA’S BIG CYCLE FROM 1945-49 UNTIL NOW IN A TINY NUTSHELL + +position of not knowing if a large portion of its debt assets would be paid back and questioning the United States’ financial strength. I was in the midst of that situation and must say that the Chinese side handled the debt crisis with grace and understanding. + +In 2008, the Group of 20 (G20) countries, which was formed to be a more realistically representative group of powerful countries than the G7 given the shifts in world power, had its first summit to deal with the global financial crisis. They agreed to be very stimulative, so China and virtually all countries increased the credit they made available, which improved conditions, increased wealth gaps, and raised debt levels relative to income levels. As explained earlier, in the US the widening wealth gaps and economic suffering of those left behind created a change in sentiment to blame the Chinese for their job-loss problems. Those American workers who were most adversely affected were the non-college-educated men Donald Trump later appealed to. At the same time, American companies complained that they were not allowed to fairly compete in China and that the Chinese were stealing Americans’ intellectual property. + +China’s skills and powers continued to grow, which gave China the resources to develop its economic, geopolitical, military, and technological powers, which led it to become more assertive and seemingly threatening. In 2009, pointing to an old map that demarcated the South China Sea boundary, China asserted that the proper boundaries of its territory were far beyond what other countries claimed they were. Although in 2016 the Permanent Court of Arbitration ruled against China’s claim, the dispute continues today. President Xi Jinping and the new leadership team came to power in 2012. Their main goals were to reform the economy and eliminate corruption. Because of my expertise and my long and trusted relationships, I was able to participate in the discussions about these things in the third plenum (the new government’s big planning meeting after the top people are appointed). I experienced a very open and + + + +--- + +HOW COUNTRIES GO BROKE: THE BIG CYCLE + +collaborative environment in which key issues were discussed, and we exchanged thoughts about them openly. I found the quality of those discussions about how to eliminate corruption and make reforms to be sincere and excellent. There was a great desire and enthusiasm from the new strong leaders to improve China and I was thrilled to be of help. + +Reforming the economy meant modernizing it to be more market-driven. For example, back then five major banks made loans to state-owned enterprises that were implicitly guaranteed by the government, which had the printing press to guarantee them, and there was little lending to small- and medium-size enterprises. The leadership wanted to change that, so they sought to develop capital markets that improved access to borrowing, lending, and investing. + +I was closely involved with that, so I saw how those responsible for it thought about it and what they did. I found that for most of Xi’s first five-year term, there was a) an openness to outside thinking, b) a strong desire to further reform the economy by making it more market-driven and taking actions to build and reform the capital markets, and c) strong action taken to eliminate corruption. The senior leaders chosen were the ones who were inclined to do those things. Of course, how to do these things was debated, and some people benefited from the changes while others were hurt by them, which created divisions. + +After coming to power, Xi immediately purged a prominent rival (Bo Xilai) and moved strongly to make big changes to eliminate corruption and reform the economy. Late in Xi’s first term, there was a movement to consolidate political power around him via a move to “core leadership.” If you think politics in the United States is brutal, you should see politics in China. This became most clear in the leadership changes that accompanied the shift from Xi’s first five-year term to his second and then to his third. + +Up until then, there were remarkable accomplishments—by many measures the greatest in human history. In the years since I first started going to China in 1984, China’s per capita income increased 20x, the average life expectancy increased by 12 years, and the poverty rate fell from 81% to less than 1%. + + + +--- + +CHINA’S BIG CYCLE FROM 1945-49 UNTIL NOW IN A TINY NUTSHELL + +At the same time, starting in 2009, China significantly increased its levels of indebtedness in real estate, local governments, and companies. That was stimulative at the time and led to accelerating debt and the debt problem that China now faces. This problem was made worse by the severe demographic issue of the one-child policy, which has created financial problems related to pensions and elder-care. Further, the way that China’s economy runs—which is driven by government, especially local government, financing and companies spending in ways that value the quantity produced over profitability and fosters severe uneconomic competition—led to profits falling short of debt service expenses. These issues remain. + +Geopolitically, in 2014, Russia annexed the Crimean Peninsula from Ukraine, which is a whole other story to be discussed at another time. Suffice it to say that at the time, though the Russians and the Chinese had a dislike and distrust for each other, they were drawn together by their common enemy and saw that they could have a symbiotic economic relationship. + +In 2015, Xi put out his 2025 plan, which described the need for China to rise and dominate certain industries. This was viewed as aspirational by the Chinese and threatening by the Americans. China could no longer “hide power.” Also, China became more threatening to other countries as it grew a lot in world trade, as its riches grew, as it asserted itself more geopolitically, and as it “stole” intellectual property. At this time, Americans began to blame China for their economic problems and viewed China as a greater threat. + +Due to middle-class job losses in the US, which were attributed to Chinese imports and China’s greater assertiveness internationally, the pendulum of sentiment toward China swung from positive to negative. When President Trump came to power in 2017 and President Xi began his second term in 2018, the great power conflict began in earnest, starting with trade negotiations that evolved into tests of power and a type of cold war. At the time, it became clear to Chinese leaders that the classic great power conflict was emerging. I was assured by a Chinese senior leader that the Chinese leadership + +277 + +--- + + +# HOW COUNTRIES GO BROKE: THE BIG CYCLE + +didn’t want to change the multilateral world order with respect to multinational organizations like the UN, the World Trade Organization, the World Health Organization, the World Bank, and the IMF. This senior leader argued that the changes to the world order and threats to multilateralism were instead the result of the Trump administration’s move toward a unilateral, “America First” approach, which put US interests ahead of the global community’s and made containing China its top priority. By this time, Russia and China increasingly viewed the United States as the common threat, so they became more aligned. + +Then in 2019-20, COVID emerged. At the same time, China’s debt bubble and wealth gaps grew, and relations with the US worsened, so there was a classic convergence of big debt/financial, internal order, external order, and acts of nature forces into a risky mix. Also, the Taiwan issue was (and still is) a very big, contentious issue because China expected the One China unification promise to be delivered on while instead there seemed to be movement toward more independence. This has been intensified because most of the advanced computer chips in the world were (and still are) produced in Taiwan, and whichever country controls them controls the most powerful technology in the world. Seeing all those contentious domestic and international issues evolve, in addition to his understanding of history, led Xi to convey that there is a big 100-year storm on the horizon. + +In 2018, Xi began his second five-year term with more consolidated power around him as the head of the core with four of the seven members of the Standing Committee of the Politburo as his close allies. + +In 2020, much of China was shut down due to COVID, which raised some internal ire about how it was being handled. And then in 2021, a bit more than halfway through Xi’s second term, China’s domestic debt bubble burst. Xi emphasized the importance of “common prosperity” and did not like how rich business leaders were. + + + +--- + +CHINA’S BIG CYCLE FROM 1945-49 UNTIL NOW IN A TINY NUTSHELL + +Arrogantly seeking to exert influence over how China was being run, so the government took some seemingly arbitrary actions that were not consistent with the type of rule of law and traditional property protections that investors thought were important. The leadership also knocked back some billionaire business leaders and their businesses to put them in their place. + +At the beginning of Xi’s third term in October 2022, China’s leadership shifted from reform-minded globalists to loyal, patriotic communists with tighter controls over the media and possible opposition, and it shifted from being highly free-market-oriented with capital markets flourishing to focusing more on achieving more common prosperity in an increasingly difficult time. It is important to remember that despite its economic advances, the great majority in China remain poor. At this time, there was a shift to economic, internal conflict, and international great power conflict policies that sounded more like those under Mao, while the conflict with the US intensified. + +Now China is: + +1. Experiencing a big debt problem at the same time as it is also turning to less capitalist “common prosperity” policies, while +2. There is increased internal political conflict that is being eliminated by more strict, autocratic policies directed by the president/chairman, while +3. There is increased international conflict with the United States and great changes in the world, which China is increasingly playing a leading role in shaping, while +4. Climate change is happening and is likely to have a big effect on China, while +5. China is in a technology war that neither it nor the United States can afford to lose. + +Simultaneously, it is making great advances in many areas, especially in technology-enabled manufacturing that it sells very inexpensively, with emerging countries that account for 85% of the world’s population being China’s big new target market. + +At the time of my writing this in March 2025, the second Trump administration has recently come into power in the US and has to + + + +--- + + +# HOW COUNTRIES GO BROKE: THE BIG CYCLE + +deal with 1) the big debt issue, while 2) internal conflict is leading it to employ more strict, semi-autocratic policies to overpower the opposition and its leftist policies, while 3) there is increased international conflict with China, countries aligned with it, and great changes in the world order with the US under Trump shifting from being a global leader to becoming an “America First” nationalistic participant in the changing world order, while 4) climate change is likely to have a big effect, while 5) the US is in a technology war that neither it nor China can afford to lose. The under-the-surface attacks on each other have been vicious. + +So, we are now seeing a squaring-off of these two great powers, along with their allies lining up behind them and their ideologies, which looks a lot like what we saw in the 1930s when the world was at a similar stage in the Big Cycle. The trade war is now most obvious. At the same time, there is a rapprochement of the US toward China as President Trump has described President Xi as a “great leader” who “controls 1.4 billion people with an iron fist.” What will happen in the US and China and the world will be another test of the relative strengths of these two great powers and their two very different approaches and systems. These two great powers are now in a war that fortunately for the world hasn’t yet turned into a military confrontation. This is shaping up to be the greatest great power conflict ever. Many years ago, a very senior Chinese leader explained how differently these two sides fight war; he explained to me how Western countries follow a Mediterranean approach to war, which is head-on, while the Chinese use a much subtler, deceptive approach along the lines of what was described in The Art of War by Sun Tzu, which was written about 2,500 years ago. Over my many years and through my close contacts in China, I have learned about the power of such timeless principles that affect Chinese leaders’ approaches to dealing with + + + +--- + +CHINA’S BIG CYCLE FROM 1945-49 UNTIL NOW IN A TINY NUTSHELL + +the Chinese people and the outside world. + +# CHINA AND THE FIVE BIG FORCES + +In this ultra-brief summary, I will look at what has happened in China vis-à-vis my Five Big Forces template: + +1. The debt/economic force led to China’s debt rising relative to + +46 A timeless guiding principle is *da (which means big/grand) tong* (which means unity, harmony, and coordination), which dates back to ancient China (around the time of Confucius). It describes how good things should be shared by all, leaderships should operate for the public good rather than for their own interests or the interests of any group, resources should be distributed equitably, and people should live in harmony. These are essential things that they will strive to get at all costs. How do they strive for them? The approaches are conveyed in 1) Confucianism (which is a series of ways of operating to have harmony through clear hierarchy and moral leadership in which the leaders put the society’s well-being ahead of their self-interest and put education, meritocracy, family, quality relationships, and paternalistic governance as priorities; it was formed around 500 BCE) and 2) legalism (which emphasizes very strict rule of law and pragmatism over morality; it was formed around 250 BCE). I learned that running China as a hierarchical family is important (e.g., the word “country” in Chinese is made up of two characters that are “state” and “family”). Of some but lesser influence are Taoism, which emphasizes harmony and the nature of all things, and Buddhism, which emphasizes harmony among people and all things, the acceptance of how things are, and materialism’s lack of value. By understanding such principles and how deeply rooted they are, I could understand the leadership’s perspectives and their system better than if I didn’t understand such things. For example, I could understand why they are inclined toward Marxism (which to them represents common prosperity), autocratic leadership, and the desirability of people in the society to know their place and to faithfully follow the leader (which they believe is required for order to exist), unless the leader fails them, which will be shown in great disorder that will lead the leader/emperor to lose “the mandate of heaven” and be overthrown, which will change the dynasty/order. And I can understand how they can find capitalism and individualism antithetical to their beliefs because they see both as selfishness that will fragment people and lead to disharmony and disorder. I am not commenting on what I think of Chinese approaches versus American or more generally Western approaches other than to say that it seems to me that humanity has struggled with their relative merits (i.e., the relative merits of capitalist self-interest and democracy and communist common interest and dictatorship) and has swung back and forth between different versions of them for all recorded history. I also think that the Chinese core values about how people should be with each other are more similar to the core values that Christianity espouses than is generally recognized and that both of these are quite different from those of capitalism when capitalism is taken to an extreme. I also know that capitalism has been a far more effective approach in producing prosperity, including broad-based prosperity, than the other approaches, though that approach has tended to operate in the Big Cycle way that has produced the booms and busts that we are looking at comprehensively in this study. + + + +--- + + +# HOW COUNTRIES GO BROKE: THE BIG CYCLE + +incomes, though not relative to liquid assets until 2009 (coming out of the global financial crisis). Then debt—especially local government, corporate, and real estate debt—started to grow into a bubble that burst in 2021, which began a deleveraging. Like Japan’s, most of China’s debt is denominated in its local currency, which allows it to engineer a “beautiful deleveraging,” which Japan failed to do. We don’t yet know whether China will manage this well, though it now appears to me that China has been slow to deal with it and is in the late part of the Big Debt Cycle that is most analogous to Japan in the 1990s. At the same time, China has highly competitive innovative sectors that are not at all encumbered by debts. + +1. The internal conflict and internal politics force led the government to tighten controls, leading to an environment of more fear, which has slowed decision making, which has chilled the economy and hurt capital and people flows, which has contributed to economic slowness in China. It has moved about halfway back toward Maoist-Marxist communist policies. At the same time, Chinese policies have been known to swing a lot as a way of creating fear, cleaning things out, and then rebuilding. +2. The external conflict force led to the classic great power conflict with the United States, which has hurt flows of trade, capital, and people and led to greater military preparation and risk. +3. The acts of nature force took the form of the COVID pandemic problem that started in late 2019 and continued through 2022, which strained the population’s satisfaction for how the leadership was handling it, which contributed to the government increasing controls. China also used its remarkable inventiveness, its government-directed economic policies, and its advanced manufacturing capabilities to make such great strides in solar and wind power that it has become the world’s most cost-effective producer of these items, which is another story that I won’t digress into. + + + +--- + +CHINA’S BIG CYCLE FROM 1945-49 UNTIL NOW IN A TINY NUTSHELL + +5. The technology force led both China and the US to make advances in a number of new technologies, most importantly in advanced AI, with China seemingly having fallen behind the US in the development of the most advanced chips while at the same time excelling in inexpensive AI and advanced manufacturing, especially in robotics. China is very competitive in a number of technology areas. + +So, in brief, in recent years four out of the five major forces (i.e., debt/economic, internal conflict, international conflict, and acts of nature) have become increasingly threatening to China, and the fifth, the technology force, appears to be a mixed picture of great advances and falling behind and leaping ahead of the US in different ways. In Part IV, I will tell you what I think about the future. + +283 + +--- + + +H O W C O U N T R I E S G O B R O K E : T H E B I G C YC L E + +# APPENDIX: CHINA’S BIG DEBT CYCLE IN A FEW CHARTS + +I am now going to show you a bunch of charts that do a good job of painting China’s debt picture, but I won’t get into an analysis with a commentary because a more complete proper analysis would be too much of a digression for now. Also, notably not all the debts are properly accounted for, so these charts are meant to just be broadly indicative. + +As shown, China is in the part of the Big Debt Cycle in which non‐central‐government debt burdens have become excessive and a problem so that the central government and the central bank will have to help manage it. Fortunately, most of the debt is denominated in local currency and most of the debtors and creditors are domestic so that the central government and the central bank have much greater ability to manage this situation than if they weren’t. However, China’s currency (the renminbi) is not a widely held reserve currency, so it isn’t an effective storehold of wealth. Ideally, Chinese policy makers would have both the ability and the courage to swiftly engineer a beautiful deleveraging. However, as previously explained, such adjustments are initially painful because they cause great shifts in wealth and, if not balanced properly, can just shift the debt burdens, worsen the long‐term central government debt burdens, and/or so severely undermine the value of the currency as to do great damage to the capital markets and through it to the economy. The Japanese case, and the next chapter on it, provides some valuable lessons for Chinese policy makers (as well as for other policy makers, investors, and businesspeople). + +As shown, China’s debts are reaching new highs, even as its economy is weaker than desired. That’s been the dynamic in Japan over recent decades as well. + +2 8 4 + + +--- + +# CHINA’S BIG CYCLE FROM 1945-49 UNTIL NOW IN A TINY NUTSHELL + +# CHINA DEBT LEVEL (% GDP) + +| Govt | Non-Fin Bus + LGFVs | +| ---------- | ------------------- | +| Households | 2024 Proj | + +# CHINA PRIVATE DEBT LEVEL (% GDP) + +Household + Non-Fin Bus + LGFVs + +# Debt Level Projections + +| 200% | 220% | +| ---- | ---- | +| 150% | 180% | +| 100% | 160% | +| 50% | 140% | +| 0% | 120% | + +# CHINA GENERAL GOVT DEBT LEVEL (% GDP, EST PRE-1981) + +| Government Debt | 2024 Projection | +| --------------- | --------------- | + +# CHINA GENERAL GOVT DEBT SERVICE (% REVENUE) W/PROJECTIONS + +| Total | o/w Interest | o/w Principal | +| ----- | ------------ | ------------- | + +# Debt Service Projections + +| 100% | 120% | +| ---- | ---- | +| 90% | 100% | +| 80% | 80% | +| 70% | 60% | +| 60% | 40% | +| 50% | 20% | +| 40% | 0% | + +Next, the chart on the left shows the levels of 10-year bond yields relative to the stated one-year and three-year average headline inflation numbers. Actual deflation in both items and in investments held has been worse than shown here. Also, as shown in the chart on the right, real bond yields are about 0.5%, so a) they are relatively unattractive in a normal environment but b) still relatively attractive in relation to a deflating economy with falling asset prices and also c) relatively unattractive relative to other countries’, especially the US dollar bond. + +2 8 5 + +--- + + +# HOW COUNTRIES GO BROKE: THE BIG CYCLE + +market’s interest rates.⁴⁷ As shown in the last chart in this group, nominal government bond rates are approaching zero, so other “non‐conventional” fiscal and monetary policies will likely have to be used. + +| CHN 10Yr Bond Yield | | CHINA REAL YIELD | | | +| ------------------- | ------------------------------ | ---------------------- | ----- | ---- | +| Inflation (Y/Y) | Inflation (3Yr Moving Average) | Real Yield (Estimated) | | | +| 2% | 10% | | 3.0% | | +| | 8% | | 2.5% | | +| | 6% | | 2.0% | 1.5% | +| | 4% | 1.0% | | | +| | 2% | | 0.5% | | +| | 0% | | 0.0% | | +| | -2% | | -0.5% | | + +1960 1980 2000 2020 1960 1980 2000 2020 + +# CHINA ESTIMATED RATES + +| Nominal Rate | Real Yield Est | +| ------------ | -------------- | +| BEI Est | 2% | +| | 5% | +| | 4% | +| | 3% | +| | 2% | +| | 1% | +| | 0% | + +1960 1980 2000 2020 + +As shown in the following charts, the yield curve (as of late February 2025) is inverted, which makes cash relatively attractive at a time when that encourages a holding of cash, which leads to a “pushing on a string” issue. I previously conveyed my thinking about this in Chapter 1 so I won’t repeat it. Also as shown, various measures of + +47 China does not have inflation‐linked bonds, so I am showing an estimate of real yields based on nominal yields and an estimate of market 10‐year inflation expectations. + + + +--- + +CHINA’S BIG CYCLE FROM 1945-49 UNTIL NOW IN A TINY NUTSHELL + +liquidity (e.g., total social financing, money supply, total loans from the financial sector) continue to rise without producing a rebound in real economic activity—another sign of “pushing on a string.” + +# CHINA SHORT-TERM YIELD CURVE + +| | 3M Minus 10Yr Rate | 3M Divided by 10Yr Rate | +| --- | ------------------ | ----------------------- | +| 16% | 2% | 145% | +| 12% | 1% | 120% | +| 8% | 0% | 95% | +| | -1% | 70% | +| 4% | -2% | 45% | + +1980 2000 2020 0% -3% 1980 2000 2020 20% 1960 1960 + +# Total Social Financing (% GDP) + +| Total Social Financing (% GDP) | M2 (% GDP) | M0 (% GDP) | Loans in RMB (from Financial Inst) (% GDP) | +| ------------------------------ | ---------- | ---------- | ------------------------------------------ | +| 350% | | | | +| 300% | | | | +| 250% | | | | +| 200% | | | | +| 150% | | | | +| 100% | | | | +| 50% | | | | + +1960 1970 1980 1990 2000 2010 2020 0% + +While the previous charts focused on the debt issue in China, I want to conclude this chapter by making the following clear: the debt issue is a big, important issue that could be a terrible burden for the Chinese economy as it was for the Japanese economy if Chinese policy makers don’t handle it well—i.e., if the leaders don’t engineer a beautiful deleveraging, which they have the ability to do because their debts are denominated in their own currency and most debtors and creditors are their own citizens. + +287 + +--- + + +H O W C O U N T R I E S G O B R O K E : T H E B I G C YC L E + +However, I want to reiterate that there are important non-debt-burdened parts of the economy that are innovating and flourishing that will certainly be viable both in and out of China in the years to come and that Chinese assets are now very cheap. Chinese policy makers would be well-served to read the next chapter on the Japanese case and the lessons it provides, as would the rest of us. + +2 8 8 + + + +--- + +# CHAPTER 16 + +# THE JAPANESE CASE AND THE LESSONS IT PROVIDES + +This chapter shows how a heavily indebted reserve currency country, Japan, handled its debts with reference to the earlier‐described template. It shows the Big Debt Cycle transpiring in the very classic way, with the cause/effect relationships working as I described, but it is especially interesting because for more than two decades Japanese policy makers did the exact opposite of what should be done to execute a beautiful deleveraging—i.e., they did not restructure the debts for nine years and they didn’t drive interest rates below inflation rates and nominal growth rates for 23 years. While this Japanese case study tells a very interesting story for those who are interested in seeing how the economic machine works, it does get a little technical. Those who don’t want the technical details can skip them by just reading the highlights in bold, which will take only about 10 minutes. + +Japan’s story, like China’s story, is a very interesting one that extends back to its Big Cycle prior to the one that began in 1945. To put Japan’s history into the clear context of its Big Cycle, I will summarize what has happened since the beginning of the new world and domestic orders starting in 1945 and take a very brief look at what happened before 1945. I’m doing that because, as with China’s story, Japan’s story since 1945 would be greatly lacking in + +--- + + +# HOW COUNTRIES GO BROKE: THE BIG CYCLE + +context if we didn’t at least brieXy touch on the Big Cycle dynamics of the 100 years before. + +# BEFORE 1945 + +I will brieXy recount Japan’s history in the roughly 100 years prior to 1945. Besides using it to help you understand what has happened since then, be sure to observe how the classic Big Cycle of ups and downs repeated in that period before going on to observe how it con‐tinued from 1945 up until now. + +In brief, like China, Japan had an elevated civilization that was happily isolated from the rest of the world until foreign powers came and demanded to “trade” with Japan and then threatened and exploited Japan. This led to a period in Japan similar to China’s Century of Humiliation and the collapse of Japan’s internal order, which aVected the world order. + +In Japan’s case, it started with US Commodore Matthew Perry and his American Xeet arriving in 1853 and led to the fall of Ja‐pan’s 250‐year‐old domestic order under the Tokugawa family sho‐gunate. Because the foreign powers clearly had greater powers than the Japanese, their obvious military superiority led to the collapse of the then‐existing domestic order and then‐existing monetary order, which were replaced by new ones. As the Japanese realized that the foreign, more modern approaches were better, the Japanese gov‐ernment was replaced by a new government in 1868, which largely copied the Western powers’ approaches. + +The new domestic order was a constitutional monarchy, which had a parliament and a new emperor (Meiji). That led to the mod‐ernization of Japan, which was achieved largely by following West‐ern styles for education, the economy, and the military. (Puccini’s magniWcent Madama Butterfly plays out during this Meiji era.) + +These policies of reform and opening up led to Japan becoming a great power in a way similar to what happened in China when Deng + + + +--- + + +# T H E J A PA N E S E C A S E A N D T H E L E S S O N S I T P R OV I D E S + +Xiaoping did a similar reform and opening up about a hundred years later. Under this new order, Japan fought and defeated its two rival regional powers̶China in 1894‐95 and Russia in 1904‐05̶and conquered and annexed Korea in 1910. During World War I, it allied itself with the British and took advantage of Germany’s fighting in Europe to take over German territories in Asia, as well as some Chinese territories. At the end of World War I, since it was on the winning side, Japan was given formal control of the German territories and the Shandong province in China. + +From 1912 to 1926, Japan’s domestic order was a parliamentary democracy. But when economic problems began, the classic combination of a debt/economic crisis and the dysfunction of its democracy led to a collapse of public trust and a classic hard-right takeover, characterized by rising nationalism, militarism, and expansionism to secure economic resources and territory. In 1921, Japan’s prime minister was assassinated by a young nationalist. After the crash of 1929, the nationalistic military seized control. To consolidate power, the new regime treated opponents as threats and used laws to silence leftists and democratic activists (e.g., the 1925 “Peace Preservation Law”). The Great Depression made the economic situation worse and from 1937 to 1940 all political parties were dissolved, and there was increasing autocratic control that left the power exclusively in the hands of the military. In other words, events followed the classic script. + +Geopolitically, this newly nationalistic and militaristic Japan invaded and took over China’s Manchuria region (in 1931) and more of China (in 1937). Then it got into a conflict with the United States, which led the US to impose trade sanctions, similar to what’s happening with the US-China conflict today. The US, the UK, and the Netherlands imposed export restrictions that hurt the Japanese economy and Japanese security by freezing Japanese assets and cutting off oil exports to Japan. This led to Japan attacking the US naval fleet at Pearl Harbor, which led to a war with the United States that Japan lost due to the United States secretly. + +2 9 1 + + + +--- + + +# HOW COUNTRIES GO BROKE: THE BIG CYCLE + +inventing a powerful technology that could be used for both peace and war—nuclear power. Because of Japan losing World War II, all Japanese money and debt were destroyed, and Japan was occupied and reconstructed by the United States from 1945 until 1952. + +The following chart shows the total debt-to-GDP ratio going back to 1870. It shows both the Big Debt Cycle prior to 1945 and the one since. As you can see, there was the big run-up in debt in the 1930-45 period before and during the war, the debt wipeout that brought it down to low levels until 1970, the big debt bubble leading to the debt bust in 1989-90, and the rise in that ratio until recently. That is what the Big Debt Cycles have looked like since 1870. As is normal when looking at the Big Debt Cycles, the short-term debt and economic cycles are imperceptible. + +# JAPAN GENERAL GOVERNMENT DEBT LEVEL (% GDP) + +| Government Debt | Rough Estimate | +| ------------------- | -------------- | +| 1990 IMF Projection | 300% | +| 2024 IMF Projection | 250% | + +200% + +150% + +100% + +50% + +1870 1890 1910 1930 1950 1970 1990 2010 20300% + +# SINCE 1945 + +In brief, from 1945 through 1990, Japan rebuilt itself to become the second-greatest economic power in the world and in the process built up a huge debt burden that funded a bubble that burst in 1989-90, which has had a huge weakening effect on Japan ever since. I will now look at the time from the debt bubble bursting until today because that is the most relevant period to understanding the + + + +--- + + +# T H E J A PA N E S E C A S E A N D T H E L E S S O N S I T P R OV I D E S + +part of the Big Debt Cycle that this study is focused on. The lessons that examining this part of the Big Debt Cycle