This Study & How I Came to Do It

One study led to another that led me to do this study. More specifically: Studying money and
credit cycles throughout history made me aware of the long-term debt cycle (which typically
lasts about 50-100 years), which led me to view what is happening now in a very different way
than if I hadn’t gained that perspective. For example, before interest rates hit 0% and central
banks printed money and bought financial assets in response to the 2008-09 financial crisis, I had
studied that happening in the 1930s, which helped us navigate that crisis well. From that
research, I also saw how and why these central bank actions pushed financial asset prices and the
economy up, which widened the wealth gap and led to an era of populism and conflict. We are
now seeing the same forces at play in the post-2009 period.

In 2014, I wanted to forecast economic growth rates in a number of countries because they were
relevant to our investment decisions. I used the same approach of studying many cases to find
the drivers of growth and come up with timeless and universal indicators for anticipating
countries’ growth rates over 10-year periods. Through this process, I developed a deeper
understanding of why some countries did well and others did poorly. I combined these indicators
into gauges and equations that we use to produce 10-year growth estimates across the 20 largest
economies. Besides being helpful to us, I saw that this study could help economic 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.

The Timeless and Universal Fundamentals of Money and Credit

debts have to be paid above all else so that when one has “equity” ownership—e.g., in one’s
investment portfolio or in one’s house—and one can’t service the debt, the asset will be sold or
taken away. All countries can create money and credit out of thin air to give to people to spend
or to lend it out. The monies (i.e., currencies) that are widely accepted around the world are
called reserve currencies. 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 store hold of wealth.

The Fundamentals

money and credit is stimulative when it’s given out and depressing when it has to be paid back.
That’s what normally makes money, credit, and economic growth so cyclical. 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 say 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.

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 store holds of wealth. When it is widely
perceived that the money and the debt assets that are promises to receive money are not good
store holds 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.

The Monetary System That We Are in, from Its Beginning until Now

the new world order began after the end of World War II in 1945, with the Bretton Woods agreement
having put the dollar in the position of being the world’s leading reserve currency in 1944. The new
monetary system was a Type 2 (i.e., claims on hard money) monetary system, in which “paper dollar”
claims on gold could be exchanged by other countries’ central banks for an ounce of gold. The US
Federal Reserve allowed the creation of a lot more claims on gold (i.e., dollar-denominated money and
credit) than could actually be converted into gold at that $35 price. As a result, the Bretton Woods
monetary system broke down on August 15, 1971 when President Nixon, like President Roosevelt on
March 5, 1933, defaulted on the US’s promise to allow holders of paper dollars to turn them in for gold.
Thus, the dollar devalued against gold and other currencies. That is when the US and all countries went
to a Type 3 fiat monetary system. This move to a fiat monetary system freed the Federal Reserve and
other central banks to create a lot of dollar-denominated money and credit, which led to the inflationary
1970s. 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. 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%.

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. 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. 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.

Printing and Devaluing Money Is the Easiest Way out of a Debt Crisis

While people tend to think that a currency is pretty much a permanent thing and believe that “cash” is
the safe asset to hold, that’s not true because all currencies devalue or die and when they do cash and
bonds (which are promises to receive currency) are devalued or wiped out.

there are four levers that policy makers can pull to bring debt and debt-service levels down relative to
the income and cash-flow levels that are required to service one’s debts:

1-Austerity (spending less)

2-Debt defaults and restructurings

3-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)

4-Printing money and devaluing it, currency and devaluing debt is the most expedient way of reducing
or wiping out debt burdens. printing money is the most expedient, least well-understood, and most
common big way of restructuring debts Most people don’t pay enough attention to their currency risks.
All Currencies Have Been Devalued or Died

Of the roughly 750 currencies that have existed since 1700, only about 20% remain, and of those that

remain all have been devalued.

What Do They Devalue Against?

The most important thing for currencies to devalue against is debt. That is because the goal of printing
money is to reduce debt burdens. Debt is a promise to deliver money, so giving more money to those
who need it lessens the debt burden. Increases in the supply of money and credit both reduce the value
of money and credit (which hurts holders of it) and relieve debt burdens. In cases in which the debt
relief facilitates the flows of this money and credit into productivity and profits for companies, rising real
stock prices (i.e., the value of stocks after adjusting for inflation) happens. When it sufficiently hurts the
actual and prospective returns of “cash” and debt assets so that it drives flows out of these assets and
into inflation-hedge assets and other currencies, that leads to a self-reinforcing decline in the value of
money. To do that I will show you the value of currencies in relation to both gold and consumer price
index weighted baskets of goods and services because gold has been the timeless and universal
alternative currency and because money is meant to buy goods and services so its buying power is of
paramount importance. I will also touch on their value in relation to other currencies/debt and in
relation to stocks because they too can be store holds of wealth.

In Relation to Gold

The chart below shows spot currency returns of the three major reserve currencies in relation to gold
since 1600. While we will examine these in depth in this study, for now I would like to focus your
attention on both the spot currency returns and the total returns of holding interest-earning cash in all
the major currencies since 1850.

As shown in the next two charts, devaluations typically occur as relatively abrupt declines during debt
crises that are separated by periods of currency stability during periods of prosperity
The Value of Currencies in Relation to Goods and Services

Thus far we have looked at the market values of currencies in relation to the market value of gold. That
raises the question about how much of this picture is because we are looking at the value of currencies
relative to gold and whether that is an appropriate gauge. The next chart shows the value of interest-
rate-earning cash currency in terms of the CPI baskets of goods and services in these currencies, so it
shows changes in buying power. As shown the two world wars were very bad, and since then there have
been ups and downs. In about half of the currencies interest-rate-earning cash provided a return that
was above the rate of inflation, in the other half it provided bad real returns, and in all cases, there were
big and roughly 10-year-long swings around these averages. In other words, history has shown that
there are very large risks in holding interest-earning cash currency as a store hold of wealth especially
late in debt cycles.
The Patterns of Countries Devaluing and Losing Their Reserve Currency
Status

Currencies devaluing and currencies losing their reserve currency position aren’t necessarily the same
things though they are caused by the same things (debt crises) and a currency losing its reserve currency
status comes from chronic and large devaluations.

The Big Cycles of the Dutch and British Empires and Their Currencies

the rises and declines of the Dutch, British, and American empires and their reserve currencies and will
touch on the rise of the Chinese empire. While the evolution of empires and currencies is one
continuous story that started before there was recorded history, in this chapter I am going to pick up the
story around the year 1600. My objective is simply to put where we are in perspective of history and
bring us up to date. the decline of the British empire and the pound evolved into the rise of the US
empire and US dollar and I will take a glimpse at the emergence of the Chinese empire and the Chinese
renminbi. That will bring us up to the present and prepare us to try to think about what will come next.
The Big Cycle of the Life of an Empire

Just as there is a human life cycle that typically lasts about 80 years (give or take) and no two are exactly
the same but most are similar, there is an analogous empire life cycle that has its own typical patterns.

