• 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 policy makers 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.
• 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.

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.

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[1] 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.

[1a] 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 Crisesin free digital form at 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.

[2] 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.

[3] 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.

I’m passing it along to you to take or leave as you like.

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.

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.

• 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.

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.

• 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.

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.

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.

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.

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.

[1] 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.

[2] 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.

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.

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.

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.

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.2 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 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.

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.

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.3 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.

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.

• 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.

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.

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.

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.

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 trigged 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.

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, Bloomberg Finance L.P., Capital Economics, CBRE, Inc., CEIC Data Company Ltd., Consensus Economics Inc., Corelogic, Inc., CoStar Realty Information, Inc., CreditSights, Inc., Dealogic LLC, DTCC Data Repository (U.S.), LLC, Ecoanalitica, EPFR Global, Eurasia Group Ltd., European Money Markets Institute – EMMI, Evercore ISI, Factset Research Systems, Inc., The Financial Times Limited, GaveKal Research Ltd., Global Financial Data, Inc., Haver Analytics, Inc., ICE Data Derivatives, IHSMarkit, The Investment Funds Institute of Canada, International Energy Agency, Lombard Street Research, 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, Renwood Realtytrac, LLC, 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), Refinitiv, Totem Macro, 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 as of the date of this report and are subject to change without notice. Bridgewater may have a significant financial interest in one or more of the positions and/or securities or derivatives discussed. Those responsible for preparing this report receive compensation based upon various factors, including, among other things, the quality of their work and firm revenues.

[1] 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.

[2] 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.

[3] 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.

• 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.

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.

 

• 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.

Since 2000 we have seen a more gradual and orderly loss of total return in currencies when measured in gold, consistent with the broad fall in real rates across countries during those decades.

• 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).

The next chart shows the real returns of holding gold throughout the period from 1850 to the present. As shown, from 1850 until 1971 gold returned (through its appreciation) an amount that equaled the amount of money lost to inflation, with the exception of Germany, though there were big variations around that average such as those previously described (e.g., until the 1930s currency devaluations and the end of World War II devaluations of money that were part of the formation of the Bretton Woods monetary system in 1944). Gold stayed steady in price while money and credit expanded until 1971. Then in 1971 currencies were devalued and delinked from gold so there was a shift from a Type 2 monetary system (e.g., notes backed by gold) to a fiat monetary system. That delinking of currencies from gold and going to a fiat monetary system gave central banks the unconstrained ability to create money and credit. In turn that led to high inflation and low real interest rates that led to the big appreciation in the real gold price until 1980-81 when interest rates were raised significantly above the inflation rate, which led currencies to strengthen and gold to fall until 2000. That is when central banks pushed interest rates down relative to inflation rates and, when they couldn’t push them any lower by normal means, printed money and bought financial assets, which was supportive to gold prices.

• 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 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:
  • For the Dutch, the collapse of the guilder was massive and relatively quick in taking place over less than a decade, with the actual circulation of guilders falling swiftly by the end of the Fourth Anglo-Dutch War. This collapse came as the Netherlands entered a steep decline as a world power, first losing a major war against the British and subsequently facing invasion on the continent from France.
  • For the British, the decline was more gradual: it took two devaluations before it fully lost its reserve currency status, though it experienced periodic balance of payments strains over the intervening period. Many of those who continued to hold reserves in pounds did so due to political pressures and their assets significantly underperformed US assets during the same time.
  • 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.
  • Typically leading up to a country losing its reserve currency position 1) there is an already established loss of economic and political primacy to a rising rival that creates a vulnerability (e.g., the Dutch falling behind the UK or the UK falling behind the US) and 2) there are large and growing debts that are monetized by the central bank printing money and buying government debt, leading to 3) a weakening of the currency in a self-reinforcing run from the currency that can’t be stopped because the fiscal and balance of payments deficits are too great for cutbacks to close.

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.

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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.

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).1

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.

• 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. At 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)2 , 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 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.

• 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 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.

• 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.

• 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 healthcare) 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.

• 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.8
• 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.9
• 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. 10
• The Second Anglo-Dutch War (1665–1667): England and the Netherlands fought again over another trade dispute, which again ended with a Dutch victory. 11
• 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.12 The Dutch largely stopped French plans to conquer the Netherlands and forced France to reduce some of its tariffs against Dutch trade,13 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.14

The chart below shows the Dutch power index with the key war periods noted.

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.15 While debt burdens had grown through most of the 1700s,17 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.17 (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 1784.18

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.19 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.20 The war required heavy expenditure by the Dutch to rebuild their dilapidated navy: the Dutch East India Company lost half its ships21 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.22

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.23 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.24 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.25 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.

 26As 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.

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.27 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.28 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.

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.29 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).30

 31Interest rates rose and the Bank of Amsterdam had to devalue, undermining the credibility of the guilder as a storehold of value.32 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.33 It also led to the British pound clearly replacing the Dutch guilder as the leading reserve currency.

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 (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).34 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.35 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.36

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,37 and in 1795 the French revolutionary government overthrew the Dutch Republic, establishing a client state in its place.38 After being nationalized in 1796, rendering its stock worthless, the Dutch East India Company’s charter expired in 1799.39

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.40

 41The 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.

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.

 42

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.

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.

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.53 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.54

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.55 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.56 The charts below paint the picture.

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.57 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.

 64By 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.

[1] 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.

[2] 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

[3] 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.

[4] Rough estimate based on internal calculations

[5] Rough estimate based on internal calculations

[6] Rough estimate based on internal calculations

[7] 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”).

[8] Encyclopedia Britannica, Eighty Years’ War, https://www.britannica.com/event/Eighty-Years-War

[9] Encyclopedia Britannica, The Anglo-Dutch Wars, https://www.britannica.com/event/Anglo-Dutch-Wars

[10] Israel, Dutch Primacy in World Trade, 1585-1740, 219

[11] Encyclopedia Britannica, The Anglo-Dutch Wars, https://www.britannica.com/event/Anglo-Dutch-Wars

[12] Encyclopedia Britannica, The Dutch War, https://www.britannica.com/event/Dutch-War

[13] Israel, The Dutch Republic: Its Rise, Greatness, and Fall 1477-1806, 824-825

[14] Encyclopedia Britannica, The Anglo-Dutch Wars, https://www.britannica.com/event/Anglo-Dutch-Wars

[15] 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.

[16] Hart, Jonker, and van Zanden, A Financial History of the Netherlands, 20-21

[17] Quinn & Roberds, “Death of a Reserve Currency,” 13

[18] Encyclopedia Britannica, The Anglo-Dutch Wars, https://www.britannica.com/event/Anglo-Dutch-Wars

[19] Encyclopedia Britannica, The Anglo-Dutch Wars, https://www.britannica.com/event/Anglo-Dutch-Wars

[20] Encyclopedia Britannica, The Anglo-Dutch Wars, https://www.britannica.com/event/Anglo-Dutch-Wars

[21] de Vries & van der Woude, The First Modern Economy, 455

[22] de Vries & van der Woude, The First Modern Economy, 126

[23] de Vries & van der Woude, The First Modern Economy, 685-686

[24] de Vries & van der Woude, The First Modern Economy, 455

[25] de Vries & van der Woude, The First Modern Economy, 455-456 & https://www.britannica.com/event/Anglo-Dutch-Wars

[26] 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.

[27] Quinn & Roberds, “Death of a Reserve Currency,” 17

[28] “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.

[29] Quinn & Roberds, “Death of a Reserve Currency,” 17-18

[30] Quinn & Roberds, “Death of a Reserve Currency,” 16

[31] Quinn & Roberds, “Death of a Reserve Currency,” 34

[32] Quinn & Roberds, “Death of a Reserve Currency,” 15-16

[33] 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

[34] Quinn & Roberds, “Death of a Reserve Currency,” 19, 26

[35] Quinn & Roberds, “Death of a Reserve Currency,” 19-20

[36] Quinn & Roberds, “Death of a Reserve Currency,” 16

[37] Quinn & Roberds, “Death of a Reserve Currency,” 24

[38] de Vries & van der Woude, The First Modern Economy, 685-686

[39] 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

[40] 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.

[41] 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).

[42] Gelderblom & Jonker, “Exporing the Market for Government Bonds in the Dutch Republic (1600-1800),” 16

[43] 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)

[44] See Schenk, Decline of Sterling, 39

[45] 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).

[46] Schenk, Decline of Sterling, 44

[47] Schenk, Decline of Sterling, 31

[48] Alex Cairncross, Years of Recovery: British Economic Policy 1945-51, 124-126

[49] Schenk, Decline of Sterling, 63

[50] Schenk, Decline of Sterling, 48

[51] Schenk, Decline of Sterling, 62

[52] As quoted in Schenk, Decline of Sterling, 62-63

[53] Ibid

[54] Schenk, Decline of Sterling, 66-67

[55] For more detail, see Cairncross & Eichengreen, Sterling in Decline, 139-155

[56] See also Cairncross & Eichengreen, Sterling in Decline, 151-155 for a discussion of other contributing factors

[57] Schenk, Decline of Sterling, 39, 46; for further description, see https://eh.net/encyclopedia/the-sterling-area/

[58] 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?”

[59] John Singleton & Catherine Schenk, “The Shift from Sterling to the Dollar, 1965–76: Evidence from Australia and New Zealand,” 1162

[60] For more detail on the dynamics of the Sterling Area, see Catherine Schenk, Britain and the Sterling Area, 1994

[61] As quoted by Schenk, Decline of Sterling, 156

[62] Schenk, Decline of Sterling, 174

[63] For fuller coverage of this, see Schenk, Decline of Sterling, 273-315

[64] Data from Schenk, “The Retirement of Sterling as a Reserve Currency After 1945: Lessons for the US Dollar?,” 25

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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.

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.

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.

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 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 though 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.

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.

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 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.”1 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 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 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.

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.

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.

[1]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.

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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.

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.

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.

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 than to let the free market allocate money and credit.3 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%.4 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 moon and to fight to eliminate poverty and assure civil rights.5 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 collage 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 787.6 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.

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.

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). 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.

This shift had big effects and implications.

 7

 8

 9

 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.

 10

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.

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.

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 Americans 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.

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.

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.

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.

[1]https://avalon.law.yale.edu/20th_century/trudoc.asp

[2]For example, Americans were by and large not allowed to own gold from 1933 to 1974.

[3]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.

[4]https://www.mercatus.org/publications/economic-history/economic-recovery-lessons-post-world-war-ii-period

[5]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.

[6]https://www.federalreserve.gov/pubs/bulletin/1999/0999lead.pdf

[7]Charts based on data from World Inequality Database.

[8]Based on data from voteview.com.

[9]Based on data from voteview.com.

[10]Spliced back with goods balance only prior to 1930.

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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.

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, think than America’s history and its Judeo-Christian-European philosophical roots have 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” 2 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.3

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 economy4 —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,5 Xi’s new China Standards 2035 plan, and the usual five-year plans.6

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-terms 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 coincidently 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.

• 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. (These differences of 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.7 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.8 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.9

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 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 taking 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.10 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.

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.

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,11 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.

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.

As far as ideological inclinations for Chinese people and Chinese leaders more generally, Confucianism, Marxism, and some strict Legalism were all are 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.15

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) 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.

• 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 1962.16 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.17 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 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.”18

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.19 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 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.

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.

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.22 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.23

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 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).24 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 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%25 of the population lived in extreme poverty; at his death that number was around 40% and fell to less than 2% by 2013.26 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.

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.28 If you want to read some American studies some are recommended in this footnote.29

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.

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.

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.

 30The 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.

That brings us up to date. On Thursday September 24th, I’ll be releasing the follow-up chapter to this one, which is about US-China relations and wars. Unlike the prior ones that were on the past, that chapter is about the most important things that are going on between these two countries now. If you found this one interesting, you’ll find the next one even more so.

[1]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.

[2]John Wang, Tso-chuan, in The Indiana Companion to Traditional Literature, 805.

[3]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.

[4]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.

[5]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.

[6]In October they will come up with their 14th five-year plan and targets for 2035.

[7]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.”

[8]If you haven’t read The Art of War I suggest you read it to get a flavor for what I am referring to.

[9]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 seminomadic 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.”

[10]I produced the diagram to apply this template to Chinese monetary history through working with Professor Jiaming Zhu.

[11]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.

[12]China began its nuclear-weapon research in the early 1950s and acquired nuclear-weapon capability in 1964.

[13]From US News & World Report: https://www.usnews.com/education/best-global-universities/rankings

[14]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.

[15]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 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.

[16]https://www.jstor.org/stable/652030?seq=2#metadata_info_tab_contents

[17]Estimates of the death toll of the Cultural Revolution range from hundreds of thousands to 20 million.

[18]As quoted in Henry Kissinger, On China, 211.

[19]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.

[20]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.”

[21]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.”

[22]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.

[23]https://www.lowyinstitute.org/the-interpreter/chart-week-global-trade-through-us-china-lens

[24]To clarify, while Madame Gu’s first husband passed, she remarried so I’m referring to her second husband.

[25]https://www.worldbank.org/en/news/feature/2010/03/19/results-profile-china-poverty-reduction

[26]https://data.worldbank.org/indicator/SI.POV.DDAY?locations=CN

[27]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.

[28]https://www.cnbc.com/2019/02/28/1-in-5-companies-say-china-stole-their-ip-within-the-last-year-cnbc.html

[29]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.”

[30]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.

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• Both parties in a relationship can choose whether they will have a win-win cooperative-competitive relationship or a lose-lose mutually threatening relationship, though it takes both of them to agree on what type of relationship they will have. If they choose to have a primarily win-win cooperative-competitive relationship they will take into consideration what is really important to the other and try to give it to them in exchange for them reciprocating. In that type of win-win relationship, they can have tough negotiations done with respect and consideration, competing like two friendly merchants at a bazaar or two friendly teams at the Olympics. If they chose to have a lose-lose mutually threatening relationship they will primarily think about how they can hurt the other in the hope of forcing the other into a position of fear in order to get what they want. In that type of lose-lose relationship they will have more destructive wars than productive exchanges. History has shown that small wars can get beyond anyone’s control and turn into big wars that are much worse than even the leaders who chose this path imagined so that virtually all parties wish that they chose the first path. Either side can force the second path on the other while it takes both sides to follow the first path. In the back of the minds of all parties, regardless of which path they choose, should be their relative powers. In the first case, the parties should realize what the other could force on them and appreciate the quality of the exchange without getting too pushy, while in the second case, the parties should realize that power will be defined by the relative abilities to endure pain as much as the relative abilities to inflict it. When it isn’t clear exactly how much power either side has to reward and punish the other, the first path is the safer way because there is great uncertainty around how each side can hurt the other. On the other hand, the second path will certainly make clear which party is dominant and which one will have to be submissive after the hell of war is over. That brings me to my main power principle.