provides in helping us understand other cases̶most importantly the current cases in the United States, China, and Europe̶are very valuable. Since I am focused on the deleveraging part of the Big Cycle, I won’t cover the 1945‐90 period and will focus on the post‐1990 period. + +# THE BIG DEBT CYCLE SINCE 1990 + +The Japanese government’s handling of its debt problem from 1990 until 2013 exemplified exactly what not to do. It was the exact opposite of what I described should be done to execute a beautiful deleveraging even though Japan had the capacity to execute a beautiful deleveraging because almost all of its debt was denominated in its local currency and almost all of the difficult debtor-creditor relationships were between Japanese parties, plus it was a net creditor to the rest of the world. More specifically, policy makers did not restructure their debts so the debt burdens lingered on bank and company balance sheets making them “zombie institutions,” they held to employment and cost policies that were rigid so that they couldn’t effectively cut costs and adapt, they didn’t make interest rates low in relation to both nominal growth rates and inflation, and they did not meaningfully monetize their debts until after there was deflation and interest rates were near zero in 1995. For nearly two decades, the amount of fiscal and free‐market policy adjustments and the amounts of monetary stimulus and debt purchases were woefully insufficient to engineer a beautiful deleveraging. As a result, until mid‐2013, Japan had continuous deflation and economic stagnation as companies and people didn’t have the previously described financial conditions to get this debt burden crisis behind them. The Japanese government did not deal with its non‐performing‐loan problem until 1999 (so for nine years after the debt bubble popped) when the government finally forced the banking system to restructure its debts and injected huge + +2 9 3 + + + +--- + + +# HOW COUNTRIES GO BROKE: THE BIG CYCLE + +amounts of capital into the banks, and it didn’t monetize debt and bring interest rates significantly below nominal growth and inflation rates until 2013. Additionally, Japan’s aging population was a headwind (e.g., in 1990, 12% of the population was over 65 and 69% of the population was working-age while now 29% of the population is over 65 and only 59% is working-age). + +Fiscal and monetary policies changed greatly and appropriately when Bank of Japan Governor Kuroda and Prime Minister Abe came to power in late 2012/early 2013 and initiated their “three arrows” policy to 1) increase the money supply, 2) boost central government spending, and 3) enact economic and regulatory reforms to make the Japanese economy more competitive, which, as previously described, are classically the best policies to negate deflationary, depressionary forces. As a result, from 2013 through 2019, there was no deflation and there was low positive growth (0.9% per year) and the beginning of a healing period, though the deflationary and depressing psychological conditions lingered. The psychological overhang of 23 years of debt depression has had lasting negative effects on the strength and vibrancy that characterized Japan prior to 1990 and many times throughout history. + +During this period, extremely large debt monetization and fiscal deficit stimulus (5% of GDP deficits on average) and extremely large central bank buying of Japanese yen debt (the BoJ now holds government bonds worth more than 90% of GDP) took place, which pushed interest rates 0.9% below the nominal growth rate and 1% below the inflation rate on average, and depreciated the yen, all of which were very stimulative. The combined lower interest rates and currency depreciation led to Japanese government bonds being a terrible storehold of wealth, losing 45% relative to US bonds and 60% relative to gold. These and other actions provided + + + +--- + +# T H E J A PA N E S E C A S E A N D T H E L E S S O N S I T P R OV I D E S + +an average interest rate that was about 2.2% below the US rate and depreciated the currency by an average rate of 5.5% per year in real terms versus the dollar. More specifically, the -45% cumulative return of a Japanese government bond versus a US government bond was almost entirely attributable to currency depreciation, since the lower carry/accrual from Japanese bonds was entirely offset by price gains (roughly 20%) due to falling Japanese yields. At the same time, Japanese inflation averaged only 1.1% per year relative to US inflation of 2.7% per year because of domestic deflationary pressures. The principle should resonate: ⓢ don’t own government bonds when there are extreme amounts of debt monetization. + +Let’s look at what happened more closely. + +While there has been modest inflation of 0.8% per year in average worker compensation in yen terms since 2013, the big yen depreciations—along with greater wage gains in other nations—made them more competitive. For example, there has been a total decline of 58% in the cost of a Japanese worker relative to an American worker since 2013. Similarly, other domestic items in Japan have fallen a lot in cost relative to the costs in other countries. Both have helped to make Japan more competitive. These changes are shown in the following charts. + +# USA VS JPN WAGES IN USD + +| JPN Typical Wage in USD | USA Typical Wage in USD | +| ----------------------- | ----------------------- | +| 80K | | +| 70K | | +| 60K | | +| 50K | | +| 40K | | +| 30K | | +| 20K | | +| 10K | | +| 1980 | | +| 1985 | | +| 1990 | | +| 1995 | | +| 2000 | | +| 2005 | | +| 2010 | | +| 2015 | | +| 2020 | | +| 2025 | | + +# WAGES VS FX (INDEXED TO 2013) + +| JPN Typical Wage in JPY | JPY vs USD | +| ----------------------- | ---------- | +| 20% | | +| 10% | | +| 0% | | +| -10% | | +| -20% | | +| -30% | | +| -40% | | +| -50% | | + + +--- + + +# HOW COUNTRIES GO BROKE: THE BIG CYCLE + +# WAGES VS FX (INDEXED TO 2013) + +| | 1980 | 1985 | 1990 | 1995 | 2000 | 2005 | 2010 | 2015 | 2020 | 2025 | +| ----------------------- | ---- | ---- | ---- | ---- | ---- | ---- | ---- | ---- | ---- | ---- | +| JPN Typical Wage in JPY | | | | | | | | | | | +| JPY vs USD | | | | | | | | | | | + +Low interest rates reduced debt service costs a lot—since 2013, Japanese interest debt service has fallen over 50% (and has fallen over 65% since 2001), making it much easier to service the debt. + +Still, the Japanese debt relative to the size of the economy has increased by almost 10%. To neutralize its effects, the Bank of Japan bought over half of all the government debt and absorbed the debt service costs, which it monetized. The declines in interest rates engineered by the BoJ also contributed to the debt relief (though more of that benefit occurred even before Governor Kuroda took the helm, as short rates had already hit zero). + +# HOW JAPAN MANAGED BIG INCREASES IN TOTAL GOVT DEBT AND BIG DECLINES IN INTEREST PAYMENTS + +| | 2001 | 2013 (Pre-QE) | Today | % Chg | +| ----------------------------------- | ---- | ------------- | ----- | ----- | +| Govt Debt (% GDP) | 99% | 197% | 215% | 9% | +| ex-CB Holdings | 93% | 178% | 123% | -31% | +| Average Interest Rate on Govt Debt | 2.3% | 0.9% | 0.6% | -40% | +| ex-CB Govt Interest Service (% GDP) | 2.1% | 1.7% | 0.7% | -56% | + +Meanwhile, average interest rates fell 40... and the interest govt pays to the public is down >50%. + +The following charts show these trends. The bottom-left chart shows the substantial declines in the interest service actually paid by + + + +--- + + +# T H E J A PA N E S E C A S E A N D T H E L E S S O N S I T P R OV I D E S + +the government to the public, and the other charts show how Japan got there: through central bank purchases and large declines in interest and principal payments. + +# JAPAN GOVERNMENT DEBT LEVEL + +| Total (as % GDP) | ex-CB Holdings | | | | | | +| --------------------- | -------------- | ---- | ---- | ---- | ---- | - | +| Debt monetization | 250% | | | | | | +| really starts in 2013 | 200% | | | | | | +| with “Abenomics” | 150% | | | | | | +| | 100% | | | | | | +| | 50% | | | | | | +| 1975 | 1985 | 1995 | 2005 | 2015 | 2025 | | +| | 0% | | | | | | + +# JAPAN GOVERNMENT DEBT SERVICE + +| Total (as % GDP) | ex-CB Holdings | | | | | | +| ---------------- | -------------- | ------------------ | ---- | ---- | ---- | - | +| | | Debt service | 30% | | | | +| | | falls considerably | 25% | | | | +| | | | 20% | | | | +| | | | 15% | | | | +| | | | 10% | | | | +| 1975 | 1985 | 1995 | 2005 | 2015 | 2025 | | +| | 0% | | | | | | + +# PUBLIC DEBT SERVICE COMPONENTS (% GDP) + +| Principal Pmts | Interest Pmts | | | | | | +| ------------------------ | ------------- | -------------------- | ---- | ---- | ---- | - | +| Falling debt burden | 30% | | | | | | +| comes from both | 25% | | | | | | +| longer issuance | | | | | | | +| and lower interest rates | | | 20% | | | | +| | | | 15% | | | | +| | | | 18% | | | | +| | | Combination of | 16% | | | | +| | | lower rates and | 14% | | | | +| | | smaller principal | 12% | | | | +| | | payments leads to | | | | | +| | | lower debt service | | | | | +| | | as a percent of debt | | | | | +| 1975 | 1985 | 1995 | 2005 | 2015 | 2025 | | +| | 0% | | | | | | + +Remarkably, the massive increase in debt that occurred in this period was concurrent with an improvement in Japan’s central government balance sheet. Net assets (government assets minus government liabilities) are now 20% better in dollar terms compared to 2013 because the Bank of Japan accumulated dollar reserves (primarily in the 2001‐12 period) and Japan’s debts as measured in dollars are not up as much due to the yen depreciation. + +2 9 7 + + + +--- + + +H O W C O U N T R I E S G O B R O K E : T H E B I G C YC L E + +# HOW JAPAN MANAGED BIG INCREASES IN GOVT DEBT AND BIG IMPROVEMENTS IN ITS BALANCE SHEET + +| | 2001 | (Pre-QE) | Today | Change | +| -------------------------------------- | ------ | -------- | ------ | ------ | +| Total Debt (% GDP) | 99% | 197% | 215% | 116% | +| Debt ex-CB (% GDP) | 93% | 178% | 123% | 33% | +| Debt ex-CB (JPY, Tln) | 504 | 893 | 748 | 49% | +| Debt ex-CB (USD, Bln) | 4,322 | 9,734 | 4,650 | 8% | +| USD/JPY Spot | 117 | 92 | 144 | 23% | +| Reserves (USD, Bln) | 358 | 1,371 | 1,408 | 293% | +| Assets (Reserves) - Liabilities (Debt) | -3,965 | -8,363 | -3,242 | 18% | +| Assets - Liabilities (% GDP) | -85% | -153% | -76% | 9% | + +Who were the winners and who were the losers? Clearly the big losers were the Japanese debt holders, including the Japanese central bank. Japanese bond holders lost a total of 6% in real terms (as real yields were generally negative), 45% versus if they had instead held US bonds, and 60% relative to the old “hard money” of gold. Next is a chart of the real return of just holding JGBs as a Japanese investor (in local currency) and their performance relative to US bonds and gold. + +# JAPAN 10YR BOND CUMULATIVE RETURNS + +In Local Currency (Real Terms) Unhedged vs USA Bond vs Gold + +| | 2014 | 2016 | 2018 | 2020 | 2022 | 2024 | +| - | ---- | ---- | ---- | ---- | ---- | ---- | +| | -60% | -40% | -20% | 0% | 20% | | + +2 9 8 + + +--- + + +# T H E J A PA N E S E C A S E A N D T H E L E S S O N S I T P R OV I D E S + +During this period, there was also a big deterioration in the BoJ’s balance sheet. These losses will be very large if Japanese real and nominal bond yields rise to more reasonable levels (e.g., 2% and 3%, respectively). + +For example, if Japan were to have a 3% rise in real interest rates (from ‐0.3% to 2.7%), then: + +- The BoJ would experience about a 30% of GDP mark‐to‐market loss on its bond holdings and would be in a seriously negative cash flow situation of around ‐2.5% of GDP. +- The government would see the deficit widen from roughly 4% of GDP to around 8% of GDP over the next 10 years due to the increase in interest costs (not including any outlays to cover central bank losses). The government debt level would surpass its post‐WWII peak, rising from 220% to 300% over the next 20 years. + +| BOJ MTM BOND LOSSES | | JAPAN GOVERNMENT DEFICIT (% GDP) | | +| ------------------------------------------------------------------------------ | ----------------------------------------------------------------------------------------------- | -------------------------------- | - | +| Rates Rise 3% | (% GDP) | | | +| Current Pricing | Assuming 3% Rise in Yields | | | +| 10% | | | | +| 0% | | | | +| A moderate real rate rise would produce huge mark-to-market losses for the BoJ | | | | +| | And would produce sustained big government deficits, putting Japan on the path of a debt spiral | | | +| -5% | | | | +| -10% | | | | +| -15% | | | | +| -20% | | | | +| -30% | | | | + +The combined cash flow need across the central bank and the central government would be around 5-6% of GDP per year, which is huge. That would have to be handled through debt issuance, money printing, and/or deficit reduction. If it were financed by central bank printing, this would be the + +2 9 9 + + + +--- + +# HOW COUNTRIES GO BROKE: THE BIG CYCLE + +equivalent of another round of QE in terms of expansion of the money stock, not including any additional printing needed to offset selling by the private sector. + +Resolving it would require even greater write-downs in debt and devaluations of the currency—with the Japanese people becoming relatively poorer in the process—until Japan is competitive enough to begin a new cycle. + +Key non-tradable goods—local wages, local services, local housing—have seen essentially no price increases in yen terms and significant devaluation in global currency terms since 2000. The affordability of rent (rent compared to wages) has barely moved. This is despite tradable goods and commodities being way up because of the currency’s depreciation. And Japanese workers are more competitive than ever. That said, Japan has seen dramatically lower dollar incomes, meaning purchases on imports are much more expensive. Using the most apples-to-apples comparison (dollar GDP per capita), individuals in Japan used to be richer than individuals in the US, and now they are some 60% poorer. This is obvious to any Japanese person traveling abroad. + +# JPN GDP Per Capita in USD Terms vs USA GDP Per Capita + +| | 0K | 10K | 20K | 30K | 40K | 50K | 60K | 70K | 80K | +| ---- | -- | --- | --- | --- | --- | --- | --- | --- | --- | +| 1970 | | | | | | | | | | +| 1980 | | | | | | | | | | +| 1990 | | | | | | | | | | +| 2000 | | | | | | | | | | +| 2010 | | | | | | | | | | +| 2020 | | | | | | | | | | + + +--- + +# T H E J A PA N E S E C A S E A N D T H E L E S S O N S I T P R OV I D E S + +For a different angle of who the winners and losers were, it’s helpful to take a look at how prices have changed in Japan at a very granular level because it provides a window into what it’s like to earn, spend, and save there. The following table provides a lot of details, but to summarize: + +- Since 2000, the yen is down 30%. If you were a US investor who kept their money in yen versus dollars earning the dollar interest rate, you’d be down 84%. +- Your returns for holding unhedged Japanese bonds versus US bonds were slightly better (but still very bad, down roughly 70%) and slightly better (but still very bad) for unhedged Japanese equities versus US equities (down around 67%). +- Meanwhile, prices in Japan (aggregate CPI) are up 10%—much less than in the US, where prices are up 90%. +- At the same time, all Wat currencies have devalued versus goods. The dollar has depreciated about 50% in the last 25 years. +- Whereas total average inflation is similar across major categories, the composition of inflation is very different. In Japan, there has been deflation in non-tradables—housing and labor especially—while prices of tradable goods (i.e., things you can purchase from abroad like electronics, toys, oil, etc.) have soared with some key tradable commodities up more than 3x in yen terms. +- Non-tradables are about flat in price while tradable commodities are up 2-10x (3x on average). + +--- + +# HOW COUNTRIES GO BROKE: THE BIG CYCLE + +| | | | JPY | | | USD | | +| ------------------- | ---------------- | ------------------------ | ------------- | ----------- | ------------------------ | ----- | ---- | +| Price in 2000 | Price Today | % Chg in FX Buying Power | Price in 2000 | Price Today | % Chg in FX Buying Power | | | +| FX vs USD | | 107 | 156 | -31% | - | - | | +| Aggregate CPI | | 1 | 1.11 | -10% | 1 | 1.95 | -49% | +| Non-Tradables | | | | | | | | +| Housing | | 1 | 0.98 | 2% | 1 | 2.14 | -53% | +| Services | | 1 | 1.07 | -6% | 1 | 2.08 | -52% | +| Tradables | | | | | | | | +| Goods (CPI Indices) | | | | | | | | +| | Food/Beverage | 1 | 1.32 | -24% | 1 | 1.84 | -46% | +| | HH Durables | 1 | 0.86 | 16% | 1 | 1.16 | -14% | +| | Clothes/Footwear | 1 | 1.14 | -12% | 1 | 1.04 | -4% | +| Commodities | | | | | | | | +| | Soybeans | 52,318 | 174,594 | -70% | 488 | 1,122 | -57% | +| | Wheat | 27,650 | 85,725 | -68% | 258 | 551 | -53% | +| | Oil | 2,933 | 12,637 | -77% | 27 | 81 | -66% | +| | Natural Gas | 288 | 328 | -12% | 3 | 2 | 28% | +| | Coal | 2,254 | 20,961 | -89% | 21 | 135 | -84% | +| | Aluminum | 184,000 | 353,235 | -48% | 1,715 | 2,270 | -24% | +| | Copper | 194,410 | 1,395,822 | -86% | 1,812 | 8,970 | -80% | +| | Lean Hogs | 6,375 | 13,971 | -54% | 59 | 90 | -34% | +| | Live Cattle | 7,390 | 30,137 | -75% | 69 | 194 | -64% | +| | Gold | 30,436 | 377,104 | -92% | 284 | 2,423 | -88% | +| | Silver | 568 | 4,561 | -88% | 5 | 29 | -82% | +| | Avg of CMDs | 1 | 3.2 | -69% | 1 | 2.23 | -55% | + +Return of Holding Yen in a Bank, Converting at End: -29% + +Return of Holding Yen Financed with Borrowed USD, Converting at End: -84% + +--- + +# T H E J A PA N E S E C A S E A N D T H E L E S S O N S I T P R OV I D E S + +# PRICE INDICES (1980=1) + +| Housing | Services | Oil | Gold | | | +| ---------------------------------------------------------------------------- | -------- | ------------------------------------------------------- | ---- | - | -- | +| JAPAN SPOT FX VS USD (IN MARKET CONVENTION) | | | | | | +| Post-2000, non-tradables | 2.5 | Big rally and smaller sell-off in yen during the bubble | 3.0 | | | +| Pre-2000, non-tradables totally flat; up and tradable CMDs down in yen terms | | 2.0 | | | | +| | | 1.5 | | | | +| | | 1.0 | | | | +| | | 0.5 | | | | +| 1980 1990 2000 2010 2020 | | | | | | +| | | 0.0 | | | | +| 1980 1990 2000 2010 2020 | | | | | | +| | | | | | 50 | + +ⓤ All of this is largely the inverse of what happened in the lead‐up to the bubble (1980‐90), when overheating growth and strong capital inflows led to both significant non‐tradables inflation (+40%) and yen strength (+70%). These changes reflect the changes in the Big Cycle in Japan. + +The following charts convey the picture for a Japanese worker. As shown, in the past 25 years, typical worker wages were relatively flat in yen terms, just shy of 400,000 yen a month, but fell significantly in dollar and world currency terms. In other words, while the average Japanese worker used to make the equivalent of $3,500 a month, they now make about $2,500. In gold terms, they used to earn 13 ounces of gold‐equivalent a month; now it’s 1 ounce. + +3 0 3 + +--- + + +# HOW COUNTRIES GO BROKE: THE BIG CYCLE + +# MONTHLY CASH EARNINGS FOR ONE EMPLOYEE + +# (BUSINESS W/OVER 30 PEOPLE) + +| JPY (Thous) | USD (Thous) | +| ----------- | ----------- | +| 440 | 5500 | +| 420 | Bubble | +| Bust | 4500 | +| Bust | 400 | +| 380 | 3500 | +| 360 | 2500 | +| 340 | | +| 320 | 1500 | +| 300 | 500 | + +# Oz of Gold + +| Oz of Gold | | +| ---------- | -- | +| 16 | | +| Bubble | 14 | +| 12 | | +| Bust | 10 | +| 8 | | +| 6 | | +| 4 | | +| 2 | | +| 0 | | + +For the Japanese people, the relevant question is how much of their labor it takes to afford what they purchase, and the fact that non‐tradable essentials stayed affordable was important. The rent on a typical apartment̶maybe the purest non‐tradable̶has stayed almost flat in hours‐of‐work terms, at 0.6 months of labor (though it’s way less expensive in dollar terms). + + + +--- + + +# T H E J A PA N E S E C A S E A N D T H E L E S S O N S I T P R OV I D E S + +# TYPICAL APARTMENT MONTHLY RENT (ABOUT 700 SQ FT) + +| JPY (Thous) | Months of Typical Wage | +| ----------- | ---------------------- | +| 280 | 1.0 | +| 260 | 0.9 | +| 240 | 0.8 | +| 220 | 0.6 | +| 200 | 0.5 | + +Mild deflation in housing costs little change in apartment affordability + +2000 2005 2010 2015 2020 + +Source: ARES JP + +You can also see the impact by looking at some real prices of items that mix commodities with heavy doses of domestic labor. The data on costs of vehicles tends to wiggle a lot, but roughly speaking a domestically made car used to cost eight months of labor, and now it’s nine months. A convenience store boxed lunch used to take 10 minutes of work to afford, now it’s 16 minutes (up more than 60%). Going to a theme park used to cost a third of a day of labor, now it’s a half a day. + +# TYPICAL CONVENIENCE STORE BOXED LUNCH (EST)— HOURS OF TYPICAL WAGE + +| | COST OF DOMESTIC MOTOR VEHICLE— MONTHS OF TYPICAL WAGE | +| ---- | ------------------------------------------------------ | +| 0.45 | 12 | +| 0.40 | 11 | +| 0.35 | 10 | +| 0.30 | 9 | +| 0.25 | 8 | +| 0.20 | 7 | +| 0.15 | 6 | +| 0.10 | 5 | + +1980 1990 2000 2010 2020 + +--- + + +# HOW COUNTRIES GO BROKE: THE BIG CYCLE + +| THEME PARK ADMISSION FEE (USD) | DAYS OF TYPICAL WAGE | +| ------------------------------ | -------------------- | +| 85 | 0.60 | +| 75 | 0.55 | +| 65 | 0.50 | +| 55 | 0.45 | +| | 0.40 | +| 45 | 0.35 | +| 35 | 0.30 | +| 25 | 0.25 | +| 15 | 0.20 | + +1980 1990 2000 2010 2020 1980 1990 2000 2010 2020 + +The charts reflect the dramatic changes that took place and are likely to continue to take place due to the previously described typical mechanical process of the Big Debt Cycle in which the country has a lot of debt denominated in its own currency and it is a reserve currency country. + +Remarkably during this period, there were no really big internal or external conflicts, though Japan is now preparing for war with China (though it doesn’t want it) as the United States’ most important ally in the region. + +# HOW DID JAPAN GET HERE? + +I want to highlight five dynamics at play in Japan that helped bring about these sets of winners and losers. Here is what happened: + +1. The government’s deficit spending floods the private sector with cash, aiding in private sector deleveraging. +2. The central bank monetizes the debt to keep long rates low, lower debt service, and boost demand. The government’s debt burden minus central bank holdings begins to fall as a percent of GDP. +3. The resulting currency depreciation acts as a sort of tax on foreign investors holding unhedged domestic bonds and + +306 + + + +--- + +# T H E J A PA N E S E C A S E A N D T H E L E S S O N S I T P R OV I D E S + +Domestic investors who didn’t invest outside the country, while it lowers the government debt burden as that falls in value when measured in foreign FX and gold. + +1. Domestic savers are similarly taxed, though to a lesser degree because, even though their buying power abroad decreases, that fall in buying power isn’t as much domestically. +2. The country gets more competitive as both assets and factors of production get cheaper. + +More specifically it happened in the following way. + +# Dynamic 1: Public sector deficit spending floods the private sector with cash, helping the private sector delever. + +The following chart shows that dynamic, with public sector debt rising from roughly 1990 to 2020, during the period of private sector deleveraging. After that government leveraging, Japan was left with the highest government debt levels of any major country. There are many historical cases of other governments struggling to deal with their debt burdens. Japan was able to manage it because of the second dynamic. + +| JAPAN | Non-Fin Private Debt (as % GDP) | Govt Debt Level (as % GDP) | | | | | | | | +| ----- | ------------------------------- | -------------------------- | ---- | ---- | ---- | ---- | ---- | ---- | ---- | +| 1970 | 1980 | 1990 | 2000 | 2010 | 2020 | | | | | +| | | 100% | 120% | 140% | 150% | 160% | 180% | 200% | 250% | + +# Dynamic 2: The central bank monetizes the debt to keep long rates low, lower debt service, and boost demand. + +The government’s debt burden minus central bank holdings begins to fall as a percent of GDP. + +3 0 7 + +--- + + +# HOW COUNTRIES GO BROKE: THE BIG CYCLE + +The following table shows how Japan’s debt service (interest and principal repayment) in yen effectively fell by around 7% during a period in which debts rose by nearly 30%. About half of that was because of lower interest rates (shown in the second chart) and debt being termed out. The other half was because of BoJ purchases of the debt. + +| Metric | Contribution | Level (2013) | Level (2023) | +| -------------------------------- | ------------ | ------------ | ------------ | +| Δ in Debt Service as % GDP | -11% | 26% | 15% | +| Δ in Debt Service (Yen) | -7% | 128 Tln | 85 Tln | +| Δ in ex-CB Govt Debt | -3% | 898 Tln | 748 Tln | +| Δ in Total Govt Debt | 6% | 997 Tln | 1270 Tln | +| Δ in CB Holdings | -9% | 99 Tln | 522 Tln | +| Δ in Debt Service as % Govt Debt | -4% | 14% | 11% | +| Δ in Avg Interest Rate | -1% | 0.9% | 0.6% | +| Δ in Principal Payments | -4% | 13% | 11% | +| Δ in GDP (Yen) | -4% | 497 Tln | 583 Tln | +| Δ in Price Level | -2% | - | - | +| Δ in Real GDP | -2% | - | - | + +Lower interest rate and longer maturity issuance helped decrease debt service costs. Expansion of CB balance sheet largely offset additional government debt. + +# DEBT MONETIZATION VS REAL YIELDS + +BoJ Bond Holdings (% GDP) + +10Yr Real Yield + +| 100% | | | 5% | | +| ---- | -- | --- | -- | - | +| 80% | | | 4% | | +| 60% | | 3% | | | +| 40% | | 2% | | | +| 20% | | 1% | | | +| | 0% | 0% | | | +| | | -1% | | | + +1975 1985 1995 2005 2015 2025 + + + +--- + + +# T H E J A PA N E S E C A S E A N D T H E L E S S O N S I T P R OV I D E S + +Dynamic 3: The resulting currency depreciation acts as a sort of tax on foreign investors holding unhedged domestic bonds and lowers the government debt burden in foreign FX and gold. BoJ actions significantly contributed to declines in the yen, as shown in this chart. + +| DEBT MONETIZATION VS REAL FX | | +| ---------------------------- | -------------- | +| BoJ Bond Holdings (% GDP) | Real FX vs USD | +| 100% | 40% | +| 80% | 20% | +| 60% | 0% | +| 40% | -20% | +| 20% | -40% | +| 0% | -60% | + +This meant that holders of yen‐denominated assets saw their holdings lose a significant amount of value. The following charts compare the returns of yen bonds to dollar bonds, and yen currency to USD currency. In both cases, yen holdings lost more than half of the value. This is not dissimilar to a default. + +| JAPAN VS USA | | +| ------------------ | -------------------------------- | +| UNHEDGED BOND DIFF | Cumulative Returns (Idx to 2001) | +| 50% | 25% | +| 25% | 0% | +| 0% | -25% | +| -25% | -50% | +| -50% | -75% | +| -75% | | + +1950 1975 2000 2025 2000 2010 2020 + +3 0 9 + + + +--- + +# HOW COUNTRIES GO BROKE: THE BIG CYCLE + +This also has produced a deleveraging of Japanese government debt as measured in other currencies. Measured in dollars, debt service is down since 2001, a period with rapid government borrowing. Measured in gold, debt levels are down some 80%. + +| JAPAN CENTRAL GOVT DEBT LEVEL (JPY, TLN) | JAPAN CENTRAL GOVT DEBT LEVEL (USD, TLN) | +| ---------------------------------------- | ---------------------------------------- | +| 1400 | 14 | +| 1200 | 12 | +| 1000 | 10 | +| 800 | 8 | +| 600 | 6 | +| 400 | 4 | +| 200 | 2 | +| 0 | 0 | + +1975 1985 1995 2005 2015 2025 1975 1985 1995 2005 2015 2025 + +# JAPAN CHANGE IN PUBLICLY HELD DEBT IN USD AND GOLD + +| Metric | % Change Since 2001 | Level (2001) | Level (2023) | +| --------------------------- | ------------------- | ------------ | ------------ | +| Δ in Total Debt (USD) | 30% | 4.3 Tln | 5.6 Tln | +| o/w Δ in Debt (JPY) | 48% | 504 Tln | 748 Tln | +| o/w Δ in Spot vs USD | -12% | 117 | 133 | +| Δ in Debt Service (USD) | -16% | 0.8 Tln | 0.6 Tln | +| o/w Δ in Debt Service (JPY) | -4% | 88 Tln | 85 Tln | +| o/w Δ in Spot vs USD | -12% | 117 | 133 | +| Δ Total Debt (Gold) | -82% | 16 Bln | 3 Bln | +| o/w Δ in Debt (JPY) | 48% | 504 Tln | 748 Tln | +| o/w Δ in Spot vs Gold | -88% | 31 Thous | 262 Thous | + +Debt and debt service in foreign FX and gold falls. Sub-components for each category are multiplicative, i.e., sum geometrically. + +Dynamic 4: Domestic savers are similarly taxed, though to a lesser degree because, even though their buying power abroad decreases, it’s not as bad domestically. + +--- + + +# T H E J A PA N E S E C A S E A N D T H E L E S S O N S I T P R OV I D E S + +We’ll look at this point through two lenses: + +- Holders of Japanese government debt without the currency exposure have done OK, even while the assets have done quite badly in dollar terms. + +| JAPAN 10YR CUMULATIVE REAL RETURN | | JAPAN 10YR REAL RETURNS IN USD | | +| ------------------------------------------------------------------------------------------------------- | ---- | --------------------------------------------------------------------------------- | ---- | +| Idx to 2001 | 50% | Idx to 2001 | 25% | +| 25% | 0% | 0% | -25% | +| -25% | -50% | -50% | -75% | +| JPN hedged bond returns have been decent since 2001, with a notable worsening since COVID-era inflation | -75% | However, JPN bond returns have been very poor in USD terms, especially since 2013 | | +| 1980 | 2000 | 2020 | | + +- Japanese households have seen muted inflation over the period (discussed in more depth previously). The weak economy has kept the currency declines from translating into much domestic inflation. + +| JAPAN PRICES (IDX TO 2001) | | | +| ------------------------------------------------------------------------------------------------------------ | ------------- | ------------ | +| CPI | Import Prices | Services CPI | +| Import prices rose as the yen devalued, but that was offset by low domestic price growth (like services CPI) | 20% | 10% | +| 0% | -10% | -20% | +| Tradables/imports rose in price; domestic goods stayed steady, keeping a lid on domestic inflation | | | +| 2000 | 2010 | 2020 | + + +--- + + +H O W C O U N T R I E S G O B R O K E : T H E B I G C YC L E + +# Dynamic 5 + +The country gets more competitive as both assets and factors of production get cheaper. In the next charts, note how just about everything in Japan became much cheaper and how that attracted FDI inflows. + +# JAPAN HOME PRICES + +IN USD (IDX TO 2001) + +| | 50% | 25% | 0% | -25% | -50% | -100% | +| ---------------------------------------------- | ---- | ---- | -- | ---- | ---- | ----- | +| Home prices in USD have fallen considerably... | | | | | | | +| 1980 | 2000 | 2020 | | | | | + +# JAPAN PROD-ADJ WAGES + +IN USD (IDX TO 2001) + +| | 50% | 25% | 0% | -25% | -50% | +| ---------------- | ---- | ---- | -- | ---- | ---- | +| ...as have wages | | | | | | +| 1980 | 2000 | 2020 | | | | + +# JAPAN FDI INFLOWS (% GDP) + +While still low in level terms, FDI has increased since 2013, consistent with JPN getting more competitive. + +| | 1.00% | 0.75% | 0.50% | 0.25% | 0.00% | -0.25% | +| ---- | ----- | ----- | ----- | ----- | ----- | ------ | +| 1990 | 2000 | 2010 | 2020 | | | | + +3 1 2 + + +--- + + +# T H E J A PA N E S E C A S E A N D T H E L E S S O N S I T P R OV I D E S + +Asset valuations have mirrored this as well. Japan went from one of the more overvalued markets (at least as measured by imperfect statistics like P/Es) to inexpensive relative to the US. + +| FWD P/E | JPN | USA | EUR | GBR | CAN | AUS | +| --------------------------------------- | --- | --- | --- | --- | --- | --- | +| ![FWD P/E Chart](chart_placeholder.png) | | | | | | | + +Starting in 2013, equities began cheapening relative to other developed countries, but that has started to reverse in the past few years. + +| FWD P/E (MORE RECENT HISTORY) | JPN | USA | EUR | GBR | CAN | AUS | +| ----------------------------------------------------------- | --- | --- | --- | --- | --- | --- | +| ![FWD P/E More Recent History Chart](chart_placeholder.png) | | | | | | | + +Start of QE + +3 1 3 + + + +--- + + +H O W C O U N T R I E S G O B R O K E : T H E B I G C YC L E + +# APPENDIX: JAPAN’S BIG DEBT CYCLE IN A FEW CHARTS + +As with China, we’ll end this chapter with charts that are more zoomed out, which helps show the Big Cycle transpiring over many decades. + +The first chart shows Japan’s Big Debt Cycle in the form of the government’s debt‐to‐GDP ratio going back to 1900; that way you can see two Big Cycles, though we will focus on the second. + +| GOVT DEBT (% GDP) | Recession | Government Debt | 1990 IMF Projection | +| ---------------------------------------------------------------------- | --------------------------- | ------------------- | ------------------- | +| Major War | Government Debt (Rough Est) | 2024 IMF Projection | | +| ![Chart showing Japan's government debt to GDP ratio](chart_image.png) | | | | +| JPN effectively defaults on wartime debt | | | | + +The next chart shows the amount of central government debt service as a percent of the amount of revenue the government took in. In it, you can see the debt busts that happened when it exceeded 150%, and you can see how, in recent years, it has risen toward—but stayed below—150%. + +3 1 4 + + +--- + + +# T H E J A PA N E S E C A S E A N D T H E L E S S O N S I T P R OV I D E S + +# JAPAN ESTIMATED GOVT DEBT SERVICE (% REVENUE) + +| Total | o/w Principal | o/w Interest | +| ------------------- | ------------- | ------------ | +| 1990 Fwd Projection | | | +| 2024 Fwd Projection | | | + +# Graph Data + +400% + +350% + +300% + +250% + +200% + +150% + +100% + +50% + +0% + +1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010 2020 2030 + +I will now shift to a post‐1950 perspective. Through these charts, you can see how the last couple of decades are best characterized by “pushing on a string,” with nominal rates falling below 0%, real rates a bit negative,⁴⁸ large amounts of money printing, and the yield curve just slightly upward‐sloping. Corporate spreads have stayed low (for perspective, as of this writing, they are around 1% in the US and 0.6% in Japan for Baa‐rated companies). All of these are characteristics of very stimulative monetary policy, especially in the last decade or so. Despite the stimulative policy, inflation has remained much lower than policy makers have generally desired, slipping in and out of deflation. + +⁴⁸ I am showing real yields since the creation of the Japanese inflation‐linked bond market in 2004. Prior to this, I am showing an estimate of real yields based on nominal yields and an estimate of market 10‐year inflation expectations. + +3 1 5 + + + +--- + +# HOW COUNTRIES GO BROKE: THE BIG CYCLE + +# JPN 10Yr Bond Yield JAPAN REAL YIELD + +| | Inflation (3Yr Moving Average) | Real Yield | Real Yield Est | +| --- | ------------------------------ | ---------- | -------------- | +| 2% | 18% | 8% | | +| 16% | | 6% | | +| 14% | 4% | | | +| 12% | 2% | | | +| 10% | 0% | | | +| 8% | | | | +| 6% | | | | +| 4% | | | | +| 2% | | | | +| 0% | | | | + +# JAPAN RATES (ESTIMATED AND ACTUAL) + +| Nominal Rate | BEI | JPN Short-Term Interest Rate | +| ------------ | --- | ---------------------------- | +| Real Yield | 2% | | +| 16% | 20% | 140% | +| 120% | 12% | 15% | +| 100% | 8% | 10% | +| 80% | 60% | 4% | +| 5% | 40% | 0% | +| 0% | 20% | 0% | + +49 We show rough estimates of the real yield and breakeven inflation rate (using surveyed inflation expectations and recent inflation) for periods when those were unobservable because inflation-linked bond markets did not exist. + +50 Id. + +--- + +# THE JAPANESE CASE AND THE LESSONS IT PROVIDES + +# JAPAN YIELD CURVE + +# JAPAN BAA CORPORATE SPREADS + +| | 3M Minus 10Yr | 3M Divided by 10Yr | +| --- | ------------- | ------------------ | +| 8% | 200% | 3.5% | +| 4% | 150% | 2.5% | +| 0% | 100% | 2.0% | +| -4% | 50% | 1.5% | +| -8% | 0% | 1.0% | +| | | 0.5% | +| | | 0.0% | + +Highly stimulative policy comes with risks. So far, the BoJ has remained profitable: the bonds it’s bought (with printed money) haven’t seen big sell-offs, and the interest it’s had to pay on excess reserves has remained quite low (because of low short-term interest rates). But if rates rise, the BoJ will become significantly unprofitable, fast. That recently happened to the Federal Reserve, producing moderate but manageable losses—up to 0.5% of GDP. But with the BoJ’s monetary base at around 5x the Fed’s, losses could be much more meaningful. + +# JAPAN ESTIMATED CENTRAL BANK PROFIT (% GDP) + +| | 0.8% | +| ---- | ----- | +| | 0.4% | +| | 0.0% | +| | -0.4% | +| | -0.8% | +| 1950 | | +| 1970 | | +| 1990 | | +| 2010 | -1.2% | + + +--- + + + +# T H E J A PA N E S E C A S E A N D T H E L E S S O N S I T P R OV I D E S + +NOTE: MY FAILURE TO COVER A LOT + +While it might seem like I covered a lot in this review of the period since 1945, what I left out was vastly greater than what I included. While I briefly looked at what happened in the United States, China, and Japan, I showed virtually nothing of what happened in the other developed powers (e.g., European powers) and Middle Eastern countries, and I barely mentioned most emerging countries, also known as the Global South (which includes many countries in Asia, Africa, Latin America, and Oceania). They all had and are having their Big Cycles. I am excited to say that with AI I am beginning to get my head around it all, and I have reason to believe that my digital self will evolve way beyond me to make sense of all these Big Cycles and communicate with you about them. (By the way, if you are interested in communicating with my digital self, you can receive updates on this AI initiative on my social media and by signing up at principles.com.) + +Of the many countries I haven’t been able to mention, it is worth taking a moment to look at rising countries with strong fundamentals (as reflected in my strength gauge that consists of 18 measures), like India, ASEAN countries (such as Singapore, Indonesia, and Vietnam), the UAE, and Saudi Arabia, which have benefited by being neutral vis-à-vis the power conflicts. A number of them are at take-off points in their developmental cycles because their people, governance systems, and capital markets are approaching being capable of competing in ways that they couldn’t previously. Also, the conflicts between the United States and China are making the United States and China less desirable, which is driving capital, businesses, and talented individuals to these places. If you want to look at them more closely, I recommend that you look at my Country Power Index that summarizes the conditions and prospects of the top 24 countries. They are available for free at economicprinciples.org. + +3 1 9 + + + +--- + +# PART IV + +--- + +# LOOKING AHEAD + +--- + + +# Part IV + +The first three parts of this book outlined the Big Debt Cycle based on my research of history and showed its mechanics in concepts, numbers, and historical examples. This final part, Part IV, applies the template to the present day, including my financial health and risk measures for central governments and central banks (Chapter 17) and my recommended solutions for the US given its current debt projections and pending problems (Chapter 18). Then, to conclude the book, I attempt to look into the future using my previously described template for how the machine works, taking into consideration the current and projected conditions of all the major forces that together make up the Overall Big Cycle. (Chapter 19). + +--- + + +# CHAPTER 17 + +# WHAT MY INDICATORS SHOW + +In making my assessments of risks, I weigh a number of factors, many of which I have described and the most important of which are shown in the following table. The table shows these indicators across major countries as of my writing this in March 2025. Though they aren’t all of my indicators and they are not enough to convey the whole picture, they paint a good enough picture. Think of this table as a dashboard that paints a rough, current picture of health in order to assess central government and central bank long‐term debt risks. In addition to showing risks from existing and projected debt and debt service levels, it includes measures of whether a country has a reserve currency because being a reserve currency country̶i.e., having one’s currency widely accepted around the world as both a medium of exchange and a storehold of wealth̶is a great risk mitigator, especially if the country is a good place to invest, as is currently the case for the US and its money and debt. + +By looking at the indicators in the table, you can get a pretty good picture of what a country’s debt risks are. You can see that the US has very large central government debts (which is a big risk) and low liquid savings/reserves (which means it has little protection from its debts), but its currency is the dominant world reserve currency (which is a... + +--- + + +# HOW COUNTRIES GO BROKE: THE BIG CYCLE + +great mitigator of the risk), which the US is undermining by a number of things it is doing (which I won’t reiterate because it would be too much of a digression). From all this, you can see that its financial well-being hinges on maintaining its existing reserve currency status. + +You can also see that the Japanese central government has very large debts (which is a big risk) that are denominated in its currency (which mitigates the risk) and relatively large FX reserves (which reduces the risk). You can see that China has relatively big debts (which is risky), its debts are denominated in its own currency (which is risk-mitigating), it has relatively big reserves (which are risk-mitigating), it has a currency that is not widely accepted around the world as a storehold of wealth (so there isn’t much support from that), and the attraction of and usage of its capital markets by foreign investors—while they were moderately large—are falling fast (which lessens the protection it would get from having more). + +You can also see that Singapore, Norway, and Saudi Arabia currently have good income statements and balance sheets that have much more in liquid assets than they have in debts, and you can get that sort of picture for the other countries shown. + + + +--- + +ASSESSING CENTRAL GOVERNMENT AND CENTRAL BANK LONG-TERM DEBT RISKS: GOVERNMENT DEBT + +| | JPN | USA | BRZ | GBR | CAN | SAF | TUR | EUR | CHN | IND | MEX | KOR | AUS | SWE | CHE | NOR | RUS | SAR | SGP | +| ------------------------------------------ | ----- | ---- | ---- | ---- | ---- | ---- | ---- | ---- | ---- | ---- | ---- | ---- | ---- | ---- | --- | ---- | --- | --- | ---- | +| Govt Assets vs Govt Debt (% Ctry GDP) | -183% | -96% | -70% | -87% | -45% | -59% | -22% | -76% | -63% | -40% | -27% | -15% | -21% | -22% | 84% | 383% | 19% | 94% | 108% | +| Govt Debt (% Ctry GDP) | 215% | 99% | 81% | 92% | 50% | 73% | 26% | 85% | 90% | 56% | 40% | 49% | 35% | 32% | 15% | 14% | 14% | 26% | 177% | +| Govt Debt 10Yr Fwd Projection (% Ctry GDP) | 214% | 122% | 114% | 101% | 53% | 79% | 15% | 87% | 112% | 67% | 36% | 40% | 40% | 26% | 12% | 0% | 15% | 47% | 158% | + +# WHAT MY INDICATORS SHOW + +| 2% | - | - | NO | - | +| --- | --- | --- | --- | --- | +| 0% | 16% | 11% | YES | - | +| - | - | - | YES | 4% | +| 0% | 6% | 8% | NO | 0% | +| 0% | 11% | 3% | NO | 2% | +| 7% | 18% | 7% | NO | 2% | +| 11% | 8% | 15% | NO | 3% | +| 1% | 38% | 10% | NO | 5% | +| 0% | 28% | 12% | YES | 16% | +| 4% | 48% | 3% | NO | 42% | +| 1% | 87% | 2% | NO | 3% | +| 30% | 41% | 14% | NO | 8% | +| 0% | 16% | 9% | YES | 15% | +| 1% | 51% | 22% | YES | 18% | +| 9% | 16% | 25% | NO | 7% | +| 23% | 45% | 24% | NO | 8% | +| 21% | 52% | 8% | NO | 38% | +| 13% | 57% | 29% | NO | 22% | +| 92% | 96% | 27% | NO | 8% | + + + +--- + + +ASSESSING CENTRAL GOVERNMENT AND CENTRAL BANK LONG-TERM DEBT RISKS + +# H O W C O U N T R I E S G O B R O K E : T H E B I G C YC L E + +| | JPN | USA | BRZ | GBR | CAN | SAF | TUR | EUR | CHN | IND | MEX | KOR | AUS | SWE | CHE | NOR | RUS | SAR | SGP | +| ----------- | --- | --- | --- | --- | --- | --- | --- | --- | --- | --- | --- | --- | --- | --- | --- | --- | --- | --- | --- | +| FX Reserves | 32% | 3% | 11% | 5% | 5% | 14% | 4% | 9% | 20% | 16% | 13% | 23% | 4% | 11% | 99% | 17% | 33% | 40% | 84% | + +| | 201% | 353% | 19% | 0.6% | 0.0% | 0.3% | 0.0% | | | | +| ---- | ---- | ---- | ----- | ----- | ----- | ----- | ---- | - | - | - | +| 80% | 89% | 5% | 0.5% | 0.0% | 0.0% | 0.0% | | | | | +| | 233% | 5% | 0.9% | 0.0% | 0.1% | 0.0% | | | | | +| 380% | 323% | 21% | 0.5% | 0.0% | 0.1% | 0.0% | | | | | +| | 300% | 7% | 1.2% | 0.4% | 1.9% | 0.0% | | | | | +| | 322% | 6% | 0.6% | 0.0% | 0.7% | 0.0% | | | | | +| 12% | 219% | -1% | 1.7% | 0.7% | 1.5% | 2.0% | | | | | +| 11% | 325% | 3% | 0.9% | 0.3% | 0.9% | 0.0% | | | | | +| | 130% | -1% | 0.8% | 0.2% | 0.2% | 0.0% | | | | | +| | 181% | -2% | 0.4% | 0.3% | 1.9% | 0.0% | | | | | +| 7% | 289% | 2% | 3.6% | 1.0% | 5.9% | 2.0% | | | | | +| | 169% | 2% | 15.4% | 10.4% | 6.5% | 20.0% | | | | | +| | 167% | -6% | 0.7% | 0.2% | 0.1% | 0.0% | | | | | +| | 139% | -1% | 0.4% | 0.0% | 0.3% | 0.0% | | | | | +| | 377% | -1% | 1.8% | 1.3% | 2.6% | 3.0% | | | | | +| | 258% | -2% | 9.2% | 1.5% | 3.0% | 5.0% | | | | | +| | 181% | -2% | 0.9% | 0.2% | 0.4% | 0.0% | | | | | +| | 340% | -4% | 52.6% | 80.7% | 65.7% | 57.0% | | | | | +| | 486% | 4% | 2.6% | 1.5% | 4.7% | 6.0% | | | | | + +| GDP) | 3Yr | Account | FX) | Central | Global | FX) | +| ---- | ----- | ------- | ----- | ------- | -------- | ----- | +| Ctry | GDP) | | Trade | Ctry | External | Debt | +| (% | World | of | Debt | of | World | World | +| (% | (% | (% | (% | (% | (% | (% | + + + +--- + + +# WHAT MY INDICATORS SHOW + +I aggregate indicators into models designed to show the risks and rewards of things happening. + +# LONG-TERM AND SHORT-TERM INDICATORS OF THE RISKS FOR CENTRAL GOVERNMENTS AND CENTRAL BANKS + +Using the above and other previously described indicators, I measure both long-term risks (which I view like measuring the long-term risks of having a heart attack) and short-term risks (like measuring the heart attack actually happening and its damage) for both central governments and central banks. While short-term risks are often due to long-term vulnerabilities becoming manifest in sudden problems (like a person at long-term risk of having a heart attack actually having a heart attack), this isn’t always the case. For example, a pandemic (like COVID) could happen, or a war could break out, even if the underlying long-term vulnerabilities are low, which would lead to greater short-term risks that will show up in this risk gauge rising. My measures of both the long-term and the short-term risks for the US are shown in the charts that follow. Please know that while these are good indicators, they, like most leading indicators of someone having a heart attack, are very imprecise for previously explained reasons. + +# THE US CENTRAL GOVERNMENT’S DEBT RISKS + +The next chart on the left shows my measure of the US government’s long-term debt risks, and the one on the right shows my measure of the US government’s short-term risks going back to 1900. At this time, I judge the long-term risks of US government debt to be very high because the current and projected levels of US government debt and debt service, and sales of new debt and debt to + + + +--- + + +H O W C O U N T R I E S G O B R O K E : T H E B I G C YC L E + +be rolled over, are the highest ever and there are big debt rollover risks ahead. In fact, I judge the US government’s debt situation to be nearing the point of no return. By that, I mean that the debt and debt service levels are nearing those that cannot be reduced without great losses to debt investors because at such levels a self-reinforcing debt “death spiral” occurs due to the need to borrow to service debt and due to interest rates rising because the risks of holding the debt/currency become apparent. At the same time, I judge the short-term risks to be low because inflation and growth are relatively moderate, credit spreads are low, real interest rates are high enough for lender-creditors without being too high for borrower-debtors, and the private sector’s income statements and balance sheets are in relatively good shape—good enough to tax if that is needed to help the central government’s finances. However, if the demand for new debt sales and debt rollovers falls off and/or there is the selling of debt assets, that would quickly raise the short-term risk gauge. By the way, this gauge can change very quickly—e.g., overnight. + +# USA Long-Term Government Risk Gauge + +# USA Short-Term Government Risk Gauge + +| Current Reading (100%) | Current Reading (0%) | +| ---------------------- | -------------------- | +| 100% | 100% | +| 80% | 80% | +| 60% | 60% | +| 40% | 40% | +| 20% | 20% | +| 0% | 0% | + +1900 1950 2000 1900 1950 2000 + +Next is a table showing some of the most important readings that feed into my long-term risk rating for the US central government. It’s measured in Z-scores, or standard deviations above/below the mean. All you need to know is that above 2 is quite bad. + +3 3 0 + + + +--- + + +# WHAT MY INDICATORS SHOW + +# USA LONG-TERM RISK GAUGE CONSTRUCTION + +(UP = MORE VULNERABLE) + +| Central Government Long-Term Risk | - 2.4z | | | +| ---------------------------------------------------- | --------------------------------------------------------- | ---- | ----- | +| Current Borrowing Need | - 2.4z | | | +| Current Borrowing Need (% Revenue) | | 39% | 2.3z | +| Current Borrowing Need, If Roll Problems (% Revenue) | | 239% | 2.5z | +| Projected Borrowing Need | - 2.8z | | | +| 10Yr Forward Borrowing Need (% Revenue) | | 44% | 2.8z | +| | 10Yr Forward Borrowing Need, If Roll Problems (% Revenue) | 254% | 2.9z | +| Share of Debt in Own Currency | | 100% | -2.0z | + +In short, it appears to me that there is a very high long-term risk of a US central government debt crisis of the sort I have been describing, but currently there is a very low imminent risk of that problem happening. + +# THE US CENTRAL BANK’S DEBT RISKS + +The following charts show my gauges of the long-term and the short-term risks of the Federal Reserve. While the long-term risk gauge is now higher than it has almost ever been because a) the + +51 This central bank risk gauge is based on timeless and universal principles developed from looking at many countries over long periods of time. It is based on: + +1. How big the central bank’s exposures are. +2. The size of the balance sheet and the vulnerability of its cash flows to interest rate changes, with consideration given to how profitable or unprofitable the central bank is today and how unprofitable it would be if interest rates changed adversely. +3. How strong the balance sheet is, e.g., how close the central bank is to running out of reserves (i.e., the number of months the central bank could sustain the current pace of reserve sales before running out). +4. The value of the debt/currency as a storehold of wealth. Based on logic and empirical evidence, countries’ reserve currency statuses and track records of producing good outcomes make them more attractive to investors and therefore less risky. +5. The shares in this country/currency of world reserves, world trade, world capital flows, and world capital markets. + + + +--- + + +# HOW COUNTRIES GO BROKE: THE BIG CYCLE + +amounts of government debt held by the Fed are high, b) the losses taken by the Fed are the highest they have ever been, and c) the Fed has a poor net worth, these numbers are currently not large. So right now, the long-term risk is small but is in a place where it could accelerate very quickly. And, as of now, I measure the Fed’s short-term risks to be relatively low because the US economy and markets are near their equilibrium levels. More specifically, while the reading is moderately bad relative to what it has been in the past, owing to a large balance sheet with few hard assets to back it up (with limited cash flow losses), it is not yet significant because the numbers remain very manageable and are nowhere near the levels that proved to be problematic for central banks in other countries in which the central bank problem became severe and led to a self-reinforcing downward spiral. Also, a) neither high and quickly rising inflation nor deflation and falling prices are a problem, b) the Fed is not actively monetizing debts but rather is slowly shrinking its debt holdings, and c) the Fed isn’t encountering currency changes that are so large that they would affect inflation and growth enough to affect its monetary policy. + +| USA Central Bank Long-Term Risk Gauge | Current Reading (46%) | 100% | +| -------------------------------------- | --------------------- | ---- | +| USA Central Bank Short-Term Risk Gauge | Current Reading (0%) | 100% | +| | | | +| 1900 | 1950 | 2000 | +| 1925 | 1950 | 1975 | +| 2000 | 2025 | | + +In fact, the US economy would at this moment in time appear to be in an excellent equilibrium level judging by its levels of growth, inflation, real interest rates, and central bank debt monetizations, which can create the mistaken impression that all is now good. But + +3 3 2 + + + +--- + +# WHAT MY INDICATORS SHOW + +All is not good because there is the government debt supply-and-demand picture, which we’ve discussed, that is growing like a cancer, and the Fed’s existing balance sheet has losses that would rise if interest rates rose, leading to its capital falling in a debt crisis. Besides increasing the financial risks, such a confluence of events would increase the risk to the Fed’s independence because the Fed’s actions would be put under greater political scrutiny, which, if confidence in the Fed’s independence is undermined, would likely contribute to a negative reinforcing cycle because the confidence in the value of money being maintained would be undermined. At this time, we are a relatively long way from that. The two things that we should expect not to happen but if we see them happen should be viewed as big red flags that are signaling that the real value of money and debt are at great risk are 1) another round of quantitative easing to increase liquidity and force real interest rates down and 2) the central government gaining control over the central bank. + +# Table of Important Inputs to Long-Term Risk Rating for the US Central Bank + +| Central Bank Income Statement | Balance Sheet Vulnerability | +| ----------------------------------------------- | --------------------------------------- | +| Not particularly bad | About as vulnerable as it has ever been | +| Large amount of money (74% of GDP) | Small amount of reserves (3% of GDP) | +| Unprofitable, but magnitude is relatively small | | + +Also, as shown in the table, the United States has the world’s dominant reserve currency, its capital markets are dominant, and the dollar has been a mediocre storehold of wealth. When I net these factors, I see the US as a good storehold of wealth, which reduces long-term risk. Having said that, it should be noted that these supports can deteriorate very quickly as they did for prior world powers and their currencies. For a review of the declines of the British pound and the Dutch guilder before it, please reference my book *Principles for Dealing with the Changing World Order* at economicprinciples.org. + +--- + + +# HOW COUNTRIES GO BROKE: THE BIG CYCLE + +# LONG-TERM RISK GAUGE CONSTRUCTION + +(UP = MORE VULNERABLE) + +| Indicator | Reading | Today | +| ------------------------------------------------ | ------- | ----- | +| Central Bank Long-Term Risk | - | 1.0z | +| Central Bank Income Statement | - | 0.2z | +| Current Central Bank Profitability (% GDP) | -0.2% | 0.1z | +| Central Bank Profitability If Rates Rise (% GDP) | -0.4% | 0.2z | +| Central Bank Balance Sheet | - | 1.0z | +| Unbacked Money (% GDP) | 71% | 0.3z | +| Reserves/Money | - | 1.5z | +| Months of Reserve Sales Before Running Out | - | 0.0z | +| Currency Is Bad Storehold of Wealth Gauge | - | -2.0z | +| Reserve FX/Financial Center | - | -3.3z | +| Share of Reserves in Currency | 57% | -1.9z | +| Financial Center Status (Z) | - | -2.7z | +| Safety and Stability for Investors | - | -0.8z | +| Institutional Quality | - | -1.2z | +| Rule of Law (Z) | - | -1.1z | +| Internal Conflict (Z) | - | 0.3z | +| Macroeconomic Track Record | - | -1.2z | +| Volatility of Growth (Ann) | 2.2% | -0.8z | +| Volatility of Inflation (Ann) | 1.4% | -2.1z | +| Long-Term GDP Per Capita Growth | 1.5% | 0.0z | +| History of Losses for Savers | - | 1.1z | +| Long-Term Real Cash Return (Ann) | -1.4% | 0.7z | +| Long-Term Gold Return (Ann) | 9.8% | 0.8z | + +Please keep in mind that these indicators only reflect the debt/financial part of the picture and not the complete picture, and that the other big forces will have a great impact on this picture just as this picture will have a big impact on the other forces (i.e., domestic conflict, international conflict, acts of nature, and technology changes), so what we don’t know is very large relative to what we do know. + +3 3 4 + + + +--- + +# CHAPTER 18 + +# MY 3% 3-PART SOLUTION + +This chapter is a quick and easy read for those who want to get the key points without spending too much time. It also provides thoughts and numbers that those who are analytical might want to spend some time pondering, so I recommend it for everyone. + +I want to make this clear and easy to remember. If you keep in mind the number 3, that will help you remember that: + +- The budget deficit should be cut to 3% of GDP (from what it is currently projected to be by the CBO, about 6% of GDP), and +- These cuts can come from 3 sources (spending cuts, tax increases, and interest rate cuts, with interest rate cuts being the most impactful). + +If the president and those in Congress agree that they need to do that, and they agree on a bipartisan backstop approach to doing that (I will suggest an option), they will achieve the goal of greatly reducing the odds of the US government going broke. + +That’s it in a nutshell. I will now explain. + +--- + + +H O W C O U N T R I E S G O B R O K E : T H E B I G C YC L E + +# THE PICTURE AS I SEE IT + +It appears to me that: + +1. Policy makers who are working on getting the debt issue under control (some have given up on the idea) are approaching the problem from the bottom up, by which I mean by working on which spending cuts and/or which tax increases are better than others, rather than working from the top down, by which I mean by looking at how much it will take in total to meet the goal, then looking at the three big levers that government policy makers can pull to reduce the deficit (i.e., spending cuts, tax increases, and interest rate reductions), and finally deciding which spending cuts, which tax increases, and which interest rate changes to make. +2. Policy makers are so tied up in arguing about the particulars in order to get exactly what they want that they have made the likelihood of a disastrous outcome—either not limiting the debt or having a bad government shutdown—much greater than the likelihood of an attainable good outcome. + +To tackle this problem, I believe that they should: + +1. Work from the top down, by which I mean agree on the size of the cuts to the deficit and the size of the deficit as a percentage of GDP that need to be made to stabilize the debt. +2. Agree on a fallback plan that achieves the necessary budget cuts that would automatically happen if they can’t reach agreement on the particulars. This fallback plan could be something like equal percentage cuts to all spending that can be cut and equal percentage increases on all taxes that can be increased so that combined they will achieve the goal if they can’t agree on anything else, so they will be assured of having a deal. Then, they can go on and try to create a plan that they can agree is better than that one. + +I will now propose a fallback plan that policy makers should be able to agree on. + +3 3 6 + + + +--- + + +# MY 3% 3-PART SOLUTION + +# WHAT MY 3% 3-PART SOLUTION LOOKS LIKE + +The following chart shows the US debt level as a percentage of government revenue. The current debt trajectory is shown with the blue dashed line, and based on how I understand the mechanics to work and on indicators of what is most likely to happen, it appears to me that to prevent the central government from going broke, policy makers have to change the government debt level trajectory to the green dashed line. Changing that trajectory will require some cut in spending, and/or some increase in tax revenue, and/or some cut in the interest rate on the debt such that these three moves in total will add up to cutting the deficit down to 3% of GDP. Such a deficit cut would lead to the debt burden being about 17% lower in 10 years than it would be if the US were to continue on its currently projected path (which amounts to debts being $9 trillion lower in 10 years). In 20 years, my 3% 3-part solution would make government debt 31% lower, which is $26 trillion lower. Doing that would greatly reduce the risks of the central government, those who are lending to it, and all those who would also be affected by a big debt issue from suffering a “heart attack.” + +# USA CENTRAL GOVT DEBT LEVEL (% GOVT REVENUE) + +| Current Path (CBO) | 3% Plan | +| ------------------------------------------------------------------------------------------- | ------- | +| ![Chart showing US debt level as a percentage of government revenue](chart_placeholder.png) | | +| 800% | | +| 700% | | +| 600% | | +| 500% | | +| 400% | | +| 300% | | +| 200% | | +| 100% | | +| 0% | | +| 1960 | | +| 1970 | | +| 1980 | | +| 1990 | | +| 2000 | | +| 2010 | | +| 2020 | | +| 2030 | | + +There are three main types of levers that can be pulled to control the deficit, and in Chapter 3 I showed tables that conveyed the effects of pulling them. To achieve the goal of stabilizing debt + +# 3 3 7 + + + +--- + + +# HOW COUNTRIES GO BROKE: THE BIG CYCLE + +relative to income, it would take about an 11% increase in taxes, about a 12% cut in spending, or about a 3% cut in interest rates, all else equal, if just one lever were used alone. Of course, any one of these numbers alone is way too large, so managing the adjustment will require a good combination of two or three of them. + +Let’s look more closely at those numbers, which are interesting because they show how much more powerful a change in interest rates would be than a change in taxation. For instance, interest rates falling by 1% is about four times more effective at reducing the debt-to-income ratio over the next 20 years than a 1% increase in tax revenue. The numbers also show how much more powerful a change in taxation would be than a change in spending—a 1% increase in tax revenue is 1.2x more effective than a 1% reduction in spending over the same 20-year time frame. But these estimates of the direct effects understate what the total effects are likely to be after accounting for the likely secondary effects. More specifically, a cut in interest rates is even more powerful than the estimate I gave you because, besides lowering government debt service payments, interest rate cuts would boost asset prices, which would raise capital gains tax receipts and be stimulative to the economy, and raise inflation, which would raise tax revenues. It’s also worth noting that 1) the second-order effects of cutting spending would be negative for economic activity and thus negative for income taxes and 2) the second-order effects of raising taxes would also be negative because of the reduction in spending and economic growth. + +In other words, there are two important takeaways. First, the biggest influence on the government’s deficit is ironically not Congress, which determines spending and taxes—it is the Federal Reserve, which determines interest rates. Second, while trimming the budget deficit and cutting interest rates each reduces the debt problem, they would have offsetting effects on economic growth, inflation, and taxes. This means that if these actions are balanced well, the budget deficit can be reduced significantly without creating unacceptable effects on the economy. + +Given that, if I were deciding for the president and/or Congress, I + + + +--- + + +# M Y 3 % 3 - PA R T S O L U T I O N + +would want the Federal Reserve to lower the interest rate. I expect that the president and Congress will pressure the Fed to do that, but, of course, Congress and the president don’t determine what the Fed does. If I were on the Federal Reserve Board of Governors, I would be willing to work with the president and Congress to implement such a plan because a fiscal tightening (which would have the first-order effects of reducing the deficit and being negative for economic growth and inflation) in conjunction with a monetary easing (which would also be deficit-reducing while being positive for economic growth and inflation) looks like a great plan. It is obvious that a fiscal tightening with a monetary easing would be a good thing. In fact, if Congress and the president enacted a significant deficit reduction, it would trigger a rally in bonds and a decline in interest rates that would help reduce the deficit. Some people worry about a cut in the fiscal deficit of that size being too negative on the economy, but that’s not my worry because if the fiscal tightening were too negative on growth and inflation, it would trigger a monetary easing to rectify that. So, what’s the problem with cutting spending and raising taxes other than the political problem of anger from those who are getting less money from spending or who are paying more in taxes? I don’t see it. + +A fiscal tightening with a monetary easing makes financial and economic sense because the biggest imbalance that now exists that should be rectified is between the central government’s finances (it has dangerously too much debt and too much borrowing) and the private sector’s finances (which are in relatively good shape, particularly in the booming areas of the market and the economy). This state of affairs came about because the Fed helped to fund the large budget deficits that allowed the big spending and the central government’s debt problem to happen in the first place. So, the Fed cooperating to negate whatever pain that might come as a result of a large (3% of GDP) deficit cut would make sense, especially since the private sector has received lots of deficit-funded support, is now in pretty good shape, and could use some fiscal tightening, which the Fed could help manage with its monetary policy. It would bring private and public + + + +--- + + +# HOW COUNTRIES GO BROKE: THE BIG CYCLE + +sector Wnances into better balance. Who would suVer from the lower interest rate? While bond holders will get a lower real yield, they would beneWt from interest rates falling because bond prices would go up, plus they would get a safer bond. The world