The Big Cycle of the United States and the Dollar, Part 1 and Part 2

The New World Order from 1945 until Now

As is typical after wars, World War II’s winning powers—most importantly the US, Britain, and the Soviet Union (then called “the Big Three”)—led meetings to create the new world order, which included carving up the world into geographic areas of control and establishing new money and credit systems.  While France, China, and a couple of other countries were technically aligned with these winning countries, they were lesser players.  And with Germany, Japan, and Italy defeated and broken by the war, they were neither leading nor independent powers; they were subordinate to and aligned with the US.  Britain, which was essentially bankrupt, was also aligned with the US.  The Soviet Union was the leading rival power that was not aligned with the US, so it formed its own camp with its own allies.  While there was relatively good cooperation between the two camps immediately after the war, it didn’t take long for the world to become divided between the US-led capitalist/democratic camp and the Soviet-controlled communist/autocratic camp, each with its own monetary/economic systems, though there were a small number of less significant countries that were non-aligned.

The chart below shows the aggregate power indices for the US, UK, Russia, and China since the end of the war, which conveys this big picture.  

We will now delve into this story more closely.

The Post-War Geopolitical and Military System

The three major powers and others got together in different conferences—the Yalta Conference, the Potsdam Conference, and the Bretton Woods Conference were the most notable—and carved up the world with US-controlled capitalist/democratic countries on one side and Soviet-controlled communist/autocratic countries on the other, with each bloc having its own monetary systems.  Germany was split into pieces, with the United States, Great Britain, and France having control of West Germany and Russia controlling East Germany.  Japan was under US control, and China returned to a state of civil war between communists and the capitalists (i.e., the Nationalists).  Unlike after World War I when the United States chose to be relatively isolationist, after World War II the United States took the primary leadership role in the world as it had most of the economic, geopolitical, and military power.

Geographically the US-led Western world extended east from the US through Western Europe into Germany, which was split into West Germany (which was controlled by the US and its allies) and East Germany along a line of division that became known as the Iron Curtain.  East of that line, going through Eastern Europe and the Soviet Union to Korea was Soviet-controlled.  Korea, like Germany, was split with the Soviets controlling the north and the Americans controlling the south.  China, which was essentially left weak and in civil war, got back Shanghai and other previously held areas within the mainland but was left without Hong Kong (though with an agreement from 1898 to get large portions of it back after 99 years) and Formosa (now Taiwan).  China had an initially cooperative relationship with the Soviet Union that didn’t last long.  In the other direction, going west of the US into the Pacific, the US-controlled areas extended all the way to the southern half of Korea.  The British Empire’s areas of control or influence remained largely the same right at the end of the war, except for some minor additions.  As for geopolitical institutions, the United Nations was created in 1945, and it was located in the US (New York), reflecting the US being the leading world power.

Ideologically, the US-led world was capitalist and democratic while the Soviet-led world was communist and autocratic.  The US-led monetary system for the US-led countries linked the dollar to gold and most other countries’ currencies were tied to the dollar.  This system was followed by over 40 countries.  Because the US had around two-thirds of the world’s gold then and because the US was much more powerful economically and militarily than any other country, this monetary system has worked best and carried on until now.  The Soviet Union and those countries that were brought into the Soviet Union’s bloc were much less rich and were built on a much weaker foundation.

The split was clear from the outset.  President Truman summarized it outlining what is now referred to as the “Truman Doctrine” in a March 1947 speech:

“At the present moment in world history nearly every nation must choose between alternative ways of life.  The choice is too often not a free one.  One way of life is based upon the will of the majority, and is distinguished by free institutions, representative government, free elections, guarantees of individual liberty, freedom of speech and religion, and freedom from political oppression.  The second way of life is based upon the will of a minority forcibly imposed upon the majority.  It relies upon terror and oppression, a controlled press and radio, fixed elections, and the suppression of personal freedoms.  I believe that it must be the policy of the United States to support free peoples who are resisting attempted subjugation by armed minorities or by outside pressures.”[1]

Governance between countries is very different from governance within countries.  That is because within countries there are laws and standards of behavior that govern, whereas between countries raw power matters most, and laws, rules, and even mutually agreed treaties and organizations for arbitration such as the League of Nations, the United Nations, and the World Trade Organization don’t matter much.  Operating internationally is like operating in a jungle in which there is survival of the fittest and most anything goes.  That is what makes having a strong military so important.  

Military alliances were built along the same ideological and geopolitical lines.  In 1949 a military alliance of 12 countries (with more joining later) that were in the US camp formed the North Atlantic Treaty Organization (NATO), and in 1954 the Southeast Asia Treaty Organization was established among the US, UK, Australia, France, New Zealand, the Philippines, Thailand, and Pakistan to prevent the spread of communism in Southeast Asia. In 1955, a military alliance of seven countries that were in the Soviet camp formed the Warsaw Pact.

As shown in the chart below the Americans and Soviets invested massively in building up their nuclear weapons and a number of other countries followed.  These weapons were never used because of the deterrence of mutually assured destruction.  Still there were a couple of times it came close (e.g., Cuban Missile Crisis of 1962).  Today, in varying amounts and degrees of capabilities, 11 countries have nuclear weapons or are on the brink of having them.  Having nuclear weapons obviously gives one a big negotiating chip in the world power game so it’s understandable why some countries would want to have them and other countries would not want other countries to have them.  Of course, in addition to building nuclear capabilities, various new other weapons systems were created, and though there were no nuclear wars, there were a number of wars to counter communism and other geopolitical US adversaries, most notably the Korean War in the 1950s, the Vietnam War in the 1960s, the two Gulf Wars in 1990 and 2003, and the War in Afghanistan from 2001 until now.  These were costly in terms of money, lives, and public support for the United States.  Were they worth it?  That’s for others to decide.  For the Soviet Union, which had a much smaller and weaker economy than the US, spending enough to compete with the US militarily and to maintain its empire was bankrupting.

