BOOK: Principles for Dealing with the Changing World Order by Ray Dalio
Manny Bernabe • 2022-10-02
Note:
This page provides notes “Principles for Dealing with The Changing World Order” by Ray Dalio (Amazon). Get the book and share your thoughts with me on social media (LinkedIn, Twitter) .
Book notes updated through Chapter 3 (10/07/2022)
Introduction & Chapter 1
NOTES
“History doesn’t repeat, but it rhymes.”
Most fail to anticipate events that have not happen in their lifetime. For example, when Nixon moved off the Gold Standard in 1971, that was a first for Dalio. The market reaction was a surprise. HOWEVER, similar actions have been serval times by governments in history. The result (market rally) was predicable with that context.
It’s helpful to put our current state (US Empire) in context of past empires: Dutch → British → US.
Appreciate that empires, like humans have a standard life span: The rise, top, decline. This is what Dalio calls “The Big Cycle”.
All empires have gone through this cycle, but in different ways.
Like humans, you can take factors (beyond age) to consider where empires are in the cycle:
Education
Innovation & Technology
Trade
Economice Output
Competitiveness
Financial Center
Military
Reserve FX Status
These factors are measurable, as such you can track levels at various points of an empire’s cycle to gauge where an empire is in its respective life cycle.
We can use these metrics to further map out sub-stages within the rise, top and decline in an empire’s life cycle.
The last major transition happen with the decline of the British Empire and the rise of the US Empire. The next one is likely the decline of the US Empire and rise of the Chinese Empire.
There are three big cycles that drive The Big Cycle
Big Debt/Money/Capital Markets/Economic Cycle
Big Cycle of Internal Order and Disorder
Big Cycle of External Order and Disorder
Late stage empires express the following symptoms:
Over extended military, excessive expenditures
Large debts
Internal conflicts
Printing money
etc.
QUESTIONS TO PONDER
Will the future always be like the past? Do technologies like AI, nuclear, space technology radically shift what we can expect in terms of cycles for empires?
Can the decline of an empire be reversed? Prolonged? If so, how?!Asking for a friend. 😅
INTERACT with this [perpetual-motion] machine and try to understand how it works
WRITE DOWN observations of its workings, along with principle learned for dealing with them
BACKTEST principles through time
CONVERT principles into equation and program into a computer to aid decision making
LEARN/REFLECT to refine principles
Do it over and OVER AGAIN
Dalio believes in a “perpetual motion machine” that drives human outcomes. If you can map out and mode ever determinant, you could have a perfect crystal ball.
EDITOR’S NOTE: A similar argument is made in Laplace’s demon (Wikipedia)
Big three determinants: These are the biggest drivers (determinants) of the rise and fall of empires.
The cycle of good and bad finances (e.g., the capital markets cycle)
The cycle of internal order and disorder (due to degrees of cooperation and fighting over wealth and power largely caused by wealth and values gaps)
The cycle of external order and disorder (due to degrees of competitiveness of existing powers fighting for wealth and power).
Two more determinant that are next in importance:
The pace of innovation and technology
Acts of nature— e.g. droughts, floods, and diseases
“These are the five most important forces, which I call the "Big Five," so
when they are moving in the same direction--toward improving or
toward worsening most everything else follows.”
Dynamics less quantifiable, but still important to note.
Determinants and dynamics fall into two types:
Inherited Determinants: They include a country's geography, geology, and acts of nature such as weather and diseases.
Human Capital Determinants: They are the ways people are with themselves and each other. They are driven by human nature and different cultures (which differentiate their approaches).
QUESTIONS TO PONDER 🤔
Dalio presents a very deterministic, positivist view of the world. Where might this view go wrong?
How would you rate your country on the big three cycles? Big five?
What would rather have: Inherited (strong geography) or human capital (educated public) advantages?
Chapter 3: The Big Cycle of Money, Credit, Debt, and Economic Activity
All entities — people, companies, government, with the same basic realities
This is reflected in their income statements and balance sheets.This is the biggest driver of change in internal and world orders.
Generally, debt is more important than equity — thus debt eats equity, BUT central banks can feed debt by printing money instead
Having a reserve currency is great…. while it lasts
Gives the country exceptional borrowing and spending power and significant power in international trade.
Most money and credit has no intrinsic value (fiat currency)
Money & Credit ≠ wealth
Wealth comes from a countries productivity
“The relationship between the creation of money and credit and the creation of wealth is often confused, yet it is the biggest driver of economic cycles.”
Financial economy ≠ real economy, related but different
We must watch movements in the supplies and demands of both the real economy and the financial economy to understand what is likely to happen financially and economically.
Price of a good (money)≠ value of the thing (wealth)
Generally, increase wealth is more illusion for two reasons:
The increase credit that pushes price and production up has to be paid back, which will have opposite effect when “bill comes due”
Intrinsic value of a thing doesn’t increase just because the price goes up.
Governments can use monetary policy to stimulate markets. “A bottle of stimulant can
inject into the economy as needed.”
These moves come in short-term (8 years) and long-term debt cycles. Aka, business cycle.
Long-term debt cycles go for 50-70 years.
Current LT debt cycle started in 1944 with the Bretton Woods system (Wikipedia).
6 Stages of the LT debt cycle
Stage 1 —Little or no debt and money being “hard” (gold, silver, etc.)
Stage 2 — Then come claims on hard money (i.e., notes or paper money).
Stage 3 — Then comes increased debt.
Remember, there is always a limited amount of goods and services because the amount is constrained by the economy’s ability to produce.