would celebrate such an accomplishment, both be - cause of the reduced US government debt risk and because it would demonstrate that the American political system can work well to solve at least this big problem. Also, other major markets like equities would beneWt from those changes. So, just about everyone other than special interest groups should like the immediate eVects of this plan. + +Let’s now play around with the numbers and these three levers to see what speciWc changes could get the 3% of GDP deWcit goal achieved by making the adjustments come roughly equally from spending cuts, taxes, and interest rate cuts. That would take about a 4% cut in spending, a 4% increase in taxes, and a 1% cut in real interest rates. That way, policy makers would spread out where they get the 3% of GDP from so it’s not too big for anyone, it’s pretty politically ag - nostic, and the depressing Wscal eVects would be oVset by the stimu - lative monetary eVects of the real interest rate cuts. That would be my solution to the problem with one possible modiWcation: because those amounts of cuts in spending and increases in taxes would cause abrupt changes, I would phase these changes in over three years. As men - tioned, I would try to make that a bipartisan fallback position to use if no other solution is reached because everyone would be relieved if policy makers could agree on an acceptable plan and negotiate the tweaks to it. + +# WHAT IF THE FED DOESN’T GO ALONG WITH THIS? + +Of course, the Fed can’t openly say that it will go along with this plan (though deals between the Fed keeping interest rates low while the government was cutting the deWcit have been made in the past), so let’s look at the possibility that Congress and the + + + +--- + + +# MY 3% 3 - PART SOLUTION + +The president will have to make the changes come only from spending cuts and raising tax revenue by the same percentages. That percentage would be about 6% (i.e., cutting spending by 6% and raising taxes by 6%), which would also equal about a 3% of GDP deficit reduction. While those amounts of adjustments would be large by historical standards, I know that they can occur without problems if balanced well and I know that if they are too depressing to economic growth, the Fed will respond by lowering interest rates because that’s what the central bank does when the economy and inflation are too depressed. For these reasons, I know that if this 3% 3-part plan is followed it would be worlds better than if it is not followed. + +# MY PROPOSED DEFICIT CUT COMPARED WITH PAST DEFICIT CUTS + +While many will say that these changes are draconian, my study of past deficit cuts leads me to believe that they are very manageable if monetary policy is managed sensibly at the same time. Phasing in my plan and assuming the Fed will run monetary policy sensibly would lead to the adjustment looking something like what is shown in the blue dashed line, which is very close to the original 3% plan (green line). + +# USA CENTRAL GOVT DEBT LEVEL (% GOVT REVENUE) + +| Current Path (CBO) | 3% Plan | 3% Plan (Phased In over 3 Yrs) | +| ------------------------------------------ | ------- | ------------------------------ | +| ![Debt Level Chart](chart_placeholder.png) | | | +| 800% | | | +| 700% | | | +| 600% | | | +| 500% | | | +| 400% | | | +| 300% | | | +| 200% | | | +| 100% | | | +| 0% | | | + + + +--- + + +# HOW COUNTRIES GO BROKE: THE BIG CYCLE + +However, I need to point out a fly in the ointment. As mentioned, the numbers I showed are based on the bipartisan Congressional Budget Office’s numbers. These numbers are based on the existing plan for the 2017 Trump tax cuts to roll off, so if they are extended as President Trump has promised to do, the deficit will be larger by an estimated 1.5% of GDP, so the deficit cut will have to be over 4% of GDP rather than about 3% to stabilize government debt-to-income. + +While such a budget deficit cut is large, it’s not very large by historical standards. The following table lists all major fiscal policy tightenings in all countries going back to 1960. It shows that big fiscal tightenings (3% of GDP or even much larger) went well if put into place when 1) growth was strong, 2) the monetary/currency policy was easy, and 3) debts were in currencies that the central bank could print. Notably, the fiscal tightening in these cases helped to lower bond yields, which reduced interest costs on the debt and encouraged private sector activity that raised taxes, and to the extent the fiscal tightening weakened the economy more than desired, it led to monetary easings that negated the fiscal tightening effects on the economy. + +The most successful US case of cutting the budget deficit happened in the 1993-98 period, which took the deficit from 4% of GDP to a surplus of 1% of GDP (a 5% of GDP improvement) over those years, which would be like cutting the deficit by $1.5 trillion today. My plan would cut the deficit by much less than that amount. + +My timeless and universal principle about this is: + +- When there are large government debts that are growing quickly so that large cuts to budget deficits are needed, the most important things to do are to 1) cut the deficit by enough to rectify the problem, 2) cut the deficit when economic conditions are good so the cuts are counter-cyclical, and 3) have monetary policy be stimulative enough to keep the economy strong in the face of such cuts. + + + +--- + + +# M Y 3 % 3 - PA R T S O L U T I O N + +# CASES WHERE SIGNIFICANT FISCAL ADJUSTMENTS WERE MADE + +| CASE DESCRIPTION | Median (All Cases) | Median (Painless) | Median (Painful) | +| ---------------- | ------------------ | ----------------- | ---------------- | +| Length | 4 | 5 | 4 | + +# FISCAL OUTCOMES + +| Chg in Primary Structural Deficit (% GDP) | Share from Revenue Increases | Share from Primary Spending Cuts | +| ----------------------------------------- | ---------------------------- | -------------------------------- | +| 5.7% | 59% | 41% | +| 5.4% | 59% | 41% | +| 6.3% | 54% | 46% | + +# MACROECONOMIC OUTCOMES (AVERAGE OVER ADJUSTMENT) + +| Growth vs Potential | UE Rate vs 10Yr Avg | Slack | Inflation vs Target\* | Avg Bond Yield vs Starting Level | +| ------------------- | ------------------- | ----- | --------------------- | -------------------------------- | +| -0.3% | 1.0% | -1.1% | -0.2% | -0.6% | +| 0.9% | 0.4% | -0.5% | -0.5% | -1.2% | +| -2.3% | 2.6% | -1.7% | 0.4% | 0.6% | + +# DETERMINANTS OF ECONOMIC OUTCOMES + +| | Did Country Have Significant Hard Currency Debts? | Did Fiscal Changes Occur into Strong Domestic or Global Economy? | Did Fiscal Changes Coincide with or Produce Easier Financial Conditions? | Did Fiscal Changes Include or Coincide with Big Productivity Enhancing Reforms? | +| - | ------------------------------------------------- | ---------------------------------------------------------------- | ------------------------------------------------------------------------ | ------------------------------------------------------------------------------- | +| | 10 of 40 Cases | 17 of 40 Cases | 25 of 40 Cases | 23 of 40 Cases | +| | 0 of 21 Cases | 17 of 21 Cases | 17 of 21 Cases | 10 of 21 Cases | +| | 10 of 19 Cases | 0 of 19 Cases | 8 of 19 Cases | 13 of 19 Cases | + +*Note for this and the following tables: before inflation targets were adopted, I use the trailing 10-year average inflation rate, bounded between 4.5% and 1.5%. + + + +--- + + +# CASES WHERE SIGNIFICANT FISCAL ADJUSTMENTS WERE MADE—PAINLESS CASES (1 OF 2) + +| CASE DESCRIPTION | BEL | ITA | SWE | DNK | IRE | NOR | CAN | GBR | NLD | AUS | +| ---------------- | --- | --- | --- | --- | --- | --- | --- | --- | --- | --- | +| 82-87 | 6 | 8 | 8 | 4 | 3 | 5 | 4 | 7 | 5 | 3 | +| FISCAL OUTCOMES | | | | | | | | | | | + +# H O W C O U N T R I E S G O B R O K E : T H E B I G C YC L E + +| 5.6% | 0.8% | -2.1% | | 0.4% | | 0.8% | | 3.9% | NO | YES | YES | YES | | | +| ----------- | ----- | ----- | ----- | ----- | ----- | ----- | ---- | ----------------- | --- | --- | --- | --- | -- | -- | +| -1.2% | -0.4% | 5.8% | 94% | 1.8% | 0.8% | -0.7% | NO | YES | YES | YES | | | | | +| 6% | 6.0% | -1.5% | -1.1% | 54% | 1.3% | 0.0% | 0.6% | 46% | NO | YES | YES | YES | | | +| -1.2% | 7.2% | 0.9% | -0.2% | 21% | 0.1% | 0.9% | 79% | NO | YES | YES | NO | | | | +| -1.0% | -2.5% | 7.3% | 2.9% | -2.2% | 2% | 98% | 0.7% | NO | YES | YES | NO | | | | +| -1.8% | -1.4% | 7.9% | 100% | 2.6% | -3.2% | NO | NO | YES | NO | | | | | | +| 0% | 100% | -6.6% | 9.6% | 0% | - | 0.6% | NO | NO | YES | NO | | | | | +| - | 10.2% | -1.6% | -0.2% | 100% | 1.1% | -2.7% | 0% | 3.6% | NO | YES | YES | YES | | | +| ADJUSTMENT) | 10.4% | -0.5% | -0.1% | -2.7% | 100% | 0.9% | 0.2% | NO | YES | YES | YES | | | | +| 0% | OVER | 10.6% | -0.3% | -1.8% | -3.4% | 0.8% | 1.6% | (AVERAGE OUTCOMES | YES | - | - | NO | NO | NO | + +# Cuts OUTCOMES Level + +GDP) ECONOMIC Productivity Increases Coincide Spending Significant Include (% Starting Occur or Dfct Debts? Easier Domestic Conditions? Revenue Reforms? + +# MACROECONOMIC DETERMINANTS + +Avg Potential Changes Changes Primary Target* OF Changes Struct vs Have Economy? w/Big 10Yr Yield Produce + +# Currency + +Prim Country Coincide from from vs vs vs Bond Strong Enhancing Fiscal Fiscal Fiscal Rate Inflation Financial in Growth Global Share or Chg Share Slack Avg Hard into with UE Did Did Did Did + +# 3 4 4 + + + +--- + + +# CASES WHERE SIGNIFICANT FISCAL ADJUSTMENTS WERE MADE—PAINLESS CASES (2 OF 2) + +# CASE DESCRIPTION + +| | IND | JPN | USA | CAN | BEL | PHP | AUS | SWE | PLD | FRA | TLD | +| ------ | --- | --- | --- | --- | --- | --- | --- | --- | --- | --- | --- | +| Length | 5 | 7 | 6 | 5 | 6 | 4 | 6 | 6 | 4 | 6 | 4 | + +# FISCAL OUTCOMES + +| Chg in Prim Struct Dfct (% GDP) | 5.4% | 5.3% | 4.9% | 4.8% | 4.4% | 4.2% | 4.0% | 4.0% | 3.8% | 3.8% | 2.8% | +| -------------------------------- | ---- | ---- | ---- | ---- | ---- | ---- | ---- | ---- | ---- | ---- | ---- | +| Share from Revenue Increases | 85% | 79% | 59% | 44% | - | - | 100% | 60% | 0% | 29% | 79% | +| Share from Primary Spending Cuts | 15% | 21% | 41% | 56% | - | - | 0% | 40% | 100% | 71% | 21% | + +# M Y 3 % 3 - PA R T S O L U T I O N + +| -0.6% | -1.2% | 2.1% | 0.4% | -1.2% | NO | YES | YES | YES | | | +| ----------- | ----- | ----- | ----- | ----- | ---- | ----- | --- | --- | --- | -- | +| -1.6% | 0.4% | -1.6% | 1.1% | 0.4% | NO | YES | YES | NO | | | +| -1.7% | -1.1% | -1.3% | 0.0% | -1.4% | NO | YES | YES | YES | | | +| -0.6% | -0.4% | 1.6% | 1.7% | 1.5% | NO | YES | YES | NO | | | +| -0.4% | -0.3% | 1.2% | -0.2% | 0.8% | NO | YES | NO | YES | | | +| -0.5% | -0.2% | 0.7% | -1.3% | NO | YES | NO | NO | | | | +| | - | -0.1% | -1.2% | -1.4% | 0.9% | -1.2% | NO | NO | YES | NO | +| -0.1% | -1.0% | -0.3% | 2.1% | 0.4% | NO | YES | NO | NO | | | +| -0.7% | -0.4% | -1.2% | 1.2% | -0.5% | NO | YES | YES | YES | | | +| ADJUSTMENT) | -0.3% | 0.9% | -1.0% | 0.5% | 1.8% | NO | YES | NO | YES | | + +# OVER + +| -1.1% | 2.0% | -0.6% | (AVERAGE | 0.8% | OUTCOMES | YES | YES | - | NO | NO | +| ----- | ---- | ----- | -------- | ---- | -------- | --- | --- | - | -- | -- | + +# OUTCOMES + +| Level | ECONOMIC | Coincide | Productivity | Significant | Include | +| --------- | -------- | -------- | ------------ | ----------- | ------- | +| Starting | Debts? | Changes | Changes | Changes | Changes | +| Target\* | vs | vs | vs | vs | vs | +| 10Yr | Yield | Currency | Country | Bond | Rate | +| Inflation | Growth | Slack | Avg | Hard | Did | +| UE | Did | Did | Did | or | | + + + +--- + +CASES WHERE SIGNIFICANT FISCAL ADJUSTMENTS WERE MADE—PAINFUL CASES (1 OF 2) + +# CASE DESCRIPTION + +| | GRC | IRE | GRC | ESP | HUN | PRT | PRT | NZL | DEU | ARG | +| ------ | --- | --- | --- | --- | --- | --- | --- | --- | --- | --- | +| Length | 5 | 4 | 5 | 5 | 3 | 4 | 4 | 8 | 4 | 1 | + +# FISCAL OUTCOMES + +| | | H O W C O U N T R I E S G O B R O K E : T H E B I G C YC L E | | | | | | | | | | | | | +| ----------- | ----- | ------------------------------------------------------------ | ----- | ----- | ----- | ---- | ---- | ----------------- | --- | --- | --- | --- | --- | --- | +| 230.6% | 6.3% | 100% | -1.6% | -6.0% | YES | NO | YES | YES | | | | | | | +| 0% | - | - | -0.7% | -0.7% | -1.5% | 6.9% | 1.6% | -0.8% | 47% | 53% | NO | NO | YES | YES | +| 100% | -0.9% | -2.3% | -5.4% | 8.3% | 0% | 2.6% | 2.3% | NO | NO | YES | YES | | | | +| -2.4% | 18.8% | 100% | -1.3% | 8.6% | 0% | 2.6% | 1.4% | NO | NO | NO | NO | | | | +| -2.8% | -4.0% | 8.8% | 4.7% | -0.7% | 68% | 1.1% | 32% | YES | NO | NO | YES | | | | +| 9.0% | -5.2% | -0.7% | 1.7% | 26% | 1.7% | 1.3% | 74% | YES | NO | NO | NO | | | | +| -2.9% | -4.1% | 9.8% | 9.4% | -1.2% | 14% | 0.6% | 86% | YES | NO | NO | YES | | | | +| 10.0% | -1.2% | 11.6% | 100% | 1.0% | 0% | 0.0% | - | NO | NO | NO | NO | | | | +| ADJUSTMENT) | | | | | | | | | | | | | | | +| 10.6% | -5.5% | -1.8% | 0.9% | -3.4% | 4% | 96% | 5.3% | YES | NO | NO | YES | | | | +| OVER | | | | | | | | | | | | | | | +| 16.6% | 10.2% | -6.8% | -5.1% | -2.1% | 82% | 8.1% | 18% | (AVERAGE OUTCOMES | YES | NO | NO | YES | | | + +# Cuts + +| OUTCOMES | Level | GDP) | ECONOMIC | Productivity | Increases | Coincide | Spending | Significant | Include | (% Starting | Occur | or | Dfct | Debts? | Easier | Domestic | Conditions? | Revenue | Reforms? | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | +| ------------- | ----- | --------- | -------- | ------------ | --------- | -------- | -------- | ----------- | ------- | ----------- | ----- | -------- | ----- | ------ | ------ | -------- | ------------ | -------- | -------- | ------- | -------- | ---- | ---- | -- | -- | -- | ---- | ------ | --------- | ------ | ------ | ------ | ---- | --------- | --------- | -- | ------ | ------ | ----- | -- | --- | ----- | ----- | --- | --------- | ---- | -- | --- | --- | --- | --- | +| MACROECONOMIC | Avg | Potential | Changes | Changes | Primary | Target\* | OF | Changes | Struct | vs | Have | Economy? | w/Big | 10Yr | Yield | Produce | DETERMINANTS | Currency | Prim | Country | Coincide | from | from | vs | vs | vs | Bond | Strong | Enhancing | Fiscal | Fiscal | Fiscal | Rate | Inflation | Financial | in | Growth | Global | Share | or | Chg | Share | Slack | Avg | Hard into | with | UE | Did | Did | Did | Did | + + + +--- + + +# CASES WHERE SIGNIFICANT FISCAL ADJUSTMENTS WERE MADE—PAINFUL CASES (2 OF 2) + +# CASE DESCRIPTION + +| | ARG | ESP | HUN | HUN | DEU | NLD | TUR | ITA | MEX | | +| ------ | --- | --- | --- | --- | --- | --- | --- | --- | --- | - | +| Length | 4 | 6 | 1 | 1 | | 3 | 3 | 2 | 2 | 3 | + +# FISCAL OUTCOMES + +| Chg in Prim Struct Dfct (% GDP) | Share from Revenue Increases | Share from Primary Spending Cuts | +| ------------------------------- | ---------------------------- | -------------------------------- | +| 6.1% | 88% | 12% | +| 5.1% | 76% | 24% | +| 4.2% | 61% | 39% | +| 4.1% | - | - | +| 3.4% | 0% | 100% | +| 3.2% | 39% | 61% | +| 3.1% | 0% | 100% | +| 2.9% | 100% | 0% | +| 2.5% | 45% | 55% | + +# M Y 3 % 3 - PA R T S O L U T I O N + +| -0.7% | -0.7% | 1.7% | 0.4% | 0.6% | NO | NO | NO | YES | +| ------ | ------ | ----- | ----- | ----- | --- | -- | --- | --- | +| -1.8% | -0.1% | 1.9% | 0.3% | 0.6% | YES | NO | NO | YES | +| -10.3% | 47.9% | -5.8% | 2.4% | 0.9% | YES | NO | NO | NO | +| -2.4% | -3.4% | -0.2% | 5.8% | 0.4% | NO | NO | YES | YES | +| -1.9% | -1.0% | 0.7% | 0.6% | 1.8% | NO | NO | YES | YES | +| -2.2% | 18.1% | - | -1.7% | - | NO | NO | YES | YES | +| -3.3% | -5.6% | -1.6% | 2.7% | -2.1% | YES | NO | YES | NO | +| -0.7% | -1.6% | -0.1% | 1.4% | -1.5% | NO | NO | YES | YES | +| -2.8% | -10.4% | 37.9% | 2.6% | 5.5% | YES | NO | NO | NO | + +# OUTCOMES + +| Level | ECONOMIC | Coincide | Productivity | +| ------------- | --------- | -------- | ------------ | +| MACROECONOMIC | Avg | Changes | Changes | +| Potential | Target\* | OF | Changes | +| vs | vs | vs | Bond | +| Rate | Inflation | Growth | Slack | +| Avg | Did | into | with | +| UE | | | | + + + +--- + + +# HOW COUNTRIES GO BROKE: THE BIG CYCLE + +# MORE SPECIFICALLY, WHICH EXPENSES SHOULD BE CUT AND WHICH TAXES SHOULD BE RAISED? + +While I am tempted to get into what I believe are the relative merits of the different specific types of spending cuts, tax increases, and interest rate cuts, I’m not going to do that because I don’t think there is any reason that my preferences should matter. It also would be too big of a digression and would lead to all sorts of arguing with all sorts of people who have different preferences. The problem of all sorts of people having all sorts of preferences that they will fight for and not being able to resolve their disagreements is to me the biggest problem that we face—i.e., as a country and a civilization—which is that there is so much arguing over the exact ways to prevent the disaster that it won’t be prevented. That’s why I am recommending the equal and proportionate cut in spending and increase in taxes as the fallback plan if no other plan can happen. Then, once that is in place, as has been proposed in the past, policy makers could authorize a bipartisan fiscal commission to examine the debt issue and propose specific alternatives that are preferable to the fallback plan. But frankly, I don’t care exactly how congressional policy makers do it nearly as much as I care that they do it. + +Nonetheless, let’s look at the constraints that must be considered. A selection of highly impactful potential spending cuts and tax increases and their impacts are shown in the following table. This list of items came primarily from the bipartisan Congressional Budget Office, which most policy makers refer to. Looking at that list tells me that tweaking existing spending programs and taxes in moderate, tolerable ways could achieve the 3% of GDP deficit goal without unacceptable pain. This list also shows the revenue that + +| Potential Spending Cuts and Tax Increases | | +| ----------------------------------------- | -------- | +| Item | Impact | +| Spending Cut 1 | Impact 1 | +| Tax Increase 1 | Impact 2 | +| Spending Cut 2 | Impact 3 | +| Tax Increase 2 | Impact 4 | + +To say a little more, because my goal would be to raise broad-based productivity, I would a) make sure that spending cuts and tax changes do not hurt those who can least afford them and do not hurt high-productive functions like education, which are shown to be most effective in increasing broad-based productivity, and b) cut taxes and regulations in areas that would free up productive spending and improve efficiency where possible. + + + +--- + + +# M Y 3 % 3 - PA R T S O L U T I O N + +can be brought in by tariVs (which during many periods of history have been a greater source of government revenue than anything else). According to the CBO, 10% tariVs on all imports could bring in about 0.6% of GDP. Also, if Elon Musk’s claim that he can cut the budget deWcit by $2 trillion is half true (i.e., if DOGE can cut the budget deWcit by $1 trillion), that would be 3% of GDP. There are several other radical changes and considerations on the table so I’m conWdent that one way or another policy makers can do it, and I like some of the aspirations as I’m all in favor of radically improving the eYciency of the government and the economy. So, it’s not hard for me to imagine how a pragmatic “grand bargain” between reasonable Republicans and Democrats could be reached. My only ques - tion is whether the people involved will operate together logically to do sensible things. + +Now is the time for policy makers to put up or shut up. To be clear, whatever form of grand bargain cuts the deWcit to about 3% of GDP is good with me. That leads me to conclude that if our representatives in Washington don’t get a debt limit deal done, it will be because of their lack of reasonableness and their inability to compromise—not because a good and workable plan is beyond their reach. Because the failure to reach an agreement will produce a much bigger problem than reaching an agreement along the lines of my 3% solu - tion, it seems to me that the electorate should hold their represen - tatives in Congress accountable to get a debt limit deal done. + +In the following table are some of the choices and their eVects on the budget deWcit, which were put out for informational purposes mostly by the Congressional Budget OYce. I am sharing them simply to convey a picture of the alternatives. + +| Choices and Effects on Budget Deficit | | +| ------------------------------------- | ------------------------ | +| Choice | Effect on Budget Deficit | +| 10% Tariffs on All Imports | 0.6% of GDP | +| Elon Musk's Budget Cut Claim | 3% of GDP | + + + +--- + +# HOW COUNTRIES GO BROKE: THE BIG CYCLE + +# SAMPLE OF OPTIONS FOR REDUCING DEFICITS THROUGH SPENDING CUTS + +“3% PLAN” TARGET REDUCTION IN SPENDING = ~1% OF GDP + +Savings over 10 Yrs| | | | | | +| -------------------------------------------------------------------- | ------------------ | ---------------------- | ----- | ---- | +| Est Annual Savings | Est Deficit Impact | Share of Target Cuts\* | | | +| Cutting Government Benefits That Go to High Earners | $Bln | $Bln | % GDP | | +| Phase Out VA Disability Payments That Go to High Earners | 384 | 38 | 0.10% | 10% | +| Decrease Social Security for Higher-Income People (5yr Phase In) | 197 | 20 | 0.05% | 5% | +| Limiting Entitlements and Transfers | | | | | +| Lower Implicit Subsidies for Medicare Advantage Plans | 489 | 49 | 0.13% | 13% | +| Overall Cap on Federal Spending for Medicaid (Adj for Inflation) | 459 | 46 | 0.12% | 12% | +| Eliminate Federal Farm Subsidies | 311 | 31 | 0.08% | 8% | +| Uniform Social Security Capped at 150% of Federal Poverty Level | 283 | 28 | 0.08% | 8% | +| Use Chained Inflation for Social Security and Mandatory Programs | 278 | 28 | 0.07% | 7% | +| Limit Transfers to States and Health Providers for Medicaid | 241 | 24 | 0.06% | 6% | +| Raise Full Retirement Age for Social Security from 67 to 70 (Phased) | 95 | 9 | 0.03% | 3% | +| Reduce Payments for Medical Education at Teaching Hospitals | 94 | 9 | 0.03% | 3% | +| Reducing Discretionary Spending | | | | | +| Limit Military Personnel to \~1 Million People (<20% Reduction) | 1,118 | 112 | 0.30% | 30% | +| Rescind Inflation Reduction Act Climate and Energy Provisions | 1,045 | 105 | 0.28% | 28% | +| Limit Annual Non-Defense Spending Growth to 1.5% | 592 | 59 | 0.16% | 16% | +| Reduce Highway and Education Transfers to States by 33% | 406 | 41 | 0.11% | 11% | +| 25% Reduction in Diplomatic Programs, Health and Military Aid | 187 | 19 | 0.05% | 5% | +| Total Potential Savings from Spending Cuts | 6,179 | 618 | 1.67% | 167% | + +*“Share of Target Cuts” figures shown against a target of roughly 1% of GDP improvement in the deficit from each lever. Sources: CBO, Joint Committee on Taxation, Penn Wharton Budget Model + +--- + + +# M Y 3 % 3 - PA R T S O L U T I O N + +# SAMPLE OF OPTIONS FOR REDUCING DEFICITS THROUGH TAX INCREASES + +“3% PLAN” TARGET INCREASE IN SPENDING = ~1% OF GDP + +Savings over 10 Yrs| | | | | | +| ---------------------------------------------------------------- | -------------------- | ----------------------------- | ----- | --- | +| Est Annual Savings | Deficit Impact % GDP | Share of Target New Revenue\* | | | +| Tax Increases Targeted at High Earners | $Bln | $Bln | % GDP | | +| Apply Social Security Taxes to Incomes over $250,000 | 1,427 | 143 | 0.38% | 38% | +| 2% Increase in Income Tax Rates for Four Highest Brackets | 570 | 57 | 0.15% | 15% | +| Impose Net Investment Income Taxes on Business Income | 420 | 42 | 0.11% | 11% | +| Lower Contribution Limits on IRAs and 401(k)s | 187 | 19 | 0.05% | 5% | +| Increase Medicare Part B Premiums for High-Income People | 72 | 7 | 0.02% | 2% | +| Remove Deductions and Tax Subsidies | | | | | +| Cap Tax Benefits of Itemized Deductions to 4% of Income | 736 | 74 | 0.20% | 20% | +| Cap Ability to Pay Pre-Tax for Employer Health Insurance | 521 | 52 | 0.14% | 14% | +| Eliminate Mortgage Interest Deduction | 349 | 35 | 0.09% | 9% | +| Include Veterans’ Disability Payments in Taxable Income | 235 | 23 | 0.06% | 6% | +| Remove Step-Up in Basis on Inherited Assets with Capital Gains | 197 | 20 | 0.05% | 5% | +| Remove Tax Credits for Post-Secondary Education | 130 | 13 | 0.04% | 4% | +| Other Increases in Taxes | | | | | +| 5% VAT Tax (ex-Necessities like Food and Healthcare) | 2,180 | 218 | 0.59% | 59% | +| Enact 10% Tariffs on All Imports to the US | 2,100 | 210 | 0.57% | 57% | +| Enact 60% Tariffs on All Chinese Imports | 700 | 70 | 0.19% | 19% | +| Tax on Greenhouse Gases ($25 Per Ton Emissions), ex-Gasoline | 700 | 70 | 0.19% | 19% | +| Remove Tax Exemptions on US Corporations’ Foreign Income | 340 | 34 | 0.09% | 9% | +| Increase Tax on Financial Transactions from 0.002% to 0.01% | 297 | 30 | 0.08% | 8% | +| Require Half of Advertising Expenses to Be Amortized over 10 Yrs | 177 | 18 | 0.05% | 5% | +| Increase Corporate Income Taxes by 1% | 136 | 14 | 0.04% | 4% | +| Uniform Alcohol Tax of $0.25/oz of Pure Alcohol (Indexed) | 102 | 10 | 0.03% | 3% | +| Raise Taxes 2% on Long-Term Capital Gains/Qualified Dividends | 103 | 10 | 0.03% | 3% | + +Total Potential Revenue from Tax Increases: $11,678 Bln, Est Annual Savings: $1,168 Bln, Deficit Impact: 3.15% of GDP, Share of Target Cuts: 315% + +*“Share of Target Cuts” figures shown against a target of roughly 1% of GDP improvement in the deficit from each lever. Sources: CBO, Joint Committee on Taxation, Penn Wharton Budget Model + + + +--- + +# HOW COUNTRIES GO BROKE: THE BIG CYCLE + +In considering which spending to cut, when one looks at the possibilities, one quickly notices that about 70% of the non-interest spending is considered “mandatory”̶i.e., it is either contractually required or politically nearly impossible to cut. The breakdown is shown in the following chart. + +| Interest on Debt | $1.0T | Social Security | $1.6T | +| ---------------- | --------- | ------------------------------ | ----- | +| Education | $83B | Net Interest | $1.0T | +| Defense | $862B | 2025 Federal Government Budget | | +| Discretionary | $1.8T | Mandatory | $4.3T | +| | $7T Total | | | +| Medicare | $1.1T | Other Non-Defense | $878B | +| | 16% | | 12% | +| Medicaid | $666B | Other | $898B | +| | 9% | | 13% | + +That said, in the “mandatory” spending part of the budget, there are a number of relatively modest changes that could have big impacts. For instance, two changes to Social Security (phasing in an increase to the retirement age from 67 to 70 and using a more realistic inflation measure to calculate the increase in benefits), which wouldn’t affect virtually anyone immediately, would produce about a tenth of the required spending cuts. + +3 5 2 + +--- + + +# M Y 3 % 3 - PA R T S O L U T I O N + +The roughly 30% of spending that is “discretionary” that Congress has to reauthorize every year (which is shrinking fast as a share of spending because entitlement programs are growing) includes defense spending (which is almost half of the discretionary budget), medical care for veterans, rental assistance for low-income households, funding for transportation, medical and scientific research, education transfers to states, and hundreds of other functions of the government. Because a bill needs to be passed every year to authorize this spending, these are the easiest to cut (though they have not been cut). If you cut just from these “discretionary” items to achieve the goal of cutting spending by about 4%, that would require 15% cuts in these on average. I find the distinction between discretionary and non‐discretionary spending to be a bit arbitrary because cuts can be made to both. The important thing is getting to a reasonable mix that adds up to a deficit reduction of 3% of GDP to get the deficit down to 3% of GDP. + +# DO IT NOW! DO IT COUNTER-CYCLICALLY! + +To re-emphasize: When there are large government debts that are growing quickly so that large cuts to budget deficits are needed, the most important things to do are to 1) cut the deficit by enough to rectify the problem, 2) cut the deficit when economic conditions are good so the cuts are counter-cyclical, and 3) have monetary policy be stimulative enough to keep the economy strong. + +Now is an exceptionally good time to implement a significant debt limit plan because: + +- It is much better to reduce government deficits in good economic times than to wait for a debt crisis to happen in bad times. +- The US economy is near full employment, growth is moderately strong, inflation is a bit high, and the private sector’s + + + +--- + + +# HOW COUNTRIES GO BROKE: THE BIG CYCLE + +Income statements and balance sheets are in pretty good shape (mostly because the government took on the burden, though it should probably shift at least some of it back). + +If the plan is not implemented now, the debt problem will grow and be more difficult to deal with. That is especially true because the debt cycle is now at the stage in which more borrowing and more debt are needed to service existing debts, so they are increasing in a self-reinforcing and compounding way. + +Implementing this plan now would be a confidence booster that would have all sorts of beneficial knock-on effects. It’s also worth noting that there are other, less commonly discussed ideas out there that could have a big impact on the debt picture. I’m in favor of marking the government’s assets to market, creating a US government sovereign wealth fund, and exploring a US-backed stablecoin if these things can be done well. Imagine if the government’s assets were managed economically—i.e., if they were valued, bought, sold, and/or developed economically rather than not even looked at economically, as is the case now—and imagine there was a well-funded, well-run sovereign wealth fund behind the government’s financing and debt. That’s an interesting subject for another time. + +In concluding this chapter, I want to reiterate that even with the best of budget plans, there are very big uncertainties that can throw them off. For example, we don’t know if there will be wars that will cost more and worsen the budget deficits, or if there will be bigger-than-expected productivity gains from new technologies that will produce higher incomes and tax revenues that will reduce budget deficits. There are many such uncertainties that will undoubtedly disrupt these projections, so the ranges of possibilities around them are large. To me, that suggests that US policy makers should be more, not less, conservative in dealing with the government’s finances because the worst thing possible would be to have its finances in bad shape during difficult times. + + + +--- + + +# M Y 3 % 3 - PA R T S O L U T I O N + +# APPENDIX: LOOKING IN MORE DETAIL AT THE EFFECTS OF DIFFERENT SPENDING, TAX, AND INTEREST RATE CHANGES ON THE DEFICIT IN THE US + +Achieving the goal of stabilizing government debts relative to government revenues is kind of like playing with a Rubik’s Cube, in that changing one lever changes the impact of all the others. The following tables show how different combinations of government spending cuts, tax increases, and interest rate changes would lead to different outcomes for the government’s debt-to-income ratio. + +The first table shows the status quo—what the US government debt picture looks like in 20 years if there are no changes in revenue, spending, or real interest rates from those now projected by the Congressional Budget Office. In that baseline scenario, US government debt will reach over 130% of GDP in 20 years. However, it’s important when doing these calculations to compare debt levels to tax revenue, not nominal GDP. GDP is often used by default, but that can be misleading because levels and changes in tax revenue can be very different from levels and changes in GDP. When dealing with government finances, what matters are the revenues and expenses of the government. Translating this projection into a share of government revenue, the US is projected to reach debt that is 7.2x government income, up from about 5.8x right now. + +To give you a sense of how the different pieces interact, I also show in this table how this projection would change as the government changes its spending (x-axis, with spending declining as you move to the right) and/or revenues (y-axis, with taxes rising as you move down). This shows how challenging it is to stabilize the debt if lower real rates are not part of the solution—it requires relatively large cuts in spending and increases in revenue. + + + +--- + +# HOW COUNTRIES GO BROKE: THE BIG CYCLE + +# GOVT DEBT-TO-INCOME IN 20 YRS + +ASSUMING CBO INTEREST RATES + +CURRENT DEBT/INCOME = 583% + +BASELINE PRIMARY DEFICIT = 12% OF INCOME (CBO) + +| % Change in Government Spending | 6% | 3% | 0% | -3% | -6% | | | +| ------------------------------- | --- | ----- | ---- | ---- | ---- | ---- | - | +| Income | -6% | 1014% | 947% | 882% | 818% | 755% | | +| | -3% | 929% | 864% | 801% | 739% | 678% | | +| | 0% | 847% | 784% | 723% | 662% | 603% | | +| | 3% | 768% | 707% | 648% | 589% | 532% | | +| | 6% | 693% | 634% | 576% | 519% | 463% | | + +Current path projected by the CBO + +# GOVT DEBT-TO-INCOME IN 20 YRS + +IF REAL INTEREST RATES FALL 1% + +CURRENT DEBT/INCOME = 583% + +BASELINE PRIMARY DEFICIT = 12% OF INCOME (CBO) + +| % Change in Government Spending | 6% | 3% | 0% | -3% | -6% | | +| ------------------------------- | --- | ---- | ---- | ---- | ---- | ---- | +| Income | -6% | 831% | 773% | 717% | 661% | 607% | +| | -3% | 782% | 724% | 668% | 612% | 558% | +| | 0% | 732% | 674% | 618% | 563% | 508% | +| | 3% | 681% | 624% | 