My main principle about power is:

• Have power, respect power, and use power wisely. Having power is good because power will win out over agreements, rules, and laws all the time. That’s because, when push comes to shove, those who have the power either to enforce their interpretation of the rules and laws or to overturn the rules and laws will get what they want. The sequence of using power is as follows. When there are disagreements, the parties disagreeing will first try to resolve them without going to rules/laws by trying to agree on what to do by themselves. If that doesn’t work, they will try using the agreements/rules/laws that they agreed to abide by. If that doesn’t work, those who want to get what they want more than they respect the rules will resort to using their power. When one party resorts to using its power and the other side in the dispute isn’t sufficiently intimidated to knuckle under, there will be a war. A war is the testing of relative power. Wars can be all-out or they can be contained; in either case they will be whatever is required to determine who gets what. A war will typically establish one side’s supremacy and will be followed by a peace because nobody wants to fight the clearly most powerful entity until that entity is no longer clearly the most powerful. At that time, this dynamic will begin again. It is important to respect power because it’s not smart to fight a war that one is going to lose; it is preferable to negotiate the best settlement possible (that is unless one wants to be a martyr, which is usually for stupid ego reasons rather than for sensible strategic reasons). It is also important to use power wisely. Using power wisely doesn’t necessarily mean forcing others to give you what you want—i.e., bullying them. It includes recognizing that generosity and trust are powerful forces for producing win-win relationships, which are fabulously more rewarding than lose-lose relationships. In other words, it is often the case that using one’s “hard powers” is not the best path and that using one’s “soft powers” is preferable.1 If one is in a lose-lose relationship, one has to get out of it one way or another, preferably through separation though possibly through war. To handle one’s power wisely, it’s usually best not to show it because it will usually lead others to feel threatened and build their counter-threatening powers, which will lead to a mutually threatening relationship. Power is usually best handled like a hidden knife that can be brought out in the event of a fight. But there are some times that, when push comes to shove, showing one’s power and threatening to use it is most effective for improving one’s negotiating position and preventing a fight. It is valuable to know what matters to the other party most and least, especially what they will and won’t fight for and how they will fight. That is best discovered by looking at the types of relationships they have had and the ways they used power in the past, by imagining what they are going after, and by testing them through trial and error. Sometimes mutual testing leads to tit-for-tat escalations that dangerously put both parties in the difficult position of having to choose between fighting and being caught bluffing. Escalating tit-for-tat wars often take conflicts beyond where either side would logically want them to go. Knowing where the balance of power lies—i.e., knowing who would gain and lose what in the event of a fight—should always be kept in mind because it is essentially the equilibrium level that parties keep of in the back of their minds when considering what a “fair” resolution of a dispute is—like thinking about what results a court fight would lead to when considering what the terms of a negotiated agreement should be. Though it is generally desirable to have power, it is also desirable to not have powers that one doesn’t need. That is because maintaining power consumes resources, most importantly your time and your money. With power comes the burden of responsibilities. While most people think that having lots of power is best, I have often been struck by how happy less powerful people can be relative to more powerful people. When thinking about how to use power wisely, it’s also important to think about when to reach an agreement and when to fight. To do that, it is important to imagine how one’s power will change over time. It is desirable to use one’s power to negotiate an agreement, enforce an agreement, or fight a war when one’s power is greatest. That means that it pays to fight early if one’s relative power is declining and fight later if it’s rising. Of course there are also times that wars are logical and necessary to keep or get what one needs. That brings me to my main principle about war.

My main principle about war is:

• When two competing entities have comparable powers that include the power to destroy the other, the risks of a war to the death are high unless both parties have extremely high trust that they won’t be unacceptably harmed or killed by the other. Imagine that you are dealing with someone who can either cooperate with you or kill you and that you can either cooperate with them or kill them, and neither of you can be certain what the other will do. What would you do? Even though the best thing for you and your opponent to do is cooperate, the logical thing for each of you to do is to kill the other before being killed by the other. That is because survival is of paramount importance and you don’t know if they will kill you, though you do know that it is in their interest to kill you before you kill them. In game theory being in this position is called the “prisoner’s dilemma.” It is why establishing mutually assured protections against existential harms that the opponents can inflict on each other are necessary to avoid deadly wars. Establishing exchanges of benefits and dependencies that would be intolerable to lose further reinforces good relations. Because a) most wars occur when it isn’t clear which side is most powerful so the outcomes are uncertain, b) the costs of wars are enormous, and c) losing wars is ruinous, they are extremely dangerous and must only be entered into if there is confidence that you will not have unacceptable losses, so you must think hard about what you will really fight to the death for.

While I am primarily focusing on US-China relations in this chapter, the game we and global policy makers are playing is like a multidimensional chess game that requires each player to consider the many positions and possible moves of a number of key players (i.e., countries) that are also playing the game, with each of these players having a wide range of considerations (economic, political, military, etc.) that they have to weigh to make their moves well. For example, the relevant other players that are now in this multidimensional game include Russia, Japan, India, other Asian countries, Australia, and European countries, and all of them have many considerations and constituents that will determine their moves. From playing the game I play—i.e., global macro investing—I know how complicated it is to simultaneously consider all that is relevant in order to make winning decisions. I also know that what I do is not as complicated as what those in the seats of power do and I know that I don’t have access to information that is as good as what they have, so it would be arrogant for me to think I know better than they do about what’s going on and how to best handle it. For those reasons I am offering my views with humility. With that equivocation I will tell you how I see the US-China relationship and the world setting in light of these wars, and I will be brutally honest.

Thus far in this book we looked at the history of the last 500 years focusing especially on the rise and decline cycles of the Dutch, British, and American reserve currency empires and the last 1,400 years of China’s dynasties, which has brought us up to the present. The goal has been to put where we are in the context of the big-picture stories that got us here and to see the cause/effect patterns of how things work so that we can put where we are into better perspective. Now we need to drop down and look at where we are in more detail, hopefully without losing sight of that big picture. As we drop down, imperceptibly small things—TikTok, Huawei, Hong Kong sanctions, closing consulates, moving battleships, unprecedented monetary policies, political fights, social conflicts, and many others—will start to appear much larger, and we will find ourselves in a blizzard of them that comes at us every day. Each warrants more than a chapter-long examination, which I don’t intend to do here, but I will touch on the major issues.

History has taught us that there are five major types of wars—1) trade/economic wars, 2) technology wars, 3) geopolitical wars, 4) capital wars, and 5) military wars—that need to be considered. While all sensible people wish that these “wars” weren’t occurring and that cooperation was occurring in their places, we must be practical in recognizing that they exist, and we should use past cases in history and our understandings of actual developments as they are taking place to think about what is most likely to happen next and how to deal with it well. We see them transpiring in various degrees of play now. They should not be mistaken as individual conflicts but rather recognized as interrelated conflicts that are extensions of one bigger evolving conflict. In watching them transpire we need to observe and try to understand each side’s strategic goals—e.g., are they trying to hasten a conflict (which some Americans think is best for the US because time is on China’s side because China is growing its strengths at a faster pace) or are they trying to ease the conflicts (because they believe that they would be better off if there is no war)? In order to prevent these from escalating out of control, it will be important for leaders of both countries to be clear about what the “red lines” and “trip wires” are that signal changes in the seriousness of the conflict. Let’s now take a look at these wars with the lessons from history and the principles they provide in mind.

1. The Chinese government pursues a wide range of evolving interventionist policies and practices aimed at limiting market access for imported goods, services, and businesses, thus protecting its domestic industries by creating unfair practices.
2. The Chinese offer significant government guidance, resources, and regulatory support to Chinese industries, most notably including policies designed to extract advanced technologies from foreign companies, particularly in sensitive sectors.
3. The Chinese are stealing intellectual property, with some of this stealing believed to be state-sponsored and some of it believed to be outside the government’s direct control.

Generally speaking the United States has responded to these things both by trying to alter what the Chinese are doing (e.g., to get them to open their markets to Americans) and by doing its own versions of these things (closing American markets to the Chinese). Americans won’t admit to doing some of the things they are doing (e.g., taking intellectual property) any more than the Chinese will admit doing them because the public relations’ costs of admitting to doing them are too great. When they are looking for supporters of their causes, all leaders want to appear to be the leaders of the army that is fighting for good against the evil army that is doing bad things. That is why we hear accusations from both sides that the other is doing evil things and no disclosures of the similar things that they are doing. As a principle…

When things are going well it is easy to keep the moral high ground. However, when the fighting gets tough, it becomes easier to justify doing that which was previously considered immoral (though rather than calling it immoral it is called moral). As the fighting becomes tougher a dichotomy emerges between the idealistic descriptions of what is being done (which is good for public relations within the country) and the practical things that are being done to win. That is because in wars leaders want to convince their constituents that “we are good and they are evil” because that is the most effective way to rally people’s support, in some cases to the point that they are willing to kill or die for the cause. Though true, it is not easy to inspire people if a practical leader explains that “there are no laws in war” other than the ethical laws people impose on themselves and “we have to play by the same rules they play by or we will stupidly fight by self-imposing that we do it with one hand behind our backs.”

Regarding the trade war I believe that we have pretty much seen the best trade agreement that we are going to see and that the risks of this war worsening are greater than the likelihood that it will improve, and we won’t see any treaty or tariff changes anytime soon as all trade negotiations are on hold until well after the US presidential elections. Beyond the elections, a lot hinges on who wins and how they will approach this conflict. That will be a big influence on how Americans and the Chinese approach the Big Cycle destinies that are in the process of unfolding. As things now stand, the one thing, maybe the only thing, that both US political parties agree on is being hawkish on China. How hawkish and how exactly that hawkishness is expressed and reacted to by the Chinese are now unknown.

How could this war worsen?

Classically, the most dangerous part of the trade/economic war comes when countries cut the other off from essential imports (e.g., China cutting the US off from rare earth elements that are needed for the production of lots of high-tech items, auto engines, and defense systems, and the US cutting China off from essential technologies) and/or from essential imports from other countries (e.g., the US cutting China off from semiconductors from Taiwan, crude oil from the Middle East or Russia, or metals from Australia)—much like the US cutting off oil to Japan was a short leading indicator of the military war that followed. Thus far we haven’t seen this, though we have seen movements in this direction. I’m not saying such a move is likely but I do want to be clear that moves to cut off essential imports from either side would signal a major escalation that could lead to a much worse conflict. If that doesn’t happen evolution will take its normal course so international balances of payments will evolve primarily based on each country’s evolving competitiveness.

For these reasons both countries, especially China, are shifting to more domestic production and “decoupling.”2 As President Xi has said, the world is “undergoing changes not seen in a century” and “in the current external environment of rising protectionism, downturn in the world economy, and shrinking global markets, [China] must give full play to the advantages of the domestic super-large-scale market.” Over the last 40 years it acquired the abilities to do this. Over the next five years we should see both countries become more independent from each other. Obviously the rate of reducing one’s dependencies that can be cut off will be much greater for China over the next 5-10 years than for the United States.

Regarding the stealing of technologies, while it is generally agreed to be a big threat (1 in 5 North America-based companies in a 2019 CNBC Global CFO Council survey claimed to have had intellectual property stolen by Chinese companies3), it does not fully explain actions taken against Chinese tech companies. If a company is breaking a law within a country (e.g., Huawei in the US) one would expect to see that crime prosecuted legally so one could see the evidence that shows the spying devices embedded within the technologies. We aren’t seeing this. Fear of growing competitiveness is as large or larger a motivator of the attacks on Chinese technology companies, but one can’t expect policy makers to say that. American leaders can’t admit that the competitiveness of US technology is slipping and can’t argue against allowing free competition to the American people, who for ages have been taught to believe that competition is both fair and the best process for producing the best results. As a practical matter stealing intellectual property has been going on for as long as there is recorded history and has always been difficult to prevent. As we saw in earlier chapters the British did it to the Dutch and the Americans did it to the British to make themselves more competitive. “Stealing” implies breaking a law. When the war is between countries there are no laws, judges, or juries to resolve disputes and the real reasons decisions are made aren’t always disclosed by those who are making them. I don’t mean to imply that the reasons behind the United States’ aggressive actions are not good ones; I don’t know if they are. I’m just saying that they might not be exactly as stated. Protectionist policies have long existed to protect companies from foreign competition. Huawei’s technology is certainly threatening because it’s better than American technology. Look at Alibaba and Tencent and compare them with American equivalents. Americans might ask why these companies are not competing in the US. It is mostly for the same reasons that Amazon and a number of other American tech companies aren’t freely competing in China. In any case, there is a tech decoupling going on that is part of the greater decoupling of China and the US, which will have a huge impact on what the world will look like in five years.

What would a worsening of the tech war look like?

Still, the United States has a technology lead (though it’s shrinking fast). As of result, as of now the Chinese have great dependencies on imported technologies from both the US and non-US sources that the US can influence. This creates a great vulnerability for China, which creates a great weapon for the United States. It most obviously exists in advanced semiconductors, though it exists in other technologies as well. The dynamic with the world’s leading chip maker—Taiwan Semiconductor Manufacturing Company, which provides the Chinese and the world with needed chips and which can be influenced by the United States—is one of many interesting dynamics to watch. There are many such Chinese technology imports that are essential for China’s well-being, and much fewer American imports from China that are essential for the United States’ well-being. If the United States shuts off Chinese access to essential technologies that would signal a major step up in war risks. On the other hand, if events continue to transpire as they have been transpiring, China will be much more independent and in a much stronger position than the United States technologically in 5-10 years, at which time we will see these technologies much more decoupled.

Generally speaking the Chinese appear to want tributary-like relationships with most non-rival countries, though the closer their proximity to China, the greater the influence China wants over them. In reaction to these changing circumstances most countries, in varying degrees, are wrestling with the question of whether it is better to be aligned with the United States or China, with those in closest proximity needing to give the most consideration to this question. In discussions with leaders in different parts of the world I have repeatedly heard it said that there are two overriding considerations—economics and military. They almost all say that if they were to choose on the basis of economics, they would choose China because China is more important to them economically (in trade and capital flows), while if they were to choose on the basis of military support, the United States has the edge but the big question is whether the United States will be there to protect them militarily when they need protection. Most doubt that the US will fight for them, and some in the Asia-Pacific region question whether the US has the power to win if it wanted to.

The economics that China is providing these countries is significant and is working in a way that is broadly similar to the way the United States provided economic benefits to key countries after World War II to help secure the desired relationships. America’s influence relative to China’s influence is fading fast. It was not many years ago that there were no significant rivals to the United States so it was quite easy for the United States to simply express its wishes and find that most countries would comply; the only rival powers were the Soviet Union (which wasn’t much of a rival), its allies, and a few of the developing countries that were not economic rivals. Over the last few years Chinese influence over other countries has been expanding while US influence has been receding. That is also true in multilateral organizations—e.g., the United Nations, the IMF, the World Bank, the World Trade Organization, the World Health Organization, the International Court of Justice—most of which were set up by the United States at the beginning of the American world order. As the United States has been pulling back from them, these organizations are weakening and China is playing a greater role in them.

Over the next 5-10 years, in addition to there being the decouplings6 in other areas, we will be seeing which countries align themselves with each of these leading powers. Beyond money and military power, how China and the US interact with other countries (i.e., how they use their soft powers) will influence how these alliances will be made—i.e., style and values will matter. For example, over the last few years I have heard leaders around the world describe both countries’ leaders as “brutal,” which is creating increased fears that they will be punished if they don’t do exactly what these two countries’ leaders want, and they don’t like it to the point of being driven into the other’s arms. It will be important to see what these alliances will look like because throughout history the most powerful country is typically taken down by alliances of less powerful countries that are collectively stronger. Perhaps the most interesting relationship to watch is between China and Russia. Since the new world order began in 1945, among China, Russia, and the United States, two out of the three of them have allied to neutralize or overpower the third. Russia and China each has a lot of what the other needs (e.g., natural resources and military equipment for China from Russia and financing for Russia from China). Also, because Russia is militarily strong it would be a good military ally. We can start to see this happening by watching whether the countries line up on the issues (e.g., whether to allow Huawei in) with the United States or China.