It is pretty easy to tell what phases people are in because of obvious markers, and it is sensible for them
to know what stages they are in and to behave appropriately in dealing with themselves and with others
based on that. The same thing is true for countries. The major phases are shown on this chart. It’s the
ultra-simplified archetypical Big Cycle that I shared in the last chapter:

In brief, after the creation of a new set of rules establishes the new world order, there is typically a
peaceful and prosperous period. As people get used to this, they increasingly bet on the prosperity
continuing, and they increasingly borrow money to do that, which eventually leads to a bubble. As the
prosperity increases the wealth gap grows. Eventually the debt bubble bursts, which leads to the
printing of money and credit and increased internal conflict, which leads to some sort of wealth
redistribution revolution that can be peaceful or violent. Typically, at that time late in the cycle the
leading empire that won the last economic and geopolitical war is less powerful relative to rival powers
that prospered during the prosperous period, and with the bad economic conditions and the
disagreements between powers there is typically some kind of war. Out of these debt, economic,
domestic, and world-order breakdowns that take the forms of revolutions and
wars come new winners and losers. Then the winners get together to create the new domestic and
world orders. That is what has repeatedly happened through time. The lines in the chart signify the
relative powers of the 11 most powerful empires over the last 500 years. In the chart below you can see
where the US and China are currently in their cycles. As you can see the United States is now the most
powerful empire by not much, it is in relative decline, Chinese power is rapidly rising, and no other
powers come close.

The next chart offers an even more simplified view.

1) The Last 500 Years

The Rise & Decline of the Dutch Empire and the Dutch Guilder
In the 1500-1600 period the Spanish empire was the pre-eminent economic empire in the
“Western “world while the Chinese empire under the Ming Dynasty was the most powerful
empire in the “Eastern” world, even more powerful than the Spanish empire. 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 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. 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
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.

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. The Dutch and
British had lots of conflicts over economic issues. 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. at that time, in the late 18th century, there was a lot of
fighting between countries with various shifting alliances within Europe. Finally, after around a
quarter century of frequent fighting since the start of the French Revolution, the British and its
allies won in 1815.

The Rise & Decline of the British Empire and the British Pound
As is typical after wars, the winning powers (most notably the UK, Russia, Austria, and Prussia)
met to agree on the new world order. That meeting was called the Congress of Vienna. In it the
winning powers reengineered 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. 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. 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. 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. 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. 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 comparability’s 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. 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.

The Rise of the American Empire and the US Dollar After World War I

As is typical after wars, the winning powers—in this case the US, Britain, France, Japan, and Italy
—met to set out the new world order. 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. 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. 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.

The Rise of the American Empire and the US Dollar After World War II
As is typical after wars, the winning powers—most importantly the US, Britain, and Russia—met
to set out the new world order. 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. 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.”

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. 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. 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. 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.
A Closer Look at the Rises and Declines of the Leading Empires Over the
Last 500 Years

The Dutch Empire and the Dutch Guilder

In it, you can see the story behind the rise and decline.

After declaring independence in 1581, the Dutch fought off the Spanish and built a global
trading empire that became responsible for over a third of global trade largely via the first
mega-corporation, the Dutch East India Company. Income per capita rose to over twice that of
most other major European powers.6 They invested more in education. Literacy rates became
double the world average. They created an empire spanning from the New World to Asia, and
they formed the first major stock exchange with Amsterdam becoming the world’s most
important financial center. As deposit holders at the Bank of Amsterdam realized the bank was
“lending” freshly printed guilders to save the Dutch East India Company, there was a run on the
Bank of Amsterdam. As investors pulled back and borrowing needs increased, gold was
preferred to paper money, those with paper money exchanged it for gold at the Bank of
Amsterdam, and it became clear that there wouldn’t be enough gold.

The 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.

Interest rates rose and the Bank of Amsterdam had to devalue, undermining the credibility of
the guilder as a store hold of value. 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.

The British Empire and the British Pound

In it, you can see the story behind the rise and decline.

The British empire’s rise began before 1600, with steadily strengthening competitiveness,
education, and innovation/technology—the classic leading factors for a power’s rise. despite
winning both World War I and World War II the British were left with large debts, a
huge empire that was more costly than profitable, numerous rivals that were more competitive,
and a population that had big wealth gaps which led to big political gaps. Although the US had
overtaken the UK militarily, economically, politically, and financially long before the
end of World War II, it took more than 20 years after the war for the British pound to fully lose
its status as an international reserve currency. Still, the pound began to lose its status right at
the end of the war. The decline in the British pound was a chronic affair that happened through
several significant devaluations over many years.
1) The Pound’s Suspended Convertibility in 1946 and Its Devaluation in
1949

the UK emerged from World War II with strict controls on foreign exchange. The Bank of
England’s approval was required to convert pounds into dollars, whether to buy US goods or
purchase US financial assets (i.e., current and capital account convertibility was suspended). To
ensure the pound would function as an international reserve currency in the post-war era, and
to prepare the global economy for a transition to the Bretton Woods monetary system,
convertibility would have to be restored. However, because the US dollar was now the
international currency of choice, the global economy was experiencing a severe shortage of
dollars at the time. As a result, the first effort to restore convertibility in 1947 failed completely,
and it was soon followed by a large devaluation (of 30%) in 1949, to restore some
competitiveness. An agreement was reached after the war, under which the UK would
reintroduce convertibility swiftly, and the US would provide the UK with a loan of $3.75 billion49
(about 10% of UK GDP).

When partial convertibility was introduced in July 1947, the pound came under considerable
selling pressure. the UK and other Sterling Area countries turned to austerity and reserve sales
to maintain the peg to the dollar. 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 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. 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. In September 1949,
the pound was devalued by 30% versus the dollar. the immediate post-war experience made it
clear to knowledgeable observers that the pound was vulnerable to more weakness and would
not be able to enjoy the same international role it had prior to World War II.
2) The Failed International Efforts to Support the Pound in the 1950s and
1960s and the Devaluation of 1967

As a result, numerous arrangements were made to try to shore up the pound and preserve its role as a
source of international liquidity. By the mid-1960s, the average share of central bank reserves held in
pounds had fallen to around 20%. This effectively ended following a series of runs on the pound in the
1960s. As in many other balance of payments crises, policy makers used a variety of means to try to
maintain the currency peg to the dollar, including spending down reserves, raisin grates, and using
capital controls. In the end they were unsuccessful, and after the UK devalued by 14% versus the dollar
in 1967, even Sterling Area countries were unwilling to hold their reserves in pounds, unless the UK
guaranteed their underlying value in dollars. Throughout the 1960s, the UK was forced to defend the
peg to the dollar by selling about half of its Fx reserve holdings and keeping rates higher than the rest of
the developed world. When the pound came under extreme selling pressure again in 1967 (following
rising rates in the developed world, recessions in major UK export markets, and heightened conflict in
the Middle East),62 British policy makers decided to devalue sterling by 14% against the dollar So all
countries that continued to hold a high share of their reserves in pounds after 1968 were holding de
facto dollars with the British bearing the risk of a further sterling devaluation the United States and
China.