567% | 512% | 457% | +| | 6% | 629% | 572% | 515% | 460% | 405% | + +in % GDP Terms + +--- + + +# M Y 3 % 3 - PA R T S O L U T I O N + +# GOVT DEBT-TO-INCOME IN 20 YRS + +# IF REAL INTEREST RATES FALL 2% + +CURRENT DEBT/INCOME = 583% + +BASELINE PRIMARY DEFICIT = 12% OF INCOME (CBO) + +# % Change in Government Spending + +| | 6% | 3% | 0% | -3% | -6% | +| --- | ---- | ---- | ---- | ---- | ---- | +| -6% | 725% | 672% | 620% | 569% | 519% | +| -3% | 680% | 627% | 575% | 524% | 474% | +| 0% | 634% | 581% | 529% | 478% | 428% | +| 3% | 587% | 534% | 482% | 431% | 381% | +| % | 6% | 540% | 487% | 435% | 384% | + +1.2% 0.6% 0.0% -0.6% -1.2% + +in % GDP Terms + +Finally, I show how much of each lever you’d need to pull on its own. For instance, just cutting discretionary spending would require nearly 50% cuts to those programs, while just cutting interest rates on the government debt would require them to fall by around 3%. That’s why I like my 3% 3‐part solution̶because it spreads the adjustments across the levers. + + + +--- + + +# HOW COUNTRIES GO BROKE: THE BIG CYCLE + +# HOW THE US CAN STABILIZE DEBT-TO-INCOME IN THE NEXT 10 YEARS + +| Central Government Debt Today (% GDP) | 100% | +| ------------------------------------------- | ---- | +| Central Government Debt Today (% Revenue) | 583% | +| Proj Debt in 2035 (% GDP, CBO) | 118% | +| Proj Debt in 2035 (% Revenue, CBO) | 648% | +| Proj Nominal Growth Rate (CBO) | 3.9% | +| Proj Real Growth | 1.9% | +| Proj Inflation | 2.0% | +| Proj Effective Nominal Interest Rates (CBO) | 3.5% | +| Current Interest Rate (Avg 3M and 10Yr) | 4.5% | + +# If Lower Interest Rates Were the Only Lever... + +| Interest Rate Required to Stabilize Debt | 1.0% | +| -------------------------------------------------------- | ----- | +| Change in Interest Rates vs Current Interest Rate | -3.5% | +| Change in Interest Rates vs CBO’s Proj Avg Interest Rate | -2.5% | + +# If Higher Inflation Were the Only Lever... + +| Required Inflation Rate to Stabilize Debt | 4.5% | +| -------------------------------------------------------- | ---- | +| Change in Inflation Required (vs Current Proj Inflation) | 2.5% | + +# If Cutting Expenses Were the Only Lever... + +| % Spending Cut Required to Stabilize Debt | 12% | +| ----------------------------------------- | --- | +| % of Discretionary Spending | 47% | + +# If Raising Tax Revenue Were the Only Lever... + +| % Revenue Increase Required to Stabilize Debt | 11% | +| --------------------------------------------- | --- | + + + +--- + + +# CHAPTER 19 + +# WHAT THE FUTURE LOOKS LIKE TO ME + +In this chapter, I try to look into the future using my measures of where things now stand and my principles about how changes occur, which are based on what I think are the most important cause/effect relationships. I expect that you will find this chapter very controversial, very interesting, and very valuable. + +He who lives by the crystal ball is destined to eat ground glass is an adage I learned early in my investment career. It has stuck with me ever since because it has repeatedly proven true. I know that whatever success I have had has been more due to my knowing how to deal with what I don’t know than with anything I do know. So I will begin by explaining a bit about how I bet on the future. + +# BETTING ON THE FUTURE + +From very early on in my investment career, I based my decision-making approach on seeing the cause/effect relationships that drive what happens in markets and economies. I saw how the cause/ + + + +--- + + +# HOW COUNTRIES GO BROKE: THE BIG CYCLE + +eVect relationships that I identiWed interacted with everything to drive how all things happen as a sort of perpetual motion machine that drives developments over time. Seeing how this perpetual motion machine has driven everything that has happened led me to believe that everything (other than the quantum world) is predestined and that if we had a perfect model that took every cause/eVect relationship into consideration, we could almost perfectly forecast the future. I believe that the only thing standing in the way of that perfect forecasting is our ability to understand and model all those cause/eVect dynamics—and that we will get much closer to achieving this with AI. + +Most people don’t see things that way. They believe the future is unknowable and that destiny doesn’t exist. I am conWdent that this view is by and large wrong now, and I believe that it will quickly become even more apparent that it is wrong to those who seek, obtain, and use the understandings that are increasingly available to us. In my own career, I found success by building AI expert decision-making systems to describe these cause/eVect dynamics; in the future, the way that I—and I presume others—will model things will be through more advanced forms of AI such as generative AI and explainable AI. + +To be clear, while having a perfect model that gives a nearly perfect picture of what the predestined future looks like would be great, I don’t expect that my model will come close to that, so my goal is simply to have a crude, quickly evolving model that gives me a leg up relative to the competition and relative to the position I would be in if I didn’t have the model. I have found that this works well because, though forecasting exactly, or even nearly exactly, is now impossible because there are too many determinants that are themselves highly uncertain and together determine what happens, there are many things about the future—such as death, taxes, the life cycles of individuals, demographic shifts, the eVects that people’s DNA and environments have on them, and untold other cause/eVect relationships—that are relatively knowable and good indicators of roughly what will happen. I especially look for big, unsustainable conditions and I position myself to bet that they won’t be sustained. + + + +--- + + +# WHAT THE FUTURE LOOKS LIKE TO ME + +I play my betting/investing game by knowing as much as possible about the timeless and universal cause/effect relationships of these relatively knowable things, and I build this understanding into templates/models of how things are likely to unfold. Because the causes come before their effects, if I know the cause/effect relationships better than my competitors, I can anticipate what will happen better than they can and, as a result, do very well in the investment game. I have found great value in building this approach into market-positioning systems that have been back-tested and can be used in an investment game plan that I execute. I constantly compare how conditions are evolving and how my bets are performing relative to my expectations. If the results are inconsistent with my expectations, I diagnose why and improve my decision-making systems. The computerized expert systems I use are designed to make decisions like I would, just better than I could because they can simultaneously and quickly process a lot more than my brain can. + +While I’ve done very well as a global macro investor betting on the future in this unique way, I am wrong a lot (at least one-third of the time relative to what the markets are expecting) and I am never exactly right. Because I know that it takes only one really bad bet or a series of moderately bad bets to knock me out of the game, I am extremely risk-averse, so I have built great risk controls. I control risks through diversification of my good risky bets rather than by avoiding risky bets. To me, the “Holy Grail of Investing” is to find and make 15 or more great uncorrelated bets. + +I have followed this approach for about 35 of my 50-plus years as a professional investor. I am as hooked on playing this game as I have ever been, though now I want to pass along what I’ve learned rather than keep it to myself. It is of course up to others to decide whether what I’m sharing is of value, but I know that from my own experience. + +53 I won’t digress further into how I invest here, but if you’re interested in learning more about my investment approach, I recommend that you take my Dalio Market Principles course, which you can find information on at principles.com. + + + +--- + + +H O W C O U N T R I E S G O B R O K E : T H E B I G C YC L E + +It is. I have made a lot of money betting on the cause/effect relationships I described earlier in this book—relationships between the short-term and long-term debt and political cycles, acts of nature, and humanity’s inventiveness creating new technologies. These relationships are also logical and have appeared across thousands of years of history. I am sure that they are the biggest and most important forces, even though there are still a lot of key unknowns and uncertainties. + +Now that I have that explanation out of the way, I will tell you what I conjecture about the future. Please remember that I use my template to see things differently than most people and that I am especially drawn to situations that I assess to be more likely to happen than most people think. This means the outcomes I am anticipating are not reflected in the price, so they are good things to bet on. Also keep in mind that I am not fully sure of anything, except death and taxes. + +# LOOKING AHEAD USING MY TEMPLATE AND MY INDICATORS + +You now know how I believe monetary orders, domestic political governance orders, and international orders evolve, break down, and transition driven by the five big forces I've outlined earlier and won't repeat here. I use my Big Cycle template and my indicators to show me where we are in these cycles and anticipate what will happen, and to make investments I convert this conceptual template into a much more specific analytical decision-making system. I will use these concepts to convey where I think things stand and what I expect. + +I will start with my big-picture summary of how I see things as of my writing in March 2025: + +1. The US and the existing world order are about 80 years into, which is about 90-95% through, the Big Cycle that began in 1945. The Big Cycle is like the human life cycle. + + + +--- + +# WHAT THE FUTURE LOOKS LIKE TO ME + +in that it progresses through relatively knowable stages, and while knowing about this cycle won’t tell you exactly what will happen, it will tell you a lot about what is likely to happen and roughly when. I broke this Big Cycle up into the six stages that I described in Principles for Dealing with the Changing World Order and touched on in this book. By my measures, the Big Cycle is in Stage 5, which is on the brink of great conflicts and seismic shifts. + +2. The US and other major economies are about five years into, which by my measures is about two-thirds through, the 13th short-term debt/economic cycle of the post-1945. As explained, this short-term debt/economic cycle interacts with domestic political and international geopolitical cycles, acts of nature developments, and new inventions to drive the shorter-term cycle swings that typically take about six years, give or take about three years. While knowing about this short-term cycle won’t tell you exactly what will happen and when, it will tell you a lot about what is likely to happen and roughly when. + +3. There are some big, unsustainable imbalances that make good bets because they likely won’t be sustained—most importantly, it is a good bet that the amount of borrowing and buying and piling up of debt assets and liabilities being faster than income growth won’t be sustained. + +4. We are at the maximum point of not knowing what actions will be taken and what effects they will have because the new leadership in the US has only been in power for a few weeks and President Trump seems to be more inclined to do previously unimaginable things than any president in the last 80 years—and perhaps any president ever. + +By my measures, the current configuration of conditions is most analogous with those that existed in 1905-14 and 1933-38 and many prior times in many countries throughout history, which, as + +--- + + +# HOW COUNTRIES GO BROKE: THE BIG CYCLE + +Just noted, is what I call Stage 5 of the Big Cycle. During Stage 5, countries are overindebted, ineYciently run, divided, and threatened by other countries, so there is a strong tendency for leaders with populist, nationalistic, protectionist, militaristic, and autocratic approaches to emerge. + +By studying history, we can see that such challenging times have always led to much more autocratic governance because democracies become too divisive to be effective, and their leaders lose their abilities to compromise effectively. At these times, only power matters so those who get it and become the more autocratic leaders in positions of power tend to be more inclined to engage in conflict, not cooperation, with both their internal and their external opponents. + +The new leaders always vow to fight to improve national strength and are more willing to engage in economic, geopolitical, and military conflicts, which bring them to the brink of major conflicts and big changes in the monetary order, the domestic political order, and the world geopolitical order. + +By my measures, this is where all of the major powers now are—i.e., they are overindebted, ineYciently run, and divided—and it is this configuration of conditions that is increasingly leading to the emergence of more nationalistic, protectionist, militaristic, and autocratic leaders and policies. These leaders, especially President Trump in the US, want to fight to improve national strength and are more willing to engage in economic, geopolitical, and military conflicts to win. Recent events are by and large following the classic Big Cycle template that I have laid out and that has brought the world to the brink of great conflicts and big changes. To be clear, these changes don’t have to be bad ones because what they will be like is still in the hands of those who control the levers of power. + +Let’s now look a bit more closely at each of the five forces and what’s happening with them, using as a guide some of the principles I shared earlier in this book. I will focus mostly on the United + + + +--- + + +# WHAT THE FUTURE LOOKS LIKE TO ME + +States because it is the most important country by most measures and its changes will have the biggest effects on what will happen to the world, though the other G7 countries and China all are in similar positions and intertwined in this Big Cycle, and all countries will be affected by them, while also affecting what happens. It’s also worth noting that, along with all of what you read from here, there is the demographic force to reckon with. This will lead to a lot of older people who won’t be working and will be expensive to support (because of healthcare costs) at the same time that the workforce will be shrinking, so that only a small percentage of people will be truly productive. + +# 1. The Debt/Money Force + +Regarding where we are in the Big Debt Cycle, as shown earlier in this book, by my measures the US and most major countries (the other G7 countries and China) are overindebted, in the late stages of their Big Debt Cycles, and have to frequently rely on Monetary Policy 3 (i.e., big fiscal deficits that are funded by central banks buying the debt). As a result, if their long-term Big Debt Cycle issues are not controlled in some way, the probability of an unwanted major restructuring/monetization of debt assets and debt liabilities that are denominated in the major reserve currencies happening is very high—something like 65% over the next five years and something like 80% over the next 10 years. This is because the debt assets and debt liabilities are already very large, and they are projected to rise to significantly higher levels that will make it increasingly difficult to have interest rates high enough and money tight enough to satisfy the lender-creditors without having interest rates so high and money so tight that they will hurt the borrower-debtors. The following charts show the average total debt and debt service as a percent of GDP going back to 1900 across the G7 countries. + + + +--- + + +# HOW COUNTRIES GO BROKE: THE BIG CYCLE + +| G7 Average Total Debt (% GDP, Non-Fin) | G7 Average Total Debt Service (% GDP, Non-Fin) | +| -------------------------------------- | ---------------------------------------------- | +| Projected | Projected | + +| | 50% | | 40% | | 30% | | 20% | | 10% | +| ---- | ---- | ---- | ---- | ---- | --- | --- | --- | - | --- | +| 1900 | 280% | 230% | 180% | 130% | 80% | 30% | | | | +| 1920 | | | | | | | | | | +| 1940 | | | | | | | | | | +| 1960 | | | | | | | | | | +| 1980 | | | | | | | | | | +| 2000 | | | | | | | | | | +| 2020 | | | | | | | | | | + +As described earlier, the next big red flag to watch out for that would signal that a debt crisis is about to happen is significant selling of government debt assets (e.g., bonds) by existing holders of them. This would come together with the issuing and sales of new government debt to create a huge supply relative to the demand, which would put central banks in the position of having to choose between letting nominal and real interest rates rise a lot or printing a lot of money and buying long-term government debt to keep these interest rates down, thus devaluing debt and money. It seems to me that now is a good time to remember the following principle: + +During times when there is too much debt relative to the quantity of money that is needed to service debts, the need to either increase the amount of money that exists and/or cut the amount of debt there is leads governments to break their promises and do some combination of a) raising the amount of money and credit, b) reducing the amount of debt (e.g., by restructuring it), and/or c) preventing the free-market ownership and movement of the hard money (e.g., gold). At such times, there is a run away from bad money to good money that the government wants to stop. This often leads to prohibiting good money from being freely held and freely moved. + +Clearly, it is in these countries’ interests to not have such large debt burdens. As I have seen by studying history, when countries were in analogous positions, they reduced their debt burdens using + + + +--- + + +# WHAT THE FUTURE LOOKS LIKE TO ME + +various, seemingly extreme ways that were then, and would be now, considered unimaginable. These extreme actions have included freezing debt payments, seizing assets of adversary nations, imposing confiscatory taxes and capital/foreign exchange controls, defaulting on debts/extending maturities, and changing the type of money in circulation (by de-linking it from a hard asset like gold or creating a new type of money). + +I’m not saying it’s certain that these things will happen, but I do want to point out that these kinds of radical changes were made by much more conventional leaders than Donald Trump, like Franklin D. Roosevelt and Richard Nixon. While at this time I consider most of these to be more unlikely possibilities than high probabilities, there is no doubt in my mind that, one way or another, leaders must manage the debt supply-and-demand issue well. It is important to be aware of the risks these extreme actions present and stay tuned as things change. In my opinion, my 3% 3-part solution in conjunction with a well-coordinated “beautiful deleveraging” in which the deflationary ways of deleveraging (e.g., fiscal tightening and debt restructuring) are balanced with the inflationary ways of deleveraging (e.g., the easing of monetary policy and debt monetization) would be best. + +In any case, the days of borrowing much more than can be paid back to support excess consumption by unproductive people are coming to an end. Going forward, the primary goals will be to simultaneously increase productivity and diminish the burden of the debt (which will also diminish the value of the debt and money). + +As mentioned above, the US and most major countries are probably now about two-thirds into their short-term cycles. This puts them close to their equilibrium levels, judging by real and nominal economic growth and interest rates and inflation rates. The monetary tightening that began in March 2022 ended the last paradigm in which the US Fed and other G7 central banks gave away lots of money and credit for free. Starting in or around March 2022, the Fed and most other central banks shifted from a) monetary policies that were great for borrower-debtors and bad for lender-creditors and inflationary + + + +--- + + +# HOW COUNTRIES GO BROKE: THE BIG CYCLE + +to b) monetary policies that were slightly tight (by my measures). As a result of this tightening and supply chain problems lessening, inflation rates declined to levels that are now modestly above their stated targets, which has led these central banks to gradually ease. Most countries are now in a new paradigm in which central banks are having a relatively neutral monetary policy with relatively moderate conditions, depending on the country (e.g., economic growth is stronger in the US, particularly in the tech sector, and weaker in other G7 countries), though the UK, France, and some developing countries like Brazil are encountering the sort of government debt supply-and-demand problems that I described earlier in this book. By and large, nominal and real interest rates now appear about right—i.e., high enough to be acceptable for lender-creditors without being so high that they are too problematic for borrower-debtors—judging by inflation and growth rates alone. But they are not high enough (by my measures) given the fiscal supply-and-demand dynamic explained in this book. + +Additionally, this is all impacting different companies in different sectors very differently—in fact, more so than at any time I can remember—because of the disruptive changes that are underway. The main reason that debt service didn’t rise to new highs while debts increased over the last few decades is that interest rates went down from 1980-81 until the recent rise. Since actual debt service payment changes lag interest rate changes (because interest rates on fixed-rate debt don’t rise until the debts mature), we should expect debt service payments to continue to rise to catch up with current interest rates. + +Based on inflation and growth readings as of this writing in March 2025, a Fed easing is not appropriate now. That begs the question of how the Fed, which is essentially the central banker for the world, is going to run a monetary policy that works for most everyone. I think that is a virtually impossible job that will subject the Fed to much more criticism and interference. Given the circumstances and the history of what happens with central banks at such times, the independence of the central bank should not be taken for granted. + +This most recent short-term debt cycle tightening was a bit different + + + +--- + + +# WHAT THE FUTURE LOOKS LIKE TO ME + +from other historical examples in two ways. First, because there was an engineered big shift in wealth to the private sector from the government sector (which is now carrying a lot of the debt and borrowing a lot to support the private sector), the private sector is currently in pretty good financial shape while the government sector is having financial problems, as previously described. In most developed economies, most importantly in the three major reserve currency economies—the US, the Eurozone, and Japan—the central governments have been and are still borrowing a lot to make distributions to households, and this is hurting these governments’ finances and threatening them in the ways described throughout this study. Said differently, in recent years central government and central bank income statements and balance sheets deteriorated so that household and corporate income statements and balance sheets would improve. This has created a safer environment for the private sector because central governments and central banks don’t have to worry about their debt problems as much, don’t get squeezed for money as much, and don’t have to worry about market losses as much. + +The second thing that makes this short-term debt cycle less typical is that the picture of the private sector is one of abnormally large divergences between companies. The tightening that began in 2022 hurt some sectors much more severely than other sectors, and technological, political, and geopolitical changes created big divergences. More specifically, in the most recent short-term debt cycle tightening, the over-levered, cash-short, interest-rate-sensitive, and/or bubble companies and investors who invested in them were hurt while the cash-flush, interest-rate-insensitive, financially sound, and/or hot-tech-related companies and their investors did great. Also, even with the wealth transfer from the government sector to the private sector, wealth gaps have continued to increase, with the relatively uneducated bottom 60% of the population in bad shape while the top 1% (about 3 million people) who are amazingly well-educated and productive contributors to the boom areas are being tremendously rewarded in their jobs and in the investments that they own. This is most obviously exemplified in the large number of unicorn companies that are coming up with + +3 6 9 + + + +--- + + +# HOW COUNTRIES GO BROKE: THE BIG CYCLE + +amazing new things that are enhancing productivity and producing billionaires (on paper) at a fast pace. By my measures, there is a significant risk that both a debt squeeze and an economic downturn will simultaneously happen two or three years from now. + +# WHAT ABOUT THE MARKETS? + +In looking at the markets, it is helpful to start with the following principle: + +- There is always a current most popular meme that just about everyone believes. It is reflected in the price and is bound to be wrong in some way. These memes typically are due to a mix of extrapolating what happened before and emotional considerations. Also, most investors typically don't take into consideration market pricing. In other words, they tend to identify what has been a great investment (e.g., a strongly performing company) as great, and they don't pay enough attention to its pricing, even though its pricing (whether it is cheap or expensive) is the most important thing. At this time, it is typical for almost everyone to be looking to make money by buying assets that they believe will go up (rather betting on them going down), and they quite often use leverage. + +At the time of my writing this in early March 2025, the most popular meme is that we should be optimistic about the future because by and large things are now good, AI companies are great and will make things better, and the Trump administration will improve things because there are many inefficiencies and weaknesses that need to be fixed. He will fix them because he is taking a strong, practical, capitalist, and business-like approach and he is working with Elon Musk, who has an amazing track record of making brilliant inventions and world-changing products. To summarize the meme, the United States has demonstrated that it has “American exceptionalism.” + +I believe that this meme about American exceptionalism has + + + +--- + + +# WHAT THE FUTURE LOOKS LIKE TO ME + +merit, but at the same time, by my measures, it is now more than reflected in the prices and there could be other big problems ahead. More specifically, I have no doubt that the US is exceptional in having a well‐developed system. It is characterized by: + +1. innovation, +2. well‐developed capital markets that finance smart risk‐taking in the pursuit of profits (which by and large naturally produce cost efficiencies and survival of the fittest), and +3. a well‐developed legal system in which most people know the rules of the game and disagreements can be resolved without fighting to produce exceptional successes when measured against key performance indicators (KPIs) like total wealth and power. + +At the same time, the system is producing great gaps in education levels, productivities, incomes, wealth, power, and opportunities that are extremely difficult to rectify and that threaten the long‐term health of the country. The big debt issue of there being too much debt relative to the demand for it will almost certainly lead to big fundamental changes in the monetary system, which will change what money is and how it works, which will happen either before the crisis in an attempt to prevent it or in response to the crisis. At a high level, while there are variations in how each of these debt crisis cases plays out, it almost always becomes relatively undesirable to hold the debt assets (e.g., bonds) compared with other storeholds of wealth that don’t lose buying power when the value of money goes down. + +It’s also worth noting that during Stage 5 of the Big Cycle, which we are now in, the domestic debt/economic situation is greatly affected by the domestic political and social order force, the international geopolitical force, acts of nature, and changes in technology. It is now the case that the internal political and external geopolitical conflicts that most countries are in are having bigger effects on countries’ finances than at any time since the 1930s. For example, onshoring, friendshoring, and other forms of ensuring that critical supplies cannot be cut off by foreign + + + +--- + + +# HOW COUNTRIES GO BROKE: THE BIG CYCLE + +Enemies have become more important economic policy drivers than cost efficiency. This is happening for the first time since World War II; it is costly and typically leads to more indebtedness. Likewise, countries’ finances are also having bigger effects on the internal political and external geopolitical conflicts than at any time since the end of the last Big Cycle. + +As far as emerging countries are concerned, they break down into two types: those that are overcoming their obstacles and surging ahead economically and financially (e.g., India, Indonesia and most other ASEAN countries, and the Gulf Cooperation Council countries) and those that are falling further behind (e.g., poor and disorderly developing countries, especially those that have very little money and are adversely impacted by climate change). It is logical, and it appears to be the case, that the financially strong, orderly, and relatively geopolitically neutral countries that have the best people and the most rewarding systems are doing the best and will continue to do the best. That is because I still believe that globalization is an unstoppable force. Despite the growing nationalism and the increased desire of many countries’ leaders to protect and control, I am seeing vastly more globalized deal-making that brings together people of all nationalities who have money to brainstorm on how to do deals with each other than I did 10 years ago. The people and what they are doing are very multinational and becoming more so fast. This has been an unstoppable evolutionary trend that has existed throughout history and is accelerating. + +# 2. The Domestic Order and Disorder Force + +As for where we are in the short-term political cycle, since Donald Trump and the Republican Party won the 2024 elections by a large enough margin to avoid disputes about who won, the US has had an orderly transfer of power. The principle that applies to such transitions is: + +At the beginning of a new popularly chosen leader coming to power—e.g., in the first 100 days of a new presidency—there is a + + + +--- + + +# WHAT THE FUTURE LOOKS LIKE TO ME + +honeymoon period and great optimism. That is when dreams of great changes and great improvements exist and before realities and criticisms of how the new leader has shaped and handled them set in. As time passes, typically the big promises the leader made to get elected become difficult to deliver and bad things happen so disappointment sets in, critics and enemies become bolder, and support wanes. All this makes fighting to stay in power harder, which often leads to more extreme actions to make that happen. + +After just a few weeks of the new administration, it should not be a controversial statement that Donald Trump wants to dictate policies rather than have a classic “let’s work together across party lines” approach to governing. This confrontational approach is an extension of how great internal political conflict has become in recent decades. The following charts show two measures of how internal political conflicts in the US are among the most severe in history. The first one shows how conservative Republicans in the Senate and House and how liberal Democrats in the Senate and House have become relative to the past. Based on this measure, they have become more extreme, and their divergence has become larger than ever before. While I’m not sure that’s exactly right, I think it’s by and large right. + +# IDEOLOGICAL POSITIONS OF THE MAJOR PARTIES + +| House Republican | Senate Republican | House Democrat | Senate Democrat | | | | +| ---------------- | ----------------- | -------------- | --------------- | ---- | ---- | ---- | +| 0% | | | 60% | | | | +| -5% | More | | 50% | | | | +| -10% | | | 40% | | | | +| -15% | | | 30% | | | | +| -20% | Greatest | | 20% | | | | +| -25% | gap | | | | | | +| -30% | | | 10% | | | | +| -35% | Less | | 0% | | | | +| -40% | conservative | | | | | | +| 1900 | 1920 | 1940 | 1960 | 1980 | 2000 | 2020 | + +Also, votes along party lines for the average member of Congress are the highest ever. This continues to be reflected in the reduced willingness + + + +--- + + +H O W C O U N T R I E S G O B R O K E : T H E B I G C YC L E + +to cross party lines to compromise and reach agreements. In other words, the political splits in the country have become deep and intransigent. + +# SHARE OF CONGRESSIONAL MEMBERS’ VOTES CAST ALONG PARTY LINES + +| | 100% | | | | | | +| ---- | ---- | ---- | ---- | ---- | ---- | ---- | +| | 90% | | | | | | +| | 80% | | | | | | +| | 70% | | | | | | +| | 60% | | | | | | +| 1790 | 1830 | 1870 | 1910 | 1950 | 1990 | 2030 | + +This chart shows the average predictiveness of a given member’s left/right ideology in determining their vote across chambers for each congressional session. The fact that this is a global phenomenon and that it is happening as measured by NOMINATE, an academic model of ideological preference. + +# % WHO SAY THERE ARE VERY/SOMEWHAT STRONG CONFLICTS BETWEEN PEOPLE WHO SUPPORT DIFFERENT POLITICAL PARTIES IN THEIR OWN COUNTRY + +| Country | 2022 | 2021 | Diff | +| ----------- | ---- | ---- | ---- | +| France | 74% | 65% | 9% | +| Germany | 68% | 56% | 12% | +| Spain | 68% | 58% | 10% | +| Canada | 66% | 44% | 22% | +| UK | 65% | 52% | 13% | +| Netherlands | 61% | 38% | 23% | +| Belgium | 53% | 46% | 7% | +| Singapore | 43% | 33% | 10% | +| Sweden | 43% | 35% | 8% | + +3 7 4 + + +--- + + +# WHAT THE FUTURE LOOKS LIKE TO ME + +The following chart shows the average global levels of political polarization since 1900.