In addition to the international political risks and opportunities there are of course big domestic political risks and opportunities in both countries. That is because there are different factions who are fighting for control of both governments and there will inevitably be changes in leaders that will produce changes in policies that are hard or impossible to anticipate. While nearly impossible to anticipate, these changes are not totally impossible to anticipate because whoever is in charge will be faced with the challenges that now exist and that are unfolding in the Big Cycle ways we have been discussing. Since all leaders (and all other participants in these evolutionary cycles including all of us) step on and get off at different parts of these cycles, they (and we) have a certain set of likely situations to be encountered. Since other people in history have stepped on and off at the same parts of past cycles, by studying what these others encountered and how they handled their encounters at the analogous stages, and by using some logic, we can imperfectly imagine the range of possibilities.

Now, by watching who bought what for what reasons we can understand why. However, the lesson is the same as one regularly gets in the markets, which is that the implausible happens more often than one would expect. So while most everyone, most importantly the world’s greatest experts, agrees that we are testing the limits, no one, including me, should say with certainty that the dollar will be significantly diminished as a reserve currency anytime soon. However, we can recognize what it will look like when it comes and know that, if it comes, it probably won’t be able to be stopped. There will be a selling of dollar-denominated debt by holders of that debt as they put their assets elsewhere and there will be lot of borrowing of dollar debt by smart debtors who will take advantage of that cheap funding to make higher returns and these moves will require the Fed to choose between a) allowing interest rates to rise unacceptably (because that rise would severely damage markets and the economy) and b) printing money to buy a lot of debt, which will further reduce the real value of the dollar and dollar debt. As described in Chapters 2 and 3, it will look like a classic currency defense. As explained in that chapter, when faced with that choice central banks almost always print money, buy the debt, and devalue the currency, which becomes self-reinforcing because the interest rates being received to hold the currency are not high enough to compensate for the depreciating value of the currency. That continues until the currency and real interest rates reach levels that establish new balance of payments levels, which is a fancy way of saying until there is enough forced selling of goods, services, and financial assets, and enough curtailed buying of them by Americans so they can be paid for with less debt.

The most often asked question regarding the dollar is, “How could the United States lose its reserve currency status when there are no good alternative currencies to replace it?” So let’s look at that question more closely. The reserve currency assets and their current percentages of total foreign exchange reserves held are as follows:

These six are used in these amounts because of both historical reasons and the fundamentals that affect their relative appeal. As explained and shown in charts earlier in this study, a reserve currency’s usage, like a language’s usage, lags the fundamental reasons for using it by many years because the usage of currency is not easy to change. Right now the four most used reserve currencies—the US dollar, the European euro, the Japanese yen, and the British pound—are of the old leading empires of the post-1945 period though they have limited fundamental appeal. They came from the G5 countries and are about as anachronistic as the G5 is.

As for the fundamental appeal of each of these currencies:

• The dollar was discussed so I won’t repeat the picture.
• The euro is a weakly structured currency made by countries that are tenuously held together by a currency union that is highly fragmented on most issues and economically and militarily weak.
• The yen is a currency that is not widely used internationally by non-Japanese people and suffers from a lot of the same problems that the dollar does, including having too much debt that is increasing quickly and being monetized so that it is paying unattractive interest rates. And Japan is only a moderately powerful country, not a leading power in any important way.
• The British pound is an anachronistically held currency that has relatively weak fundamentals, and the country is relatively weak in most of our measures of a country’s economic/geopolitical power.
• Gold is held because it has worked the best for the longest time and, like the British pound, because it was held from a past time—i.e., before 1971 when gold was at the foundation of the world’s currency system. It has appeal because it doesn’t have the previously described weaknesses of the fiat currencies being overprinted. At the same time the size is limited because the gold market is limited in size.
• The Chinese RMB is the only currency to be chosen as a reserve currency because of its fundamentals—China has the largest share of world trade, its economy is roughly tied for the biggest, it has managed its currency to be relatively stable against other currencies and goods and services prices, and its reserves and its other strengths are large. Also, it doesn’t have the 0% interest rate, negative real interest rate, and the printing and monetization of debt problem though it does have a lot of domestic debt that has to be restructured. Its drawbacks are that it is not widely used, it doesn’t allow the free flowing of capital and a free-floating exchange rate, its capital markets and its financial center have to be better developed, its clearing system is undeveloped, and it has yet to build world investors’ trust.

History has shown that whenever currencies are not desired they are sold off and devalued with the capital finding other investments (e.g., gold, silver, stocks, property, etc.) to go into, so there is no need to have an attractive alternative foreign currency market to go into for the devaluation of a currency to occur. In other words the US could see its reserve currency status reduced without there being an alternative reserve currency to go into.

Without the US disrupting China’s currency and capital markets they will likely develop quickly and increasingly compete with the US currency and credit markets. You won’t see this all at once, but you will see it evolve that way at a shockingly fast pace over the next 5-10 years. As shown in the Dutch, British, and US cases that development is consistent with the natural arc of things. Also, the fundamentals are in place for that to happen if the Chinese continue to run sound policies and develop their markets well. There is a lot of potential for Chinese capital markets, the RMB, and RMB-denominated debt to grow in importance because it is so underinvested in relative to its fundamentals. For example:

• China and the US are the largest trading countries, both accounting for about 13% of global trade (including exports and imports), yet the RMB accounts for only about 2% of world trade financing while the dollar accounts for over 50%. It would be pretty easy to increase the share of trade financing in RMB.
• While China accounts for around 19% of world GDP9 (and is growing at a faster rate than the US) and has around 15% of global equity market capitalization, it has only about 5% weight currently in MSCI equity indices and its assets represent only about 2% of foreign assets in portfolios. In contrast while the United States on the whole accounts for around 20% of world GDP and is growing slower, it now accounts for over 50% weight in MSCI equity indices and has around 48% of non-American money in it. My point is that Chinese markets are underinvested in because the investment has lagged the development, especially for foreign investors.

As previously explained and shown in the development of the Dutch, British, and American empires, the development of the world’s leading capital markets and the world’s capital market centers of Amsterdam, London, and New York was an essential step in each empire’s development to become the leading empire and has traditionally lagged the country’s fundamentals the way the Chinese capital markets and Shanghai as a financial center (and to a lesser extent Hong Kong and Shenzhen) have lagged China’s developments.

The development of Chinese currency and capital markets would be detrimental for the United States and beneficial for China. So once again it seems likely that American policy makers will be forced to choose between a) trying to disrupt this evolutionary path by becoming more aggressive with their wars (in this case via a more aggressive capital war) and b) accepting that evolution will likely lead to China becoming relatively stronger, more self-sufficient, and less vulnerable to being squeezed by the US at the expense of US leadership in this area, especially over the next 5-10 years. We are seeing some early signs of US moves to curtail Americans’ investments in Chinese markets and to possibly delist Chinese companies from American stock exchanges. These are double-edged swords because while being marginally harmful to Chinese markets and listed companies they also weaken American investors’ and American stock exchanges’ abilities to be competitive, which will support the development of those in China and elsewhere. For example, the Ant Group’s choice to list on the Hong Kong and Shanghai exchanges gives investors the choice of investing on those Chinese exchanges or missing out on those investments, which are listed there and not on other exchanges.

As far as a big hot war between the United States and China is concerned, it would include all the previously mentioned types of wars plus more pursued at their maximums because, in a fight for survival, each would throw all they have at the other, the way other countries in history have, so it would be World War III, and World War III would likely be much more deadly than World War II, which was much more deadly than World War I because of the technological advances that have been made in the ways we can hurt each other.

In thinking about the timing of a war, I keep in mind the principle that when countries have big internal disorder, it is an opportune moment for opposing countries to aggressively exploit their vulnerabilities. For example, the Japanese made their moves to take control of European colonies in Southeast Asia in the 1930s when the European countries were challenged by their depressions and their conflicts. History has also taught us that when there are leadership transitions and/or weak leadership, at the same time that there is big internal conflict, the risk of the enemy making an offensive move should be considered elevated. For example, those conditions could exist in the upcoming US presidential election. However, because time is on China’s side (because of the trends of improvements and weakenings shown in prior charts), if there is to be a war, it is in the interest of the Chinese to have it later (e.g., 5-10 years from now when it will likely be more self-sufficient and stronger) and in the interest of the US to have it sooner.

I’m now going to add two other types of war—1) the culture war, which will drive how each side will approach these circumstances, including what they would rather die for than give up, and 2) the war with ourselves, which will determine how effective we are, which will lead us to be strong or weak in the critical ways that we previously explored.

For example, one should accept the fact that when choosing leaders most Chinese believe that having capable, wise leaders make the choices is preferable to having the general population make the choice on a “one person one vote” basis because they believe that the general population is less informed and less capable. Most believe that the general population will choose the leaders on whims and based on what those seeking to be elected will give them in order to buy their support rather than what’s best for them—e.g., the general voting population will choose those who will give them more money without caring where the money comes from. Also, they believe—like Plato believed and as happened in a number of countries that turned from democracies to autocracies through the millennia (most recently in the 1930-45 period)—that democracies are prone to slip into dysfunctional anarchies during very bad times while people fight over what should be done rather than support the strong, capable leader who will tell them what they should do. They also believe that their system of choosing leaders lends itself to better multigenerational strategic decision making because any one leader’s term is only a small percentage of the time that is required to progress along that developmental arc.10 They believe that what is best for the collective is most important and best for the country and is best determined by those at the top. Their system of governance is more like the governance that is typical in big companies, especially multigenerational companies, so they wonder why it is hard for Americans and other Westerners to understand the rationale for the Chinese system following this approach and to see the challenges of the democratic decision-making process as they see them. To be clear I’m not seeking to explore the relative merits of these decision-making systems; I am simply trying make clear that there are arguments on both sides and to help Americans and the Chinese see things through each other’s eyes, most importantly, to understand that the choice is between a) accepting, tolerating, and even respecting each other’s right to do what each thinks is best and b) having the Chinese and Americans fight to the death over what they believe is uncompromisable.

The American and Chinese economic and political systems are different because of the differences in their histories and the differences in their cultures that resulted from these histories. As far as economics is concerned—i.e., 1) the classic left (favoring government ownership of the means of production, the poor, the redistribution of wealth, etc.), which the Chinese call communism, and 2) the classic right (favoring private ownership of the means of production, whoever succeeds in the system, and much more limited redistributions of wealth)—exists and has had swings from one to the other in all societies especially in China, so it would not be correct to say that the Chinese are culturally left or right. Similar swings in American preferences have existed throughout its much more limited history. I suspect that if the United States had a longer history we would have seen wider swings as we have seen in Europe through its longer history, so we should consider even wider swings possible. For these reasons these “left” versus “right” inclinations appear to be more Big Cycle swings around the evolutionary trends than core values that are evolving. In fact we are seeing these swings now taking place in both countries so it’s not a big stretch to say that policies of the “right” such as capitalism are close to being more favored in China than in the United States and vice versa. In any case, the deep cultural preferences and the clear distinctions are not there. In contrast the cultural inclinations of the Chinese to be top-down/hierarchical versus bottom-up/non-hierarchal are deeply embedded in them and in their political systems and the cultural inclinations of Americans to be bottom-up/non-hierarchal are also deeply embedded in them. As for which approach will work best and will win out in the end, I will leave that for others to debate, hopefully without bias, though I will note that most knowledgeable observers of history have concluded that neither of these systems is always good or bad—that what works best varies according to a) the circumstances and b) how people using these systems are with each other. No system will sustainably work well, in fact all will break down, if a) the individuals in it don’t respect it more than what they individually want and b) the system is not flexible enough to bend with the times without breaking.

So now, as we imagine how Americans and the Chinese will handle their shared challenge to evolve in the best possible way on this shared planet, I try to imagine where their strong cultural inclinations, most importantly where the irreconcilable differences that they would rather die for than give up, will lead them.

For example, most Americans and most Westerners would fight to the death for a) the ability to have and express one’s opinions, including one’s political opinions, and b) the lack of the right and ability of the organization they are part of to stand in the way of that right. In contrast the Chinese value more a) the respect for authority, which is reflected and demonstrated by the relative parties’ powers, and b) the responsibility to hold the collective organization responsible for the actions of individuals in the collective. A recent example of such a culture clash occurred when in October 2019 the general manager of the Houston Rockets (Daryl Morey) tweeted an image expressing support for Hong Kong’s pro-democracy protest movement. He quickly pulled down his tweet and explained that his views weren’t representative of his team’s views or the NBA’s views. Morey was then attacked by the American side (i.e., the press, politicians, and people) for not standing up for free speech and by the Chinese side, and the Chinese side held the whole league responsible and punished it by dropping all NBA games from China’s state television, pulling NBA merchandise sales from online stores, and demanding that the league fire Morey for expressing his critical political views. This culture clash arose because of how important free speech is to Americans and how Americans believe that the organization that the individual is a part of should not be punished for the actions of the individual. The Chinese, on the other hand, believe that the harmful attack needed to be punished and that the group that the individual is a part of should be held accountable for the actions of the individuals in it. One might imagine much bigger cases in which much bigger conflicts would arise due to such differences in deep-seated beliefs about how people should be with each other. For example, when in a superior position, the Chinese tend to want that to be clear, to have the party in a subordinate position know that it is in a subordinate position and to obey and that, if it doesn’t do these things, it will be punished. That is the cultural inclination/style of Chinese leadership. They can also be wonderful friends who will provide support when needed. For example, when the governor of Connecticut was desperate to get personal protective equipment in the first big wave of COVID-19 illnesses and deaths and couldn’t get it from the US government and other American sources, I turned to my Chinese friends for help and they provided what was needed, which was a lot. As China goes global a number of countries’ leaders (and their populations) have been both grateful and put off by China’s acts of generosity and strict punishments. Some of these cultural differences can be negotiated to the parties’ mutual satisfaction but some of the most important ones will be very difficult to negotiate away.

I think the main thing is to realize and accept is that the Chinese and Americans have different values and will make different choices for themselves than the other would like. For example, Americans might not like how the Chinese handle their human rights issues and the Chinese might not like how Americans handle their human rights issues, so the question is what should be done about that. Should Americans fight with the Chinese to impose what they think the Chinese should do on them and vice versa, or should they agree not to intervene on what each other does? In my opinion a) it is too difficult, inappropriate, and probably impossible to force others in other countries to do what they strongly believe is not good for them and b) at the end of the day the United States’ ability to impose things on the Chinese and China’s ability to impose things on United States will be a function of our relative powers.

In thinking about practical principles that we might agree on I wonder if Americans and the Chinese and you and I can agree on the ones that are true (putting aside whether or not we would like them to be true). If we can that will help to determine the desired path forward.