Of course military power consists of a lot more than nuclear weapons and a lot has changed since the Cold War.  Where do things now stand?  While I’m no military expert, I get to speak to some who have led me to believe that, while the US remains the strongest military power overall, it is not dominant in all parts of the world in all ways, and military challenges to it are rising.  I’m told that there is a significant chance that the US would lose wars against China and Russia in their geographic areas of strength—or at least would be unacceptably harmed—and would also be unacceptably harmed by some second-tier powers.  This is not the good ol’ days early after the beginning of the post-1945 world order in which the US was clearly the sole dominant military power that could not be threatened by others.  While there are a number of high-risk scenarios, the most worrying one is a forceful move by China to bring Taiwan under its control.

What would the next military conflict look like?  It seems clear that new war technologies would be deployed so the war of the future will be very different from the last war in the same ways more recent wars were fought with different technologies than the ones before them.  Classically the country that wins wars outspends, out-invests, and outlasts the opposition.  Because spending on the military takes government money away from spending on social programs, and because military technologies go hand in hand with private sector technologies, the biggest risk for the leading powers is that they lose the economic and technology races over time.  

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[2] because governments wanted to be able to control the supply and value of people’s money and the distributions of people’s wealth.  People’s abilities to own gold could threaten the system because gold is an alternative money that is not controlled by the government that people could use instead of the government’s money.  So (to simplify a bit) within countries people or companies would use the government-controlled paper money and when they wanted to buy something from another country they would typically exchange their own paper currency for the sellers’ paper currency with the help of their central bank and the central bank would settle up with the other central bank in gold.  Or, if they were American, they would typically pay in dollars and the seller would turn that money in to its country’s central bank for its local currency and that central bank would turn its surplus of dollars in for gold, so gold would leave the US central bank reserve account and go into the other central bank account.  As a result, a central bank’s gold reserve savings would go down if a country spent more than it earned and would go up if a country earned more than it spent.

As for the particular new post-war monetary and economic systems, there was one for the US-led camp and one for the Soviet-led camp, though there were also some non-aligned countries that had their own non-aligned currencies that were not widely accepted.  Those countries in the US camp—which consisted of 44 countries—gathered in Bretton Woods, New Hampshire, in 1944 to make a monetary system that put the dollar and gold at the center of it.  The Soviet Union created its own monetary system built around its currency, the ruble.  It was a much less significant monetary system.

The Bretton Woods Agreement put the dollar in the position of being the world’s leading reserve currency.  This was natural because the two world wars made the US the richest and most powerful country by far.  It earned this money via its large exports, and by the end of World War II it had amassed the greatest gold/money savings ever.  That savings accounted for around two-thirds of the world’s government-held gold/money and was equivalent to eight years of import purchases.  Even after the war, it continued to earn a lot of money by continuing to export a lot.  In other words, the US was very rich.  

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

As for monetary policy, from 1933 until 1951 the amount of money, the cost of money (i.e., interest rates), and where that money went was controlled by the Federal Reserve to serve the greater objectives of the country rather than to let the free market allocate money and credit.[3]  More specifically it printed a lot of money to buy debt, capped interest rates that lenders could charge, and controlled what money was allowed to go into, so high inflation did not drive interest rates to unacceptable heights and there were no investment options more attractive than the debt the government wanted people to save in.

Following a brief post-war recession that was due to the government’s war spending declining, the US entered a prolonged period of peace and prosperity because the new and mutually reinforcing Big Cycles transpired.  Most importantly a new debt cycle began with the new monetary system, wealth and values gaps were reduced so the environment was one of greater unity in pursuit of peace and prosperity, and there was a dominant power that nobody wanted to fight.  Also, stock prices were very cheap.  As a result, the US economy and markets were very strong for many years to come.  

During the post-war adjustment period between mid-1945 and mid-1947 over 20 million people were released from the armed forces and related employment so unemployment rate rose from 1.9% to just 3.9%.[4]  At the same time pent-up demand and savings to finance that demand had built up so the removal of rationing laws, which had limited people’s ability to buy consumer goods, fueled a consumer spending surge.  Cheap mortgages were also available for veterans, which led to a housing boom that fueled the expansion.  There was a return to profit making activities, which raised the demand for labor so employment was very strong.  Exports were strong because the US government (via the Marshall and Dodge plans) helped build the market for US goods abroad to be strong.  Also the US private sector went global and invested abroad from 1945 through the 1970s.  That environment was great for business, profits, and stocks because American corporations were extremely profitable after the war at the same time that stocks were very cheap in relation to bonds (e.g., stock earnings and dividend yields were a lot higher than bond yields).  Stocks were cheap because those who went through the depression and war years were very risk-averse, so they significantly preferred a safe income stream to a risky one.  This set of conditions made a multi-decade prosperity and bull market in stocks that reinforced New York’s dominance as the world’s financial center, bringing in more investment and further strengthening the dollar as a reserve currency.

This peace and prosperity also provided the funds to improve education, invent fabulous technologies (e.g., go to the moon), and do a lot more.  In other words, post-war the United States was in one of those great mutually and self-reinforcing Big Cycle upswings.  It was popularly believed in the mid-1960s that economics was a science so we could expect economic prosperity and the stock market always went up with wiggles around the uptrend so one should make “dollar cost average” purchases—i.e., buy consistently so that one would buy on the dips as well as the highs.  Because of that confident psychology, which was the opposite of the conservative psychology that existed in the 1950s, the stock market hit its high in 1966, which marked the end of the good times for 16 years, until the 1982 stock market bottom, though nobody knew it at the time because the mood was one of great optimism and the decline from the market top looked like one of those dips that one should buy into.

