Economic Cycles

How the economic machine works, in 30 minutes. The economy works like a simple machine. But many people don't understand it — or they don't agree on how it works — and this has led to a lot of needless economic suffering.

I feel a deep sense of responsibility to share my simple but practical economic template. Though it's unconventional, it has helped me to anticipate and sidestep the global financial crisis, and has worked well for me for over 30 years. Let's begin. Though the economy might seem complex, it works in a simple, mechanical way. It's made up of a few simple parts and a lot of simple transactions that are repeated over and over again a zillion times.

These transactions are above all else driven by human nature, and they create 3 main forces that drive the economy. Number 1: Productivity growth Number 2: The Short term debt cycle and Number 3: The Long term debt cycle We'll look at these three forces and how laying them on top of each other creates a good template for tracking economic movements and figuring out what's happening now. Let's start with the simplest part of the economy: Transactions.

An economy is simply the sum of the transactions that make it up and a transaction is a very simple thing. You make transactions all the time. Every time you buy something you create a transaction. Each transaction consists of a buyer exchanging money or credit with a seller for goods, services or financial assets. Credit spends just like money, so adding together the money spent and the amount of credit spent, you can know the total spending.

The total amount of spending drives the economy. If you divide the amount spent by the quantity sold, you get the price. And that's it. That's a transaction. It is the building block of the economic machine. All cycles and all forces in an economy are driven by transactions. So, if we can understand transactions, we can understand the whole economy. A market consists of all the buyers and all the sellers making transactions for the same thing.

For example, there is a wheat market, a car market, a stock market and markets for millions of things. An economy consists of all of the transactions in all of its markets. If you add up the total spending and the total quantity sold in all of the markets, you have everything you need to know to understand the economy. It's just that simple. People, businesses, banks and governments all engage in transactions the way I just described: exchanging money and credit for goods, services and financial assets.

The biggest buyer and seller is the government, which consists of two important parts: a Central Government that collects taxes and spends money... ...and a Central Bank, which is different from other buyers and sellers because it controls the amount of money and credit in the economy. It does this by influencing interest rates and printing new money. For these reasons, as we'll see, the Central Bank is an important player in the flow of Credit.

I want you to pay attention to credit. Credit is the most important part of the economy, and probably the least understood. It is the most important part because it is the biggest and most volatile part. Just like buyers and sellers go to the market to make transactions, so do lenders and borrowers. Lenders usually want to make their money into more money and borrowers usually want to buy something they can't afford, like a house or car or they want to invest in something like starting a business.

Credit can help both lenders and borrowers get what they want. Borrowers promise to repay the amount they borrow, called the principal, plus an additional amount, called interest. When interest rates are high, there is less borrowing because it's expensive. When interest rates are low, borrowing increases because it's cheaper. When borrowers promise to repay and lenders believe them, credit is created. Any two people can agree to create credit out of thin air!

That seems simple enough but credit is tricky because it has different names. As soon as credit is created, it immediately turns into debt. Debt is both an asset to the lender, and a liability to the borrower. In the future, when the borrower repays the loan, plus interest, the asset and liability disappear and the transaction is settled. So, why is credit so important? Because when a borrower receives credit, he is able to increase his spending.

And remember, spending drives the economy. This is because one person's spending is another person's income. Think about it, every dollar you spend, someone else earns. and every dollar you earn, someone else has spent. So when you spend more, someone else earns more. When someone's income rises it makes lenders more willing to lend him money because now he's more worthy of credit. A creditworthy borrower has two things: the ability to repay and collateral.

Having a lot of income in relation to his debt gives him the ability to repay. In the event that he can't repay, he has valuable assets to use as collateral that can be sold. This makes lenders feel comfortable lending him money. So increased income allows increased borrowing which allows increased spending. And since one person's spending is another person's income, this leads to more increased borrowing and so on.

This self-reinforcing pattern leads to economic growth and is why we have Cycles. In a transaction, you have to give something in order to get something and how much you get depends on how much you produce over time we learned and that accumulated knowledge raises are living standards we call this productivity growth those who were invented and hard-working raise their productivity and their living standards faster than those who are complacent and lazy, but that isn't necessarily true over the short run.