• Everyone needs to know their position, and one’s power determines one’s position. If there are questions about who has what power, there will be a conflict to resolve that. Ideally that happens without a hot war, but when it is not clear and it is important it generally isn’t resolved peacefully. Over time evolution will make it clear who has what power, so if those with less power know that they have less power, they should slip into the subordinate position so the power and position change takes place without fighting. If they refuse to slip into the subordinate position, there will be fighting and the painful defeat of the weaker power. That is what makes transitions of power so painful.
• The only real rule in international relations is that there are no rules. That is because internationally there are no mutually agreed-upon laws, no police, no courts, no judges, and no other protocols that are followed in order to judge what’s fair and what’s not fair and to penalize those who are playing unfairly and are more powerful than the individual powers. What counts most is whether you win or lose. For example, in the American Revolutionary War, when the British lined up in rows for the fight and the American revolutionaries shot at them from behind trees, the British thought that was unfair and the revolutionaries won believing the British were foolish and that the emerging Americans did the right thing. That’s just how it is. So can we agree that our leaders and we should stop whining that the other side is playing unfairly and instead focus on playing the game smartly to deal with what’s going on?
• Winning means getting those things that are most important without losing those things that are most important to us, so wars that cost much more in lives and money than they provide in benefits are stupid.
• While there are no rules in international relations other than those who are the most powerful impose on themselves (e.g., rules about morality in warfare), there are different approaches that are more likely to lead to better outcomes. For example, there are approaches that are more likely to produce more win-win outcomes and approaches that are more likely to produce more lose-lose outcomes, and those that are more likely to lead to win-win outcomes are better. To get more win-win outcomes one needs to negotiate well with consideration given to what is most important to the other party and to oneself and to know how to trade these well.11, 12
• It is far too easy to slip into stupid wars (i.e., wars that cost much more in lives and money than anyone sensible would say they’re worth) because of a) the prisoner’s dilemma, b) the tit-for-tat escalation process, c) the costs of the declining power backing down, and d) misunderstandings existing when decision making has to be fast. Regarding the prisoner’s dilemma imagine that you are dealing with someone who can either cooperate with you or kill you and that you can either cooperate with them or kill them, and neither of you can be certain of what the other will do. What would you do? Even though the best thing for you and your opponent to do is cooperate, the logical thing for each of you to do is to kill the other before being killed by the other. That is because self-preservation is of paramount importance and you don’t know if they will kill you, though you do know that it is in their interest to kill you before you kill them. That is the situation rival great powers typically find themselves in; they need to have ways of assuring that the other has no ways of killing them in order not to go down the path of trying to kill them first. Another big reason that stupid wars happen is because there is a tit-for-tat escalation process that requires each side to escalate or lose what the enemy captured in the last move and be perceived as weak. For peace to prevail these must be avoided by both parties. Related to this, declining empires tend to fight rising empires more than is logical for them to do because the fight/retreat calculation tends to lead one to prefer fighting more than is logical on the basis of the expected outcome alone because a retreat is a defeat. For example, even though the United States fighting to defend Taiwan would seem to be illogical (e.g., if there is a 70% chance of the US losing), not fighting a Chinese attack on Taiwan would be a big loss of stature and power over other countries who won’t support the US if it doesn’t fight and win for its allies. Additionally such defeats can make leaders look weak to their own populations, which can cost them the political support they need to remain in power. And, of course, miscalculations due to misunderstandings when conflicts are transpiring quickly are dangerous. All these dynamics create strong pulls toward wars accelerating even though such mutually destructive wars are so much worse than cooperating and competing in more peaceful ways.
• Untruthful and emotional appeals that rile people up increase the dangers of stupid wars so it is better either to a) have the leaders be truthful and thoughtful in explaining the situation and how they are dealing with it (which is especially essential in a democracy in which the opinions of the population matter) or b) choose the best leaders possible and blindly trust them. The worst thing is to c) have the leaders be untruthful and emotional in dealing with their populations. When the populations get riled up and want to fight that increases the risk of war beyond what is logical. Political leaders often do rile their populations up to build political support. Because negative sentiment takes time to reverse, it can increase the danger of war. This is now happening in both the US and China, though more in the US. For example, in a recent Pew survey a record 73% of Americans had an unfavorable opinion of China, 73% believe the United States should promote human rights in China, and 50% believed the US should “hold China responsible” for the role it played in COVID-19.13 Though I don’t have surveys of Chinese public opinion of the United States, I am told by many people that it has deteriorated. It wouldn’t take much to have these people demand accelerations of the conflicts.
• The smartest way to fight and win a war is to outcompete the opposition in order to have the power to negotiate with them from a position of strength. Can we agree that a) the US and China are in a competition of systems and abilities, b) each will inevitably follow the system that they believe works best for them, c) Americans have a slight lead in power that is shrinking and they’re outnumbered, and d) history has shown that while numbers of people can matter a lot, other factors (e.g., the 17 I showed in Chapter 1) matter more so even small-population empires become leading world powers if they manage themselves well? That all implies that what’s most important to be strong is how we are with ourselves.

That brings me to the last and the most important war that we are now facing.

• …leadership that is strong enough and capable enough 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 the rule of law.
• People being able to work well together, united behind a common view of how they should be together 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 leads to them gaining…
• …greater competitiveness in global markets, 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 infrastructure, education systems, and research and development, which leads them to have…
• …rapidly increasing 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 the country becomes more competitive in these ways, naturally they gain
• …a rising and 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 them outside their borders. In becoming economically preeminent they develop…
• …strong, widely used currency, equity, 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 and the building of…
• …at least one of the world’s leading financial centers for attracting and distributing capital and expanding their trade globally.

It is through the mutually reinforcing and unwavering improvements in these things that countries rise and sustain their powers.

At the same time the gaining of these strengths tends to sow the seeds of the cyclical decline that one should watch out for, which shows up in the form of…

• …becoming less competitive because…
• …being successful and rich leads one to be copied by emerging competitors and leads to…
• …working less hard and engaging in more leisurely and less productive activities, especially as…
• …newer, less battle-hardened generations take the reins from those who had to be stronger and worked harder to achieve success. Also, being the richest and most powerful global power leads to one…
• …having a reserve currency, which gives one …
• …the “exorbitant privilege” of being able to borrow more money, which leads to…
• …getting deeper in debt to foreigners, which sustains their power beyond their fundamentals, financing both domestic overconsumption and military and war spending that are required to maintain their empire. When the richest get into debt by borrowing from the poorest, it is a very early sign of a relative wealth shift.
• Debt and capital market financed economic successes lead to both financial bubbles and large wealth gaps because people benefit disproportionately from them so…
• …when there is a lot of economic stress there are greater conflicts between the rich and the poor, at first gradually and then increasingly intensely, which leads to…
• …increased political extremism—i.e., populism of both the left (those who seek to redistribute the wealth, such as socialists and communists) and the right (those who seek to maintain the wealth in the hands of the rich, such as the capitalists)—which leads to…
• …the rich fearing that their money will be taken away and/or that they will be treated with hostility, which leads them to move their money and themselves to places, assets, and/or currencies that they feel are safer, which if allowed to continue leads to…
• …reduced taxes relative to spending needs, which leads to…
• …larger deficits and rising tax rates, which leads in turn to…
• …a classic self-reinforcing hollowing-out process in the places that people who were being taxed, spending money, and providing jobs are leaving. That leads to…
• …less spending on essentials, which worsens conditions, which further raises tensions between the rich and the poor and further raises tax rates and deficits, causing still more hollowing out.
• With very large debts and the central bank having pushed interest rates down to stimulate debt growth as much as possible, the central bank loses its ability to stimulate debt and economic growth with hard money so…
• …when there is an economic downturn there are both a) more internal fights over money and b) more central bank printing of money, which eventually devalues it.
• The country’s foreign empire becomes uneconomical to support and to defend militarily as the costs of maintaining it become greater than the revenue it brings in, which further weakens the leading country financially and its power abroad.
• These sorts of disruptive conditions undermine the country’s productivity, which 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.
• • A rising competitive country often gains enough economic, geopolitical, and military power to challenge the existing leading power during its time of weakness. Internationally the emerging country both a) competes more effectively to win markets and territorial influences and b) fills in the voids in these left by the retreating country.
• Other exogenous shocks such as acts of nature (e.g., plagues, droughts, or floods) can occur during times of vulnerabilities which, if they happen, increase the risk of a self-reinforcing downward spiral.

The internal wars and challenges in both China and the US are more important and bigger than external wars and challenges. These include political wars within the leadership of the country and at all levels of government, wars between different factions (e.g., the rich and the poor, the rural and the urban, conservatives and progressives, ethnic groups, etc.), demographic changes, climate changes, etc. Fortunately, the most important of these forces are within our control and are measurable, which allows us to see how we are doing and, if we’re not doing well, to make changes so these things move in the right directions. By and large we will get what we deserve. As Churchill said to the British people, “Deserve Victory!”

In the next chapter of this book, “The Internal Order,” we will look at the patterns and processes of gaining and losing order within countries, and in the concluding chapter of this book we will attempt to look into the future. Below are charts that show our indices of the eight most important powers of the United States and China. They speak for themselves. I will update them annually so you can see how things are transpiring.

[1]For example, though I always had and retained the ownership power to make decisions at Bridgewater autocratically, I chose not to use that power. Instead I created and operated an idea-meritocratic system (which I described in Principles). I also chose to be far more generous with the people I worked with than I had to be while maintaining extremely high standards because I knew that operating that way would produce the amazing relationships and outcomes that we experienced—far better than if I had used my “hard powers” more forcefully. So it’s important to remember that great relationships give one great powers and that they are wonderful rewards in and of themselves. There is nothing more powerful and rewarding for the individual and the collective than the cooperating of capable people who care for each other and who will give each other all they can.

[2]The main plan for building self-sufficiency goes under name of “dual circulation.”

[3]https://www.cnbc.com/2019/02/28/1-in-5-companies-say-china-stole-their-ip-within-the-last-year-cnbc.html

[4]It is widely recognized that “regime change” has been a commonly employed technique of the United States for managing its global world order.

[5]This statement was particularly made in connection with the Taiwan reunification issue.

[6]Decoupling, while required given the circumstances, will be difficult and will lead to significantly reduced efficiency. One knowledgeable party described it as a compartmented rather than a broad-based decoupling, which makes sense to me.

[7]See: https://www.theatlantic.com/politics/archive/2019/05/why-united-states-uses-sanctions-so-much/588625/

[8]The shares of US-dollar-denominated debt are large in relation to a) the percentage of asset allocations that international investors would hold to balance their portfolios well, b) the sizes of reserve currency holdings that are appropriate to meet trade and capital flow funding needs, c) the sizes of the US debt market capitalizations relative to other markets’ capitalizations, and d) the size and importance of the US economy relative to other economies. Dollar-denominated debt is now disproportionately large because the US dollar is the world’s leading reserve currency, which makes it perceived as a safer asset than it really is, and because US dollar borrowings have been disproportionately large. Now, most of those who are responsible for determining what the shares of their holdings should be in different markets are not inclined to increase the shares in line with the greater amounts of US bonds to be sold and are in fact considering reducing their shares held in US debt, which, if it happens, will require larger purchases by the Federal Reserve.

[9]Adjusted for purchasing power parity.

[10]In fact it is a challenge for them to deal with the lack of continuity of policies and directions in the US arising from seemingly whimsical shifts in what matters to the American public as expressed in whom they choose to represent them.

[11]To give an oversimplified example of a win-win approach, if each country picks the top 10 things that they want to get or want to be protected against and allocates 100 points in total to these to express how much they want these things, they could determine what the best trades would be. For example, I expect that high on China’s list would be the reunification with Taiwan—so high in fact that they would go to war for it. I can’t imagine that preventing that from happening would be nearly as high on the US list, whereas something on the US list would be very high so that they should be willing to trade it to make both sides happy.

[12]Though it might sound naïve, I wish the power of thoughtful disagreement could be tapped to deal with the US-China wars. For example, I visualize how wonderful it would be if leaders or representatives of each country were to have a series of publicly aired thoughtful disagreements, like presidential debates, that the populations of both countries could listen to in order to gain both sides’ perspectives. I’m sure it would make us much more knowledgeable, more empathetic, and improve the chances of peaceful resolutions.

[13]https://www.pewresearch.org/global/2020/07/30/americans-fault-china-for-its-role-in-the-spread-of-covid-19/

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I saw how 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 struggled over other things, most importantly ideology and religion. I saw how these struggles happened in timeless and universal ways throughout time, and how these struggles had huge implications for all aspects of people’s lives, starting with what happened with taxes, the economy, and how people were with each other through periods of boom and bust and peace and war, and how they unfolded in cyclical ways, like the tide coming in and out.

I saw that when these struggles took the form of healthy competition that encouraged human energy to be put into productive activities, they produced productive internal orders and prosperous times and when those energies took the form of destructive internal fighting, they produced internal disorder and painfully difficult times. I saw why the swings between productive order and destructive disorder typically evolved in cycles driven by logical cause/effect relationships and how they happen in all countries for mostly the same reasons. I saw that those who rose to achieve greatness did so because of a confluence of key forces coming together to produce that greatness and those who declined did so because these forces dissipated.

I also saw that going from one extreme to another in a long cycle has been the norm, not the exception—that it is a very rare country in a very rare century that doesn’t have at least one boom/harmonious/prosperous period and one depression/civil war/revolution, so we should expect both. Yet, I saw how most people thought, and still think, that it is implausible that they will experience a period that is more opposite than similar to that which they have experienced. That is because the really big boom periods and really big depression/revolution periods come along about once in a lifetime, and once-in-a-lifetime experiences are naturally surprising…and because the swings between great and terrible times tend to be far apart, the futures we encounter are more likely to be more opposite than similar to those that we had and expect.

For example, my dad and most of his peers who went through the Great Depression and World War II (which came about because of the Roaring ’20s debt boom) never imagined the post-World War II economic boom because it was more opposite than similar to what they had experienced. I understand why, given those experiences, they wouldn’t think of borrowing or putting their hard-earned savings into the stock market, so it’s understandable that they missed out on profiting from the boom. Similarly, I understand why, decades later, those who only experienced debt-financed booms and never experienced depression and war would borrow a lot to speculate and would consider depression and war implausible. The same is true with money: money used to be “hard” (i.e., linked to gold) after World War II until governments made money “soft” (i.e., fiat) to accommodate borrowing and prevent entities from going broke in the 1970s. As a result, most people now believe that they should borrow more of it even though borrowing and debt-financed booms have historically led to depressions and civil wars.

I have come to believe that while the lessons and warnings of history are clear if one looks for them, most people don’t look for them because most people learn from their experiences and a single lifetime is too short to give them those lessons and warnings that they need. In this chapter I will share with you the lessons and warnings that I think I have learned from my experiences and explorations. Remember that while I am doing my best to be as accurate as possible, I am not sure that my perspective is right, so I am simply presenting how I see things for you to evaluate for yourself.

To do that, in the first part of this chapter I will take you through what I believe are timeless and universal principles of how domestic orders typically change from one set of conditions to the next. The way I see it, at any moment in time there are both 1) the existing set of conditions that include the existing domestic and world orders and 2) timeless and universal forces that cause changes in these conditions. Most people tend to pay too much attention to 1) what exists relative to 2) the timeless and universal forces that produce the changes. I want to do the opposite because understanding the timeless and universal forces that produce changes is most important. I will do this exploration in two parts. In this chapter I will focus on the timeless and universal forces that produce the changes— including the timeless and universal drivers behind them and the six stages of the archetypical cycle—and in Chapter 9 I will delve into these six stages in much greater depth and look at where the US now stands within this context.

Throughout time and in all countries the people who have the wealth are the people who own the means of wealth production and, in order to maintain it, work with the people who have the power to set and enforce the rules. This has happened similarly across countries and across time. While that has always been the case, the exact form of it has evolved and will continue to evolve.

For example, for most of the 13th through 19th centuries, when agriculture was the main source of wealth and most people believed that the power to govern was granted to monarchs through the mandate of heaven, the prominent internal order all around the world, even in countries that never had any contact with each other, consisted of the ruling classes or elites being 1) the monarchy, which ruled in conjunction with 2) the nobility, which controlled the means of production (at the time that capital was agricultural land), and/or 3) the military. Workers were viewed as parts of the means of production to make the land productive to produce the wealth for the ruling-class elites; they had little or no say in how the order was run.