It was during the 1960s that my own direct contact with events began.  I started investing in 1961 at age 12.  Of course I didn’t know what I was doing at the time and had no appreciation for how lucky my contemporaries and I were.  I was born at the right time (just after the war at the beginning of a post-war Big Cycle upswing brought about by the early upswing in the long-term debt cycle and a dominant world power that produced decades of peace, prosperity, and bull markets) in the right place (in the United States, which was the most prosperous and powerful country in the world).  I was also very lucky to be raised by parents who loved and cared for me in an era when the American Dream of equal opportunity allowed me to get a good public school education and come out into a job market that gave me equal and excellent opportunity at an exciting time of idealism and dreaming big that inspired me.  I vividly remember John Kennedy, a charismatic leader who inspired the nation to journey to the moon and to fight to eliminate poverty and assure civil rights.[5] One could dream big, work hard, and make those dreams happen, and successful people were role models then.  In the 1960s it was great to be middle class.  The United States was the leading manufacturing country so labor was valuable.  Most adults could get a good job, and their kids could get a collage education and rise without limitation.  Since the majority of people were middle class the majority of people were happy.

Throughout the prosperous 1960s, the US did the classic things that helped the world to become more dollarized.  For example, US banks rapidly increased their operations and lending in foreign markets.  In 1965, only 13 US banks had foreign branches.  By 1970, 79 banks had them, and by 1980 nearly every major US bank had at least one foreign branch, and the total number of branches had grown to 787.[6] Global lending of dollars by American banks boomed.  However, as is typical, a) those that prospered overdid things by operating financially imprudently while b) global competition, especially from Germany and Japan, increased.  As a result, the lending and the finances of Americans began to deteriorate at the same time as its trade surpluses disappeared.

The Late-1960s Weakening Fundamentals That Led to the End of the Bretton Woods Monetary System

As explained in Chapter 2, when claims on hard money (i.e., notes or paper money) are introduced, at first there is the same number of claims on the “hard money” as there is hard money in the bank.  However, the holders of the paper claims and the banks soon discover the wonders of credit and debt.  They can lend these paper claims to the bank in exchange for an interest payment so they get interest.  The banks that borrow it from them like it because they lend the money to others, who pay a higher interest rate so the banks make a profit.  Those who borrow the money from the bank like it because it gives them buying power that they didn’t have.  And the whole society likes it because asset prices and production rise.

After 1945, foreign central banks had the option of holding interest-rate-paying debt or holding non-interest-rate-earning gold.  Because dollar-denominated debt was considered as good as gold, convertible into gold, and higher-earning because it provided interest (which gold didn’t provide), central banks shrank their gold holdings relative to their dollar-denominated debt holdings from 1945 until 1971.  As explained in the Appendix to Chapter 2, “The Changing Value of Money,” investors making such a move is a classic behavior and ends when a) the claims on the real money (i.e., gold) substantially exceed the amount of real money in the bank and b) one can see that the amount of real money in the bank (i.e., gold reserves) is going down.  That is when no interest rate can be high enough for it to make sense to hold the debt (i.e., claims on the real money) rather than to turn one’s paper money in for gold.  At that time a run on the bank occurs and a default and debt restructuring have to happen.  That is what led to the breakdown of the gold-linked Bretton Woods monetary system.

While the following summary repeats some of what was said in prior chapters, it is appropriate to recall it here.

As is typical of this peaceful and prosperous part of the cycle, in the 1950-70 period there was productive debt growth and equity market developments that were essential for financing innovation and development early on and became overdone later.  In the 1960s Americans spent a lot on consumption and Germany and Japan, which had largely recovered from the war, were increasingly effective competitors in producing manufactured goods such as cars so US trade balances were worsening.  At the same time, the US government was spending increasing amounts on fighting the Vietnam War and domestic social programs (called “guns and butter”).  To finance all this spending, the US Federal Reserve allowed the creation of a lot more claims on gold than could actually be converted into gold at the set $35 price.  As the paper money was turned in for the hard money (gold), the quantity of gold in the US central bank went down at the same time as the claims on it continued to rise.  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.  

As I recounted in Chapter 2, I remember the devaluation of the dollar very well.  I was clerking on the floor of the New York Stock Exchange at the time.  I was watching on TV as President Nixon told the world that the dollar would no longer be tied to gold.  I thought, “Oh my God, the monetary system as we know it is ending,” and it was.  The next day was Monday.  When I got to work I expected there to be pandemonium, with stocks falling.  There was pandemonium all right, but stocks were rising.  Because I had never seen a devaluation before, I didn’t understand how they worked.  Then I looked into history and found that on the evening of March 5, 1933, also a Sunday, President Franklin Roosevelt had given essentially the same speech, doing essentially the same thing, which yielded essentially the same result over the following months (a devaluation, a big stock market rally, and big gains in the gold price).  As I looked further, I saw that it had happened many times before in many countries for the same reason—too much debt that needed money to ease the debt burden—with essentially the same proclamations by top government officials.  More recent cases that you might remember include the Fed announcing QE on November 25, 2008, which followed Congress approving Treasury Secretary Hank Paulson’s request for the federal government to provide $700 billion for asset purchases; Mario Draghi in July 2012 stating that the ECB would “do whatever it takes,” which was followed by massive printing of money and buying of government debt; and March 15, 2020, when President Trump and leaders of both houses of Congress agreed on an over $2 trillion stimulus plan, and Fed Chair Powell announced big interest rate cuts to 0%, a $700 billion QE plan, and a slew of other supports, with both announcements followed by other big increases in these numbers.