⁵⁴ + +# GLOBAL POLITICAL POLARIZATION INDEX + +| | | 1.0 | | | | | | | | | | | | | +| ---------------------------------------- | ---- | ---- | ---- | ---- | ---- | ---- | ---- | ---- | ---- | ---- | ---- | ---- | ---- | - | +| Up = More polarization; Worst in history | | 0.8 | | | | | | | | | | | | | +| | | 0.6 | | | | | | | | | | | | | +| | | 0.4 | | | | | | | | | | | | | +| | | 0.2 | | | | | | | | | | | | | +| | | 0.0 | | | | | | | | | | | | | +| | | -0.2 | | | | | | | | | | | | | +| | | -0.4 | | | | | | | | | | | | | +| | | -0.6 | | | | | | | | | | | | | +| 1900 | 1910 | 1920 | 1930 | 1940 | 1950 | 1960 | 1970 | 1980 | 1990 | 2000 | 2010 | 2020 | 2030 | | + +These are just a few measures of many that reflect high and rising internal conflict. It appears clear that, as the gaps in people’s productivity, wealth, and values grow along with levels of dissatisfaction about how their democracies are working, it leads to more populist conflict and more policies that are like those in the 1905-14 and the 1933-38 periods. As I explained earlier, such times of conflict are often when transitions toward more autocratic forms of government happen. + +ⓢ When democracies fail, autocracies come in. + +Within countries, intensifying populist conflicts between those of the hard right, those of the weak middle, and those of the hard left are now taking place, with big political shifts (mostly toward the hard right) and revolutionary changes resulting from them. In this environment in which those who are productive are rewarded and those who are unproductive suffer, the least productive and the poorest will suffer the most. As history shows us, this situation typically has threatening consequences. + +ⓢ In times of disorder, financial, political, and military power matters more than laws, and authoritarianism works better than weak. + +54 This was sourced from “Varieties of Democracy,” a project run out of the University of Gothenburg in Sweden to create standardized global databases covering five indicators of governance and civil society. + + + +--- + + +# HOW COUNTRIES GO BROKE: THE BIG CYCLE + +disorganized collectivism. We are now seeing the dramatic part of the movie being played out by Donald Trump and his administration taking control of the US to try to reverse its decline to “make America great again.” He is doing this by trying to make America competitive again, while at the same time we are also seeing many leaders in many countries, industries, and companies, and people broadly trying to outcompete the others. That competition is now so vicious that it includes the willingness to kill competitors. + +As shown in history, the transfer of power from democracy to autocracy was more often than not orderly within the democracy because people were sick and tired of the system failing to work and wanted to give power to a leader who would take control of the mess and make it work well. Clearly this is now happening. But it has also always been the case that, after transfers of power, new leaders during periods of great conflict take steps to consolidate power—and more autocratic leaders do so more forcefully. + +Because the opposition remains threatening, it has to be dealt with so that its ability to threaten is reduced, which will likely be done by the leader and the party in power increasingly taking control of the law. We are now seeing this happen in the US through the president’s use of executive orders. As always, we will see how far this will go when what the executive leader wants to do and what the other parts of the tripartite government want to do (i.e., the judiciary and Congress) come into conflict. + +We should expect that there will be more fights—legal and otherwise—between factions and particularly between the president/executive branch and the other branches of government (especially the judicial branch) and between the federal, state, and local governments. These fights will make clear who really has the power. In a limits-of-power-testing battle between the power of the executive branch of government and the judicial branch of government, the judicial branch will lose because the executive branch has much more control over the powers of enforcement. In fact, the Department of Justice is part of the executive branch of government so is under presidential control. The powers of enforcement are the army. + + + +--- + + +# WHAT THE FUTURE LOOKS LIKE TO ME + +and the National Guard and state and local police, with the president having control over the first two and the judicial branch having control over none. For these reasons, it was easy for Donald Trump to order dropping the case against New York City Mayor Eric Adams. We should expect many more power struggles. I have little doubt that the president will win most of these. + +Different people have different views of whether this kind of leadership is a good thing or a bad thing. In Chapter 8, I described how the approaches of a strong CEO and those of a demagogue can be indistinguishable as both are people who take control and make radical changes with the goal of making radical improvements. That is certainly the case with Donald Trump. Is Donald Trump a demagogue? According to Plato, a demagogue is a political leader who gains power by appealing to people’s emotions, fears, prejudices, and desires, often using manipulative rhetoric. Demagogues typically stir up populist sentiment and promise easy solutions to complex problems, often at the expense of truth or rational discourse. The question is what will the controls be and how far will Trump push things? Unlike for a CEO, there is no board for the US president. Are there effective regulators in place? If so, it is not clear to me who they are. + +When I say that the policies President Trump is using to “make America great again” are remarkably like the policies that those of the hard-right countries in the 1930s used, that should not be controversial. It would be fair to argue that his attempts to maximize the power of the presidency by bypassing the other branches of government are analogous to the ways that Andrew Jackson (of the right) and Franklin D. Roosevelt (of the left) did, though he is even more aggressive than they were. We will see how far he will take it. In the typical historical case, in times of great conflict, aggressive leaders work to eliminate the opposition by threats and damaging action, by making changes in the law that give the leaders special powers, and by taking increased control over the media to produce pro-government propaganda. If conflicts with internal or external opponents become severe, laws and punishments targeting the opposition will be imposed. + + + +--- + + +# HOW COUNTRIES GO BROKE: THE BIG CYCLE + +While the changes to government that President Trump is making are radical in terms of intended cost savings and must be done quickly to be successfully accomplished, there are negative consequences to these cuts because many people who will be hurt by them will fight back and valuable support systems will be weakened or eliminated. For example, my wife works to help the poorest students in the worst neighborhoods who suffer from inadequate nutrition and rely on school lunch programs that are being eliminated, which will have terrible second-order consequences. Second-order consequences like these should be taken into consideration when thinking about what the future will look like after the radical changes are made. + +Remember that to be successful the system must produce adequate conditions for most people. Will that happen? The challenge in the US is that there is and has been a deep and pervasive rot in our education, family, and social systems that has resulted in many children not being brought up to lead productive, civil, and healthy lives. This is a multigenerational problem that is nearly impossible to fix, especially with fragmented leadership and inadequate resources directed to dealing with it. Currently, only a small percentage of the population is highly productive and prosperous. More specifically, the top 1% of people (and increasingly machines) are making revolutionary changes. They, along with the next 9% who help them, together make up the top 10% and are doing great. The next 30% are doing so-so, and the bottom 60% are doing terribly—i.e., they are net costs rather than net contributors. (On average, they have attained less than a sixth-grade reading level and get more in public assistance payments than they pay in taxes.) + +The Trump administration’s policies are aimed at raising productivity by shifting more money, power, and freedom into the hands of those who are most productive. This will have second-order consequences that everyone, especially those in the Trump administration, should consider. It's not easy to manage and improve a country that has been mismanaged and in such a mess while also keeping people happy at a time when democracy is fracturing. I recommend regularly checking on how those in the bottom 60% are doing and feeling. + + + +--- + + +# 3. The International Order and Disorder Force + +We are now seeing the international order changing in ways that are typical at this stage in the Big Cycle—i.e., there is a shift from a more cooperative, multilateral world order that pursues common interests (e.g., trade) to a classic great power conflict in which there is a more confrontational, unilateral world order that pursues self-interest through the bold use of financial, political, and military power. As described earlier, this is the part of a Big Cycle when there is a shift toward authoritarian, confrontational leadership. As is classic in Stage 5 and as we are seeing now, there is a type of world war going on that has turned more violent locally (e.g., Russia versus Ukraine, Israel versus Iran and its proxies) but has not yet turned violent between the leading global powers (the US and China). + +At this stage, it is increasingly true that ⓢ the strong prey on the weak. As a result, the weak empire should worry. Which is the weak empire? President Trump, Vladimir Putin, and everyone including the Europeans know that Europe is weak and easy prey, Russia will likely be an enemy of Europe, and Trump’s “America First” policy will likely lead to it not defending Europe. Also, everyone knows that Trump is hard-right, so he is inclined to align the US with those who are hard-right and capable of fighting, and to use both carrots and sticks to make people and countries do what he wants them to do. That is what is driving the reshaping of the new world order and the “allied powers” side led by the US. + +It is also important to remember that at this stage in the Big Cycle ⓢ alliances often change fast as circumstances change quickly and winning is more important than loyalties. For example, Germany and Russia quickly switched from allies to enemies in World War II. We should expect alliances to change fast and in previously unimaginable ways—e.g., it would not surprise me if Trump’s US and Putin’s Russia align, with China becoming more isolated as there is no true love and fidelity between Russia and China. Likewise, we might find Europe and China more + + + +--- + + +# HOW COUNTRIES GO BROKE: THE BIG CYCLE + +Aligned than Europe and the US. These sorts of previously unimaginable changes have often occurred at this stage in the Big Cycle. We will learn a lot shortly. + +As far as the great power conflict between the US and China goes, it cannot be objectively disputed that the United States has been in relative decline and that the conflicts with China are increasing. This is clearly shown in the following charts. The one on the left shows my measure of the total powers (including my 21 measures of power) and the one on the right shows my gauge of the intensity of the US‐China conflict. It shows the great power conflict and the Thucydides Trap dynamic in action. + +| COUNTRY POWER INDICES | US-CHINA CONFLICT GAUGE | | | +| --------------------- | ----------------------- | ----- | - | +| | | China | | +| | United States | | | +| | 100% | | | +| | 80% | | | +| | 60% | | | +| | 40% | | | +| | 20% | | | +| | 0% | | | + +1800 1850 1900 1950 2000 1960 1975 1990 2005 2020 + +President Trump is seeking to reverse that relative decline at the same time as the US and China are clearly in a war that has not yet become a military war. It is not clear at this time (early March 2025) exactly what US-China relations—or, more broadly, international relations—will be like. + +I don’t expect a military war between the US and China in the foreseeable future because both sides know that it would lead to mutually assured destruction. I think the only thing that China would go to war over is a real threat to its sovereignty, which includes the Taiwan issue. Also, I don’t think any American president would go to war unless there was an existential threat (like losing TSMC’s chip production). At the same time, I could imagine that President Trump would be willing to negotiate Taiwan away under the right circumstances. + + + +--- + +# WHAT THE FUTURE LOOKS LIKE TO ME + +terms for the right, big price. Trump and Xi are strongmen running great powers and will have regular conversations to negotiate directly with each other. Both want to avoid a military war and existential threats to their countries while each would also love to eliminate the other as a threat. + +The only way I can see either side winning a war is by secretly building a technology of overwhelming power that can be deployed without triggering an intolerable retaliation so that simply demonstrating it to the other side would lead to some form of capitulation. This has been done throughout history. This would be akin to the secretive development of the atomic bomb and the displaying of its power to the Japanese via the attacks on Hiroshima and Nagasaki. To be clear, I am not ruling out such a scenario because I am sure that both countries are working on the development of mind-blowingly powerful technologies that remain secret. + +No one on either side believes that the US-China relationship will go back to what it was. Though neither side wants military war, the US and China are currently engaged in other types of war, including diplomatic, cyber, and trade wars in which they are severely threatening and hurting each other. It is not disputable that there is a deep-seated belief that the other side is an enemy and is doing very harmful things to the other. This is risky because the most important and threatening stuff is going on in secret, so it can’t be controlled unless it is self-controlled, which, under the circumstances, neither side will do. + +Still, my bet is that China will try to stay out of an overt fight for geopolitical dominance outside its region while a) acting to build great power that can be used to harm those who harm it and b) moving to achieve the unification of Taiwan with China, which is widely believed to be a goal that President Xi, who is now in his early 70s, would like to achieve in his lifetime. For those reasons, as mentioned above, if I were the Taiwanese, I would worry about my country being used as a negotiating chip for the US to offer to China in return for great concessions. Of course, such a deal would have to eliminate any semiconductor chip vulnerabilities for the US that would result in + +381 + +--- + + +# HOW COUNTRIES GO BROKE: THE BIG CYCLE + +China controlling Taiwan. I also expect China to continue to build important relationships in the Global South using both its economic and geopolitical power because that is a huge market for its very attractively priced manufactured goods and construction companies. + +While governments are becoming more nationalistic and protectionist, the world, investors, and businesspeople have become more interdependent than at any time in history, and investment and business deal making are more international than ever before. For that reason, what is happening domestically affects what is happening internationally, and vice versa, more than ever before, and what is happening economically is affecting what is happening geopolitically, and vice versa, more than ever before. This is having policy, investment, and business implications. For example, the need to win the tech war is leading to top-down, government-directed domestic and international policies for chip production, data center investment and development, electricity production, embargoes on technologies, sanctions, CFIUS and reverse CFIUS tariffs, global talent acquisition, etc. To me, the big questions are how practical the respective world leaders are, how they and their opponents will deal with each other, and how orderly and smartly things will be managed when times get tough. My take is that international investment and business deals will get easier and increase in number rather than get harder and fewer. Keep in mind that while that is what I think about the world’s geopolitical order, I’m not sure of anything. + +# 4. The Force of Nature + +# (Droughts, Floods, and Pandemics) + +We certainly cannot overlook the power and impacts of nature. As I described in Chapter 8, throughout history acts of nature have killed more people than wars and toppled more orders than all the other four forces combined. It is likely that in the years ahead, acts of nature will increase in frequency and be very costly. Given how + + + +--- + + +# WHAT THE FUTURE LOOKS LIKE TO ME + +Heavily indebted and burdened with other demands the world’s major nations now are, very little is going to proactively prevent and prepare for the high costs of a changing natural world. But the costs will be incurred regardless—either by paying to prevent the damages or paying to fix things after damages occur from intolerably hot weather, droughts, floods, rising sea levels, health problems, damage to the oceans that will change currents and sea life, species loss, and many other things likely to happen in the years ahead. This will require significant amounts of money being spent to adapt to these changes. For countries in the Global South that are experiencing big effects from climate change and don’t have the resources to address them, this could lead to domestic conflict and emigration. Displaced people in turn will strain other countries, as we are already seeing with immigration in the US and Europe, making both domestic and international politics more unstable. + +# 5. The Technology/Human Productivity Force + +While the trends of the first four forces appear to be worsening, the technology force has never, in the whole history of humanity, been more powerful than it is now and will be over the next few years. It looks to me like we are now at the brink of a new era in which machine thinking will supplement or surpass human thinking in many ways, like how machine labor supplemented and surpassed human labor during the Industrial Revolutions. Just as we saw that doing math in our heads and remembering facts became much less important with the invention of computerized tools that do these things, and just as we have gone to Google (or its equivalents) to find information rather than gathering information in more traditional ways, we will soon be going to computers to get our instructions on what to do when we are in different situations because the computer will come up with better guidance more quickly than we can. Over the next five years, we will see dramatic advancements in most areas. Creating the AI capabilities is just the beginning of the + + + +--- + + +# HOW COUNTRIES GO BROKE: THE BIG CYCLE + +AI applications. I know that in my area of investing where I and Bridgewater have been doing AI investing through expert systems for decades, the opportunities that are being developed are nearly unbelievable. The days of people making decisions in their own heads are ending. I and others at Bridgewater have experienced and capitalized on this (r)evolution via the computerization of investment decision making, so I’m excited by what will be happening. + +Because these technologies will impact almost everything, there will be exceptionally big differences between the performance levels of countries, investors, and companies who use them well. Those who know how to use these tools effectively will be rewarded, and those who fail to do so will be penalized. It is worth noting, however, that from an investment perspective, it is not totally clear how much money will come in relative to the costs that will go out to invest in and create these new technologies. + +The US and China are now the main competitors in designing these powerful new technologies, and how effective they are will have big impacts on their economic and military powers, though several countries are also developing and benefiting from these new technologies. While the US is ahead of China in developing the most advanced semiconductor chips and weak in its production of them, China is close behind in the development of advanced chips, ahead in producing less advanced chips much less expensively, and ahead in deploying AI. There will certainly be a lot of effort from both sides to gain an advantage over the other in this race, both by stealing/borrowing what the other side has and trying to defend one’s own gains. + +I keep in mind the principle that by and large, intellectual property protections don’t work. While deep secrets that are protected with great effort (like the development of the atomic bomb) might be able to be kept hidden, anything that is openly used can almost instantly be replicated. Also, legal systems do a poor job of enforcing intellectual property protections. For these reasons, we should assume that most good ideas that are openly shown and are liked a lot will be replicated in about six months. + + + +--- + +# WHAT THE FUTURE LOOKS LIKE TO ME + +I should also make clear that AI isn’t the only important technology shaping the relative power of nations. There are many technologies beyond chips and AI that the US and China are the main real competitors in, including quantum computing, gene editing and other biotech, robotics, space, etc. China, which is home to 20 of the 40 best computer science programs in the world, is a formidable adversary to the US in the technology competition. + +In conclusion, I am very excited and optimistic about the revolutionary improvements that are likely to take place as the result of inventive/practical people being put together with capital that gets them the resources that they need (perhaps most importantly, these new AI technologies) and operating in great environments that are conducive to advancement. Of course, new technologies are double-edged swords. For example, they have advanced how we can do each other harm as well as how we can do each other good. + +As shown in the following charts, there have been exponential improvements in real GDP and life expectancy. This is because of the accelerating, compounding rate of growth of knowledge, which should continue due to the way it is compounding via AI. + +| GLOBAL RGDP | GLOBAL LIFE EXPECTANCY AT BIRTH | | | | | +| --------------------------------------------------------------------------- | ------------------------------- | ---- | ---- | ---- | ---- | +| PER CAPITA (LN) | | | | | | +| | 11.0 | 80 | | | | +| | 10.5 | 70 | | | | +| | 10.0 | 60 | | | | +| | 9.5 | 50 | | | | +| 9.0 | 40 | | | | | +| | 8.5 | | | | | +| | 8.0 | | | | | +| | 7.5 | | | | | +| | 7.0 | | | | | +| | 6.5 | | | | | +| 1500 | 1600 | 1700 | 1800 | 1900 | 2000 | +| Note: Back history in dashed line based on experience of Great Britain only | | | | | | + +Source: US News & World Report Best Global Universities for Computer Science rankings for 2024-25. + +--- + + +# HOW COUNTRIES GO BROKE: THE BIG CYCLE + +# WHERE DOES THIS LEAVE US? + +To conclude where I started, what I don’t know is much greater than what I do know, and as I write this in early March 2025, I am at a maximum point of uncertainty. That’s because the Trump administration took office just 40 days ago and its big moves to change the monetary, US political, and geopolitical world orders have just begun. At the same time, I also know that whatever changes we see happen will happen in similar ways for similar reasons to how they have happened many times before, though with contemporary twists. So, it appears to me that the changes in these orders will likely continue to track my template, which is based on the patterns of the past and the logical relationships between the five big forces. + +Looking at where things are headed over the next few years, I believe that very powerful technological advances will most likely not be enough to overpower the headwinds coming from the other forces. I derived this view by looking at the amazing digital/computer/internet boom that we have experienced since 1985 and at the impacts of great discoveries and advances in technologies (e.g., railroads, steam engines, electricity, flight) at times when the other four forces turned negative. I used these cases as references for what might happen over the next 30 years due to the new technologies that are coming in AI, robotics, quantum computing, biotech, etc., and I asked myself what effect those prior technologies’ leaps had on productivity. + +More specifically, I estimated that the positive impacts of today’s new technologies will be about 150% of what happened over the last 30 years. By my measures, this would make today’s technological revolution the most powerful ever in terms of its impact on markets and economic conditions. But my back-of-the-envelope calculations also show that this positive force will not be enough to negate the headwinds of debt, internal conflict, external conflict, climate change, and demographics. Similarly and interestingly, when I looked at other periods of high inventiveness such as in the Industrial Revolutions and the 1920s, what I saw is that the productivity-improving + + + +--- + +# WHAT THE FUTURE LOOKS LIKE TO ME + +Powers of the great new technologies were normally squelched when the other forces of the Big Cycle turned negative. So, it appears to me that the most important factor for the years ahead is that the other forces are managed well. + +I am confident that the next 5-10 years will be a period of enormous changes in all the major orders, and that going from now until then will feel like going through a time warp into a very different reality. Many countries, companies, and people who are now up will be down, and those who are down will be up. How we think and what we do will be very different, in ways that we can’t possibly anticipate. + +I also know that there are better and worse ways to play this set of circumstances, and the best way is to play the probabilities, diversify well, and stick with sound fundamentals. As far as the best places to be, I believe that they are the countries that get these fundamentals right—i.e., those that educate their people well so they are skilled and civil and have access to an environment of great opportunity for them to be productive, that earn more than they spend so they have strong national income statements and balance sheets, that have internal order rather than disorder, that have low risks of being in an international war, that have low risks of experiencing harmful acts of nature, and that benefit the most from changes in technology. + +Having great human capital will matter most. + +As I explained earlier, the biggest, most important force is how people deal with each other. If people treat their problems and opportunities as being shared and they focus on getting the best outcomes for the whole without damaging each other, they will likely get the best possible results. For example, as described in the last chapter, it is now possible for government leaders to manage their countries’ debts and monies well—e.g., for the US to cut its deficits down to 3% of GDP—which would greatly reduce the risks of. + +56 If you are interested in monitoring my KPIs of how countries are doing in these dimensions, you can find my updated Country Power Index at economicprinciples.org. + +--- + + +# HOW COUNTRIES GO BROKE: THE BIG CYCLE + +a government debt market/economic crisis. Similarly, domestic and world orders, acts of nature, and the managing of the amazing new technologies will have much better outcomes if those who have their hands on the levers of power work well together. + +Unfortunately, I believe that an objective examination of how likely these things are to transpire would conclude that the chances of cooperation for mutual benefit are not good. The reality is that the events that have brought the Big Cycle to where it is today have left strong beliefs within most factions that the people in the opposing factions are doing them harm—and that the time has come to fight and win at all costs. Those in the opposing factions also believe that they must fight to win at all costs. We know from history that extreme factionalism kills. + +Hopefully this picture makes people worry and motivates them to do what is still in their power to do to improve things, which brings me to a final principle: ⓢ If you’re not worried, you need to worry—and if you’re worried, you don’t need to worry. That’s because worrying about the things that can go wrong will protect you, while not worrying about them will leave you exposed. + +I hope you find good principles to prepare for the interesting times ahead. + +--- + +# ABOUT THE AUTHOR + +Ray Dalio has been a global macro investor for more than 50 years. In 1975, he founded Bridgewater Associates from his two‐bedroom apartment and built it over four decades into the largest and most successful hedge fund in the world and the fifth most important private company in the US, according to Fortune magazine. + +Dalio grew up a very ordinary middle‐class kid on Long Island and started investing when he was 12 years old. Over the course of his career, he has become a renowned author and speaker, an advisor to top policy makers, and one of the “100 Most Influential People in the World,” according to TIME. CIO and Wired have called him “the Steve Jobs of investing” for his uniquely inventive and industry‐changing way of thinking. He has also been named by Forbes as one of the 50 most generous philanthropists in the US. + +In 2017, he decided to pass along the principles behind his success in a series of books and animated videos. His 2017 book Principles: Life and Work was a No. 1 New York Times Best Seller and the No. 1 Amazon business book of the year, has sold more than 5 million copies worldwide, and has been translated into over 30 languages. His 2021 book Principles for Dealing with the Changing World Order was also a New York Times Best Seller and has sold more than 1 million copies worldwide. Dalio has also created a series of 30‐minute animated YouTube videos (“How the Economic Machine Works,” “Principles for Success,” and “Principles for Dealing with the Changing World Order”), which have together been watched more than 250 million times. His 2018 book Principles for Navigating Big Debt Crises was well‐received by economists, policy makers, and investors. + +In this latest book, How Countries Go Broke: The Big Cycle, Dalio is for the first time sharing his unique template for understanding the final stages of what he calls the “Big Debt Cycle” and showing how these stages help drive to the “Overall Big Cycle” that governs the kinds of radical monetary, political, and geopolitical changes we are seeing in the world today. + +--- + +# It All Has Happened Before for the Same Reasons +## Author: Ray Dalio, Founder of Bridgewater Associates, Published Sep 17, 2025 +For me, watching the news feels like watching a contemporary version of a movie that I’ve seen many times before. While the details change—the specific leaders, clothes, technologies, and stories aren’t identical—the basic story that is now unfolding and the cause/effect relationships that are driving it are the same as what I’ve seen many times in history (most recently the 1930s) and are laid out in detail in my book and video, Principles for Dealing with the Changing World Order. +Because seeing things this way has brought me great benefits and because I’m