Societies that had little or no contact with each other developed in similar ways because they had similar situations to deal with and because the nature of their decision making was similar. For example, for much of history Europe, China, and most countries had monarchies and nobles as the ruling classes, yet they were a bit different because in Europe the church was also part of the ruling mix. In Japan the monarchy (the emperor and his ministers), the military, and the business community (the merchants and artisans) were the ruling elites. All around the world the monarchs needed people to manage the day-to-day operations for them. The top people were ministers, who oversaw the bureaucracies of people who did the various jobs that needed to be done for governance to work. Across countries there were always, and still are, different levels of governance at the country level, the state/province level, the municipality level, the city level, etc., and there were timeless and universal ways that they operated and interacted with each other that were, and still are, pretty consistent across the world. Such systems of governance (i.e., orders) have existed just about everywhere in the world with relatively modest differences and they were all supported in similar ways by a hierarchy of professional bureaucrats, starting with the ministers who served the rulers and down to the functionaries who did the tasks, and over time they evolved in logical ways via class struggles. What exists today is simply the result of the natural evolutions of these timeless and universal ways of interacting, with their own cultural flavors thrown in. For example, the roles of the ministers who helped the monarchies evolved into the roles of prime ministers and other ministers that now exist in almost all countries (though in the United States they are called “secretaries”).

Over time, these systems have evolved and varied in logical ways as a result of struggles for wealth and power. For example, in England around 1200 there was a wealth and power struggle that evolved gradually at first and then abruptly into a civil war between the nobility and the monarchy, which is how these shifts tend to evolve—i.e., gradually at first and then abruptly. Like most of these, the fight was over money and the power to determine who got how much money. The monarchy under King John wanted to get more tax money and the nobles wanted to give less tax money. They disagreed over how much say the nobles should have on the matter, so they had a civil war. The nobles won and gained more power to set the rules, which led to what they first called a “council,” which soon became the first parliament, which evolved into the parliament that the English have today. The peace treaty that formalized this deal into law is called the Magna Carta. Like most laws, this one didn’t matter much relative to power so another civil war broke out in which the nobles (one class) and the monarchy (another class) again fought over wealth and power. In 1225 they wrote up a new Magna Carta that those with power got to interpret and enforce. Then the fighting picked up a few decades later. In that war, the nobles cut off tax payments to the monarchy, which forced the monarchy (then Henry III) to give in to the nobles’ demands. These struggles went on constantly, leading the orders to evolve.

Fast forward to the 15th, 16th, and 17th centuries and one can see that there were big changes in the sources of wealth, at first because of global exploration and colonialism (starting with the Portuguese and the Spaniards) and later because of the invention of capitalism (i.e., stocks and bonds) and labor-saving machines that fueled the Industrial Revolutions (particularly helping the Dutch and then the British) that made those who profited from these sources of wealth more powerful—i.e., the shifts in wealth and power over these centuries were from a) land-owning nobles (who then had the wealth) and monarchies (who then had the political power) to b) capitalists (who in the later period had the wealth) and elected representatives or autocratic government leaders (who in the later period had the political power). Almost all countries made these shifts—some peacefully but most painfully.

For example, in France for most of the 17th and 18th centuries, the king ruled in a balance of power arrangement with three other classes: 1) the clergy, 2) the nobility, and 3) the commoners. There were representatives of these groups that voted. The first two, which accounted for only 2% of the population, had more votes or eventually the same amount of votes as the commoners, who made up 98% of the population. They called this three-class-based internal order that negotiated for power the ancien régime (which means “old order”). Then practically overnight it changed in a revolutionary way via the French Revolution, which began on May 5, 1789, when the third class—the commoners—had enough of that system, overthrew all the others, and took the power for itself. In most countries around the world at the time, the same basic ruling order prevailed—i.e., the monarchy and nobles, who accounted for a very small percentage of the population and had most of the wealth, ruled until, all of sudden, there was a civil war/revolution that led the old order to be replaced by a very different new ruling order.

Though the ruling orders for managing these class struggles (i.e., the internal orders) were and are different in different countries, they evolved similarly across countries. For example, they evolved both gradually (through reforms) and abruptly (through civil wars/revolutions) and evolved into those orders that now exist in all countries. I expect they will continue to evolve gradually and abruptly to produce new domestic orders. While the classes who have wealth and political power change, the processes that produce these changes have remained pretty much the same through time right up to today. They occur through struggles that lead to both a) peaceful reforms through negotiations and b) violent reforms via civil wars and revolutions. The peaceful reforms tend to come earlier in the cycle and the violent civil wars and revolutionary reforms tend to come later in the cycle for logical reasons that we will delve into later.

I cannot overstate the importance of class struggles relative to individual struggles. We, especially those in the United States, which is a “melting pot,” tend to think more of individual struggles and not give adequate attention to class struggles. I didn’t fully realize its importance until I did my extensive study of history. My studying of history has led me to see it in a way that I hope I can convey.

In all countries throughout time (though in varying degrees) people have been typecast and placed within “classes” either because they have chosen to be with people like them or because others outside that group have typecast them, and power has been shared among three or four classes. How people are classed determines who their allies and enemies are. People are put into these classes whether they like it or not because all people stereotype. While 1) rich and poor and 2) right and left are the most common big class distinctions, there are many other distinctions around 3) race, 4) ethnicity, 5) religion, 6) gender, 7) lifestyle (e.g., liberal or conservative), and 8) location (e.g., urban versus rural). Generally speaking, people tend to cluster in these classes, and when times are good early in the cycle there is more harmony between these classes and when things are bad there is more fighting between them.

While I love that the United States is the country where these class distinctions matter least, people’s classes still matter in the US and they matter a lot more during stressful times when class conflicts intensify.

To help you get the picture in a more intimate way let’s do a simple exercise. Assume that most people who don’t know you well look at you as being of a certain class, because that’s a good assumption. Now, to imagine how you are perceived, look at the list below and ask yourself which class or classes you fall into. After you answer that, ask yourself which of the classes listed below do you feel an affinity for and expect to be your allies. Which classes do you not like or view as your enemies? Which ones are the ruling classes, and which ones are the revolutionary classes who want to topple them? Which ones are on the ascent, and which ones are on the decline? You might consider writing these down and thinking about them because during periods of greater conflict the classes you are in or are assumed to be in will become more important in determining who you will be with and against, what you will do, and where you will end up.

1. Rich or poor?
2. Right, left, or moderate?
3. Race?
4. Ethnicity?
5. Religion?
6. Gender?
7. Lifestyle (e.g., liberal or conservative)?
8. Location (e.g., urban, suburban, or rural)?

Still today only a small percentage of the population, which comes from only a few of these classes, has most of the wealth and power and rules as “the elites.” To me it is clear that a) the capitalist class now has the most financial power in most countries and b) political power in democracies lies in the hands of all the people who choose to vote while in autocracies it lies in the hands of the limited number of people selected by whatever process they have to make selections.4 So, for the most part today, those are “the ruling classes” and “the elites” that oversee the current domestic orders, though they are now under attack, so perhaps that is shifting. For example, there is now a big movement in the United States to be much more inclusive of members of different classes in both the capitalist money-making world and in the political world. These shifts can be good or bad depending on whether they are handled peacefully or violently and smartly or stupidly. One timeless and universal truth that I saw went back as far as I studied history, since before Confucius around 500 BC, is that those societies that draw on the widest range of people and give them responsibilities based on their merits rather than privileges are the most sustainably successful because they find the best talent to do their jobs well, they have diversity of perspectives, and they are perceived as the most fair, which fosters social stability.

I presume that the current internal orders of countries, like those of the past, will continue to evolve to become something different through the struggles of different classes with each other over how to divide wealth and political power. Because this wealth and power dynamic is very important, it is worth watching closely to discern which classes are gaining and which ones are losing wealth and power (e.g., AI and information technology developers are now evolving to gain it at the expense of those who are being replaced by such technologies) and also to discern the reactions to these shifts that lead the cycles to change.

So, as I see it, everything is changing in classic ways driven by a tried-and-true perpetual-motion machine. This machine has produced, and is producing, different systems, such as communism, fascism, autocracies, democracies, and evolutionary descendants and hybrids of these such as “state capitalism” in China. It will produce new forms of internal orders to divide wealth and allocate political power that will affect our lives greatly, all based on how people choose to be with each other and how human nature enters into how they make their choices.

To explain what I mean by that I’d now like to show you a few more timeless and universal drivers of changes in internal orders. I explained a couple of these in my exploration of international relations, especially those between the US and China, so I apologize if they are redundant for you.

As mentioned, the most important thing that drives changes in domestic conditions is how people are with each other, which is primarily a function of human nature. These interactions have logical cause/effect relationships that drive them. The following are a few more of the most important ones.

Have power, respect power, and use power wisely, or leave rather than fight. Having power is good because power will win out over agreements, rules, and laws all the time. That’s because, when push comes to shove, those who have the power either to enforce their interpretation of the rules and laws or to overturn the rules and laws will get what they want. The sequence of using power is as follows. When there are disagreements, the parties disagreeing will first try to resolve them without going to rules/laws by trying to agree on what to do by themselves. If that doesn’t work, they will try using the agreements/rules/laws that they agreed to abide by. If that doesn’t work, those who want to get what they want more than they respect the rules will resort to using their power. When one party resorts to using its power and the other side in the dispute isn’t sufficiently intimidated to knuckle under, there will be a testing of relative power, typically in the form of a war. Using power wisely doesn’t necessarily mean forcing others to give you what you want—i.e., bullying them. It includes recognizing that generosity and trust are powerful forces for producing win-win relationships, which are fabulously more rewarding than lose-lose relationships, though they’re not always attainable. When wars—civil or external—happen you will have to decide whether you want to be in them or get out of them. When in doubt get out. You can always get back in, but you might not be able to get out.

Let’s now look at how allies, enemies, and wars develop and are gotten past and how periods of peace and prosperity develop, over and over again.

In studying a lot of history and personally experiencing a tiny sliver of it myself I have seen how the balance of power dynamic drives virtually all struggles for power—e.g., office politics within organizations, local politics, national politics in shaping the domestic order and international politics in shaping the world order. The balance of power dynamic of forming allies and enemies and having wars transpires in a series of steps in which 1) those on opposing sides form alliances so both sides have roughly equal amounts of power, 2) then the two sides struggle with each other and eventually fight to clearly establish who the winners and losers are, 3) then those on the winning side fight among themselves for control of the winning side until one wins and consolidates power, 4) then with power clearly established and no one wanting to fight the clearly dominant power there is a period of peace and prosperity, which typically produces greater wealth and power gaps until 5) wealth and power gaps occur, the dominant power weakens, and for one reason or another there is a new wealth and power struggle that leads to the process happening all over again. More precisely, the process unfolds as follows, though how exactly it unfolds depends on the order and people at the time these stages unfold:

A) There will be the formation of alliances

When there isn’t roughly equal power (e.g., if in the US the Democrats have much more power than the Republicans, or vice versa), the more powerful party will likely take advantage of and control the less powerful party. To neutralize the stronger party, the weaker party naturally finds other parties to join them in opposing the stronger party so they collectively can have the same or more power as the opposition. If the formerly weaker party collectively gains more power than the formerly stronger party, the formerly stronger party will cut deals with other parties to ally with them to eliminate the superiority of the opposition. As a result, allies that have very different vested interests unite in opposing the common enemy—as the saying goes, “the enemy of my enemy is my friend”—and this dynamic naturally leads to the different sides having roughly equal power. The fact that these parties are bound together in the shared fight against the common enemy should not be misconstrued to mean that they are aligned. For example, one could see this balance of power dynamic at work in the recent election. It is why the Republican Party and the Democratic Party gained roughly equal numbers of supporters and became roughly equally powerful in a fight against the other, while at the same time the differences within the parties are so great that some segments want to destroy the other segments in order to gain control of their party. This alliance- and enemy-forming dynamic happens at all different levels of relationships from the most important international alliances that define the most important elements of the world order down to the most important alliances within countries that define the internal orders, down to those within states, within cities, within organizations, and among individuals. The most important evolutionary shift to affect these has been the shrinking of the world to make them more global. In the old days they were less global (e.g., European countries formed alliances to fight other European countries, Asian countries did the same, etc.), but as the world has shrunk because of improved transportation and communications it has become more interconnected and bigger and more global alliances developed. That is why there were two big sides in World Wars I and II and will be going forward.

B) Then there will be the struggle to determine winners and losers

Big fights typically happen between the sides when both sides have roughly equal powers and existential differences between them. Big fights don’t occur when there are big asymmetries in power because it would be stupid for obviously weaker entities to fight obviously stronger ones, and if they did fight, the fights would be small ones. However sometimes, when there are roughly equal levels of power on both sides, stalemates/gridlocks rather than big fights might occur when the existential threat of harming oneself in the process of trying to beat the other side is greater than the gains that would come from having a fight to the death. For example, when there is mutually assured destruction—e.g., as the US and the Soviet Union faced, which prevented them from having a fight to the death—there is likely to be a stand-off rather than a fight. Periods of peace typically happen when there are unequal levels of power and the stronger power generously subordinates the weaker entities so that all are happy.

While these big fights are typically violent, they can be nonviolent only if the entities have nonviolent rules of engagement that they adhere to that allow the resolution of disputes, most importantly the existential ones. For example, in the last US election the two political parties had roughly equal amounts of power and irreconcilable differences so they had a big fight for political control that will lead to the peaceful transfer of political power executed in accordance with the rules set out in the Constitution. However, when there are not clear rules and/or when the parties don’t abide by them, the fighting will be far more brutal, often quite literally to the death.

C) Then there will be fights among the winners

History shows us that after the fight for power in which the common enemy is defeated, those who united against the common enemy typically fight among themselves for power and those in the losing party do the same as they plan their next attack. I call that the “purge” state of the balance of power dynamic. It has happened in all cases, with the French and Russian civil wars and revolutions being the most well-known. Understanding this typical dynamic, one should look out for it right after one regime takes power from another. For example, since the US is now past the political fight stage (i.e., the election) and is now operating with the regime change in US political leadership (i.e., a new president), we should now turn our attention to how the factions of the Democratic Party fight each other for control. We should also watch for how the factions of the Republican Party fight each other for control of their party. Most importantly we should see whether the most extreme elements within their parties win, which would pull the two parties further apart and set the stage for a much greater conflict between the two more polarized sides (the Democrats and the Republicans), or if the moderates in the two parties win, which would bring the two parties closer together. When new regimes (i.e., the winning powers) come to power they have to decide what to do with the enemies that they beat knowing that, if they aren’t killed or neutered, there is a good chance they will regain strength and continue the fight. What they do depends on the system and the leaders in the system. In the US system and generally in democracies, the rules allow the losers to remain unharmed and unconstrained and allowed to try to regain power and fight again. In most others they are eliminated in one way or another.

D) Then there will be a time of peace and prosperity that will lead to wealth gaps and excesses

History shows us that because of this dynamic the best of times—i.e., when there is peace and prosperity—typically happens after a war, when the leadership and power structure are clearly established so there isn’t big fighting for power within the country or with other countries—because there is an obviously more powerful entity that enables the less powerful entities to have a good life.

E) Then there will be increasing conflict

For as long as there is peace and prosperity for the majority of the people, which will be the case only if the people remain self-disciplined and productive, the peace and prosperity are likely to continue; however, as previously explained, periods of peace and prosperity tend to cause big wealth gaps that lead to conflicts when prosperity fades and there are other things to fight over.

As mentioned, these dynamics reflect human nature, which is why they are timeless and universal. What follows are a few other important timeless and universal dynamics of human nature that drive the cycle.