The Big Cycles of the United States and the Dollar, Part 1

As we move closer to the present, I will increasingly shift from describing each country’s story
individually to weaving the most relevant countries’ stories together chronologically so you can better
see the interactions, and I will do it in greater detail. I will start in 1930 and bring the story up to the
present for both the US and China, and then I will focus more closely on US-China interactions, which
are the most important ones today. While telling the story this way will make it a bit more complicated,
it will help you see how what is happening now is similar to what happened in the past because the
most important forces and cause/effect relationships behind them are essentially the same. I will try to
keep it simple, emphasizing just the most important developments in just the most influential countries,
but if you find that the story starts getting more complicated than you’d like, remember that you can
just read the text in bold in order to get the main points without complication. I will try to keep it simple,
emphasizing just the most important developments in just the most influential countries, but if you find
that the story starts getting more complicated than you’d like, remember that you can just read the text
in bold in order to get the main points without complication. 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.
The US Empire and the US Dollar

In it you can see the story behind the US’s rise and decline since 1700. We start in 1700 because that
was just before the emergence of the United States. While the area now occupied by the United States
was of course inhabited by native people for thousands of years, the history of the United States as a
nation begins with the colonists, who revolted against the colonial power of Great Britain to gain
independence in 1776.

1930 to 1939/41: The Economic War

As a principle:

Before there is a shooting war there is usually an economic war.

And: Severe economic downturns with large wealth gaps, large debts, and ineffective monetary policies
make a combustible combination that typically leads to significant conflicts and revolutionary changes
within countries.
And:

During periods of great conflict there is a strong tendency to move to more autocratic leadership to
bring order to the chaos.

When the Federal Reserve tightened monetary policy in 1929 to curtail the speculation, the bubble
burst and the global Great Depression began. 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.

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. 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. 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.
In response to internal fighting and a desire to restore order, Hitler was appointed chancellor in January
1933.

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.

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. In democracies there are always some laws that allow countries’ leaders to grab special
powers. Hitler also took that same autocratic/fascist approach to building the economy, coupled with
big fiscal and monetary stimulation programs. 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.
In 1931, the depression in Japan was so severe that the country went broke. 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 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. 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. The US remained reluctant to enter the wars in Europe and Asia. 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. 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. 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. 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.

the most common economic warfare techniques:

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).
1939/41 to 1945: The Hot War
Just as it is worth noting what classic economic war techniques are, it is worth noting what classic
wartime economic policies within countries are. Classic wartime economic policies include government
controls on just about everything as the country shifts resources from profit making to war making—
e.g., the government determines a) what items are allowed to be produced, b) what items can be
bought and sold in what amounts (rationing), c) what items can be imported and exported, d) prices,
wages, and profits, e) access to one’s own financial assets, and f) the ability to move one’s money out of
the country. Because wars are expensive classically g) the government issues lots of debt that is
monetized, h) relies on non-credit money such as gold for international transactions because its credit is
not accepted, i) governs more autocratically, j) imposes various types of economic sanctions on enemies
including cutting off their access to capital, and k) experiences enemies imposing these sanctions on
them.

Stock market closings in a number of countries were common, leaving investors in stocks stuck without
access to their capital. 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.

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.
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. 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.

The Big Cycles of the United States and the Dollar,

Part 2

The New World Order from 1945 until Now

As is typical after wars, World War II’s winning powers—most importantly the US, Britain, and the Soviet
Union (then called “the Big Three”)—led meetings to create the new world order, which included
carving up the world into geographic areas of control and establishing new money and credit systems.

it didn’t take long for the world to become divided between the US-led capitalist/democratic camp and
the Soviet-controlled communist/autocratic camp, each with its own monetary/economic systems,
though there were a small number of less significant countries that were non-aligned.

The Post-War Geopolitical and Military System

Ideologically, the US-led world was capitalist and democratic while the Soviet-led world was communist
and autocratic. The US-led monetary system for the US-led countries linked the dollar to gold and most
other countries’ currencies were tied to the dollar.

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. 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).

The Post-War Monetary and Economic Systems

The Post-War Monetary and Economic Systems Money and transactions between countries were and
still are very different from money and transactions within countries. That is because within countries
governments get to control the key aspects of money and transactions (such as what money is used,
how much of it there is, what it costs, who handles it and how, etc.), whereas in transactions between
countries the key aspects of money and transactions have to be mutually agreed-on. For example,
within a country the government can mandate that only the paper money that it prints is acceptable,
whereas between countries only the money that those who are transacting agree is acceptable will be
acceptable.
That is why gold and reserve currencies have been so important in transactions between countries while
people within countries typically exchange this paper with others in the country, oblivious to the fact
that that money is not much valued outside the country. Within countries individuals were not allowed
to own or transact in gold because governments wanted to be able to control the supply and value of
people’s money and the distributions of people’s wealth. As for the particular new post-war monetary
and economic systems, there was one for the US-led camp and one for the Soviet-led camp. The Bretton
Woods Agreement put the dollar in the position of being the world’s leading reserve currency. This was
natural because the two world wars made the US the richest and most powerful country by far. It
earned this money via its large exports, and by the end of World War II it had amassed the greatest
gold/money savings ever. That savings accounted for around two-thirds of the world’s government-held
gold/money and was equivalent to eight years of import purchases. Even after the war, it continued to
earn a lot of money by continuing to export a lot.

In other words, the US was very rich. By comparison, other countries were broke, which made it difficult
to buy what they needed from the US and other countries. Besides not having any money Europe and
Japan had virtually nothing to sell after the war because their economies were destroyed. As a solution,
and to fight the spread of communism, the US offered massive aid packages to Western Europe and
Japan (known as the Marshall and Dodge plans) which were a) good for these devastated nations, b)
good for the US economically because these countries used the money to buy US goods, c) good for the
US’s geopolitical influence abroad, and d) good for reinforcing the dollar’s position as the world’s
dominant reserve currency because they increased its usage. All leading central banks in history have
followed variations on this process. Most recently China’s Belt and Road Initiative has offered similar
advantages to China.

The Late-1960s Weakening Fundamentals That

Led to the End of the Bretton Woods Monetary
System
in the 1950- 70 period there was productive debt growth and equity market developments that were
essential for financing innovation and development early on and became overdone later. In the 1960s
Americans spent a lot on consumption and Germany and Japan, which had largely recovered from the
war, were increasingly effective competitors in producing manufactured goods such as cars so US trade
balances were worsening. At the same time, the US government was spending increasing amounts on
fighting the Vietnam War and domestic social programs (called “guns and butter”). To finance all this
spending, the US Federal Reserve allowed the creation of a lot more claims on gold than could actually
be converted into gold at the set $35 price. As the paper money was turned in for the hard money
(gold), the quantity of gold in the US central bank went down at the same time as the claims on it
continued to rise. As a result, the Bretton Woods monetary system broke down on August 15, 1971,
when President Nixon, like President Franklin Roosevelt on March 5, 1933, broke the US’s pledge to
allow holders of paper dollars to turn them in for gold. As shown in the below charts, as the US was
spending more than it was earning and the paper money claims on gold were turned in for gold, US gold
reserves went down until the US government realized that they would run out and stopped allowing the
conversion at which time the dollar plunged in value relative to gold and the two leading alternative
currencies, which were the German deutschmark and the Japanese yen.