now at a stage in my life where I want to pass along to others what I see that might help them, I am sharing how I see what’s going on through that lens. + +--- + +# It All Has Happened Before for the Same Reasons +## Author: Ray Dalio, Founder of Bridgewater Associates, Published Sep 17, 2025 +What follows are all things I have recently seen in the news that I haven’t seen through most of my lifetime but that I have seen many times before in my study of history. These events are all following my Big Cycle template that points toward breakdowns in monetary, political, and geopolitical orders. + +--- + + +# It All Has Happened Before for the Same Reasons +## Author: Ray Dalio, Founder of Bridgewater Associates, Published Sep 17, 2025 +So here is what I’ve watched in the news and how I saw it: + The passage by the central government of the world’s leading reserve currency country, which is heavily indebted, of a budget bill that will produce big deficits that will require large bond sales and big increases in debt service payments, which will most likely be dealt with by the central bank pushing real interest rates down and monetizing its debt—increasing the risk to fiat money and debt denominated in it. + The imposition of relatively large tariffs for both economic and geopolitical reasons in an attempt to make the country more competitive, bring in tax revenue, and use trade as a weapon against opposing countries. + Moves by the country’s leader to increase his control over the central bank. + Moves by the country’s leader to gain control over both the political system and his political opponents that he believes are ruining the country, leading to conflict between those of the hard right and those of the hard left. + Moves by both the rightist (Republican) and leftist (Democratic) sides in a democracy to influence the elections to come out in their favor via redistricting initiatives (by Republicans in Texas and Democrats in California) rather than through representative democracy. + The deployment of the National Guard in cities that have social disorder and political opposition to the leader’s policies. + The shooting, martyrizing, and eulogizing of a political figure (Charlie Kirk) in a country where there is a lot of gun violence and increasing political violence. + Leaders from a group of rival powers (China, Russia, India, North Korea, Iran) gathering in meetings and for a military parade to talk about and display their powers to challenge the leading world power and its world order. + The incursion (by Russian drones) into countries (Poland and then Romania) that are in an alliance with other major countries (NATO countries) requiring them to enter a war if an attacked member country triggers that action. + The attack of a country at war (Israel) on its enemies who were being housed in a neutral sovereign country that was trying to help negotiations between Israel and Hamas. + There are many more news items that I could cite that paint a picture that is inconsistent with what we have become used to in this world order since World War II but is very consistent with what has happened at other times in history, especially during prior breakdowns in monetary, political, and geopolitical orders (e.g., in the 1930s). + +--- + +# It All Has Happened Before for the Same Reasons +## Author: Ray Dalio, Founder of Bridgewater Associates, Published Sep 17, 2025 +I have found that studying the cause/effect mechanics of history makes it possible to logically explain these cause/effect relationships because they are relatively clear. I have built my understandings of these relationships into tools and models/templates for seeing how history has transpired. Because the causes come before the effects, these models have worked well for me, and I can’t help but see things through that cause/effect lens. While I have other models that determine my day-by-day positioning in the markets, my Big Cycle template has been most important in determining my big, long-term positioning. +By the way, I agree with the idea that history rhymes rather than repeats exactly. That is because many situations are similar, but none are identical. I find that to understand the big things that are going on and where these big things are probably headed, it is most important to focus on the interactions of the big forces and not squint at the details or expect precision. I suggest that you do the same. + +--- + +# It All Has Happened Before for the Same Reasons +## Author: Ray Dalio, Founder of Bridgewater Associates, Published Sep 17, 2025 +Because I have found my Big Cycle template to be invaluable in helping me do what I do, especially in doing my investing (e.g., owning gold and having other market positions that have done well), and because at this stage in my life I want to pass it along to others who find it helpful, I laid it out in detail in my books Principles for Dealing with the Changing World Order and How Countries Go Broke: The Big Cycle. +Now, to help convey why what’s happening looks like a movie that I have seen many times before, I will very briefly explain my Big Cycle template, why it helps me bet on what will probably happen, and what the picture now looks like to me. + +--- + +# It All Has Happened Before for the Same Reasons +## Author: Ray Dalio, Founder of Bridgewater Associates, Published Sep 17, 2025 +How the Big Cycle Works +As previously explained (so I won’t dwell on it here), the Big Cycle is mostly driven by five big forces that have repeatedly interacted in basically the same ways throughout time. Because these forces and their effects can be tracked, one can see them evolve just as a doctor can watch vital signs to see a patient’s condition evolve. + +--- + +# It All Has Happened Before for the Same Reasons +## Author: Ray Dalio, Founder of Bridgewater Associates, Published Sep 17, 2025 +The five big forces are: +The Debt, Money, Economy Force: By most measures, the Big Debt Cycle is tracking the template that I laid out in my book How Countries Go Broke: The Big Cycle. Most importantly, we are now seeing that governments’ debt-service costs are very large and rising much faster than the amounts of money that governments are taking with taxes, so we are now seeing debt-service payments squeezing out spending at the same time that we are seeing the supply of debt increasing faster than the demand for it. Domestic politics and international geopolitics are now operating with these debt, money, and economic forces in ways that we haven’t seen though most of our lives but have seen in analogous times in history due to understandable cause/effect relationships. + +--- + +# It All Has Happened Before for the Same Reasons +## Author: Ray Dalio, Founder of Bridgewater Associates, Published Sep 17, 2025 +Because I have seen the dynamics that are now driving things in over 50 cases in history, I understand what central banks and central governments have done when they were in analogous positions because it is logical for them to do such things. That’s what informs my view of what will probably happen—e.g., that there will probably be a lowering of real interest rates and a printing and devaluation of money to pay the debt back with cheaper money—and this view drives my bets. From studying history and seeing what is happening, I believe that big increases in debts and deficit spending are likely to continue because the American voting population won’t accept either higher taxes or lower benefits, and those who want to be elected don’t want to impose fiscal discipline on those whose votes they need. + +--- + +# It All Has Happened Before for the Same Reasons +## Author: Ray Dalio, Founder of Bridgewater Associates, Published Sep 17, 2025 +For that reason (and for the other political and geopolitical reasons that I am about to touch on), I see that central bankers and investors have been shifting away from holding fiat currency debt as their dominant storehold of wealth reserves/savings and toward holding gold and other non-fiat currencies as their reserves/savings, which has been driving up the prices of gold, other hard currencies, and non-fiat currency storeholds of wealth. This is all logical to me. I also see that because of these circumstances, the leader of the heavily indebted country, in this case President Trump, wants to lower real interest rates, gain control over the central bank, and lean on foreign creditors to not sell their debt and to invest instead in his country. All these things have happened before during this stage in the Big Cycle. + +--- + +# It All Has Happened Before for the Same Reasons +## Author: Ray Dalio, Founder of Bridgewater Associates, Published Sep 17, 2025 +The Domestic Political Force: The existing political order is also changing in unusual and dangerous ways that haven’t happened before in our lifetimes but that have happened many times in history and that are driven by understandable forces working in logical ways. More specifically, because there are large and growing gaps in wealth and values, we are now seeing extreme political splits between those of the hard right and the hard left, and we are seeing the rise of both populism of the right and populism of the left and win-at-all-cost fights between them. These forces are changing the domestic legal and political systems in ways that we haven’t seen before in our lifetimes, but which are similar to those that happened many times before for analogous reasons in the analogous stages of the Big Cycle, most recently in the 1930s. + +--- + +# It All Has Happened Before for the Same Reasons +## Author: Ray Dalio, Founder of Bridgewater Associates, Published Sep 17, 2025 +These big changes are notable. For example, throughout most of the post-World War II period, US leaders were expected to operate by laws within a system that was designed to be run with checks and balances, broad representation of the country’s diverse perspectives, and compromises that work for the whole rather than for either side. Now, leaders are no longer willing to do that because they are in win-at-all-cost fights and are working on changing the system for their side to win. That is reflected in the recent news about people in government jobs being hired or fired based on their political alignment, the ways voting districts are being gerrymandered, and the ways the Supreme Court, Congress, and the tripartite checks-and-balances system are now working. These are all very different from what we are used to yet are both analogous to prior times in history and logical given the existing circumstances. + +--- + +# It All Has Happened Before for the Same Reasons +## Author: Ray Dalio, Founder of Bridgewater Associates, Published Sep 17, 2025 +Similarly, the news about the president ordering National Guard troops into major cities that are in disorder and that are run by the president’s political opposition is inconsistent with what we have become used to but consistent with what we have seen in the past and what is typical in this phase of the classic Big Cycle. All this is logical when a country is in a mess in many ways and when there are great differences in wealth, values, and approaches (i.e., right versus left), because those on different sides want strong leaders to take charge to fix the mess and win at all costs. Throughout history, this kind of fighting has weakened democracies and led to great conflicts that changed the domestic political order. Violence between the sides that leads to killings is a big red flag that typically signals a big fight and big disruptive changes, so the killing of Charlie Kirk naturally triggers memories of historical cases of political violence. While there have been some other recent examples of left/right politically motivated, rich/poor class motivated, religiously motivated, and ethnically motivated acts of violence, I am not yet ready to conclude that there will be a significant-enough number of these to be systematically disrupting. Still, I am watching this closely because an increase in this kind of violence is a reliable leading indicator of periods of great disruption. + +--- + +# It All Has Happened Before for the Same Reasons +## Author: Ray Dalio, Founder of Bridgewater Associates, Published Sep 17, 2025 +The International Geopolitical Force: It should now be obvious that the world order is changing from a US-led multilateral order, with multilateral institutions and agreements playing important roles in shaping how the world works, to a much more unilateral order in which the United States and its allies are on one side and China and its allies are on the other side. We can now see that these great powers are engaging in the kinds of classic economic, trade, technological, and capital wars that have typically preceded military wars. And we can see that these developments are following the classic international geopolitical cycle. The recent gathering in Beijing included Xi of China, Putin of Russia, Modi of India, Kim of North Korea, Pezeshkian of Iran, and other US-opposing or “non-aligned” leaders and was followed by a big military parade that followed President Trump’s military parade earlier this year. These events look more like the classic saber-rattling that we have seen many times before in analogous historical periods in the Big Cycle than what we are used to seeing in the post-1945 world order. The recent Russian drone incursion into Poland that I touched on earlier and the recent Israeli attack on the Hamas headquarters in Doha were notable and concerning crossings of red lines. + +--- + +# It All Has Happened Before for the Same Reasons +## Author: Ray Dalio, Founder of Bridgewater Associates, Published Sep 17, 2025 +The Force of Nature: Throughout history, droughts, floods, and pandemics have killed more people and toppled more orders than any of the previously mentioned forces. It should be obvious that it is now a very big force that will have big economic, political, and geopolitical impacts that won’t be good. +Humankind’s Learning and the Creation of New Technologies: AI and quantum computing will both be huge forces and will be used for both great and terrible purposes. Perhaps it will greatly increase learning and productivity to help mitigate the other issues, or perhaps it will exacerbate them. While nobody can predict how much of each will happen, we certainly can monitor and ride the changes. I believe that great fortunes will be made in the platforms that enable great usage of these technologies as well as by the smart users of them who raise profits and productivity a lot, so I am investing in both. + +--- + +# It All Has Happened Before for the Same Reasons +## Author: Ray Dalio, Founder of Bridgewater Associates, Published Sep 17, 2025 +To reiterate, while these Big Cycles are no more preordained than people’s life cycles, they do unfold logically and, like the progressions of human life cycles and diseases, can be monitored and measured to judge the health of the systems and their prognoses. In Principles for Dealing with the Changing World Order and my more recent book, How Countries Go Broke: The Big Cycle, I explain the cause/effect mechanics, the current and past conditions and how and why they changed, and the limited options that currently exist under these circumstances. Understanding these Big Cycle linkages isn’t just valuable for investors; it can also help leaders, policy-makers, and citizens understand what is likely to come next if events unfold as they typically do, which can lead to them steering things in ways that avoid the worst outcomes. For those interested, I’m sharing a chapter from my latest book with a distilled version of the Overall Big Cycle, which describes this Big Cycle and what is now happening in a 10-minute read. You can go here to read a quick 5-minute summary of the full book, which explains my straightforward 3-part 3% solution for getting the US debt issue stabilized. + +--- + +# In Case You Missed My Ask Me Anything +## Author: Ray Dalio, Founder of Bridgewater Associates, Published Sep 10, 2025 +My thanks to all of you for the great questions in my latest Reddit AMA. I loved the opportunity to exchange thoughts about life, work, the changing world order, markets, and the Big Cycles and principles for dealing with these things well. Very interesting! There were more than 840 questions on Reddit and hundreds more on social media. + +--- + +# In Case You Missed My Ask Me Anything +## Author: Ray Dalio, Founder of Bridgewater Associates, Published Sep 10, 2025 +I pulled all the questions that I had a chance to answer in the AMA into this article along with a few others that came in on social media. I will answer more of the questions in coming weeks and will include them here too. During the AMA, I also introduced my AI Avatar, which can answer all questions without limit. I've opened a beta test for those who would like to try it. If you're interested in doing that, sign up here: https://www.digitalray.ai/login + +--- + +# In Case You Missed My Ask Me Anything +## Author: Ray Dalio, Founder of Bridgewater Associates, Published Sep 10, 2025 +REDDIT - Questions & Answers +1. Question: When you advise investors looking at software startups, what would you advise them are the top three things to look for in a startup? +Answer: I would advise them to look at the character and capabilities of the people, how they work together (most importantly their culture) and their commitment to their mission, along with their adaptability to change in order to achieve a viable version of it. +# In Case You Missed My Ask Me Anything +## Author: Ray Dalio, Founder of Bridgewater Associates, Published Sep 10, 2025 +2. Question: What are your thoughts on Peter Zeihan’s view that China is on its way to inevitable collapse in the next decade or so? +Answer: I wouldn't bet on it any more than I would bet on the United States' collapse over the next decade. I think it's not smart to place that bet because they both have big strengths and big weaknesses. What I would bet on is these two powers having lots of big conflicts that I pray don't take the form of a military war, though I am confident that they will continue to take the form of trade, economic, technology, capital, and geopolitical influence wars. + +--- + +# In Case You Missed My Ask Me Anything +## Author: Ray Dalio, Founder of Bridgewater Associates, Published Sep 10, 2025 +3. Question: What consequences will there be if the FED will cut the interest rate despite inflation up in September? How can a single investor profit from a FED under political control? +Answer: I fear that short-term rates and the dollar will go down, especially relative to gold, long-term interest rates will rise a bit, so the yield curve will become steeper, and stocks will do relatively poorly despite the easing. If we see that kind of market action, it would reflect investors wanting to get out of debt assets and into other storeholds of wealth, and that the Fed is in a bind and the risk of stagflation is rising. +# In Case You Missed My Ask Me Anything +## Author: Ray Dalio, Founder of Bridgewater Associates, Published Sep 10, 2025 +4. Question: At 22, how can I discover the unique combination of abilities and traits that will allow me to make the most meaningful impact in life, rather than just following what others tell me to do? +Answer: Understand that life is an adventurous journey of discovery and adaptation, in which the goal is to discover your nature and match it up with what you do and who you are with. I suggest that you take the free personality test (PrinciplesYou) that I made so anyone can understand their own personality profiles and those of people they have relationships with. You can get it at www.principlesyou.com. + +--- + +# In Case You Missed My Ask Me Anything +## Author: Ray Dalio, Founder of Bridgewater Associates, Published Sep 10, 2025 +5. Question: I’m worried about the federal deficit. I assume at some point other countries will stop buying our T-bills due to our high interest costs in servicing our debt. Then I assume massive inflation and a huge recession as the Treasury starts printing money. How do I protect my investments best in that scenario? Buy Swiss bonds? +Answer: While I share your concerns, I encourage you not to get into the game of betting on what's going to happen, and I encourage you to have a well-balanced portfolio, which I call an All Weather Portfolio, that will lead you to your wealth growing at a steadier pace, regardless of what happens. Each economic environment is good for some assets and bad for other assets. For example, stocks do well when growth is strong and badly when growth is weak, bonds tend to do the opposite, and gold tends to do well when a currency is weak and inflation is high. Holding a risk-balanced portfolio that performs well in all environments (which is what I call an All Weather Portfolio) is best for most investors at most times. Because I want to teach investors principles for investing well, I am working on creating an online course that I hope to make available for everyone inexpensively, which will explain this strategy and other strategies more completely than I can fit into this answer. You can learn more about the course here: https://wmi.edu.sg/dmp-online-international/ + +--- + +# In Case You Missed My Ask Me Anything +## Author: Ray Dalio, Founder of Bridgewater Associates, Published Sep 10, 2025 +6. Question: Hi Ray, my question is why don’t you list footnotes and other works consulted in your books? Clearly, you must be relying on other sources and scholarship in them, and not showing your work limits the utility and usefulness. +For example, in the Changing World Order, p.256 there is a chart of Silver Production from Mexico and Peru from 1520 - 1760. Presumably you didn’t make these calculations yourself, and I imagine there aren’t analysts at Bridgewater that are experts on this topic. Where did this data come from? +In your works there are thousands of these data points that you relied on to draw your conclusions. It’s like doing a complicated math problem in school. The work you did was more important than the answer. Would you accept someone’s conclusions if they didn’t show you how they got there? + +--- + +# In Case You Missed My Ask Me Anything +## Author: Ray Dalio, Founder of Bridgewater Associates, Published Sep 10, 2025 +I feel like there is a lot of nuance in these data points that could aggregate and impact the veracity/accuracy of your conclusions? Why should we just take your word for it? +Answer: In order to save space in my printed books, I put almost all of my citations online at www.economicprinciples.org, which is explained at the beginning of the books. For Changing World Order, you can find them here: cwo-citations-and-bibliography.pdf +This is the specific citation for the chart you mentioned: SILVER PRODUCTION MEXICO/PERU: Henriques, António, and Nuno Palma. “Comparative European Institutions and the ‘Little Divergence’, 1385–1800.” VoxEU: CEPR, December 10, 2019. + +--- + +# In Case You Missed My Ask Me Anything +## Author: Ray Dalio, Founder of Bridgewater Associates, Published Sep 10, 2025 +At the same time, most of my understanding has come about through my experiences and research related to them in placing my bets in the market rather than from the learnings of others. I have found that most people who write books and follow more academic approaches of following the sequences of others' thinking largely to learn from others tend to think differently and, quite frankly, in a less practical way. I know that my principles are unconventional, so I put them out there and explain them in detail so that we can have quality exchanges about what is true, which I am always happy to do with the most credible authorities because it makes us all better. Anyway, that's the approach that has worked best for me. + +--- + +# In Case You Missed My Ask Me Anything +## Author: Ray Dalio, Founder of Bridgewater Associates, Published Sep 10, 2025 +7. Question: How to make decisions in a fast paced world where politics and daily news are changing the scenario everyday and global markets are having a lot of fast movement ? +Answer: I have found that the only way I could do this is by writing down my criteria/principles for making decisions and putting them into computer code in order to make a decision-making machine that makes decisions in parallel with me. It's like a chess master making a computer chess game that plays alongside him and, in the process, leads both him and the automated decision-making process to become better. I find this approach invaluable because the computer can process much more information much more quickly and much less emotionally, and by specifying and backtesting my criteria, I can have a tried-and-true game plan that I'm executing. The form of artificial intelligence that I have been using is expert system decision-making. I am now thrilled to be using a number of the new breakthrough artificial intelligence approaches to vastly improve what I am doing. I plan to share that with everyone so that they can use it to do the same. I think that the days of trying to weigh things and make decisions in one's head without this artificial intelligence helping are approaching an end, and that the way I'm describing is certainly the necessary path of the future. + +--- + +# In Case You Missed My Ask Me Anything +## Author: Ray Dalio, Founder of Bridgewater Associates, Published Sep 10, 2025 +8. Question: If the most important financial decision you'll make in your life is who you marry, what advice would you give people on choosing the right life partner? +Answer: There is no more important decision that you can make in your life than who you choose as a life partner. If you can have a great partner throughout your life, who loves and takes care of you as you love and take care of that partner, you will gain enormous practical and emotional rewards. Of course, in all relationships there will be periods of disagreement that could lead to fights that threaten the relationship. These will be tests of whether your shared values and your ways of dealing with each other are strong. If you and your partner and your relationship pass these tests, and I recommend that you strive hard for that to happen, even these difficult times will strengthen your relationship which will be invaluable. What I believe is most important to having a rewarding life is having meaningful work and meaningful relationships, especially long and deep ones. When I was 70 and reflected on if I had to choose, would I choose meaningful work or meaningful relationships, while the choice was hard because I love them both, I chose meaningful relationships. Certainly, the most meaningful one is with a great life partner. + +--- + +# In Case You Missed My Ask Me Anything +## Author: Ray Dalio, Founder of Bridgewater Associates, Published Sep 10, 2025 +9. Question: What is your biggest regret? +Answer: I, of course, have had many mistakes that I think back with hindsight that I wish I hadn't made at the time. However, because I believe that mistakes and the pains that they cause are part of the natural learning and evolutionary process when I think about them, I'm not sure that I would regret them or choose to have not to have had them. For that reason, it's difficult for me to answer your question. Also the great advice that is the Serenity Prayer which is ""God give me the serenity to accept that which I cannot control and the power to control that which I can control and the wisdom to tell the difference,"" has led me to reflect on how I've done that which I feel that I've done in a way that hasn't left me with many regrets. + +--- + +# In Case You Missed My Ask Me Anything +## Author: Ray Dalio, Founder of Bridgewater Associates, Published Sep 10, 2025 +10. Question: Ray, the FT article the other day with your interview was an interesting read. Brave to some, late to some, and fear mongering to others. +Can you expand on what drove you to doing that interview? +And trying my luck with this one, do you feel there’s a real risk to Fed independence or will the market just adapt, like equities seemingly have to Tariff and whatnot announcements. +Answer: I'm now 76 years old and at a stage in my life in which I feel the best thing I can do is speak honestly about what I think and, most importantly, how the realities that we are dealing with work, explaining the cause-and-effect relationships that drive what's happening. It's less about whether people think that I'm early, late, or instilling fear and more that I care that I'm doing the best that I can. I strive to be as accurate as I can be in a world that is changing fast with great challenges. I am concerned about how conflict and partisanship create distortions and sensationalism to be threats to everyone’s well-being. Sometimes those in the media help, and sometimes they have their own agendas. Increasingly, they have their own agendas that are more important to them than getting at the truth, which is why I appreciate this type of exchange. For me, the choice is between not saying anything and playing it safe, or trying to speak in an analytical, non-partisan way and risk being politicized. To me, the greater risk is in not speaking up. + +--- + +# In Case You Missed My Ask Me Anything +## Author: Ray Dalio, Founder of Bridgewater Associates, Published Sep 10, 2025 +11. Question: What is your favorite movie, and why? +Answer: As far as a movie that is out now that I like, it was F1 because it was both very entertaining and it showed the wonderful personal evolution of the Brad Pitt character, who clearly had his own unique nature and passions and evolved in a way through his crashing, both literally and personally, to succeed in getting what he wanted out of life. If I were to think back, there are a whole bunch that come to mind, but the one that pops up is The Big Lebowski. +12. Question: You mention America's credit circulatory system is on a path to a debt-induced economic heart attack. +If you could pull any 3 levers to save it....what would they be? +Answer: I explained more completely in my book, ""How Countries Go Broke: The Big Cycle"" and I can explain here. The three things that should be done, which I call my 3% 3-Part Solution, are to cut the budget deficit to roughly 3% of GDP, which would keep the debt-income ratio stable because the economy will probably grow by about 3%. This can be achieved by making adjustments to all three of the determinants of deficit (spending, taxes, and interest rates on the debt) because balancing the deficit using only one or two of these determinants would have unbearable consequences. + +--- + +# In Case You Missed My Ask Me Anything +## Author: Ray Dalio, Founder of Bridgewater Associates, Published Sep 10, 2025 +13. Question: What is the best way to protect my assets that are currently held mostly in US$ based securities, savings and contracts against eventual decline of values of US$ ? I live in the US but don't mind moving elsewhere. +Answer: The best way to protect your assets is to diversify your portfolio well. Certainly, there will be assets that will perform better and worse just as there are different countries that will perform better and worse and it's always better to be in the better ones. However, there are a lot of market makers who are making these bets so that what is expected to happen is handicapped in the price. It's like betting on which horse is going to win a race. With the handicap taken into consideration in the betting odds you are going to get, the worst performing horse is about as good a bet as the best performing bet. While I believe that in the AI enabled, debt burdened, turbulent world that we are in, that investments in companies that will be making great leaps forward enabled by AI, hard money assets rather than debt assets, excellent global diversification are best, my best advice is to know how to diversify well which will reduce your risks a lot without reducing your expected returns. +14. Question: You’ve said 15% gold, Bitcoin, or a mix of both are a good hedge against the devaluation of fiat currencies. I remember when you said no to Bitcoin a while back. When you publicly acknowledged Bitcoin as a hedge, it made me take crypto (BTC, specifically) seriously. Thank you, and my question is: Should we be taking Bitcoin even more seriously as it’s becoming institutionally adopted in the US as well as globally? + +--- + +# In Case You Missed My Ask Me Anything +## Author: Ray Dalio, Founder of Bridgewater Associates, Published Sep 10, 2025 +Answer: Bitcoin is now an alternative currency that has its supply limited, so, all things being equal, if the supply of dollar money rises and/or the demand for it falls, that would likely make crypto an attractive alternative currency. At the same time, it has important disadvantages in a time of turbulence, such as that it can be monitored and potentially controlled by governments, and it's conceivable that its programming can be cracked with new technologies. Also for these reasons, it's not likely to be a reserve currency, while gold is the third largest reserve currency that governments, as well as people, hold when they feel that they are threatened by others. It also has a much longer and well-established track record, though it has its drawbacks too. For that reason, I have a little bit of Bitcoin and a lot more gold, but the most important thing is to have alternative moneys that are effective storeholds of wealth