• You individually, and those who are leading, need to have a realistic understanding of the circumstances you are in, the range of possibilities that exist given these circumstances, and how to make decisions to produce the best possible outcomes given these circumstances. Because the circumstances that you will face will be unlike those you encountered before, you need to learn the lessons of history and imagine how they might apply to the handling of the circumstances you face. You also need to be very adaptable in order to do the things you might need to do that are outside your current range of possibilities.
• You can have a better future if you put deferred gratification ahead of immediate gratification.

 6  7 & 8

[1]While acts of nature (especially diseases and climate events) and changes in technologies are the two other big forces that have always had big impacts—and promise to have even bigger impacts in the future—they will have less-immediate impacts and I don’t have the bandwidth to delve into them right now.

[2]For example, in the last century, the wealth share of the top 1% in the US ranged from close to 50% in the 1920s to a bit over 20% in the late 1970s; in the UK, it ranged from over 70% in 1900 to around 15% in the 1980s and is around 35% currently (figures from World Inequality Database). These shifts in inequality can be seen at least as far back as the Roman Republic and Empire, as Walter Scheidel describes in The Great Leveler.

[3]Aristotle, Politics, IV.11 (translated by Stephen Everson)

[4]That doesn’t mean that those who run autocracies don’t ultimately report to the people, because the people could ultimately overthrow the government.

[5]Actually I’m writing this advice for my grandchildren so that they can get it when they are older and I’m not here.

[6] Source: World Inequality Database

[7] Source: World Inequality Database

[8] Based on data from voteview.com

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• 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.

Each stage presents a different set of conditions that the people facing them have to deal with. Some of these circumstances are much more difficult than others to resolve. For example, early in a long-term debt cycle, when there is plenty of capacity of governments to create debt to finance spending, it is easier to deal with the circumstances at hand than late in the long-term debt cycle when there is little or no capacity to create money and credit to finance spending. For these reasons the range of possible paths forward and the challenges that leaders face depend on where in the cycle a country is. These different stages present different challenges that require different qualities, understandings, and skills from leaders in order to effectively deal with them.1 How well those facing these circumstances—e.g., you facing your circumstances and our leaders facing our collective circumstances—understand and adapt to them affects how good or bad the outcomes will be within the range of possibilities that exist given the circumstances. Different cultures have different established ways of approaching these circumstances. Those leaders and cultures that understand them and can adapt to their circumstances will produce much better outcomes than those who don’t. That is where timeless and universal principles come in.

While the length of time spent in each of these stages can vary a lot, the evolution through them generally takes 100 years, give or take a lot and with big undulations within the cycle. This evolution occurs because of logical cause/effect relationships in which existing conditions propel the changes that create the new set of conditions that propel the next changes and so on like a perpetual-motion machine. Because a given set of conditions creates a limited set of possibilities, by properly identifying the conditions and understanding the cause/effect relationships, one can improve one’s imagination of the possibilities of what will come next.

The cycle’s archetypical evolution transpires as shown in the following diagrams.2 Like evolution in general, the evolution of internal orders typically occurs in a cyclical way in which one stage typically leads to the next through a progression of stages that repeat and, in the process, evolve to higher levels of development. For example, Stage 1 (when the new internal order is created by new leaders who came to power via a civil war/revolution) normally comes after Stage 6 (when there is a civil war/revolution, which is the low point in the cycle), which leads to the next stage and so on up to Stage 3 (which is the high point in the Big Cycle because there is a lot of peace and prosperity in that stage), which gets overdone in Stages 4 and 5 and so on, leading to the next new order (Stage 1). That happens over and over again in an upward-evolving way. Again, that archetypical cycle typically takes 100 years, give or take a lot.3 Within each of these big cycles are similar, smaller cycles. For example, there is a short-term debt cycle that leads to bubbles and recessions that come along roughly every 10 years, there are political cycles that move political controls between the right and the left that come along with roughly equal frequency, etc. Every country is going through them, and many of them are at different stages. For example, China and India are at very different stages than the United States and most European countries. What stages they are at in relation to other countries affects the relations between countries and is the primary determinant of the whole world order. We will explore all of these in the last chapter of this book rather than digress into them now.

These cycles have taken place for as long as there has been recorded civilization (and probably before) so many cycles are linked together like so (figuratively speaking), and they are upward-sloping because of evolutionary gains that are made over time.

The following chart shows our estimates of China’s absolute powers and its figurative Big Cycles going back to the year 600. This is an ultra-simplified chart (e.g., there were many more dynasties and complexities) that I am presenting in this way so you can see how this evolution transpired from the 50,000-foot level.

The next chart, which I showed you in earlier chapters, shows China’s relative powers. The differences in this chart and the previous one are due to the fact that the first one shows the absolute level of power while the second one shows the relative level of power.

Since different countries are typically in different stages of the cycle and since they take wealth and global political power from each other, some countries are rising while others are declining, so the whole is less volatile than any one country. In other words, the differences have had a diversification effect that has made the whole world’s evolution smoother than any of the individual countries’ evolutions. That is reflected in actual global real GDP, which I showed you in Chapter 1 and is shown in the following chart. The chart is not a figurative representation. It is literally the best estimates we have of real GDP per capita. Embedded in this chart are the rises and falls of major empires (particularly the Dutch, British, and the Ming and Qing dynasties in China), numerous wars, and numerous booms and busts. They don’t show up because they diversify each other and because they are small relative to the big trends, even though they are huge from the perspective of the people living through them.

To reiterate, the figurative pictures of the archetypical six-stage cycle I just painted are simplified versions of what really happens. I simplified them to provide clarity. I find that too often in order to be precise people show so many details that one can’t see the essence of the big picture, and I don’t want to do that. I wanted to show you a simplified version that conveys the essence of the stages and then descend down into the details. While the cycle by and large progresses as I described, it doesn’t always progress exactly as I described. For example, like the stages of disease (let’s say Stage 3 cancer), being in one stage doesn’t mean that the progression to the next stage is inevitable. But it does tell us a lot that is very valuable. As with a disease a) certain symptoms are clearly exhibited that allow one to identify which stage in the cycle one is in, and b) being in that stage signifies the risks and ways of treating the situation that are essential to know are different from those that exist at different stages. For example, being in Stage 5 means that certain conditions exist that make it less likely, though not impossible, that the cycle won’t progress to Stage 6 than if it was in Stage 4 with those conditions existing. By having clear and objective markers to identify at what stage each country (or state or city) is in, and by having an understanding of the cause/effect relationships that produce change, one can better know the range of possibilities and position oneself accordingly, though one can never get them exactly right.

As an example, we made an index of the number of economic “red flags” that have existed at different times in history, including measures of high inequality, high debt and deficits, inflation, and bad growth, to show how indicative they are of subsequent civil wars and revolutions. The following chart shows the estimated likelihood of a civil-war-type conflict based on the number of red flags. Based on what we have seen in the past, we estimate that when there are 60-80% 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%) there is around a 1-in-3 chance of a civil war or revolution—so still not probable but too probable for comfort. The US is in the 60-80% bucket today. In the concluding chapter of this book I will much more comprehensively pass along the indicators and what they show. Right now, I just want to convey the concept.

 4I know that this model of mine is starting to get pretty complicated for the brain to process (though it’s not complicated for a computer to process), so I will describe just the highlights of each stage and just the most important factors. While I won’t take you through all 108 factors (i.e.,18×6) in these stages and their various configurations, below I will outline the forces and milestones to pay most attention to in each stage, with a special emphasis on the current state of disorder in the United States and how things are progressing.

As a rule, 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. Interestingly, those states and cities in the US that have the highest per capita income and wealth levels tend to be the states and cities that are the most indebted and have the largest wealth gaps—e.g., New York City, Chicago, San Francisco, Connecticut, Illinois, Massachusetts, New York State, and New Jersey. If you are interested in seeing these numbers for the major states and cities in the US, they are shown in the appendix.

Facing these conditions, expenditures have to be cut or more money has to be raised in some way. The next question becomes who will pay to fix them, the “haves” or the “have-nots”? Obviously, it can’t be the have-nots. Expenditure cuts are most intolerable for those who are poorest, so there needs to be more taxation of people who can afford to pay more and there is a heightened risk of some form of civil war or revolution. But when the haves realize that they will be taxed to pay for debt service and to reduce the deficits, they typically leave, causing the hollowing-out process previously described. If bad economic conditions occur, that hastens the process. These circumstances largely drive the tax cycle.

History shows that raising taxes and cutting spending when there are large wealth gaps and bad economic conditions has, more than anything else, been a leading indicator of civil wars or revolutions of some type. To be clear they don’t have to be violent, though they could be.

I see these cycles transpiring in my personal interactions where I live. I live in the state of Connecticut, which has the highest average per capita income in the country, the largest wealth gap and income gap in the country, and one of the largest per capita debt and unfunded pension obligations in the country. I see how the haves and the have-nots don’t have contact and/or don’t worry about the other because they don’t have much contact with each other and are focused on living their own lives. I have windows into what the lives of both the haves and the have-nots are like because I have contact with the people in our community of haves and because the work my wife does to help disengaged and disconnected high school students in disadvantaged communities brings her into contact with people who live in the communities of the have-nots. I see how terrible the conditions are in those have-not communities and how the haves who appear rich and decadent to the have-nots don’t feel rich. I see how they are all focused on their own struggles—with the haves struggling with work-life balance, making sure their kids are well educated, etc., and the have-nots struggling with finding income, food security, avoiding violence, trying to have their kids well educated, etc.6 I see how they are more likely to have critical, stereotypical impressions of each other that make them more inclined to dislike each other than to view themselves empathetically as members of one community in which they help each other. I see how difficult it can be to help each other because of these stereotypes and because the haves don’t feel that they have more than enough or that the have-nots deserve their financial support and I fear what the future might hold because of the existing circumstances and how they are likely to worsen. I have seen close up how COVID-inflicted health and budget shocks have brought to the surface the terrible conditions of the have-nots and are worsening the financial gaps that could bring about the previously described dynamic that happens when there is not enough money and taxes have to rise which drives the haves away, expenses have to be cut which is inhumane for the have-nots, or obligations like those for debt and pensions have to be defaulted on which is bad for those who were promised them, unless somehow they, like the federal government, have access to the money creation that only the central bank can provide.

Averages don’t matter as much as the number of people who are suffering and their power. Those who favor policies that are good for the whole—e.g., free trade, globalization, advances in technology that replace people—without thinking about what happens if the whole is not divided in a way that benefits most people are missing the fact that the whole is at risk. To have peace and prosperity, a society must have productivity that benefits most people. Do you think we have these things today?

What does history show as the path that bankrupt governments can follow to raise productivity that benefits most people? It shows that restructuring and/or devaluing enough of the previously created debt and non-debt obligations helps a lot. That is classic in Stages 5 and 6. Once the restructuring or devaluation reduces the debt burdens, which is typically painful at the time, the reduced debt burdens allow for a rebuilding.

An essential ingredient for success is that the debt and money that is created is used to produce productivity gains and favorable return on investment rather than just being given away without yielding productivity and income gains because if it is given away without yielding these gains the money will be devalued to the point that it won’t leave the government or anyone else with much buying power. When we turn to Stage 3, we will look at how that virtuous cycle typically arises from the terrible conditions in Stages 5, 6, and 1, and how the conditions in one stage are good indicators of the probabilities of moving to the next stage. We will also look at several historical examples.

History shows that lending and spending on items that produce broad-based productivity gains and return on investment that exceed the borrowing costs result in living standards rising with debts being paid off, so these are good policies. If the amount of money being lent to finance the debt is inadequate, it is perfectly fine for the central bank to print the money and be the lender of last resort as long as the money is invested to have an ROI that is large enough to service the debt. History shows and logic dictates that investing well (i.e., so it yields productivity) in education at all levels (including job training), infrastructure, and research that yields productive discoveries works very well. For example, big education programs and infrastructure programs have paid off nearly all the time (e.g., in the Tang Dynasty and many other Chinese dynasties, in the Roman Empire, in the Islamic Umayyad Caliphate, in the Mughal Empire in India, in Japan’s Meiji Restoration, and in China’s educational development programs over the last couple of decades), though they have rather long lead times. In fact improvements in education and infrastructure (among the other things in the list of factors shown earlier), even those financed by debt, were essential ingredients behind the rises of virtually all empires and declines in the qualities of these investments were almost always ingredients behind their declines. If done well, these interventions can more than counterbalance the classic toxic mix.

While I just described the classic toxic mix, it is usually accompanied by other problems. The more of the following conditions that are in place, the higher the probability of having a severe conflict like a civil war or revolution.

+ Decadence

While early in the cycle there is typically more spending of time and money on productive things, later in the cycle time and money go more toward indulgent things (e.g., “the finer things in life” like expensive residences, art, jewelry, and clothes). This begins in Stage 4 when such spending is fashionable, but by Stage 5 it begins to appear grotesque. Often that decadent spending is debt-financed, which worsens the financial conditions. The change in psychology that typically goes along with these changes is understandable. The haves feel that they legally acquired their money so they can spend it on luxuries if they like, while the have-nots view such spending at the same time they are suffering as unfair and selfish. Besides increasing resentments, decadent spending (as distinct from saving and investing) reduces productivity. What a society spends money on matters. When it spends on investment items that yield productivity and income gains, it makes for a better future than when it spends on consumption items that don’t raise productivity and income.

+ Bureaucracy

While early in the big cycle bureaucracy is low, it is high late in the cycle, which makes sensible and needed decision making more difficult. That is because things tend to get more complex as they develop until they reach the point where even obviously good things can’t be done—necessitating revolutionary changes. In a legal and contract-based system (which has many benefits), this can become a problem because the law can stand in the way of doing obviously good things. I will give you an example that I’m close to because my wife and I care about it.

Because the US Constitution doesn’t make education a central government responsibility, it has predominantly been a state and local responsibility with school funding coming from revenue raised by taxes in local cities and towns. Though it varies from state to state, typically those children in richer towns in richer states have much better educations than those in poorer towns in poorer states. This is obviously unfair and unproductive even though most people agree that children should have equal opportunities in education. But because this structure is so ingrained in our political system, it is nearly impossible to fix without a revolutionary reinvention of how we approach it. There are more examples of the bureaucracy standing in the way of doing sensible, productive things than I have time and space to convey here—i.e., it is now a big problem.

+ Populism and Extremism

Populism is a political and social phenomenon that appeals to ordinary people who feel that their concerns are not being addressed by elites. It typically develops when there are 1) wealth and opportunity gaps, 2) perceived cultural threats from those with different values both inside and outside the country, and 3) “establishment elites” in positions of power who are not working effectively for most people. Populists come into power when these conditions create anger among ordinary people who want those with political power to be fighters for them. Populists can be of the right or the left, are much more extreme than moderates, and tend to appeal to the emotions of the common man. They present themselves as fighters for their constituents. They are typically confrontational rather than collaborative and exclusive rather than inclusive. This leads to a lot of fighting between populists of the left and populists of the right over irreconcilable differences. The extremity of the revolution that occurs under them varies. For example, in the 1930s, populism of the left took the form of communism and that of the right took the form of fascism while nonviolent revolutionary changes took place in the US and UK. More recently, in the United States, the election of Donald Trump in 2016 was a move to populism of the right while the popularity of Bernie Sanders, Elizabeth Warren, and Alexandria Ocasio-Cortez reflects the popularity of populism of the left. There are increased political movements toward populism in a number of countries. It can be said that the election of Joe Biden reflects a desire for less extremism and more moderation, though time will tell.