The Inflationary and Troubled 1970s

After the 1971 delinking of the dollar and other currencies from gold, the world moved to an unanchored fiat (Type 3) monetary system and the dollar fell in value against gold, other currencies, stocks, and eventually just about everything.  The new monetary system was negotiated by the leading economic policy makers of the United States, Germany, and Japan.  If you want to read a great description of this process of figuring out how to go from the old monetary system to the new fiat one, I recommend Changing Fortunes by Paul Volcker and Toyoo Gyohten.  Volcker was the leading American policy maker to determine how the new post-Bretton Woods monetary system would work.  He was the person who knew more about monetary systems and was more at the center of the US dollar system from before the 1971 monetary breakdown (he was the Undersecretary of International Monetary Affairs under Nixon when Nixon severed the link with gold) through the 1970s inflation that resulted from its breakdown.  He was eventually called on to break the back of inflation as head of the Federal Reserve from 1979 until 1987.  He did more to shape and guide the dollar-based monetary system before, during, and after these years than any other person.  I was lucky enough to have gotten to know him well so I can personally attest to the fact that he was a person of great character, capabilities, influence, and humility—a classic hero/role model in a world that lacks hero/role models, especially in economic public service.  I believe that he and his thinking deserve to be studied more.  

As a result of going off the gold-linked monetary system that constrained money and credit growth, there was a massive acceleration of money and credit, inflation, oil and commodity prices, and a panic out of bonds and other debt assets that drove interest rates up and caused a run into hard assets like real estate, gold, and collectibles for most of the next 10 years, from 1971 to 1981.

I remember inflation psychology very well; it led Americans to borrow money and immediately take their pay checks to buy things to “get ahead of inflation.” The panic out of dollar debt also led interest rates to rise and drove the gold price from the $35 that it was fixed at in 1944 and officially stayed at until 1971 to a then-peak of $850 in 1980.  I remember inflation becoming the biggest political problem, which led President Nixon to create controls on prices and wages, which created great economic distortions that, along with Vietnam and Watergate, brought him down.  Then President Ford passed around buttons that said “WIN,” which stood for “Whip Inflation Now.” I remember President Carter facing even worse inflation problems, and he brought Volcker back as head of the Fed to break the back of inflation.  Volcker was effective, but it cost Carter his presidency.  I saw up close how the loose money and credit policies of the 1970s led to dollar-denominated debt being liberally lent by banks to borrowers around the world, especially to those in fast-growing, commodity-producing emerging countries, and I saw how the world was in the bubble phase of the debt cycle in the late 1970s.  I saw how the panic out of dollars and dollar-debt assets and into inflation-hedge assets, as well as the rapid borrowing of dollars, risked leading dollars and dollar debt to cease being an accepted storehold of wealth.   

While most people didn’t understand how the money and credit dynamic worked, they felt the pain of it in the form of high inflation and high interest rates, so it was a chronic political issue.  At the same time, in the 1970s there was a lot of pain, conflict, and rebellion due to the war in Vietnam, oil embargoes that led to high gas prices and gas rationing, labor union fights with companies over wages and benefits, Watergate and the Nixon impeachment, etc.  At the time, it was also widely believed that the labor unions were out of control with their demands for more pay and less work and needed to be controlled, so liberalism was losing popularity and conservatism was gaining popularity.  These problems peaked in the late 1970s as inflation spiked and 52 Americans were held hostage for 444 days at the US Embassy in Tehran, Iran.  Americans felt that the country was falling apart and lacked strong leadership.  At the same time economic conditions in communist countries were even worse.

In China, Mao Zedong’s death in 1976 led Deng Xiaoping to come to power in 1978, which led to a shift in economic policies that included capitalist elements like private ownership of businesses, the development of debt and equities markets, entrepreneurial technological and commercial innovations, and even the flourishing of billionaire capitalists—all under the strict control of the Communist Party. This shift in Chinese leadership and approaches, while seemingly insignificant at the time, was going to germinate into the biggest single force to shape the 21st century.  

The 1979-82 Move to Tight Money and Conservatism

President Carter, who like most political leaders didn’t understand the monetary mechanics very well, knew that something had to be done to stop inflation and appointed a strong monetary policy maker, Paul Volcker, as head of the Federal Reserve in August 1979.  In October 1979, Volcker announced that he would constrain money (M1) growth at 5.5%.  I ran the numbers, which led me to figure that, if he really did what he said he was going to do, there would be a great shortage of money that would send interest rates through the roof and would bankrupt debtors who could not get the credit they needed and would drive up their debt-service expenses to levels that they couldn’t afford to pay.  While it was unimaginable that he would do that, Volcker stuck to that plan despite great political backlash and drove interest rates to the highest level “since Jesus Christ,” according to German Chancellor Helmut Schmidt.  

In the 1980 presidential election Jimmy Carter, who was perceived as a nice but weak liberal Democrat, was voted out and Ronald Reagan, who was perceived as a homebody conservative whom Americans expected would be stronger and impose disciplines where they were needed, was elected.  Leading countries at the time (reflected in the G7 that consisted of the US, UK, Germany, Japan, France, Italy, and Canada—which reflects how different the world power balance was 40 years ago versus today) made analogous moves in electing conservatives to bring discipline to their inflationary chaos.  On January 20, 1981, the same day Reagan was inaugurated as president, the Iranians released the hostages.  Early in their terms, both Reagan in the US and Margaret Thatcher in the UK had landmark fights with labor unions.

Economics and politics have swings between the left and the right in varying extremes as the excesses of each become intolerable and the memories of the problems of the other fade.  It’s like fashion—the width of ties and the lengths of skirts.  When there is great popularity of one extreme, one should expect that it won’t be too long before there will be a comparable move in the opposite direction.  

The move to monetary tightness broke the backs of debtors and curtailed borrowing, which drove the world economy into its worst downturn since the Great Depression.  In seeing the stock market, the economy, and the prices of inflation-hedge assets plunging, the Federal Reserve slowly started to cut interest rates, but the markets continued to decline.  Then Mexico defaulted on its debt in August 1982.  Interestingly, on the day that Mexico defaulted on its debt (August 23, 1982), the US stock market rallied, which was a straw in the wind that I missed.   