because most fiat currencies, especially those with large debts, will have problems being effective storeholds of wealth and will go down in value relative to hard currencies. + +--- + +# In Case You Missed My Ask Me Anything +## Author: Ray Dalio, Founder of Bridgewater Associates, Published Sep 10, 2025 +15. Question: What do you think about real estate investment and gold investment? +Answer: Real estate is not a safe investment because it can't be moved so it can't go with you, and it's easy to tax because it can't be moved, so it's not the sort of asset that is best to hold in times of great change and when the government needs to get tax money. +16. Question: What do you think of the future of the U.S. dollar as the reserve currency? +Answer: It is important to realize that no reserve currency has lasted forever for the same reasons. I comprehensively explain these reasons and show them happening in charts and numbers in my book Principles for Dealing with the Changing World Order. To be clear, I’m not saying that the dollar will abruptly lose its reserve currency status soon, though it could. What I am saying is that I think we are entering an era in which it and other major currencies and the debt that they are stored in will lose their effectiveness as reliable storeholds of wealth. It is easy to imagine the effects on the American economy and world because the dynamic is clear—it reduces the United States’ borrowing and buying power—and because it has happened before in the declines of other countries’ reserve currencies, such as the British pound and the Dutch guilder. It is what happens when fiat currencies stop being effective storeholds of wealth. It happened most recently in the 1970s and the 1930s. + +--- + +# In Case You Missed My Ask Me Anything +## Author: Ray Dalio, Founder of Bridgewater Associates, Published Sep 10, 2025 +17. Question: How would you weigh taking a TM course for 500-700USD versus spending that money on other aspects of your life and/or investments? +Answer: There is no better investment that you can make than in your learning TM. I believe that TM has been more responsible for whatever success that I've had than anything else. +18. Question: Hi, follow up on another question: Are you an idealist or a realist? +Answer: I am a hyper realist because I believe that understanding how reality works and how to deal with it well are essential to achieving one's goals, especially those that are idealistic. So please understand that achieving idealistic goals is enhanced by being hyper realistic. + +--- + +# In Case You Missed My Ask Me Anything +## Author: Ray Dalio, Founder of Bridgewater Associates, Published Sep 10, 2025 +19. Question: Are you going to release an AI agent based on your principles? “What would Ray Dalio Do?” +Answer: Yes. I am beta testing it now. It has been very well trained because over the last 35 years, I have written down thousands of principles for dealing with thousands of situations, and it has been very well curated because the questions and answers produced by ""Digital Ray"" have been quality controlled. I really believe that it will be effective in always being able to answer all people's questions all the time, so that we won't be limited in the way we are limited now, because I can't answer everyone's question on this Reddit AMA. I am going to have it beta tested by a few thousand people who are willing to work with me to get this well done. If you are willing, you can apply to be one of my beta testers here: https://www.digitalray.ai/login +It will be better than you imagine because it will exchange thoughts with you. In other words, you can have conversations with it and, if you like, it will get to know you so it can be more helpful based on your specifics. + +--- + +# In Case You Missed My Ask Me Anything +## Author: Ray Dalio, Founder of Bridgewater Associates, Published Sep 10, 2025 +20. Question: What questions are you still trying to answer or grapple with? +Answer: I have too many questions to list because I'm on a journey to discover how reality works and to come up with principles that I write down and use—and, in the process of using them, see how well they work, and then do it again and again. And I'm super-excited to be creating an AI partner that can do that with me, then better than me, and then replace me. I can't wait to introduce you to this partner who can be your partner too, if you’d like. +21. Question: What principles helped you shift from being a decision-maker to a legacy-builder, and how do you know when it’s time to make that transition? +Answer: I intellectually and instinctually know where I am in my life cycle (I'm 76), and I find it both logical and emotionally rewarding to pass along what I have that's of value to others. Transitioning seems like the logical thing to do when I think about what I already have and what I want most. I think that if you rise above your habits, you will find that it is natural to feel this way late in your journey. + +--- + +# In Case You Missed My Ask Me Anything +## Author: Ray Dalio, Founder of Bridgewater Associates, Published Sep 10, 2025 +Social Question (ahead of AMA): +22. Question: Ray, you are a great guy!. For someone with so much professional and life experience, and being a wise man, what can you say is the single most important thing that gives meaning to life? ..Greetings and respect from Bulgaria. +Answer: Know your nature and find the path that suits it. Pursue meaningful work and meaningful relationships that suit you. To help you know your nature I suggest that you take the personality profile test ""Principles You"" that I created for that purpose and made available for free on www.principlesyou.com. I also suggest that you have key relationships with to help you each understand each other. +22. Question: ""Firstly, thank you for inspiring so many people including myself. As I've been an ardent follower of your work, and it really helped me in my career trajectory so far. What is happiness according to you? +Answer: First, I should make clear that different people have different sources of happiness. However, for me (and for most people, I think) having both meaningful work and meaningful relationships is the greatest source of happiness. What makes meaningful work and meaningful relationships can be different for different people based on their different natures. Basically, life is a journey of discovering what one's nature is and what one should do to gain well-being. Btw, I urge you and those you have the closest relationships with to take my free online personality assessment to help you and them understand a lot about your own and their natures. You can get it at www.principlesyou.com + +--- + +# In Case You Missed My Ask Me Anything +## Author: Ray Dalio, Founder of Bridgewater Associates, Published Sep 10, 2025 +23. Question: With so many top-notch Hedge Funds out there, what drove you to take Bridgewater Associates to the top? +Answer: I had a passion for investing and for making my investment vehicle, Bridgewater, to be as great as it could be, and I wanted to have the greatest possible relationships with the people I worked with and the clients we served. We all had passions for understanding how reality works, learning principles for dealing with it well, writing those principles down, and then putting them into computer code. This gave us great advantages. I described it all in my book Principles: Life and Work. By the way, I am now equally excited about enabling others to do all that I did and more, so expect some exciting announcements about what I will be putting out. +24. Question: How do you endure the pain and biggest setback in your life? +Answer: Pain + Reflection = Progress +Meditation +Meaningful Relationships +The Serenity Prayer: God give me the serenity to accept that which I can't control, the power to control that which I can, and the wisdom to tell the difference. +Time heals all wounds. + +--- + +# In Case You Missed My Ask Me Anything +## Author: Ray Dalio, Founder of Bridgewater Associates, Published Sep 10, 2025 +25. Question: Back at you Ray Dalio - what question(s) are you still/currently trying to answer or grapple with?! +Answer: I have too many questions to list because I'm on a journey to discover how reality works and to come up with principles that I write down and use—and, in the process of using them, see how well they work, and then do it again and again. And I'm super-excited to be creating an AI partner that can do that with me, then better than me, and then replace me. I can't wait to introduce you to this partner who can be your partner too, if you’d like. +26. Question: What role and purpose does the banking system play in economics and economies in today's world? I am not referring to the textbook definition but the real role it plays. If its purpose and role are to redistribute money and wealth through credit creation, has this been considered in modern economics? If it hasn't been included, why is that the case? Could this omission distort the economic and socioeconomic reality of the world such as the ever-widening wealth gap and poverty? What will happen if the banking system stops playing the role of allocation and redistribution of resources? Could the situation improve for the better? I am curious about these questions and would greatly appreciate an explanation from someone knowledgeable and experienced in the field. + +--- + +# In Case You Missed My Ask Me Anything +## Author: Ray Dalio, Founder of Bridgewater Associates, Published Sep 10, 2025 +Answer: The banking system serves the purpose of being an intermediary to get money from those who have an excess of it to those who have a shortage of it ideally in a mutually advantageous way, and in the process it is a creator of credit. Those who do that are not just those who are called banks and how it is done varies a lot. How all that works and is changing and what it means for all that happens with money, credit and the economy is a very interesting and complex topic that is too great to try to tackle here. +27. Question: When is your economic principles book going to be released? +Will this teach us how to invest in actual asset classes to protect us against a bankrupt USA? +Answer: Principles: Investment and Economic is in the works. My guess is that it will be ready 18- to 24- months from now because I'm doing many things at the same time. With Singapore's Wealth Management Institute, I already created an online course called Dalio Market Principles, which has been tremendously well-received. If you're interested in learning about my investment principles which worked well for me, you can get it at www.wmi.edu.sg/dmp-online. I also worked with Masterclass on a briefer version that has been well-received too. +Yes, the book will teach about how to protect your portfolio in different scenarios. + +--- + +# The Financial Times’s Mischaracterizations of What I Said +## Author: Ray Dalio, Founder of Bridgewater Associates, Published Sep 2, 2025 +I did an interview with the FT in which, for accuracy, I had them submit their questions in writing and I replied in writing. They then did not publish the exchange and instead published mischaracterizations of what I said. For accuracy, I am providing the actual questions and answers here for you to read. I strive to be as accurate as I can be in a world full of harmful conflict and partisanship in which distortions and sensationalism are threats to everyone’s well-being. Sometimes those in the media help, and sometimes they have their own other agendas. For me, the choice is between not saying anything and playing it safe or trying to speak in an analytical, non-partisan way and risk being politicized. To me, the greater risk is in not speaking up. If you want to see what I was asked and what I said, here it is. +Debt, Inflation & the Fed +1. You’ve warned for years about America’s overwhelming debt burden. How do you see Trump’s tax and spending promises affecting that trajectory? Is this time more sensitive than ever? +Yes. The worsened condition is due to years of excesses, like overeating fatty foods and smoking over a lifetime. The cumulative effects have brought about the current conditions, and the great excesses that are now projected as a result of the new budget will likely cause a debt-induced heart-attack in the relatively near future—I’d say three years, give or take a year or two. +I'll explain. + +--- + +# The Financial Times’s Mischaracterizations of What I Said +## Author: Ray Dalio, Founder of Bridgewater Associates, Published Sep 2, 2025 +The credit circulatory system is like the human circulatory system in that it brings nutrients to different parts of the body. If the credit and debt are used to create income that is large enough to service the debt, then the system is working well and healthy. But if the debt and debt service expenditures grow faster than the incomes, they build up like plaque that squeezes out other spending. It is easy to see that happening. The U.S. government’s debt service payments now equal about $1 trillion a year in interest and are increasing at a fast rate, with about $9 trillion needed to roll over the debt. That squeezes out other spending. The more that happens, the closer the country is to a debt-induced economic heart attack. Also, when there is a lot of existing debt plus a lot of new debt that is being created to finance deficit spending, the supply of debt being sold is much greater than the demand for it. Over the next year, the Federal government will spend about $7 trillion and take in only about $5 trillion, so it will have to sell an additional roughly $2 trillion in debt, in addition to the $1 trillion it has to sell to pay interest plus the $9 trillion it has to raise to roll over the debt. Things are likely to get worse than that because when creditors become worried about the debt assets not being good storeholds of wealth, they sell them. + +--- + +# The Financial Times’s Mischaracterizations of What I Said +## Author: Ray Dalio, Founder of Bridgewater Associates, Published Sep 2, 2025 +That is a classic sign of the big debt cycle entering the traumatic last phase. At this stage in the cycle, the central bank must decide whether to allow interest rates to go up and have a debt default crisis, or to print money and buy the debt that others won't buy to try to hold real interest rates down, which will lower the value of money. Another classic sign of coming to the turbulent end of the big debt cycle is central banks doing a lot of printing money and buying debt and then losing so much on the debt assets that they bought that, at that stage, both the central bank and the central government need to borrow more money. This leads to the central bank printing even more money to service the large debts that they have. By all the classic measures, we are late in the big debt cycle, and if those who shape policies don't change policies, there will be a debt service problem coupled with a debt supply-and-demand problem that will cause a debt-induced economic heart attack. +2. Trump has threatened to fire Fed Chair Jay Powell and recently ousted Governor Lisa Cook. How dangerous is it if the Fed loses its independence while debt is surging? +The long tradition of central banks being independent from central governments' political leaders has existed because of the widely held belief that the government leaders will be politically motivated to lower interest rates and make credit easier than is good for creditors because doing that will lower the real interest rates that the bond holders will get. That lowers the value of debt as a storehold of wealth, which reduces the demand for the debt and leads to problems. Because one man's debts are another man's assets, for the central bank to be effective, it has to keep real interest rates high enough to satisfy creditors without being so high that they hurt debtors. If the independence of the Fed is reduced to the point where investors think there is a high risk that interest rates being unnaturally lowered so that bonds won't be a good storehold of wealth, we will see an unhealthy decline in the value of money. + +--- + +# The Financial Times’s Mischaracterizations of What I Said +## Author: Ray Dalio, Founder of Bridgewater Associates, Published Sep 2, 2025 +The fact that this dynamic is arriving at the same time as international holders of dollar-denominated bonds are reducing their holdings of U.S. bonds and increasing their holdings of gold due to geopolitical worries is also classically symptomatic of big cycle being in its late stages. +3. If a politically weakened Fed lets inflation “run hot,” what does that mean for bonds, the dollar, and America’s creditworthiness? +It would lead bonds and the dollar to go down in value and, if not rectified, would lead to them being an ineffective storehold of wealth and the breaking down of the monetary order as we know it. +Trump’s Interventionism in Business +4. Trump has taken a $10bn stake in Intel “for zero,” skimmed Nvidia and AMD’s China revenues, and imposed a golden share at US Steel. Do you see these as early signs of state capitalism with American characteristics? + +--- + +Yes. As a classic part of the Big Cycle, the increased wealth and values gaps lead to increased populism of the right and populism of the left and irreconcilable differences between them that can't be resolved though the democratic process. At such times, democracies weaken and more autocratic leadership increases as a large percentage of the population wants government leaders to get control of the system to make things work well them—e.g., ""to make the trains run on time.” Also, in a world in which there are great conflicts and possibly even wars between countries, governments increasingly take control of what businesses do. For example, it is now the case that whichever country wins the technology and economic wars will win the more important geopolitical and possibly military wars. So governments are now increasingly taking control of businesses and the economy. The part of the Big Cycle that we are in is most analogous to the 1928 to 1938 period. +5. Some call it authoritarian. Others say it resembles socialism. How would you characterize Trump’s economic model? +I'd rather not put labels on it because labels are evocative and lead to bad reactions. I'd rather try to explain the mechanics of what is happening in a less evocative way, so that is what I'm doing. +6. How do these interventions affect America’s reputation as the world’s safest place for capital? +Markets & Global Standing +7. Do Trump’s moves risk undermining global confidence in Treasuries, the dollar, and America’s debt sustainability? +Yes, though I wouldn’t just attribute this situation to Trump's moves. As mentioned, the dynamic that I am describing has been going on for a long time under presidents from both parties, though it started to intensify in 2008 and has accelerated since 2020. + +--- + +# The Financial Times’s Mischaracterizations of What I Said +## Author: Ray Dalio, Founder of Bridgewater Associates, Published Sep 2, 2025 +8. Could this interventionism accelerate a shift away from the US as the world’s financial safe haven? +Crypto & the Dollar +9. Do you see deregulation as a risk for the dollar’s reserve status? +No, but I do see the dollar and the other reserve currency governments' bad debt situations as threatening to their appeals as reserve currencies and storeholds of wealth, which is what has been contributing to the rises in gold and cryptocurrency prices. +10. Is the exposure that stablecoins have to Treasuries a potential systemic risk? +I don't think so. However, I see a fall in the real purchasing power of Treasuries as being a real risk. That shouldn't produce any systemic risk in stablecoins if they are well-regulated. +11. Could crypto meaningfully replace the dollar, or does it pose different dangers altogether? +Crypto is now an alternative currency that has its supply limited, so, all things being equal, if the supply of dollar money rises and/or the demand for it falls, that would likely make crypto an attractive alternative currency. I think that most fiat currencies, especially those with large debts, will have problems being effective storeholds of wealth and will go down in value relative to hard currencies. This is what happened in the 1930 to 1940 period and the 1970 to 1980 period. + +--- + +# The Financial Times’s Mischaracterizations of What I Said +## Author: Ray Dalio, Founder of Bridgewater Associates, Published Sep 2, 2025 +Elite Silence vs. Selective Outrage +12. When New York mayoral candidate Zohran Mamdani floated socialist ideas, CEOs and billionaires reacted with fury. Why do you think the same people are silent when Trump undermines free enterprise? +I think that what is happening now politically and socially is analogous to what happened around the world in the 1930-40 period because, like in the 1930 to 40 period, the gaps in wealth, gaps in values, and views about what policy should be have become more extreme—and the willingness to compromise, lose elections because of voting results, and trust in the system have dwindled. I think most people are silent because they are afraid of retaliation if they speak up. +13. Is the real threat to American capitalism coming from the far left — or from Trump’s brand of interventionism? +It is coming from the same five forces that have always driven big cycle changes. They are 1) the big debt cycle that will likely lead to big debt problems that will threaten the existing monetary order, 2) big political problems within countries that are threatening existing political orders, 3) big geopolitical problems between countries that are threatening the existing world geopolitical order, 4) big acts of nature such as drought, floods and pandemics (most importantly climate change), and 5) mankind's creating big impact through new technologies, most importantly artificial intelligence. The interaction of these five forces will lead to huge and unimaginable changes over the next 5 years. + +--- + +# Civility +## Author: Ray Dalio, Founder of Bridgewater Associates, Published Aug 25, 2025 +If I were to pick one word that conveys what matters most in order to have a successful society, it would be civility. +Civility has always shaped history. People have always, and still do today, run away from places that lack it to places that have it, and fights over what to do about declining civility have always been, and are now, one of the biggest sources of political and social conflict. +If you understand this, you should be able to understand the force behind the rise of fascism in the 1930s, and you should be able to understand where we are in the big cycle of political and social order and disorder, when conflicts between increasingly extreme populists of the right and the left abandon compromise and traditional rules of law to engage in win-at-all-cost battles in which people have to pick a side and fight for it. +Concerning what is going on now and where we are in the Big Cycle, I'd like to draw your attention to an excerpt from an entertaining article by Maureen Dowd that paints a vivid picture of the lack of civility that exists in Washington D.C. I point these realities out especially to my friends who live in bubbles, especially those who live in other countries, because their lack of direct contact with these realities makes them doubt that these implausible things are happening. + +--- + +# Civility +## Author: Ray Dalio, Founder of Bridgewater Associates, Published Aug 25, 2025 +Excerpt from Maureen Dowd’s New York Times column: +My sister is having a bad summer. +In fact, even as I’m typing this, Peggy is at D.C. police headquarters. +We had dinner in Georgetown recently and when we came back to my house, where her car was parked, she was short a Buick. +Two polite officers who responded to our call said they could do little, amid a rash of brazen car thefts by teenagers. +One officer said that, even if they saw the perp driving in her car, they could not chase him, because of laws passed by the D.C. Council. +Kids — some too young to drive legally — can just hot-wire cars to go home. Two 15-year-olds are charged in a carjacking attack on a former DOGE employee that helped set off President Trump’s crusade on crime in D.C. The council has been notoriously lax toward juvenile offenders. +Peggy had always loved that Buick, which she bought because Peyton Manning was the pitchman. We figured we’d never see it again. +The next morning, though, an officer from Prince George’s County, a working-class Maryland suburb, banged on her door. Her car was found in a park, running, nearly out of gas. When she collected it, after paying a $215 towing charge, she found an odoriferous collection: half-eaten pizza, grape soda cans, fast-food wrappers, a used condom and a couple of debit cards. + +--- + +# Civility +## Author: Ray Dalio, Founder of Bridgewater Associates, Published Aug 25, 2025 +She called the D.C. police to tell them about the debit cards, thinking they could help trace the thieves. (Our dad, after all, was a D.C. cop.) But the police said to throw them away, noting that the cardholders had probably already gotten new ones. +Peggy got the car detailed and celebrated its return by going shopping at Bloomingdale’s. When she got back to her parking space, someone had T-boned the poor Buick. +Then, icing on the cake, she got over $1,800 worth of speed-camera tickets that the car thieves had racked up going 70 in 25-mile-per-hour zones, and some for running red lights. One ticket revealed that the car was stolen just after she got out of it, at 7 p.m., still light outside. For all we know, the thieves watched her get out. She had to go down to headquarters on Friday to get the police report so she could appeal the tickets. +It’s hardly the most heinous crime, but you hear a lot about Washingtonians and their personal experiences being preyed on. +City officials and many liberal residents are outraged about Trump’s painting D.C. as a hellscape and flooding the zone with law enforcement and troops. Protesters around town held up signs reading “Fascists,” and a Department of Justice employee (now fired) threw a Subway sandwich at an officer and was charged with assault. + +--- + +# Civility +## Author: Ray Dalio, Founder of Bridgewater Associates, Published Aug 25, 2025 +It’s ridiculous to drag F.B.I. agents from their desks to be cops on the beat. And the tableau of National Guard troops — even unarmed — raises the specter of martial law being normalized and weaponized. (Armed and masked Border Patrol officers showing up at a Gavin Newsom gerrymandering speech in L.A. was disturbing.) +It is also true that many D.C. residents are secretly glad to see more uniforms. No matter what statistics say, they don’t feel safe. + +--- + +# My Reflections on Celebrating Bridgewater at 50 Years and Transitioning It to the Next Generation +## Author: Ray Dalio, Founder of Bridgewater Associates, Published Jul 31, 2025 +I have been asked a lot about how I feel about passing along Bridgewater after having started and built it over the last 50 years. +I am thrilled about it! I feel that it has been an amazingly wonderful journey that I vividly remember practically every moment of, starting from my creating Bridgewater out of a two-bedroom apartment with a guy I played rugby with, to building it into the largest hedge fund in the world with a great team that grew to about 1,500 people, to making more money for our clients than any other hedge fund—and now, as of July 1, to completing the last step of passing it along to the next generation of great people I really believe have what it takes to make the firm very successful over the next 50 years. What a journey! What joy! +Above all else, I am thrilled about it because I love seeing Bridgewater alive and well without me—even better than alive and well with me. That's because I see this as a as-good-as-it-gets life cycle, and, from my perspective of being a 76-year-old who loves Bridgewater and the people at Bridgewater (many of whom I have worked with for decades), it's like seeing my kids being strong and healthy without me, which is much better than being a 76-year-old parent having to take care of them. + +--- + +# My Reflections on Celebrating Bridgewater at 50 Years and Transitioning It to the Next Generation +## Author: Ray Dalio, Founder of Bridgewater Associates, Published Jul 31, 2025 +What I see is a strong 50-year old Bridgewater that was started and run by a 26-year-old guy and is now being run by people who are mostly 25 to 50 years younger than him, with the people who built the firm with him as its leaders—most importantly Bob Prince, Greg Jensen, Karen Karniol-Tambour, and Nir Bar Dea, who are going through their own life cycles in a similarly beautiful way. I see these vital people continuing to modernize Bridgewater, guided by both the same highly effective 50-year-old principles that took it from nothing to quite something and new traditions developed by the next generation. And I love it because I am now free to focus on the exciting and fulfilling things I love doing. I especially love passing along what I have that is of value to others, most importantly the principles that helped me. I still love playing the investing game, I love having more time to spend with my family and friends, and I get a kick out of ocean exploration and bringing it back to people via the media in the way Jacques Cousteau did (see what we are doing via our show, OceanXplorers on Disney Plus). +Because passing along the principles that have helped me is one of my main goals at this stage in life, I'd like to share a few of the most important ones that I believe drove Bridgewater’s 50 years of success—and tell you how you can learn and get more of them, if you’re interested. There are work principles about how to run an organization and investment principles about how to make money in the markets. + +--- + +# My Reflections on Celebrating Bridgewater at 50 Years and Transitioning It to the Next Generation +## Author: Ray Dalio, Founder of Bridgewater Associates, Published Jul 31, 2025 +The most important ""work principles"" that I believe drove Bridgewater's 50 years of success are: + The people and the culture you choose are everything. + Choose people who have great character and great capabilities and build a culture that is an idea meritocracy in which meaningful work and meaningful relationships are the goals that are achieved through radical truthfulness and radical transparency. + Create a culture in which it is okay to make mistakes and unacceptable not to learn from them. + Pain + Reflection = Progress + +--- + +# My Reflections on Celebrating Bridgewater at 50 Years and Transitioning It to the Next Generation +## Author: Ray Dalio, Founder of Bridgewater Associates, Published Jul 31, 2025 +If you want the whole batch of my work principles, it's in my book Principles: Life and Work. I also described how I applied them in building Bridgewater in this conversation with my long-time colleague Jim Haskell during Bridgewater’s 50th anniversary celebrations. +The most important investment principles that were behind Bridgewater's investment success are: + Reality works like a machine, so you need to understand how the machine works and have tried-and-true good principles for dealing with it well. + Understand the cause: effect relationships that drive changes because the causes come before the effects so that understanding will help you anticipate what will happen. + Specify your decision-making criteria, back-test them, systemize them, and computerize them so that you are executing a well-thought-out and well-tested game plan. + Recognize that what you don’t know is much greater than anything you know. + Know how to diversify well because if you do, you can reduce your risks by about 80 percent without reducing your expected returns. + Find the smartest people who disagree with you and have them stress test your thinking through thoughtful disagreement because that will raise your odds of being right and will teach you a lot. + Make sure the probability of unacceptable losses is nil. + +--- + +# Ray Dalio +In 1975, Ray Dalio founded an investment firm, Bridgewater Associates, out of his two-bedroom apartment in New York City. Over forty years later, Bridgewater has grown into the fifth most important private company in the United States, according to Fortune magazine, and Dalio himself has been named to Time magazine’s list of the 100 most influential people in the world. +Along the way, Dalio discovered a set of unique principles that have led to Bridgewater’s exceptionally effective culture, which he describes as “an idea meritocracy that strives to achieve meaningful work and meaningful relationships through radical transparency.” It is these principles, and not anything special about Dalio—who grew up an ordinary kid in a middle-class Long Island neighborhood—that he believes are the reason behind his success. + +--- + +# Official Social Links of Ray Dalio +Facebook: https://www.facebook.com/raydalio/ +X (previously Twitter): https://twitter.com/RayDalio +LinkedIn: https://www.linkedin.com/in/raydalio +Instagram: https://www.instagram.com/principles/ +Tiktok: https://www.tiktok.com/@principlesbyraydalio +YouTube: https://www.youtube.com/@principlesbyraydalio +Threads: https://www.threads.net/@raydalio" \ No newline at end of file