I remember the devaluation of the dollar very well. I was clerking on the floor of the New York Stock
Exchange at the time. too much debt that needed money to ease the debt burden.

The Inflationary and Troubled 1970s

After the 1971 delinking of the dollar and other currencies from gold, the world moved to an
unanchored fiat (Type 3) monetary system and the dollar fell in value against gold, other currencies,
stocks, and eventually just about everything. The new monetary system was negotiated by the leading
economic policy makers of the United States, Germany, and Japan. He was the person who knew more
about monetary systems and was more at the center of the US dollar system from before the 1971
monetary breakdown (he was the Undersecretary of International Monetary Affairs under Nixon when
Nixon severed the link with gold) through the 1970s inflation that resulted from its breakdown.

He was eventually called on to break the back of inflation as head of the Federal Reserve from 1979 until
1987. He did more to shape and guide the dollar-based monetary system before, during, and after these
years than any other person. I was lucky enough to have gotten to know him well so I can personally
attest to the fact that he was a person of great character, capabilities, influence, and humility—a classic
hero/role model in a world that lacks hero/role models, especially in economic public service. I believe
that he and his thinking deserve to be studied more.

I remember inflation psychology very well; it led Americans to borrow money and immediately take
their pay checks to buy things to “get ahead of inflation.” The panic out of dollar debt also led interest
rates to rise and drove the gold price from the $35 that it was fixed at in 1944 and officially stayed at
until 1971 to a then-peak of $850 in 1980. I remember inflation becoming the biggest political problem,
which led President Nixon to create controls on prices and wages, which created great economic
distortions that, along with Vietnam and Watergate, brought him down. Then President Ford passed
around buttons that said “WIN,” which stood for “Whip Inflation Now.

” I remember President Carter facing even worse inflation problems, and he brought Volcker back as
head of the Fed to break the back of inflation. Volcker was effective, but it cost Carter his presidency. I
saw how the panic out of dollars and dollar-debt assets and into inflation hedge assets, as well as the
rapid borrowing of dollars, risked leading dollars and dollar debt to cease being an accepted store hold
of wealth.

At the time, it was also widely believed that the labor unions were out of control with their demands for
more pay and less work and needed to be controlled, so liberalism was losing popularity and
conservatism was gaining popularity.

The 1979-82 Move to Tight Money and Conservatism

Volcker announced that he would constrain money (M1) growth at 5.5%. I ran the numbers, which led
me to figure that, if he really did what he said he was going to do, there would be a great shortage of
money that would send interest rates through the roof and would bankrupt debtors who could not get
the credit they needed and would drive up their debt service expenses to levels that they couldn’t afford
to pay. While it was unimaginable that he would do that, Volcker stuck to that plan despite great
political backlash and drove interest rates to the highest level “since Jesus Christ,” according to German
Chancellor Helmut Schmidt. Economics and politics have swings between the left and the right in varying
extremes as the excesses of each become intolerable and the memories of the problems of the other
fade. It’s like fashion—the width of ties and the lengths of skirts. When there is great popularity of one
extreme, one should expect that it won’t be too long before there will be a comparable move in the
opposite direction. 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. the value of
assets is the reciprocal of the value of money and credit (i.e., the cheaper money and credit are, the
more expensive asset prices are) and the value of money is the reciprocal of the quantity of it in
existence, so when central banks are producing a lot of money and credit and making it cheaper, it is
wise to be more aggressive in owning assets.

The Disinflationary and Booming 1980s

This whole 1971-91 up-and-down debt cycle, which profoundly affected just about everyone in the
world, was the result of the US going off the gold standard, the inflation that resulted from it, and having
to break the back of the inflation through tight money policies that led to the strength in the dollar and
dramatic fall in inflation. In the markets that big cycle showed up via a) the soaring of inflation and
inflation-hedge assets and bear markets in bonds in the 1970s, b) the 1979-81 bone crushing monetary
tightening that made cash the best investment and led to a lot of deflationary debt restructuring by non-
American debtors, and then c) falling inflation rates and the 1980s’ excellent performance of bonds,
stocks, and other deflationary assets.
“The 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.

The Post-1945 Story in More Charts and Tables

a) US exports soared while British
exports plunged in each of the two world wars (which made the US rich), b) British exports fell from
about 30% of the total in 1900 to less than 5% today (which made Britain a lot less rich), while c) after
World War II US exports were relatively steady between 20% and 25% until around 2000 when d)
Chinese exports rose from around 5% to around 15% now (making China much richer), which is now the
largest in the world, and US exports fell to about 14% (making it a much less strong export-income
earner).
Naturally, if one buys more than one sells one has to finance the difference by some mix of drawing
down one’s savings and/or borrowing. One can think of a country’s savings as being its foreign-exchange
reserves. The United States financed its deficits by running down its reserves/savings and building up a
lot of debt that is owed to foreigners.

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.
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.

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. 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. 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. The next chart shows
shares of world production for the US, UK, Russia, and China.

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.
China’s Giant History in Brief
showed you in the first chart but applied only to China from 600 AD until now. It conveys how powerful
China was relative to other empires in the world over that time frame. While there were many more
dynasties that existed in various parts of the country and various other slivers in time, I didn’t show
them in this chart because that would have produced too much detail for the really big picture to come
through. As you can see, for most of that time China was one of the world’s most powerful empires,
with the notable exception from around 1840 until around 1950 when it went into a steep decline. As
shown, around 1950 it started to rise again, at first slowly and then very rapidly, to regain its position as
one of the two most powerful empires in the world.
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 100 th 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. 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.

China’s Lessons and Its Ways of Operating

 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.

All of these Chinese systems from the beginning of recorded history were hierarchical and non-
egalitarian. 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. 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 outsides of China. Those that were outside China were for the
purpose of establishing China’s relative power, security, and trade, not for occupation.

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. 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.

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. 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 too high or hyperinflation.

From 1800 until Now

To begin, I will draw your attention to the eight measures of power that I showed you before for
other countries and for China since 1800. It is shown in the chart below. Notably, unlike the cycles
for the Dutch, the British, and the American empires that we looked at before, which went from
their rises through or into their declines, the cycle that we are examining for China goes from its
decline at first into rising most recently. While in a different order, as you will see, the same forces\
were behind China’s decline and rise as were behind the other empires declines and rises
The Decline from 1800 until 1949
As conveyed, the low point in these eight measures of power—i.e., education, innovation and
technology, competitiveness, military, trade, output, financial center, and reserve currency status—was
in the 1940- 50 period. Since then, most powers—most notably economic competitiveness, education,
and military—improved gradually12 until around 1980 when China’s economic competitiveness and
trade took off. Since then until around 2008 growth was very strong with debt growth being in line with
economic growth. Then the 2008 financial crisis came along and China, like the rest of the world, used a
lot of debt growth to stimulate its economy so debts rose relative to incomes, Xi Jinping came to power,
improved China’s debt management, continued innovation and technology, more boldly expanded
globally, and encountered greater conflict with the US. As shown in this chart China is now a leading
power in trade, military, and innovation and technology, and its relative powers in these areas are
increasing quickly.