What happened next created another jarringly painful learning experience for me.  While I was able to anticipate the debt crisis, which was profitable for me, it also led me to realize that the banks that had lent that money wouldn’t get paid, which led me a) to anticipate a debt-default-triggered depression that never came, b) to lose a lot of money betting on it, and c) to be very publicly wrong.  As a result of my personal losses and losses of clients, I had to let everyone in my fledgling Bridgewater Associates go and was so broke I had to borrow $4,000 from my dad to help pay for my family’s bills.  At the same time this painful experience was one of the best things that ever happened to me because it changed my whole approach to decision making.  It gave me the fear of being wrong and the humility I needed to balance with my audacity without killing my audacity.  It led me to make Bridgewater as an idea meritocracy in which I brought in the smartest independent thinkers I could find to argue with me, which resulted in our doing great over the next 40+ years.  I still carry that fear of being wrong, which is why I am doing this research, why I want the greatest thinkers in the world to challenge my thinking and to stress test it, and why I am passing this research to you for you to take or leave as you see fit.  

Why was I wrong in 1982, and what did I learn that would be an important principle for the future?  What I had missed and learned from this experience was that when debts are in the currencies that central banks have the ability to print and restructure, debt crises can be well-managed, so they are not systemically threatening.  Because the Federal Reserve could provide the banks that made the loans that weren’t being paid back with money, they didn’t have a cash flow problem, and because the American accounting system didn’t require the banks to account for these bad debts as losses, there was no big problem that couldn’t be worked out.  I also learned that the value of assets is the reciprocal of the value of money and credit (i.e., the cheaper money and credit are, the more expensive asset prices are) and the value of money is the reciprocal of the quantity of it in existence, so when central banks are producing a lot of money and credit and making it cheaper, it is wise to be more aggressive in owning assets.  

The Disinflationary and Booming 1980s

In the 1980s there was a stock market and economic boom that was accompanied by falling inflation and falling interest rates in the United States at the same time as there were inflationary depressions in the debt-burdened emerging economies that didn’t have a central bank to bail them out. The debt-restructuring process progressed slowly from 1982 until 1989 when an agreement called the Brady Bond agreement, named after Nicholas Brady, who was the US Treasury Secretary at the time, was created and started to bring to an end to “the lost decade” in these countries (as agreements were reached with different countries through the early ’90s).  This whole 1971-91 up-and-down debt cycle, which profoundly affected just about everyone in the world, was the result of the US going off the gold standard, the inflation that resulted from it, and having to break the back of the inflation through tight money policies that led to the strength in the dollar and dramatic fall in inflation.  In the markets that big cycle showed up via a) the soaring of inflation and inflation-hedge assets and bear markets in bonds in the 1970s, b) the 1979-81 bone-crushing monetary tightening that made cash the best investment and led to a lot of deflationary debt restructuring by non-American debtors, and then c) falling inflation rates and the 1980s’ excellent performance of bonds, stocks, and other deflationary assets.  The charts below convey it very well, as they show the swings up and down in dollar-denominated inflation rates and interest rates from 1945 to the present.  One needs to keep these moves and the mechanics behind them in mind in thinking about the future.

Through it all the dollar remained the world’s leading reserve currency.  The entire period was a forceful demonstration of the benefits to the US of having the world’s reserve currency that most of the world’s debts and money are denominated in.

1990-2008: Globalizing, Digitalizing, and Booming Financed by Debt

Geopolitically, because of its economic failures, the Soviet Union could not afford to support a) its empire, b) its economy, and c) its military at the same time in the face of US President Ronald Reagan’s arms race spending.  As a result the Soviet Union broke down in 1991 and abandoned communism.

It was apparent that communism failed or was failing everywhere, so many countries moved away from it.  The breakdown of the Soviet Union’s money/credit/economic system and its large foreign debts were disastrous for the Soviet Union economically and geopolitically through most of the 1990s.  That is a whole other interesting story that we won’t get into now.  In any case, it is notable that in the 1980-95 period most communist countries abandoned classic communism, and the world entered a very prosperous period of globalization and free-market capitalism.

Since the early 1990s there have been three economic cycles that brought us to where we now are—one that peaked in the 2000 dot-com bubble that led to the recession that followed, one that peaked in the 2007 bubble that led to the 2008 global financial crisis, and one that peaked in 2019 just before the 2020 coronavirus-triggered downturn.  During this 1990-2000 period we also saw the decline of the Soviet Union, the rise of China, globalization, and advances in technologies that replaced people, which was good for corporate profits and widened the wealth and opportunity gaps. 

Notable markers that reflected these developments were making the internet (i.e., the World Wide Web) available to the public on August 6, 1991, which kicked off the dot-com/tech boom, and the creation of the World Trade Organization on January 1, 1995, to facilitate globalization. “Technology development” and globalization that replaced American workers’ jobs, especially those in the manufacturing sector, flourished from the 1990s until around Donald Trump’s election in 2016.  In that roughly 30-year period countries and country borders faded in importance, and items and the incomes they produced were generally made wherever they could be most cost-effectively produced, which led to production and development in emerging countries, accelerating mobility of people between countries, narrowing wealth gaps between countries, and ballooning wealth gaps within them.  Lower-income workers in developed countries suffered, while higher-income workers in productive emerging countries made fortunes.  Though a bit of an oversimplification, it’s accurate to say that this was a period in which workers in other countries (especially those in China) and machines replaced middle-class workers in the United States. 

The chart below shows the balances of goods and services for the United States and China since 1990 in real (i.e., inflation-adjusted) dollars.  As you will see when we look at China in the next section of this book, China’s economic reform and open-door policies after Deng Xiaoping came to power in 1978 and the welcoming of China into the World Trade Organization in 2001 led to the explosion of Chinese competitiveness and exports.  Note the accelerations in China’s surpluses and the US deficits from around 2000 to around 2010 and then some narrowing of these differences, with China still tending to run surpluses and the US still running deficits.