Productivity matters most in the long run, but credit matters most in the short run. This is because productivity growth doesn't fluctuate much, so it's not a big driver of economic swings. Debt is — because it allows us to consume more than we produce when we acquire it and it forces us to consume less than we produce when we pay it back. Debt swings occur in two big cycles. One takes about 5 to 8 years and the other takes about 75 to 100 years.

While most people feel the swings, they typically don't see them as cycles because they see them too up close -- day by day, week by week. In this chapter we are going to step back and look at these three big forces and how they interact to make up our experiences. As mentioned, swings around the line are not due to how much innovation or hard work there is, they're primarily due to how much credit there is. Let's for a second imagine an economy without credit.

In this economy, the only way I can increase my spending is to increase my income, which requires me to be more productive and do more work. Increased productivity is the only way for growth. Since my spending is another person's income, the economy grows every time I or anyone else is more productive. If we follow the transactions and play this out, we see a progression like the productivity growth line. But because we borrow, we have cycles.

This isn't due to any laws or regulation, it's due to human nature and the way that credit works. Think of borrowing as simply a way of pulling spending forward. In order to buy something you can't afford, you need to spend more than you make. To do this, you essentially need to borrow from your future self. In doing so you create a time in the future that you need to spend less than you make in order to pay it back.

It very quickly resembles a cycle. Basically, anytime you borrow you create a cycle.? This is as true for an individual as it is for the economy. This is why understanding credit is so important because it sets into motion a mechanical, predictable series of events that will happen in the future. This makes credit different from money. Money is what you settle transactions with. When you buy a beer from a bartender with cash, the transaction is settled immediately.

But when you buy a beer with credit, it's like starting a bar tab. You're saying you promise to pay in the future. Together you and the bartender create an asset and a liability. You just created credit. Out of thin air. It's not until you pay the bar tab later that the asset and liability disappear, the debt goes away and the transaction is settled. The reality is that most of what people call money is actually credit.

The total amount of credit in the United States is about $50 trillion and the total amount of money is only about $3 trillion. Remember, in an economy without credit: the only way to increase your spending is to produce more. But in an economy with credit, you can also increase your spending by borrowing. As a result, an economy with credit has more spending and allows incomes to rise faster than productivity over the short run, but not over the long run.

Now, don't get me wrong, credit isn't necessarily something bad that just causes cycles. It's bad when it finances over-consumption that can't be paid back. However, it's good when it efficiently allocates resources and produces income so you can pay back the debt. For example, if you borrow money to buy a big TV, it doesn't generate income for you to pay back the debt. But, if you borrow money to buy a tractor — and that tractor let's you harvest more crops and earn more money — then, you can pay back your debt and improve your living standards.

In an economy with credit, we can follow the transactions and see how credit creates growth. Let me give you an example: Suppose you earn $100,000 a year and have no debt. You are creditworthy enough to borrow $10,000 dollars - say on a credit card - so you can spend $110,000 dollars even though you only earn $100,000 dollars. Since your spending is another person's income, someone is earning $110,000 dollars. The person earning $110,000 dollars with no debt can borrow $11,000 dollars, so he can spend $121,000 dollars even though he has only earned $110,000 dollars.

His spending is another person's income and by following the transactions we can begin to see how this process works in a self-reinforcing pattern. But remember, borrowing creates cycles and if the cycle goes up, it eventually needs to come down. This leads us into the Short Term Debt Cycle. As economic activity increases, we see an expansion - the first phase of the short term debt cycle. Spending continues to increase and prices start to rise.

This happens because the increase in spending is fueled by credit - which can be created instantly out of thin air. When the amount of spending and incomes grow faster than the production of goods: prices rise. When prices rise, we call this inflation. The Central Bank doesn't want too much inflation because it causes problems. Seeing prices rise, it raises interest rates. With higher interest rates, fewer people can afford to borrow money.

And the cost of existing debts rises. Think about this as the monthly payments on your credit card going up. Because people borrow less and have higher debt repayments, they have less money leftover to spend, so spending slows ...and since one person's spending is another person's income, incomes drop...and so on and so forth. When people spend less, prices go down. We call this deflation.