The following chart shows a populism index that is based on a combination of populists who were elected to office and populist vote share. The election shift from the Trump populist, anti-establishment presidency to the Biden moderate, establishment presidency is what led the index to fall from its highly elevated level. Still it remains relatively high, though Biden scored as a moderate. Note that voters on both sides score high for supporting populists, as reflected in US election results and polling data, which makes clear how evenly and extremely divided the country is.

Along with the rise of populists come more extreme positions on both sides and increased polarization.

Right now there is an exceptional amount of polarization in the US as reflected in the stats. In Chapter 8 I showed you charts of the Republican and Democratic voting records of those in the Senate and House of Representatives being the largest and the party-line voting being the greatest since 1900. Survey data about the sentiments of the voters who elected these representatives paints a similar picture of polarization and intransigence. For example, in a 2019 Pew survey 55% of Republicans and 47% of Democrats view the other as more immoral than average Americans, and 61% of Republicans and 54% of Democrats say that those of the other party don’t share their values. When asked whether they had warm or cold feelings to those of the other party, 79% of Democrats and 83% of Republicans had cold or very cold feelings for members of the other party, with 57% of Democrats and 60% of Republicans reporting very cold feelings about members of the other party.7 Another study reported that 80% of Democrats think that the Republican Party has been taken over by racists and 82% of Republicans think that the Democratic Party has been taken over by socialists.8 A 2020 study showed that nearly half of Republican parents and a third of Democratic parents would be displeased if their child married someone from the other political party. This compares with about 5% for both parties in 1960.9 One recent survey showed that 15% of Republicans and 20% of Democrats thought the country would be better if large numbers of the other side “just died.”10 Based on these and other surveys, it appears that large numbers of members of both parties are more inclined to fight for deeply held preferences rather than compromise. While who is president has changed, the people have not changed, and in the long run what happens in a democracy depends on what the people are like in dealing with the system.

Watch populism and polarization as markers. The more populism and polarization there is, the further along the cycle a nation is in Stage 5, and the closer it is to civil war and revolution. In Stage 5, moderates become the minority. In Stage 6, they cease to exist.

+ Class Warfare

In Stage 5 class warfare intensifies. That is because, as a rule, during times of increased hardship and conflict there is an increased inclination a) to look at people in stereotypical ways as members of one or more classes and b) to look at these classes as either being evil enemies or good allies. It is important to watch whether or not this is happening because it’s a marker. In Stage 5 this begins to become much more apparent. In Stage 6 it becomes dangerous.

A classic marker in Stage 5 that increases in Stage 6 is the demonization of those in other classes, which typically produces one or more scapegoat classes who are commonly believed to be the source of the problems, and if they are destroyed, imprisoned, or kept out, this will lead to better results. Minority ethnic, racial, rich, and poor groups are often demonized. Perhaps the most classic example of this is the demonizing and scapegoating of Jews, who were blamed and persecuted for virtually all of Germany’s problems by the Nazis. Similarly, Chinese minorities living in non-Chinese countries have been demonized and scapegoated during periods of economic and social stress. In the UK Catholics were demonized and scapegoated in numerous stressful periods since the 1500s, such as the Glorious Revolution and the English Civil War. The rich are also commonly demonized, especially those who are viewed to be making their money at the expense of the poor. Demonizing and scapegoating are a classic symptom and problem that we must keep an eye on.

+ The Loss of Truth in the Public Domain

Not knowing what is true because of distortions in the media and propaganda increases as people become more polarized, emotional, and politically motivated.

In Stage 5 those who are fighting typically work with those in the media to manipulate people’s emotions to gain support and to destroy the opposition. In other words, media folks of the left join with others of the left and media folks of the right join with others of the right in the dirty fight. For example, a common move among 1930s populists of the left (e.g., communists) and of the right (e.g., fascists) was to take control of the media and establish “ministers of propaganda” to guide them. The media they produced was explicitly aimed at polarizing the population against the groups that the governments considered “enemies of the state.” The government of the democratically run United Kingdom created a “Ministry of Information” during World War I and World War II to spread government propaganda, and leading newspaper publishers were elevated by the government if they did what the government wanted them to do to win the propaganda war11 or were vilified and suffered if they didn’t cooperate. Revolutionaries did the same distorting of the truth in all sorts of publications. During the French Revolution, newspapers run by revolutionaries pushed anti-monarchical and anti-religious sentiment, but when those revolutionaries attained power, they shut down dissenting newspapers during the Reign of Terror. During times of great wealth gaps and populist thinking, stories that bring down elites are popular and lucrative, especially those that bring down left-leaning elites in right-leaning media outlets and those that bring down right-leaning elites in left-leaning media outlets. History shows that significant increases in these activities are a problem that is typical of Stage 5, and that when combined with the ability to inflict other punishments, the media becomes a powerful weapon.

It is well-recognized this is happening now—that truth in media, both traditional and social, is lower than at any other time in our lifetimes. For example, a 2019 Gallup study12 said that only 13% of Americans surveyed have “a great deal” of trust in the media and only 41% of those surveyed said that they have either a “fair” or “great deal” of trust in media. That compares with 72% who trusted media in 1976. This is not just a fringe media problem; it is a mainstream media problem and a problem for our whole society. The dramatically decreased trustworthiness has even plagued former icons of journalistic trust such as the Wall Street Journal and the New York Times, which have seen their trust ratings plunge. In addition to being politically motivated, sensationalistic stories have become commercially rewarding at a time when the media business is in financial trouble. Most of the media folks I speak with share my concerns, though they typically won’t share them openly. Still, in reflecting on the problem, Martin Baron, executive editor of the Washington Post, said, “If you have a society where people can’t agree on the basic facts, how do you have a functioning democracy?”13 This dynamic is impeding free speech because people are afraid to speak up because of how they will be attacked in both traditional and social media by distortions that are meant to bring them down.

Even very capable and powerful people are now too afraid of the media to speak up about important matters or run for public office. Since most high-profile people are torn down, most everyone agrees that it is dangerous to be a high-profile, vocal person who fights for truth and justice, especially if one offends people who are inclined to use the media to fight. Though not discussed in public because of fears of media reprisals, this issue is continuously discussed in private. For example, during a lunch I had not long ago with a general who had held a very high political position and had just left government service, we explored what he would do next. I asked him what he was most passionate about. He said, “Of course helping my country.” I asked him whether he would consider running for elected office, and he explained that while he was willing to die for his country he couldn’t bring himself to run for public office because of how enemies would use the media and social media to make up lies to harm his family as well as himself. Ironically, the result of such untruthful media attacks is less free speech: this general and almost everyone I know who I wish the world could hear what they honestly think are afraid to speak openly because they fear that attacks by extremists who oppose them will be enabled and amplified by the sensationalistic media. Many of my friends tell me that I’m crazy to speak so openly about controversial things such as those covered in this book because it is inevitable that some people or groups will try to take me down via the media. I think they are probably right, but I won’t let the risks dissuade me.14

+ Rule-Following Fades and Raw Fighting Begins

History has shown that when the causes that people are passionately behind are more important to them than the system for making decisions, the system is in jeopardy. Rules and laws work only when a) they are crystal clear and b) most people value working within them enough that they are willing to compromise in order to make them work well. If both of these are less than excellent, the legal system is in jeopardy. If the competing parties are unwilling to try to be reasonable with each other and to make decisions civilly in pursuit of the well-being of the whole, which will require them to give up things that they want and might win in a fight, there will be a sort of “civil war” that will test the relative powers of the relevant parties. In this stage, winning at all costs is the game and playing dirty is the norm. Late in Stage 5 is when reason is abandoned in favor of passion. When winning becomes the only thing that matters, unethical fighting becomes progressively more forceful in self-reinforcing ways. When everyone has opinions that they are fighting for and no one can agree on anything, the system is on the brink of civil war/revolution.

 This typically happens in a couple of ways:

• Late in Stage 5 it is common for the legal and police systems to be used as political weapons by those who can control them. Also private police systems form—e.g., thugs who beat people up and take their assets, and bodyguards to protect people from these things happening to them. For instance, the Nazi party formed a paramilitary wing before it came to power that then became an official force when the Nazis were in power. So did the short-lived British Union of Fascists in the 1930s. The Ku Klux Klan in the US was effectively a paramilitary group as well. Such cases were quite normal, so view their development as a marker of moving to the next stage.
• Late in Stage 5 there are increasing numbers of protests that become increasingly violent. Because there is not always a clear line between a healthy protest and the beginnings of a revolution, leaders in power often struggle over how to allow protests without giving the perceived freedom to revolt against the system. Leaders must manage these situations well. A classic dilemma arises when demonstrations start to push the limits of revolution. Both giving the freedom to protest and suppressing protests are risky paths for leaders, as either path could lead the revolution to get strong enough to topple the system. No system allows people to bring down the system—in most, an attempt to do so is treason, typically punishable by death. Nonetheless, it is the job of revolutionaries to bring down systems, so governments and revolutionaries test each other to see what the limits are. When broad-based discontent bubbles up and those in power allow it to grow, it can boil over to the point that when they try to put a lid on it, it explodes. The conflicts in the late part of Stage 5 typically build up to a crescendo that triggers the violent fighting that signifies the transition into what historians stamp as the official civil-war periods, which I am identifying as Stage 6 in the Big Cycle. People dying in the fighting is the marker that almost certainly signifies the progression to the next and more violent civil-war stage, which will continue until the winners and losers are clearly determined.

That brings me to my next principle: when in doubt get out. If you don’t want to be in a civil war or a war, you should get out while the getting is good. History has shown that when things get bad, the doors typically close for people who want to leave. The same is true for investments and money as countries introduce capital controls and other measures during such times.

Before I move on to look at Stage 6, I want to distinguish between revolutions and civil wars and put them in the right buckets.

 

• 1828 US Election: Andrew Jackson—Conservative populist, refused to renew the charter of the US’s central bank (Second Bank of the US).
• 1860s Russia: Abolition of serfdom.
• 1880s Germany: Otto von Bismarck’s social legislation.
• 1890s-1920s: The Progressive Era—Trust busting, anticorruption, scientific thinking.
• 1906: Theodore Roosevelt introduced progressive estate taxation and, in 1909, the income tax.
• 1908 UK Election: H.H. Asquith’s passage of big tax hikes and the major welfare reforms that led to the emergence of the modern welfare system in the UK.
• 1912 US Election: Woodrow Wilson—First Democratic president elected in 20 years, second in 55, which kicked off big tax changes and reform.
• 1920: The women’s rights movement led to the 19th Amendment of the US Constitution, which gave women the right to vote.
• 1932 US Election: FDR’s move to the left—Upon election, Franklin Roosevelt immediately devalued the dollar to produce debt relief and implemented sweeping reforms on an unprecedented scale. His New Deal policies sought to tackle the economic depression through a vast expansion of the role of government and support for workers, debtors, and the unemployed. He created Social Security and unemployment insurance, increased financial regulation, created large government programs that directly employed people, and strengthened labor rights.
• 1936 French Election: Blum’s move to the left—Léon Blum passed a slew of labor reforms that gave workers increased rights, better working conditions, and higher pay.
• 1940s-50s Argentina: Perónist moves to the left—Juan Perón nationalized industries, increased wages for workers, increased the numbers covered by social security, and expanded health insurance.
• 1950s Soviet Union: Nikita Khrushchev’s anti-Stalin reforms to eliminate oppression and raise agricultural production.
• 1960s-70s India: Gandhi’s socialist policies— Indira Gandhi expanded the public sector and helped enable the “Green Revolution” (protecting Indians from famine and dependence on imported grains).
• 1964 US Election: Lyndon Johnson’s tax cuts and civil rights and anti-poverty programs.
• 1978: Deng Xiaoping/“Capitalist Revolution.”
• 1979 UK Election: Margaret Thatcher’s move to the right.
• 1980 US Election: Ronald Reagan’s move to the right.

Crossing the line from Stage 5 (when there are very bad financial conditions and intense internal and external conflict exists) to Stage 6 (when there is civil war) occurs when the system for resolving disagreements goes from working to not working. In other words, it happens when the system is broken beyond repair. As you might imagine, it is a much bigger deal to break a system/order and build a new one than it is to make revolutionary changes within an existing system/order. Though breaking a system/order is more traumatic, it isn’t necessarily a worse path than operating within a system.

Deciding whether to keep and renovate something old that is not working well or to dispose of it and replace it with something new is never easy, especially when the something new is not clearly known and is of the importance of a domestic order. Nonetheless, it happens, though typically it is not decided on intellectually; it is typically emotionally driven.

When one is in late Stage 5 (like the US is now) the biggest question is how much the system will bend before it breaks. The democratic system, which allows the population to do pretty much whatever it decides to do, produces more bending because the people can make leadership changes and only have themselves to blame. In this system regime changes can more easily happen in a peaceful way. However, the one-person, one-vote democratic process has the drawback of having leaders selected via popularity contests by people who are largely not doing the sort of thoughtful review of capabilities that most organizations would do when trying to find the right person for an important job. So, while having great ability to bend, in democracies there is a big risk in not filling the most important jobs with the most capable people. Democracy also requires consensus decision making and compromise, which requires a lot of people who have opposing views to work well with each other within the system. That ensures that parties that have significant constituencies can be represented, but like all big committees of people who have widely different views (and might even dislike each other), the decision-making system does not lend itself to efficient decision making. History shows us that the biggest risk to democracies is that they produce such fragmented and antagonistic decision making that they can be ineffective, which leads to bad results, which leads to revolutions led by populist autocrats who represent large segments of the population who want to have a strong capable leader get control of the chaos and make the country work well for them.

Also noteworthy: history has shown that during times of great conflict federalist democracies (like the US) typically have conflicts between the states and the central government over their relative powers. That would be a marker to look out for that hasn’t yet arisen in the US; it happening would signify the continued progression of this cycle toward Stage 6.

There are far too many breakdowns of democracies to explore, let alone describe. While I looked into a number of them to see the patterns, I haven’t fully mined them, and I’m not going to dive into them here. I will say that the factors described in the explanations of Stage 5 when taken to the extreme—most importantly, terrible finances, decadence, internal strife and disorder, and/or major external conflict—lead to a dysfunctional set of conditions and a fight for power led by a strong leader. Archetypical examples that come to mind are Athens from the late 400s to the 300s BC, the end of the Roman Republic in the century or so preceding 27 BC,18 Germany’s Weimar Republic in the 1920s, and the weak democracies of Italy, Japan, and Spain in the 1920s and 1930s that turned to autocracies of the right (fascism) to bring order to the chaos.

Different stages require different types of leaders to get the best results. When one is in Stage 5 one is at a juncture in which one path could lead to civil war/revolution and the other could lead to peaceful, and ideally prosperous, coexistence. Obviously the peaceful and prosperous path is the ideal path, but it is the much more difficult path to pull off. That path requires either a “strong peacemaker” who goes out of their way to bring the country together, including reaching out to the other side to involve them in the decision making and reshaping the order in a way that most people agree is fair and works well (i.e., is highly productive in a way that benefits most people) or a “strong revolutionary” who is capable of taking the country through the hell of civil war/revolution. In our discussion of the next two stages about civil war/revolution and the times right after them, we will explore what is required.