While China is still highly competitive economically in world markets, its rate of improvement in this
area is slowing. At the same time China remains a lagging power in its reserve currency and its financial
center. In brief, the post-1800 decline happened when a) the last Chinese royal dynasty (the Qing
Dynasty) became decadent and weak at the same time that b) the British and some other Western
capitalist countries became strong, which led the British capitalist-colonialists and a number of other
foreign capitalist-colonialists to increasingly take control of China economically, at the same time that c)
the financial and monetary system broke down under the burdens of debts that couldn’t be paid and the
printing of money that caused the collapse in the value of money and debt, at the same time that d)
there were massive domestic rebellions and civil wars.14 That severe Big Cycle decline in which all the
major strengths were in mutually reinforcing declines continued from around 1840 until 1949. The end
of World War II in 1945 led to the repatriation of most foreigners in China (except for Hong Kong and
Taiwan) and a civil war to determine how the wealth and power would be divided—i.e., a war between
the communists or the capitalists—on the Chinese mainland. This over 100-year-long period of decline,
which the Chinese call the “Century of Humiliation,” was a classic case of the archetypical Big Cycle
decline occurring due to a number of the classic weaknesses existing, leading to mutually and self-
reinforcing declines adding up to the big decline. It was followed by the classic case of a Big Cycle
upswing in which the new leader wins control, consolidates power, and begins building the basic
structures that are passed onto subsequent generations, who build on their predecessors’
accomplishments.

Mao saw capitalism as a system in which companies pursued profits through imperialism (i.e., through
the controlling and exploiting of countries, the way the British and other capitalist powers did to China)
in a way that enriched greedy rich people while exploiting workers. After all this is what happened to
China over the prior 100 years, and the world in the 1930-45 period was in one of the most extreme
wars between the “rich capitalists” and the “working class communists.”

It was interesting to me to see how Mao’s view of capitalism differed from my view of capitalism
because his experience with it was so different from mine, though both of our views about it were true.
Because capitalism provided me and most others I knew, including immigrants from all over the world,
with enormous opportunity, America was both fair and a land of opportunity in which one could learn,
contribute, and be rewarded without boundaries.

I was from a working-class background and always admired and appreciated the hard-working people
who worked together to be productive and the motivated entrepreneurs innovating and working with
devoted workers to convert their dreams into realities that the whole society benefited from. This
experience of my trying to see something (capitalism) through both my eyes and through Mao’s eyes
was another reminder for me of how important radical open-mindedness and thoughtful disagreement
are in order to find out what is true. That desire led me to study Marxism a bit so that I could imagine
how it made a lot of sense to Mao and others as a philosophy. My inclination up until then was to think
of it as at its best obviously impractical and at its worse possibly an evil threat, yet I was ignorant about
what Marx actually said.

Enter Marxism-Leninism
In a nutshell dialectical materialism, Marx’s system for producing change, is a systematic way of
observing events transpire and influencing them by watching and influencing “contradictions” of
“opposites” that produce “struggles” that, when resolved, produce progress. Marx meant it to apply to
everything. The conflict and struggle between the classes that is manifest in the conflict between
capitalism and communism is just one of many such conflicts. Whether in his words or mine, in the
1930-45 period these forces were in the decline/conflict phases of their cycles, which led to revolutions
and wars around the world that brought the two big ideological approaches—capitalism and
communism—into conflict which shaped the landscape of the 20th century. These forces that Marx was
referring to were the big things that affected China throughout Mao’s lifetime. As always happens, these
forces of decline ran their courses and new domestic and world orders began. More specifically, the
external war ended in 1945, which then led to the new world order being created and foreign forces
leaving most of mainland China. Then China had its internal war, which was between the communists
and the capitalists that ended in 1949 and led to a new domestic order, which was communism under
Mao. Put yourself in Mao’s position during the 1900-49 period, and imagine him reading what Marx
wrote and think about his actions during that period and in the post-1949 period. It makes sense why
Mao was a Marxist and pursued his version of Marxist policies and held the established Confucian
approach to harmony in disdain. As far as ideological inclinations for Chinese people and Chinese leaders
more generally, Confucianism, Marxism, and some strict Legalism were all 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.
The Rise from 1949 until Now

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.

Phase 1, 1949 to 1976: The Mao Phase of Building

the Foundation
In 1949 Mao was a philosopher-revolutionary who was leading a class war of workers against the
capitalists, had won the revolution, and was in the position of being the de facto emperor of China
(titled “president and chairman of the Central Military Commission”) and Zhou Enlai became his prime
minister (titled “premier”) in pursuit of the overarching mission of ruling the country on behalf of the
proletariat. Economically from Mao’s founding of the PRC in 1949 until Mao’s death in 1976, the Chinese
economy grew at a rather good average annual rate of about 6%, with an average annual inflation rate
of just around 1-2%, and the Chinese acquired around $4 billion in foreign exchange reserves, so it
improved moderately but remained poor. This happened with a lot of volatility.

As is classic in all cycles, internal political challenges to Mao’s leadership and ideology arose

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.

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.

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. When there is weak and divided leadership, especially during leadership
transitions, enemies see this as a time of vulnerability in which there is increased likelihood that they
will make an attack of some sort. With the leadership transition going on in China and with the moves by
Vietnam and the Soviets perceived as threatening, that was feared to be the case.

Phase 2, 1978 to 2013: The Deng and Deng

Successors Phase of Gaining Strengths Through
Economic Reforms and Opening Up Without
Creating Threats to Other Countries
Deng Xiaoping became China’s paramount leader in 1978 at age 74 with a wealth of experience under
his belt. He was a “reformer,” so from 1978 until he died in 1997 Deng Xiaoping’s most important
policies were conveyed in a single phrase: “reform” and “opening up.” Reform meant “market reforms”
which meant using the market to help allocate resources and to help motivate people, and “opening up”
meant interacting with the outside world to learn, improve, and trade. This led the Chinese Communist
Party to start to bring capitalism into the mix20 and open up to the outside world. Deng knew that these
two related directions—to greater “reform” and greater “opening up”— would make China stronger
financially if it was not disrupted by the far more powerful foreign powers wanting to prevent the
development of the weak China that he inherited, so the key was to pursue these directions in ways that
benefited and didn’t threaten those foreign powers, most importantly the United States. In 1979 Deng
established full diplomatic relations with the US, which was consistent with his strategy to open up and
reform China. At the time China was extremely poor—per capita income was less than $200 per year—
so China needed the improvement and was no threat to developed countries, especially the US. These
reforms later led to the first orderly and rule-based transition of power from Deng to others in the next
generation Politburo Standing Committee, at first led by Jiang Zemin, then led by Hu Jintao, with these
transitions occurring via the prescribed 10-year term limits. Each successive leadership team followed
Deng’s same basic path of making China richer and more powerful by making the economy more
market-driven/capitalist and by increasing China’s trade with and learning from those in other countries,
with those in other countries feeling more excited than threatened by their interactions and trade with
China.

In 1984 I had my first direct contact with China. 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. Deng was a very smart, eager learner who was helped by
knowledgeable outsiders to produce China’s economic advances along its desired development arc.

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. 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).