During this period debt and non-debt liabilities like pension and healthcare liabilities grew a lot in the US and debts were used to finance speculations leading up to the dot-com bubble of 2000 and the mortgage bubble of the mid-2000s that led to busts that were stimulated out of by the creation of more money and debt.  These debt cycles are both undesirable and understandable because there is a tendency to favor immediate gratification over long-term financial safety, particularly by politicians.  

Most people pay attention to what they get and not where the money comes from to pay for it, so there are strong motivations for elected officials to spend a lot of borrowed money and make a lot of promises to give voters what they want and to take on debt and non-debt liabilities that cause problems down the road.  That was certainly the case in the 1990-2008 period.  

Throughout the long-term debt cycle, from 1945 until 2008, whenever the Federal Reserve wanted the economy to pick up it would lower interest rates and make money and credit more available, which would increase stock and bond prices and increase demand.  That was how it was done until 2008—i.e., interest rates were cut, and debts were increased faster than incomes to create an unsustainable bubble economy that peaked in 2007.  When in 2008 the bubble burst and interest rates hit 0% for the first time since the Great Depression, that changed.  As explained more comprehensively in my book Principles for Navigating Big Debt Crises there are three types of monetary policy—1) interest-rate-driven monetary policy (which I call Monetary Policy 1 because it is the first to be used and is the preferable way to run monetary policy), 2) printing money and buying financial assets, most importantly bonds (which I call Monetary Policy 2 and is now popularly called “quantitative easing”), and 3) coordination between fiscal policy and monetary policy in which the central government does a lot of debt-financed spending and the central bank buys that debt (which I call Monetary Policy 3 because it is the third and last approach to be used when the first two cease to be effective in doing what needs to be done).  The charts below show how the debt crises of 1933 and 2008 both led to interest rates hitting 0% and were followed by big money printing by the Federal Reserve.  

This shift had big effects and implications.  

The 2008-20 Money-Financed Capitalist Boom Period

In 2008 the debt crisis led to interest rates being lowered until they hit 0%, which led the three main reserve currency countries’ central banks (led by the Fed) to move from an interest-rate-driven monetary policy (MP1) to a printing-of-money- and buying-financial-assets-driven monetary policy (MP2).  Central banks printed money and bought financial assets, which put money in the hands of investors who bought other financial assets, which caused financial asset prices to rise, which was helpful for the economy and particularly beneficial to those who were rich enough to own financial assets, so it increased the wealth gap.  The putting of a lot of money into the financial system and the driving down of bond yields provided companies with a lot of cheap funding that they used to buy back their own stocks and stocks of related companies that they wanted to acquire, which further bid up stock prices.  Basically, borrowed money was essentially free, so investment borrowers and corporate borrowers took advantage of this to get it and use it to make purchases that drove stock prices and corporate profits up.  This money did not trickle down proportionately, so the wealth and income gaps continued to grow.  As shown in the charts below, the wealth and income gaps are now the largest since the 1930-45 period.

In 2016, appealing to those white, socially and economically conservative voters who were hurt by these trends, Donald Trump, a blunt-speaking businessman/capitalist populist of the right, led a revolt against establishment politicians and “elites” to get elected president by promising to support people with conservative values who had lost jobs and were struggling.  He went on to cut corporate taxes and run big budget deficits that the Fed accommodated.  This was good for stocks, capital markets, businesses, and the capitalists who owned them.  While this debt growth financed relatively strong market-economy growth and created some improvements for lower-income earners, it was accompanied by a further widening of the wealth and values gap leading the “have-nots” to become increasingly resentful of the “haves.”   At the same time the political gap grew increasingly extreme with intransigent capitalist Republicans on the one side and intransigent socialist Democrats on the other.  This is reflected in the two charts below.  The first one shows how conservative Republicans in the Senate and House (via the dashed and solid red lines) and how liberal Democrats in the Senate and House (via the dashed and solid blue lines) have become relative to the past.  Based on this measure they have become more extreme, and their divergence has become larger than ever before.  While I’m not sure that’s exactly right, I think it’s by and large right.

The next chart shows the percentage of votes along party lines.  As shown approximately 95% of the votes in the House and the Senate have been along ideological lines as of 2016, the highest level in over a century.  It continues to be reflected in the reduced willingness to cross party lines to compromise and reach agreements.  In other words, the political splits in the country have become deep and intransigent. 

At the same time, as the US dominance and relative wealth decline and rivalries are intensifying in the US under Trump, this more populist and nationalist leader has taken a more aggressive negotiating posture concerning economic and geopolitical disagreements a) with international rivals, particularly China and Iran, and b) with allies such as Europe and Japan regarding trade and paying for military expenditures.  The conflicts with China over trade, technology, geopolitics, and capital are the most important and are intensifying.  Economic sanctions such as those that were used in the 1930-45 period are being used or put on the table for possible use.

Then, in March 2020 after the coronavirus pandemic came along and with it the isolation it necessitated, incomes, employment, and economic activity plunged, the US central government took on a lot of debt to give people and companies a lot of money, and the Federal Reserve printed a lot of money and bought a lot of debt.  So did other central banks.  As a reflection of this the charts below show the unemployment rates and central bank balance sheets of major countries for as far back as data is available.  As shown, all the levels of central bank printing of money and buying of financial assets are near or beyond the previous record amounts in the war years.

As history has shown and as explained in the appendix to Chapter 2, “The Changing Value of Money,” when there is a great increase in money and credit, it drives down the value of money and credit, which drives up the value of other investment assets—much like Nixon’s August 1971 move, which led me to realize that it was the same as Roosevelt’s March 1933 move, which was like Volcker’s August 1982 move, which was like Ben Bernanke’s November 2008 move, which was like Mario Draghi’s July 2012 move, and has become standard operating procedure by central banks that will persist until that approach no longer works.  