Stage 5 — Then comes fiat money, which eventually leads to the debasement of money.
Caveat: Nothing wrong with money growth if put to productive use
😮 Throughout history, ruler have run up debts that won’t come due until long after their own reigns are over, leaving it to their successors to pay the bill. [Editor’s Note: Principal–agent problem?]
Four ways to service debt overhang
Austerity
Debt defaults and restructuring
Transfer of money and credit (e.g. Taxes)
Money printing and devaluing (easiest, therefore the default of every government).
Stage 6 —Then the flight back into hard money
Governments forced back to hard currency (gold, silver, etc.) to rebuild faith in value of currency
QUESTIONS TO PONDER 🤔
Dalio states that the cycle of money and credit is the number one factor that drives human events. Do you agree?
How can we measure intrinsic value? How do you practically desegregate from price (money). [If you find out, please let value investors know. They’ll be interested. 🤣]
Chapter 4: The Changing Value of Money
TLDR;
Real economy ≠ financial economy, related but different
Most currencies die, all will be SEVERELY devalued
When finances get bad, government WILL money-print/devalue as a default
NOTES
Real economy ≠ financial economy, related but different
Each operates with its own supply-demand dynamics
Most pay attention to asset prices, but neglect value of currency in which those assets are denominated
Of 750+ currencies introduced since 1700
Only 20 % remain
ALL have been devalued
The goal of money printing is to reduce debt burdens
2 things happen with newly created money
Flows into productive companies; inflation-adjusted value of stocks rise
When hurts actual prospective return of cash and debt assets, flows into inflation-hedging assets (gold, commodities, TIPS, other currencies), leading to self-reinforcing decline in the value of money
Devaluations typically occur fairly abruptly during debt crises that are separated by long periods of prosper and stability.
What devaluations have in common:
Economies experience classic “run” dynamic, where more claims on central bank than hard currency to satisfy
Central bank reserves start falling
Run on bank tend to occur alongside significant debt problems
Initially, central banks respond by letting short term rates to rise, but that is too economically painful so they quickly capitulate and increase the money supply (money printing, devaluation, etc.)
Outcomes vary, but key factors include economic and military power at time of devaluation
In the case of the US, there were two big abrupt devaluations (in 1933 and 1971) and more gradual devaluations against gold since 2000, but they haven't cost the US its reserve currency status.
QUESTIONS TO PONDER 🤔
QE, COVID stimulus payment— would these be considered major devaluations?
Chapter 5: The Big Cycle of Internal Order and Disorder
TLDR;
6 stages of Big Cycle
US in stage 5, right before “Civil War”
Based on certain economic red flags, US at 15% (3/20) chance of civil war
Toxic mix that brings about big internal conflicts consists of 1) bad financial shape (e.g., having big debt and non-debt obligations), 2) large income, wealth, and values gaps within that entity, and 3) a severe negative economic shock. 💥
NOTES
“The biggest thing affecting most people in most countries through time is how people struggle to make, take, and distribute wealth and power, though they also struggle over other things, most
importantly ideology and religion.”
Stages of Big Cycle
Stage 1, when the new order begins and the new leadership consolidates power, which leads to …
Stage 2, when the resource-allocation systems and government bureaucracies are built and refined, which if done well leads to
Stage 3, when there is peace and prosperity, which leads to …
Stage 4, when there are great excesses in spending and debt and the widening of wealth and political gaps, which leads to …
Stage 5, when there are very bad financial conditions and intense conflict, which leads to ..
Stage 6, when there are civil wars/revolutions, which leads to ...
Stage 1, which leads to Stage 2, etc., with the whole cycle happening over again.
Countries will go thought this stages in the BIG CYCLE. China is in early (the rise) while the US is at the tail end (decline).
This cycle repeats, but has tended to lead to progressively better outcomes.
Best exemplified in China’s history.
For the US, it’s important to note that the red flags that have marked the end of cycle with civil war conflict: measures of high inequality, high debt and deficits, inflation, and bad growth.
“Based on what we have seen in the past, we estimate that when there are 60-80 percent of the red flags present, there is around a 1-in-6 chance of severe internal conflict. When lots of these conditions are in place (greater than 80 percent) there is around a 1-in-3 chance of a civil war or revolution-so not very probable but still too probable for comfort. The US is in the 60-80 percent bucket today.”
Editor’s Note: Thus, currently the US has ~3/20 (17%) of civil war based on economic measures.
“The classic toxic mix of forces that brings about big internal conflicts consists of 1) the country and the people in the country (or state or city) being in bad financial shape (e.g., having big debt and non-debt obligations), 2) large income, wealth, and values gaps within that entity, and 3) a severe negative economic shock.”
“Those places (cities, states, and countries) that have the largest wealth gaps, the largest debts, and the worst declines in incomes are most likely to have the greatest conflicts.”
“History shows that raising taxes and cutting spending when there are large wealth gaps and bad economic conditions, more than anything else, has been a leading indicator of civil wars or revolutions of some type. To be clear they don't have to be violent, though they can be.”
Additional red flags to look out for in the late-stages (5 and 6) of the Big Cycle.
Decadence
Bureaucracy
Populism and Extremism
Class Warfare
The Loss of Truth in the Public Domain
Rule-Following Fades and Raw Fighting Begins
Crossing the line from Stage 5 (when there are very bad financial conditions and intense internal and external conflict exist) to Stage 6 (when there is civil war) occurs when the system for resolving disagreements goes from working to not working.
QUESTIONS TO PONDER 🤔
What is the best way to to transition from stage 5 to stage1? What are the best examples in history?