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 would worry a lot if we were to see a “Fourth Taiwan Strait Crisis.”

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). 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.

Since 2008: The Emergence of US-China Conflicts

and the End of Globalization
As is classic, periods of prosperity financed by debt growth lead to a debt bubble and a large wealth gap.
The bubble burst in 2008 (like in 1929), so the world economy contracted and middle-class Americans
and others in other countries were hurt (like in 1929-32), interest rates were pushed down to 0% (like in
1931), which wasn’t enough easing so central banks printed a lot of money and bought a lot of financial
assets in 2008 (like in 1934), which drove financial asset prices in most countries up starting in 2009 (like
in 1933-36), which benefited those people who had financial assets (the “haves”) more than the “have
nots” so the wealth gaps grew (like in 1933-38). That is when the

“have nots” who were losing to globalization, especially those who were seeing their jobs being taken
by the Chinese and by immigrants, started to rise up against the elites who were benefiting from
globalization. As is typically the case, with economic bad times coinciding with large wealth gaps,
populism and nationalism grew around the world, like in the 1930s. That is when the threats of the
rising powers challenging the leading world powers started to become more apparent and the era of
peace, prosperity, and globalization started to wane and the era of conflicts between the rich and the
poor within countries and between the rising country (China) and the dominant world power (the US)
began.

During the 2009-12 period, debt growth in China was significantly faster than economic growth as a
result of large fiscal and monetary policy stimulations that were deployed to help pull the Chinese and
the world economies out of their weakness.

Phase 3, 2012 until Now: The Xi Phase of

Becoming a World Power
In 2012 Xi Jinping came to power and a new administration was chosen. As far as economics and
markets are concerned, under the Xi administration China aggressively pursued policies to reform and
open up its markets and its economy, to gain control of and manage its debt growth, to more flexibly
manage its currency, to support entrepreneurship and market-oriented decision making especially in
industries that China wants to be a world leader in, to establish sensible regulations run by well-
developed regulatory organizations, to build its capabilities in technologies and industries of the future,
to broaden the economic benefits to extend to those people and those parts of the country that were
lagging the most, and to control environmental pollution. It accomplished a lot that was consistent with
these objectives. it is up to all government leaders in all countries to get the best balance between
“state” (i.e., government influence and control of the economy) and “capitalism” (free market control of
the economy and capital markets) through the proper management and coordination of monetary and
fiscal policy.

They each do it differently. How the Chinese are doing this can be confusing to people who don’t discuss
what they are doing with their policy makers and can’t see the consistencies that exist amid these
seeming inconsistencies. I suggest that you not view what they are doing through a lens of simple
stereotypes (e.g., of “what communists do”) and accept that they will run their economy via monetary
and fiscal policy in the ways that they believe are best for them and seek to understand those ways
better. Since their results are extremely impressive, we should not expect them to abandon their
approach for ours and we should study their approach to see what we can learn from it, the same way
they have studied and learned from ours. After all, what we have is a competition of approaches and
presumably what we want most is to follow the best approach. As far as foreign policy is concerned,
during the Xi term, China has gotten stronger and more forceful while the United States has become
more confrontational.

More specifically, from 2012 until now China’s strengths grew; that became increasingly apparent and
more openly shown (e.g., the Made in China 2025 plan openly showed bold plans to dominate certain
industries that the United States was dominating) at the same time that the American populist backlash
emerged. This became most apparent after the election of Donald Trump. In 2016 Donald Trump’s
election as a populist president of the United States came as he tapped into the sentiment of those who
suffered from globalization and were sympathetic to the view that China was unfairly taking their jobs
and unfairly competing. That is when globalization began to be smothered and protectionism and
nationalism began to be nurtured. At the time, China had become so obviously strong and followed a
number of practices that American policy makers and most people found objectionable. Also, President
Xi didn’t hide China’s economic strength and its ambitious goals to dominate a number of industries that
the US was dominant in, to go global economically, and to more forcefully assert itself in the South and
East China Seas and with countries in the ASEAN region.

As a result, the perception of China as a threat/enemy emerged, globalization reversed, and the “wars”
began, starting with the trade war and economic war, expanding to the technology war, the geopolitical
war, and most recently the capital war.
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. 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. 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 noncyber 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. 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.

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 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.

US-China Relations and Wars

My main principle about relationships that I think is relevant to the US China relationship is:

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.

The Positions the Americans and Chinese Are In

the successes of all countries depend on sustaining the strengthening forces without producing the
excesses that lead to their declines. The really successful ones have been able to do that in a big way for
200-300 years. None has been able to do it forever.

The Trade/Economic War

Thus far we haven’t seen the US-China trade war taken very far. 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.”
Classically, the most dangerous part of the trade/economic war comes when countries cut the other off
from essential imports which means moving to cut off essential imports from either side would signal a
major escalation that could lead to a much worse conflict. both countries, especially China, are shifting
to more domestic production and “decoupling.”

The Technology War

The technology war is a much more serious war than the trade war because whoever wins the
technology war will probably also win the economic and military wars. The United States appears now
to have greater technology abilities overall, though it varies by type of technology and the US is losing its
lead. China will probably advance its technologies and the quality of its decision making that is enabled
by them faster than the US will.

To fight the technology threats the United States is responding by preventing Chinese companies (like
Huawei, TikTok, and WeChat) from being used in the United States, trying to undermine their usage
internationally, and possibly hurting their viability through sanctions that prevent them from getting
items needed for production. 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. 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.

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. 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.
The Geopolitical War
Sovereignty, especially as it relates to the Chinese mainland, Taiwan, Hong Kong, and the East and South
China Seas, is probably China’s biggest issue. As you might imagine, the “100 years of humiliation”
period and the invasions by foreign “barbarians” during it gave Mao and the Chinese leaders to this day
compelling reasons to a) have complete sovereignty within their borders, b) get back the parts of China
that were taken away from them (e.g., Taiwan and Hong Kong), and c) never be so weak that they can
be pushed around by foreign powers. Probably the most dangerous important sovereignty issue that is
difficult to imagine the peaceful resolution of is the Taiwan issue. I would worry a lot if we were to see
an emerging fight over sovereignty, especially if we were to see a “Fourth Taiwan Strait Crisis.” it is my
belief that China has a strong desire not to have a hot war with the US or to forcibly control other
countries (as distinct from having the desire to be all that it can be and to influence countries within its
region). Regarding influence around the world, for both the United States and China there are certain
areas that each finds most important, primarily on the basis of proximity (they care most about
countries and areas closest to them) and/or obtaining essentials (e.g., they care most about not being
cut off from essential minerals and technologies), and to a lesser extent their export markets.

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.

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.

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.

The Capital War

The goal is to cut the enemy off from the capital that the enemy needs because no money = no power
the United States has by far the greatest arsenal of sanctions. Most importantly the United States has
the greatest influence over the global financial system and it has the world’s leading reserve currency.
Because financial market sanctions are so effective, they naturally lead those countries that are most
likely to be harmed by them to work on approaches either to get around them (e.g., by developing an
alternative payment system) or to undermine the United States’ power to impose them.