 19

With a moderate/establishment president (Biden) and the Senate likely to be in Republican hands, it now appears most likely that neither side will be able to dominate the other and fighting for changes will most likely continue within the system. That is likely to force either gridlock or compromise. Greater gridlock could lead to more unethical fighting that the other side will find intolerable and reply to in kind, while compromise would require moderates to split from the extremists in their parties. For these reasons it would be unwise to be confident about whether the cycle will or will not progress to Stage 6. However, because that would be a very big deal, it will be important to watch the markers closely. In my opinion they will be best reflected in the 18 factors previously mentioned, though they can also be reflected by other markers.

To reiterate, some of the most important markers I am looking at are:

• The combination of financial circumstances, wealth gaps, and economic shock (“Classic Toxic Mix”)
• Decadent spending of money and time
• Bureaucracy
• Populism and extremism
• Polarization and loss of moderates
• Class warfare and demonization of people in different classes
• Polarized and distorted media
• Rule-following fading and power-grabbing increasing
• Legal and political systems increasingly used for personal political power
• Fighting with fatalities

History shows us that when empires decline they decline in most of these ways because when each of these types of strengths and weaknesses improve or decline, they reinforce the others. It also shows us that past a certain point, the factors deteriorate very rapidly together.

The periods of civil war are typically very brutal. Typically early in them these wars are forceful and orderly struggles for power, and as the fighting and emotions intensify and the sides do anything to win, the levels of brutality accelerate unexpectedly so the actual levels of brutality that occur in the Stage 6 civil wars and revolutions will have been considered implausible in Stage 5. Reading the stories of the civil wars and revolutions that I studied, such as the Spanish Civil War, the Chinese Civil War, the Russian Revolution, and the French Revolution, made my hair curl. The elites and moderates flee, are imprisoned, or are killed.

How do they transpire? Earlier I described the dynamics of Stage 5 that led to crossing the line to Stage 6. During this stage all of those intensify greatly. I will explain.

To make matters even worse, typically when there was internal disorder, such as civil wars and revolutions, foreign enemies were more likely to challenge the country. This happens because domestic conflict causes vulnerabilities that make external wars more likely. For example, internal conflict splits the people within a country, is financially taxing on them, and demands attention that leaves less time for the leaders to tend to other issues—all things that create vulnerabilities for foreign powers to take advantage of. That is the main reason why internal wars and external wars tend to come close together. Other reasons include: emotions and tempers are heightened; strong populist leaders who tend to come to power at such times are fighters by nature; when there are internal conflicts leaders find that a perceived threat from an external enemy can bring the country together in support of the leader so they tend to encourage the conflict; and being deprived leads people/countries to be more willing to fight for what they need, including resources that other countries have. Almost all civil wars have had some foreign powers participating in attempts to influence the outcome to their benefit.

Entering and leaving civil wars and revolutions aren’t clear when they are happening, though it is clear that one is happening when deeply in the middle of it. While historians assign dates to the beginnings and ends of civil wars, they are arbitrary. The truth is that almost no one at the time knows that a civil war has begun or that it has ended although they know when they are in them. For example, many historians have designated July 14, 1789, as the day the French Revolution began because an armory and prison called the Bastille was stormed by a mob, but nobody at the time thought it was the beginning of the French Revolution or had any idea how terribly brutal that civil war and revolution would become. While one might not know what’s to come, one can have imprecise markers that help one place where one is, to see the direction that one is moving, and to know something about what the next stage will be like.

Civil wars are incredibly brutal because they are fights to the death. Everyone is an extremist because everyone is forced to pick a side and fight. Also moderates lose out in knife fights.

As for what types of leaders are best for civil wars and revolutions, they are the “inspirational generals”—people who are strong enough to marshal support and win the various types of battles they have to win. Because the fight is brutal they have to be brutal enough to do whatever is necessary to win.

Fortunately these civil war/revolutionary periods eventually come to an end, though the ends like the beginnings are not as clearly defined as historians convey.

The time that historians stamp as the civil-war period typically lasts a few years and determines the official winners and losers, which is conveyed by who gets to occupy the government buildings in the capital. But the fighting to consolidate power can go on for a long time after the official civil war has ended. That brings us to the next stage in this big cycle, Stage 1.

While civil wars and revolutions are typically extremely painful, they often lead to restructurings that, if done well, can establish the foundation for improved future results. What the future after the civil war/revolutions looks like depends on how the next steps are handled. Let’s take a peek.

This stage is over when the new power authorities are clear, and everyone is sick of the fighting and the rebuilding process begins.

This sequence of rebuilding happens all the time in varying degrees depending on the amount of change that is warranted. In some cases it comes after brutal revolutions when there needs to be a rebuilding of nearly everything, and in other cases it comes when the instructions and systems that are there just need to be modified to suit the new leader. For example, there will be some changes in the United States after the presidential election that will lead to some amount of purging of those in government who were sympathetic to the old administration and fighting for power between moderate Democrats and very left Democrats.

• In the British Empire’s Victorian Age in the mid-to-late 1800s, Prime Minister William Gladstone simultaneously a) maintained high levels of productivity, b) imposed strict budget controls that led to strong finances, and c) supported the common man so much that he was known as “The People’s William.” He also ran a peaceful and prosperous foreign policy.
• In the German Empire in the late 1800s, Chancellor Otto von Bismarck united the disparate populations of 39 different states and people of different religions to build Germany as a country and an economic powerhouse. Under him Germany had an economic boom with sound finances while brilliantly navigating international relations to have it benefit internationally and avoid debilitating major wars.
• Singapore’s Prime Minister Lee Kuan Yew successfully took the country through these stages by running the country as prime minister from 1959 to 1990 and mentoring until his death in 2015. He created the principles and shaped the culture to be successful way beyond him and avoided wars without losing power.
• In the postwar US, John F. Kennedy in his 34 short months as president from January 20, 1961, to November 22, 1963, simultaneously inspired the country to go to the moon, advanced the civil rights movement, undertook the war on poverty with Vice President Lyndon Johnson, and kept the United States out of major wars while simultaneously strongly containing opposition to the American Empire.
• In China, Deng Xiaoping transitioned a weak and inefficient communist system to a highly productive state capitalist system, quickly changing the nation’s psychology to make these changes with sayings, such as “it is glorious to be rich” and “it doesn’t matter whether the cat is black or white as long as it catches mice”; built China’s economy and finances to be very strong; enormously improved the education and quality of life of most people; dramatically lengthened life expectancies and reduced poverty rates; successfully led China through internal political conflicts; and strictly maintained China’s sovereignty while avoiding major external conflicts.

The longer countries stay in this stage, the longer their good times last.

During this stage the developments to pay attention to that reflect the big risks that naturally develop and undermine the self-sustaining good results are the widenings of the opportunity, income, wealth, and values gaps accompanied by bad and unfair conditions for the majority, luxurious and unfairly privileged positions for the elites, declining productivity, and bad finances in which excess debts are created.

History shows us that the great empires and great dynasties that were able to sustain themselves stayed in Stage 3 by avoiding these risks. The failure to avoid these risks leads to the next stage, which is a period of excesses. This is the stage in which the temptation to do everything and borrow money to do everything can lead to the movement to the next stage.

• There is the rapidly increasing debt-financed purchases of goods, services, and investment assets, so debt growth outpaces the capacity of future cash flows to service the debts. So, bubbles are created. These debt-financed purchases emerge because investors, business leaders, financial intermediaries, individuals, and policy makers tend to assume that the future will be like the past so they bet heavily on the trends continuing. They mistakenly believe that investments that have gone up a lot are good rather than expensive so they borrow money to buy them, which drives up their prices, which reinforces this bubble process. That is because as their assets go up in value their net worth and spending-to-income level rise, which increases their borrowing capacities, which supports the leveraging-up process, and so the spiral goes until the bubbles burst.22
• There is a shift in spending of money and time to more on consumption and luxury goods and less on profitable investments. The reduced level of investments in infrastructure, capital goods, and R&D slows their productivity gains and leads their cities and infrastructures to become older and less efficient.
• There is a lot of spending on the military at this stage to expand and protect global interests, especially if the country is a leading global power.
• The country’s balance of payments positions deteriorate, reflecting its increased borrowing and reduced competitiveness. If the country is a reserve currency country, this borrowing is made easy and the result of non-reserve currency savers having a preference to save/lend to their currency.
• Wealth and opportunity gaps are large and resentments between classes emerge.

During this phase, the archetypical best leader is the “well-grounded, disciplined leader” who understands and conveys sound fundamental behaviors that yield productivity and sound finances and creates restraints when the crowd wants to overdo things. These leaders are the ones who lead the country to continue to reinvest a significant amount of their earnings and their time to being productive when they become richer. As mentioned, Lee Kuan Yew, the former Prime Minister of Singapore, assured that his country and fellow citizens had the culture to become well-educated, disciplined, and of strong character even after becoming successful and rich. However, these leaders are few and far between because their fighting the ebullience of the masses is very unpopular. In almost all cases, after becoming rich, the country (and its leaders) become decadent, borrow to finance excess consumption, and lose competitiveness. This period of decline is exemplified by decadent leaders such as the notorious Roman emperor Nero (who used a city-wide fire in Rome to confiscate land to build an expansive palace)23 as well as Louis XIV (who similarly expanded the Palace of Versailles while productivity fell and people endured hardships at the height of his power)24 and the Ming Dynasty’s Wanli Emperor25 (who withdrew from actively governing and focused on the construction of his own immense tomb).

[1]To get a rich picture of what makes great leaders great in different types of circumstances I recommend Henry Kissinger’s upcoming book on leadership.

[2]There are a lot of developments and changes in psychology behind these cycles, which range from good developments and corresponding emotions that lead to harmony and effectiveness in Stages 2 and 3 to bad developments and emotions that lead to fighting and ineffectiveness in Stages 5, 6, and 1. Because each stage is distinctive—e.g., Stage 5 looks almost opposite to Stage 3—it is easy to see which stage any country is in, though the exact points of transition can be challenging to identify since the transitions tend to blend into each other.

[3]See Appendix for more detail on the duration of major empires through time.

[4]Based on historical analysis of nine great powers (covering about 2,200 years of history in total). The likelihood of conflict is based on major cases of civil war, rebellion, and revolution but excludes peaceful revolutions that did not change the existing system. The analysis does not count the probability of conflict arising in a period when a country is already in the midst of internal conflict (and the five years following) to avoid counting periods in which economic conditions were bad because of the conflict itself.

[5]To be clear, when a government’s finances are in bad shape that does not necessarily mean it will run out of buying power. But it does mean that there is a much higher risk of that happening than if the government were in a financially strong position.

[6]Of course, these two kinds of struggles aren’t equivalent. Still, in both cases, I have found that people are focused on their own issues and communities and don’t understand the circumstances of those they don’t have direct contact with. In many communities, people, and most heart-breakingly the children, are desperately poor and neglected. There is an acute shortage of money for basics such as adequate school supplies, nutrition, and basic healthcare and an environment of violence and trauma that perpetuates a cycle in which children are brought up intellectually and physically malnourished and traumatized; this leaves them disadvantaged as they grow into adulthood, which makes it hard for them to earn a living, which perpetuates the cycle. Consider this fact: a recent study that our foundation funded showed that 22% of the high school students in Connecticut—the richest state in the country by income per capita—are either “disengaged” or “disconnected.” A disengaged student is one who has an absentee rate of greater than 25% and is failing classes. A disconnected student is one who the system can’t track because they dropped out. Imagine the consequences in 10 years and the human and social costs of this cycle. Our society has not established limits to how terrible it will allow conditions to get.

[7]https://www.pewresearch.org/politics/2019/10/10/how-partisans-view-each-other/

[8]https://www.prri.org/research/fractured-nation-widening-partisan-polarization-and-key-issues-in-2020-presidential-elections/>

[9]https://www.vox.com/xpress/2014/9/23/6828715/heres-how-many-republicans-dont-want-their-kids-to-marry-democrats

[10]From Nathan Kalmoe and Lilliana Mason, “Lethal Mass Partisanship: Prevalence, Correlates, & Electoral Contingencies,” NCAPSA American Politics Meeting, 2019.

[11]Viscount Northcliffe, who controlled just under half of daily newspaper circulation in the UK around World War I, was known for anti-German coverage and was made “Director of Propaganda in Enemy Countries” by the government in 1918.

[12]https://news.gallup.com/poll/267047/americans-trust-mass-media-edges-down.aspx

[13]https://www.nytimes.com/2016/11/07/business/media/medias-next-challenge-overcoming-the-threat-of-fake-news.html

[14] What can be done? The news media is unique in being the only industry that operates without quality controls or checks on its power. I and most others believe that it would be terrible for our government to regulate it and, at the same time, believe that something has to be done to fix the problem. Perhaps if people protest enough the media could be motivated to create a self-regulatory organization to regulate and create ratings the way the Motion Picture Association did. I don’t have a clue about what should be done because this problem isn’t in my areas of expertise, and it’s not my place to offer suggestions to try to fix the problem; however, it is my responsibility to point out that we are in an era in which sensationalism, commercialism, and political desires to manipulate people’s views have superseded accuracy and journalistic integrity as the primary objectives of most of those in the media and that this is like a cancer that threatens our well-being. If you believe that fake and distorted media is a problem and you are interested in watching the media/propaganda for clues about whether and how this is transpiring, here are a few commonly recommended things to look out for. Ask yourself:

1. Does the story consist of emotionally triggering, unsubstantiated accusations or are the facts substantiated and the sources provided? When the facts are put aside to create an exciting story and the sources are undisclosed, don’t believe the story.
2. Does the writer welcome or not welcome replies or arguments that refute what they are asserting, and are they willing or not willing to publish them along with what they published?
3. Are the accusations in the story consistent with what has been identified and proven in the legal system? If people or groups are accused in the media of doing bad things but they haven’t been accused and judged to have done bad things in the legal system (which follows a process that tries to weigh the evidence to get at what is true), at least ask yourself why that is and probably don’t believe the story.
4. If the writer or outlet has shown themselves to be biased, assume that they and their stories are biased.

[15]Historians require more than 1,000 deaths a year to call such internal conflict a civil war.

[16]Notably after the Napoleonic Wars (when the then-new world order was established at the Congress of Vienna in 1815), Western Europe and particularly the UK by and large experienced 100 years of peace and prosperity and great wealth creation until World War I developed in 1914, which was followed by a very painful and turbulent 30 years.

[17]In some nondemocratic countries, capitalists were also killed.

[18]The Roman Republic and Athens both had democratic elements, but not everyone was able to participate or vote equally. Although democracies have existed for thousands of years, it is only recently that most people were allowed to vote. For example, in the US African American men were not universally allowed to vote until 1870, and women of all races until 1920.

[19]Note: shade of coloring indicates degree of polarization.

[20]Though it is unlikely that a third party of moderates could elect a president or large numbers of senators or representatives soon, it wouldn’t take much to elect the few whose votes would be needed by the opposing parties to get what they want passed, which would give these moderates great power. It also, with time, would give moderate voters and moderate politicians a party to go to that could better reflect their desired positions, which could negate some of the pull to the extremes.

[21]Aristotle, Politics, IV.11 (translated by Stephen Everson)

[22]Japan in 1988-90, the US in 1929, the US in 2006-07, Brazil and most other Latin American commodity producers in 1977-79 are classic examples.

[23]https://www.britannica.com/topic/Golden-House-of-Nero

[24]https://www.britannica.com/biography/Louis-XIV-king-of-France

[25]https://www.britannica.com/biography/Wanli

[26]Note: a couple cities have a positive net worth (liquid assets in excess of liabilities), appearing as negative on the charts. Analysis based on data from a variety of US government organizations and Truth in Accounting’s January 2020 report: Financial State of the Cities.

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