That brings us up to now.  

The Post-1945 Story in More Charts and Tables

What follows is a series of charts that show the most important financial and economic shifts over the period that we just covered.  They tell an interesting story of how things have changed.  Before I show you them I’d like to remind you of what the archetypical cycle looks like so you can keep it in mind while reviewing these charts.  

As explained in Chapter 2, “The Big Cycle of Money, Credit, Debt, and Economic Activity,” for all countries—like for all individuals, companies, nonprofit organizations, and local governments—the basic money equation is reflected in a simple income statement of revenue and expenses and a simple balance sheet of assets and liabilities.  When one’s revenue, most importantly from what one sells, is greater than one’s expenditures, there is positive net income, which leads one’s assets to rise relative to one’s liabilities (most importantly debt), which, all else being equal, raises one’s net savings.  When one’s income is less than one spends the reverse happens.

Exports are the main revenue source between countries.  To convey the picture of export earnings, the chart below shows the share of global export sales of the United States, Britain, the Soviet Union/Russia, and China from 1900 until the present.  It shows which countries were and are the biggest export earners.  As you can see, a) US exports soared while British exports plunged in each of the two world wars (which made the US rich), b) British exports fell from about 30% of the total in 1900 to less than 5% today (which made Britain a lot less rich), 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).  

But exports are only half the net-income picture.  It is export earnings minus import spending (i.e., the balance of goods and services) that makes the net income of a country that comes from trading with foreigners.  To convey that picture for the US, the next chart shows US exports of goods and services minus US imports of goods and services since 1900.  As shown the US sold more than it bought until around 1970 and then started to buy more than it sold.

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 chart below shows the net international investment position of the United States as a percent of US GDP.  It conveys that, while the US used to hold more foreign assets than foreigners held US assets, that has strongly reversed.  That is because the US borrowed a lot from the rest of the world and drew down assets.

The charts below show the debt piece—i.e., a) the total debt the United States owes the rest of the world and b) the total debt the United States owes the rest of the world minus the total debt the rest of the world owes the United States.  As shown, while the US had no significant foreign debt at the beginning of this new world order, it now has large foreign debts.  Fortunately for the US (and less fortunately for others), this debt is in US dollars.

As for reserve assets, the charts below show both gold and non-gold reserves for these four major powers since 1900.  

The first set of charts below shows a) the total amount of gold reserves (in volume of gold terms), b) the total value of the gold reserves as a percent of the country’s imports, and c) the total value of gold reserves as a percent of the size of the economy for the US, Britain, the Soviet Union/Russia, and China.  They are meant to convey a picture of how much savings in gold these countries had and have a) in total, b) in relation to their needs to import from abroad, and c) in relation to the size of their economies.  As shown, the United States had enormous gold reserves—approximately 10x those in the UK—and was tremendously rich by these standards in 1945, which came about by its large net earnings previously shown, and the US spent down these gold reserves until 1971 when it was forced to stop redeeming its paper money for gold.  Since then the quantity of US gold reserves has remained virtually unchanged and the value of these reserves has changed with changes in its market price.  As shown below the UK drew down its gold reserves to very low levels, while Russia and China have built theirs up in recent years, though they remain low.

However, gold reserves are not a country’s only reserves, especially lately.  Since central banks hold foreign-currency debt assets (e.g., bonds) as well as gold assets in their reserve savings, the size of their total reserves does a better job of conveying their savings.  The picture of the changes in this measure of relative savings is shown in the charts below.  Note in the charts how enormous the US total reserves were in 1945 (accounting for about 8.5 years of imports) relative to those of other countries and note how enormously the relative sizes of these reserves have shifted since then, especially with the rise in total reserves in China.  Note that China now has the largest foreign-exchange reserve and the US doesn’t have much.  As shown above, the US and the UK have around 70 days of imports in reserves, while for Russia and China that figure is around 700 and 600 days, respectively.  The gap in the chart in the war years period was due to an absence of data during that period.  As explained in Chapter 1, a classic dynamic is that non-reserve-currency countries that want to save naturally want to save in reserve currencies, which results in them lending to the reserve currency country.  That happened with the US and its dollar-denominated debt.  It was especially true in the US-Chinese relationship over the 30-40 years when the Chinese produced goods inexpensively and sold these goods to eager Americans buyers who wanted to pay for them with borrowed money that the Chinese lent them from their export earnings because the Chinese wanted to save in dollars.  As a result of that the Chinese are now holding about $1.1 trillion of US debt, which is about a third of their total reserves though less than 5% of US debt.  Japan holds about $1.2-1.3 trillion of it.  Because these debts are denominated in US dollars the US won’t have a problem paying them back because the US Federal Reserve can print the money and pay them off with depreciated dollars.

At this time, China has the world’s largest reserves.  The United States, while not having large reserves, has the power to print the world’s reserve currency.  The ability to print money and have it accepted by the world, which is an ability that only a major world reserve currency country (especially the United States) has, is the most valuable economic power a country can have.  At the same time, a country that does not have sizable reserves (which is the position the US is in) is highly vulnerable to not having enough “world money.”  That means that the US is now very powerful because it can print the world’s money and would be very vulnerable if it lost its reserve currency status.  