Whatever progress will be made to have China’s currency as a broadly accepted reserve currency at the
expense of the dollar will take time and should be viewed as part of the big decoupling phase of the
relationship that will take place over the next five years. The United States’ greatest power comes from
being able to print the world’s money (i.e., from having the world’s leading reserve currency) and all the
operational powers (e.g., influences on the clearing system) that go along with that. The United States is
at risk of losing some of this power while the Chinese are in the position of gaining some of it.

The United States is testing the limits of how much there can simultaneously be a) enormous amounts
of dollar-denominated money and debt created, b) falling and negative real returns, c) the dollar being
used as a weapon (e.g., the usage can be limited via capital controls), and d) a fiat monetary system. We
won’t know what the limit is and we can’t say it is here until it is reached. At that point it will be too late
to fix.

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.

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.
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.

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.

The Military War

It is impossible to visualize what the next major war will be like, though it probably will be much worse
than most people imagine. the headline is that a) the United States and

China’s geopolitical war in the East and South China Seas is escalating militarily because both sides are
testing each other’s limits, b) China is now militarily stronger than the United States in the East and
South China Seas so the US would probably lose a war in that region, while c) the United States is
stronger around the world and overall and would probably “win” a bigger war, though d) a bigger war is
too complicated to imagine well because of the large number of unknowns, including how some other
countries would behave in it and what technologies secretly exist.
The only thing that most informed people agree on is that such a war would be unimaginably horrible.
Also notable, a) China’s rate of improvement in its military power, like its other rates of improvement,
has been extremely fast, especially over the last 10 years, and b) the rate of progress in the future is
expected to be even faster, especially if its economic and technological improvements continue to
outpace those of the United States. Some people imagine that China could achieve broad military
superiority in 5-10 years.

When countries have big internal disorder, it is an opportune moment for opposing countries to
aggressively exploit their vulnerabilities. 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.

The Culture War

How people are with each other is of paramount importance in determining how they will handle the
circumstances that they jointly face, and the cultures that they have will be the biggest determinants of
how they are with each other. Chinese culture compels its leaders and society to make most decisions
from the top down, demanding high standards of civility, putting the collective interest ahead of
individual interests, requiring each person to know their role and how to play it well, and having filial
respect for those superior in the hierarchy. They also seek “rule by the proletariat,” which in common
parlance means that the benefits of the opportunities and fruits of productivity created are broadly
distributed.
In contrast American culture compels its leaders to run the country from the bottom up, demanding
high levels of personal freedom, favoring individualism over collectivism, admiring revolutionary
thinking and behavior, and not respecting people for their positions as much as for the quality of their
thinking.

These core cultural values drove the type of economic and political systems they chose. these cultural
differences subtly affect most everything, and in times of great conflict, they are the defining differences
that determine whether the parties fight or peacefully resolve their disputes. The main challenge the
Chinese and Americans have with each other arises from some of them failing to understand and
empathize with the other’s values and ways of doing things, and not allowing each other to do what
they think is best. Some of these cultural differences are minor and some of them are so major that
many people would fight to the death over them.

the cultural differences that make Americans and the Chinese are deeply embedded in them so one
can’t expect the Chinese not to be Chinese and Americans not to be Americans. there is no more chance
of the Chinese giving up their values and their system than there is of Americans giving up theirs. 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.

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 take 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.
 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.
 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. 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.

 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.

The War with Ourselves: The Enemy Is Us

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.
The Cycle of Internal Order and Disorder &
Where We Are in It
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.
The Timeless and Universal Forces That Produce
Changes to the Internal Order
1)The Wealth and Power Class Struggle Dynamic For as long as there has been recorded history, in
almost all societies a very small percentage of the population (the “ruling classes” or “the elites”)
controlled most of the wealth and the power. (Though those percentages have varied)

As Aristotle said a long time ago: “The poor and the rich quarrel with one another, and whichever side
gets the better, instead of establishing a just or popular government, regards political supremacy as the
prize of victory.” 3 Classically, the big cycle transpires with periods of peace and productivity that
increase wealth in a disproportionate way, which leads to a very small percentage of the population
gaining and controlling exceptionally large percentages of the wealth and power, then becoming
overextended, then encountering bad times that hurt those who are the least wealthy and powerful the
hardest, which then leads to conflicts that produce revolutions and/or civil wars, which after completed,
then lead to the creation of a new order and the cycle beginning again. What drives these cycles is
human nature. Because all people have that in common, people all over the world who face similar
circumstances tend to deal with them similarly, which is what gives us the timeless and universal
cause/effect relationships that we will explore in this and the next chapters.

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.

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.

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.

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 fairest, which fosters social stability.

2) The Balance of Power Dynamic.

When two competing entities have comparable powers that include the power to destroy the other, the
risks of a fight to the death are high unless both parties have extremely high trust that they won’t be
unacceptably harmed or killed by the other. The odds of having peace rather than war depends on the
willingness of people to abide by the rules that exist, the willingness to be mutually agreeable in
adapting them when circumstances require adaptation to avoid war, and the threat of mutually assured
destruction—i.e., the more these things exist the greater the chance for peace, and the less they exist
the greater the chance for war. Have power, respect power, and use power wisely, or leave rather than
fight.

3) The Dynamic of Favoring Short-Term Enjoyment over Long-Term Health.

4) The Failure to Learn from History

Delving into the Six Stages of the Internal Cycle

with a Particular Focus on the US Now

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,

The Classic Toxic Mix

The classic toxic mix of forces that brings about big internal conflicts consists of 1) the country and the
people in the country (or state or city) being in bad financial shape (e.g., they have big debt and non-
debt obligations like pension and healthcare obligations), 2) large income, wealth, and values gaps
within that entity, and 3) a severe negative economic shock. The single most reliable leading indicator of
civil war/revolution is bankrupt government finances, often after an economic shock and when there are
big wealth gaps.

A classic marker of being in Stage 5 and a leading indicator of the loss of borrowing and spending power,
which is one of the triggers for going into Stage 6, is that the government has large deficits that are
creating more debt to be sold than buyers other than the government’s own central bank are willing to
buy—i.e., that leading indicator is turned on when governments that can’t print money have to raise
taxes and cut spending, or when those that can print money print a lot of it and buy a lot of government
debt.

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. 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.

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. 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. Averages don’t matter
as much as the number of people who are suffering and their power. To have peace and prosperity, a
society must have productivity that benefits most people.
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. 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.

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. 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.

The following chart shows a populism index that is based on a combination of populists who were
elected to office and populist vote share.

Right now, there is an exceptional amount of polarization in the US as reflected in the stats. 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. 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.

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. Even very capable and powerful people are
now too afraid of the media to speak up about important matters or run for public office. 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. 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.
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.

Late in Stage 5 there are increasing numbers of protests that become increasingly violent.

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.

What Is the Difference between a Civil War and a Revolution?

A revolution is the process of bringing about revolutionary changes in how the system works.
Revolutions needn’t be violent, though they typically are. They can occur within the system/order
without breaking the system, or they can occur after disposing of the old order and starting a new one.
Civil wars, on the other hand, are violent fights for controlling wealth and political power or fights over
ideologies that people feel are even more important than themselves.

revolutionary changes that take place within a system/order can be as large as those that come from
civil wars This period was also called the Gilded Age in the US, the Victorian Era in the UK, and the Belle
Époque in France because of the decadent spending that set in motion the revolutionary changes that
started gradually and then accelerated to wipe out or redistribute virtually all wealth by 1950.