What types of money and credit have been and now are most important?  The chart below shows the percentages of reserve assets that are held in all countries’ reserves combined.  As shown, gold’s share of total reserves has fallen from 65% in 1945 to about 10% today, though devaluation of the dollar and the surge in gold’s price led gold’s share of central bank reserves to be the largest until the early 1990s, after which its share of world reserves declined to only 10%.  The US dollar accounts for over 50% of reserves held and has unwaveringly remained the primary reserve currency since 1945, especially after it replaced gold as the most-held reserve asset after there was a move to a fiat monetary system.  European currencies have remained steady at 20-25% since the late 1970s, the yen and sterling are around 5%, and the Chinese RMB is only 2%, which is far below its share of world trade and world economic size, for reasons we will delve into in the Chinese section of this book.  As has been the case with the Dutch guilder and the British pound, the status of the US dollar has significantly lagged and is significantly greater than other measures of its power.  That means that if the US dollar were to lose its reserve status and significantly depreciate in value it would have a devastating effect on the finances of those countries holding those reserves as well as private-sector holders of dollar-debt assets.  Who would be the winners?  Those with dollar-debt liabilities and those with non-dollar assets would be the big winners.  In the concluding chapter, “The Future,” we will explore what such a shift might look like.

The next chart shows shares of world production for the US, UK, Russia, and China.  It is shown on a purchasing power parity basis, which means after being adjusted for differences in prices of the same items in different countries.  For example, if an item in one country was twice the price of the same item in a different country, it would be counted as twice as much production even though it’s the same thing if counted on a non-purchasing power adjusted basis and it would be counted as the same amount of production if counted on a purchasing power parity basis.  As shown the United States produced many times as much as the other major countries produced in 1945, and though its share declined, it remained much higher than any other country until recently when it was surpassed by China.  In non-purchasing power parity terms China’s output is about 70% of the US output and growing at a significantly faster pace.  Let’s not split hairs over small differences in imprecise measures.  The most important headline is that the United States was the dominant economic producer in 1945 and didn’t have a comparably sized economic competitor anytime in the last 100 years up until recently and now it does in China, which is of comparable size.  China is also growing significantly faster, so if this continues, it will soon be as dominant an economic power as the United States was in 1945.

Where the US Is in Its Big Cycle

I think we know roughly where it is.

As previously explained the Big Cycle of rising and declining empires and their reserve currencies is a cycle that begins with a new world order that comes after a war in which a) there is an environment of peace, prosperity, and productivity in which debt growth is allocated well and sustainably (i.e., most debts are used productively to produce incomes that are greater than debt service so most debts are paid back), equities do well, and the society gets rich with individuals benefiting from the prosperity, though they benefit disproportionately, which eventually leads to b) excessive debt growth to finance speculation and over-consumption, which results in incomes being inadequate to service the debt, which leads to c) central banks lowering interest rates and providing more credit, which produces greater wealth gaps and more over-indebtedness, until d) over-indebtedness becomes so large and central banks lose their ability to create credit growth that produces self-funding debt growth (i.e., in which debts don’t accelerate relative to the incomes needed to service them without central bank subsidies), which e) produces severe economic downturns with large wealth gaps that lead to internal conflict and leads to f) lots of printing of money, big debt restructurings, and big wealth distributions via tax changes g) that create financial, economic, and political vulnerabilities for the leading power relative to emerging powers that lead to wars that define the winners and losers and produce the new world order.  

The stats seem to suggest that the US is roughly 75% through that cycle, +/- 10%. 

Is it reversible?  

Most world powers that experience this cycle have their “time in the sun,” which is brought about by the uniqueness of their circumstances and the nature of their character and culture (i.e., they have to have the essential elements to work hard and smart, be disciplined, become educated, etc.) and have their decline phases continue through them slipping into relative obscurity.  Some do this decline traumatically, and some do it gracefully.  

From studying history we can see that reversing a declining power is very difficult because that requires undoing a lot that has already been done.  For example, bringing one’s finances to the point that one’s spending is greater than one’s earnings and one’s assets are greater than one’s liabilities can only be reversed by either working harder or consuming less, which is not easily done.    

Still, this cycle needn’t transpire this way if those in their rich and powerful stages stay productive and safe by continuing to work hard and smart, earn more than they spend, save a lot, and make the system work well for most of the population.  A number of empires and dynasties have sustained themselves for hundreds of years and the United States, at 244 years old, has proven itself to be one of the most durable now in existence.  I think the most important question is how we adapt and change by asking ourselves and honestly answering some difficult questions.  For example, while the capitalist profit-making system allocates resources relatively efficiently, we now need to ask ourselves, “Who is it optimizing these efficiencies for?” and “What should be done if the benefits are not broad-based?”  “Will we modify capitalism so that it both increases the size of the pie (by increasing productivity) and divides it well?” These questions are especially important to answer in an era when the greatest efficiencies can be gained by technologies replacing people so employing people will increasingly become unprofitable and inefficient, making one uncompetitive.  “Should we, or should we not, invest in people to make them productive even when it’s uneconomic to do so?”   “What if our international competitors choose robots over people so we will be uncompetitive if we choose to employ people rather than robots?”  “Is our democratic/capitalist system capable of asking and answering such important questions and then doing something to handle them well?”  So many more important questions come to mind.  When we think about the future, which we will do in the concluding chapter of this book, we will have to wrestle with these questions and many other difficult ones.  

Disclosures:

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

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

[3] While 1933 to 1951 was the period from the Roosevelt peg break to the Monetary Accord between the Federal Reserve and Treasury, the policy of explicit yield curve control, in which the Federal Reserve controlled the spread between short-term and long-term interest rates, lasted from 1942 to 1947.

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

[5] While I subsequently discovered that the equal opportunity I was afforded wasn’t made available to a lot of people, I learned from all the people around me—so it was a common belief for all of those I knew—that it should be made available to all people regardless of race, creed, color, or gender so programs like the Civil Rights Movement and the War on Poverty were aimed at providing it. Unlike my earlier descriptions of earlier times that were solely based on my research, my descriptions of the post-1960s period comes with vivid memories of what I had contact with.

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

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

[8] Based on data from voteview.com.

[9] Based on data from voteview.com.

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