In the 30 years from 1914 and 1944, there were two world wars and the global depression, which led to
the creation of a lot of debt that had the interest rates on it legally capped while all major currencies
were delinked from gold, gold ownership was outlawed, the abilities to take money out of most
countries were eliminated, and price controls on rent and other items were created. Then central banks
printed a lot of money, which produced a lot of inflation, sharply reducing the real value of fixed income
and equity assets. Additionally, in most countries (especially in Europe) businesses were expropriated or
nationalized, and the war damage destroyed a lot of property. Capitalists and capitalism were widely
blamed and hated especially as a result of the stock market crashes and depressions, so many of them
were killed. 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. 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 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. 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.

The US Now
The United States is now in Stage 5 and has not yet crossed the line into Stage 6 (the civil-war stage).
When moderates are in the minority and extremists are in the majority in each party there is a self-
reinforcing pull to greater polarization and increased conflict. History has shown us that greater
polarization equals either a) greater risk of political gridlock, which reduces the chances of revolutionary
changes that rectify the problems, or b) some form of civil war. 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.

 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

What Would Good Look Like?

It would be great to keep the peace and do the things necessary to have the 18 factors stop moving to

the right (bad) part of the continuum and to start moving to the left (good) part of the continuum. How
should we judge whether policy makers are making the right moves to improve these things? Very
simply, what governments do economically is reflected in just two types of policy—fiscal and monetary
—and each can be either easy or tight. Easy means a lot of debt and money is created, which will lead it
to become worthless if the country doesn’t raise productivity by more than a commensurate amount,
but it is stimulative for the economy and is an innocuous way of getting money into the hands of those
who would not get it through the normal means.

Tight means that a lot less debt and money is produced so it will be devalued less, all else being equal,
but it is less stimulative to the economy and gets less money into the hands of those who most
desperately need it. So, we can watch how those trade-offs are handled. In addition to paying attention
to the tight or easy fiscal and monetary trade-offs, which tell us the amount of borrowing and spending,
we need to pay attention to what that borrowing and spending is used for; most importantly, will it
increase productivity and the well-being of most people, or will it not? History has shown that what
matters most is what the system puts the credit and money into. We can watch that and judge whether
or not it will raise productivity and real incomes for the whole and for most people.

Of course, non-fiscal and non-monetary policies such as laws and regulations matter too, so they also
should be assessed in terms of whether or not they will increase the country’s strengths. The challenges
of doing what is needed are that getting the necessary cooperation requires a) moderates to split from
the extremists in their parties to try to pull the country together, which is very difficult to pull off, and b)
big restructurings and revolutionary changes to be pushed through to yield revolutionary improvements,
which is also very difficult to pull off.

Stage 6: When There Are Civil Wars

History shows us that civil wars inevitably happen, so rather than assuming that “it won’t happen here,”

which most people in most of the countries assume after an extensive period of not having them, one

should be wary of them and look for the markers to indicate how close to one is. In this section we will
look at those markers. Civil wars and revolutions inevitably take place to radically change the internal
order (i.e., the system of distributing wealth and power). They include total restructurings of wealth and
political power that include complete restructurings of debt and financial ownership and political
decision making. These changes are the natural consequence of needing to make big changes that can’t
be made within the existing system.

Almost all systems encounter them. That is because almost all systems benefit some classes of people
at the expense of other classes, which eventually becomes intolerable to the point that there is a fight to
determine the path forward. When the gaps in wealth and values become very wide and economically
bad conditions ensue so that the system is not working for a large percentage of the people, the people
will fight to change the system. Those who are economically suffering the most will fight to get more
wealth and power against those who have wealth and power and who benefit from the existing system.
Naturally the revolutionaries want to radically change the system, so naturally they are willing to break
the laws that those in power demand that they adhere to. These revolutionary changes typically happen
violently through civil wars, though as previously described, they can come about peacefully without
toppling the system. The periods of civil war are typically very brutal.

How Civil Wars and Revolutions Transpire

While most of the archetypical civil wars and revolutions shifted power from the right to the left, many
shifted wealth and power to the right and away from those on the left. Typically, the people who lead
the civil war/revolution were (and still are) well-educated people from middle-class backgrounds. They
also typically were (and still are) charismatic and able to work well with others to build big, well-run
organizations that have the power to bring about the revolutions that they led. If you want to look for
the revolutionaries of the future, you might keep an eye on those who have these qualities. Over time
they typically evolve from being idealistic intellectuals wanting to change the system to be fairer to
brutal revolutionaries willing to win at all costs. While having large wealth gaps during economically
difficult times was typically the biggest source of conflict, there were always also other reasons for
conflict that added up to a lot of opposition to the leadership and the system. during the civil
war/revolution stage of the cycle the governments in power almost always had an acute shortage of
money, credit, and buying power. That shortage created the desire to grab money from those who had
it, which led those that had wealth to move them into places and assets that were safe, which led the
governments to stop these movements by imposing capital controls— i.e., controls on movements to
other jurisdictions (e.g., other countries), to other currencies, or to assets that are more difficult to tax
and/or are less productive (e.g., gold). 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.

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.

Stage 1: When the New Order Begins and the New

Leadership Consolidates Power

During this stage the leaders who do best are “consolidators of power.”

Stage 2: When Resource-Allocation Systems and

Government Bureaucracies Are Built and Refined
to be successful the system has to produce prosperity for the middle class. The leaders who are best
during this stage are typically very different from those who succeeded in Stages 6 and 1. I call them
“civil engineers.” While they need to be smart, and ideally, they are still strong and inspirational, above
all else they need to be great civil engineers or have great civil engineers working for them to design and
build the system that is productive for most people

Stage 3: When There Is Peace and Prosperity

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.

Stage 4: A Period of Excesses

I also call this “the bubble prosperity phase.”

Conclusion
My study of history has taught me that nothing is forever other than evolution, and within evolution
there are cycles that are like tides that come in and go out and that are hard to change or fight against.
To handle these changes well it is essential to know what part of the cycle one is in and to know timeless
and universal principles for dealing with them. As conditions change the best approaches change—i.e.,
what is best depends on the circumstances and the circumstances are always changing in the ways we
just looked at. History shows us that the best internal systems/orders depend on the circumstances at
the time. For that reason, it is a mistake to rigidly believe that any economic or political system is always
best because there will certainly come times that that system is not best for the circumstances at hand,
and if a society doesn’t adapt it will die. That is why constantly reforming systems to adapt well is best.
The test of any system is simply how well it works in delivering what most of the people want. The
effectiveness of any system can be objectively measured, which we will continue to do. Having said that,
the lesson from history that comes through most loudly and most clearly is those skilled collaborations
to produce productive win-win relationships to both grow and divide the pie well, so that most people
are happy, is much more rewarding and much less painful than fighting civil wars over wealth and power
that lead to one side subjugating the other side.