Economic activity decreases and we have a recession. If the recession becomes too severe and inflation is no longer a problem, the central bank will lower interest rates to cause everything to pick up again. With low interest rates, debt repayments are reduced and borrowing and spending pick up and we see another expansion. As you can see, the economy works like a machine. In the short term debt cycle, spending is constrained only by the willingness of lenders and borrowers to provide and receive credit.

When credit is easily available, there's an economic expansion. When credit isn't easily available, there's a recession. And note that this cycle is controlled primarily by the central bank. The short term debt cycle typically lasts 5 - 8 years and happens over and over again for decades. But notice that the bottom and top of each cycle finish with more growth than the previous cycle and with more debt. Why? Because people push it — they have an inclination to borrow and spend more instead of paying back debt.

It's human nature. Because of this, over long periods of time, debts rise faster than incomes creating the Long Term Debt Cycle. Despite people becoming more indebted, lenders even more freely extend credit. Why? Because everybody thinks things are going great! People are just focusing on what's been happening lately. And what has been happening lately? Incomes have been rising! Asset values are going up! The stock market roars!

It's a boom! It pays to buy goods, services, and financial assets with borrowed money! When people do a lot of that, we call it a bubble. So even though debts have been growing, incomes have been growing nearly as fast to offset them. Let's call the ratio of debt-to-income the debt burden. So long as incomes continue to rise, the debt burden stays manageable. At the same time asset values soar. People borrow huge amounts of money to buy assets as investments causing their prices to rise even higher.

People feel wealthy. So even with the accumulation of lots of debt, rising incomes and asset values help borrowers remain creditworthy for a long time. But this obviously can not continue forever. And it doesn't. Over decades, debt burdens slowly increase creating larger and larger debt repayments. At some point, debt repayments start growing faster than incomes forcing people to cut back on their spending. And since one person's spending is another person's income, incomes begin to go down... ...which makes people less creditworthy causing borrowing to go down.

Debt repayments continue to rise which makes spending drop even further... ...and the cycle reverses itself. This is the long term debt peak. Debt burdens have simply become too big. For the United States, Europe and much of the rest of the world this happened in 2008. It happened for the same reason it happened in Japan in 1989 and in the United States back in 1929. Now the economy begins Deleveraging.

In a deleveraging; people cut spending, incomes fall, credit disappears, assets prices drop, banks get squeezed, the stock market crashes, social tensions rise and the whole thing starts to feed on itself the other way. As incomes fall and debt repayments rise, borrowers get squeezed. No longer creditworthy, credit dries up and borrowers can no longer borrow enough money to make their debt repayments. Scrambling to fill this hole, borrowers are forced to sell assets.

The rush to sell assets floods the market This is when the stock market collapses, the real estate market tanks and banks get into trouble. As asset prices drop, the value of the collateral borrowers can put up drops. This makes borrowers even less creditworthy. People feel poor. Credit rapidly disappears. Less spending › less income › less wealth › less credit › less borrowing and so on. It's a vicious cycle. This appears similar to a recession but the difference here is that interest rates can't be lowered to save the day.

In a recession, lowering interest rates works to stimulate the borrowing. However, in a deleveraging, lowering interest rates doesn't work because interest rates are already low and soon hit 0% - so the stimulation ends. Interest rates in the United States hit 0% during the deleveraging of the 1930s and again in 2008. The difference between a recession and a deleveraging is that in a deleveraging borrowers' debt burdens have simply gotten too big and can't be relieved by lowering interest rates.

Lenders realize that debts have become too large to ever be fully paid back. Borrowers have lost their ability to repay and their collateral has lost value. They feel crippled by the debt - they don't even want more! Lenders stop lending. Borrowers stop borrowing. Think of the economy as being not-creditworthy, just like an individual. So what do you do about a deleveraging? The problem is debt burdens are too high and they must come down.

There are four ways this can happen. 1. people, businesses, and governments cut their spending. 2. debts are reduced through defaults and restructurings. 3. wealth is redistributed from the 'haves' to the 'have nots'. and finally, 4. the central bank prints new money. These 4 ways have happened in every deleveraging in modern history. Usually, spending is cut first. As we just saw, people, businesses, banks and even governments tighten their belts and cut their spending so that they can pay down their debt.

This is often referred to as austerity. When borrowers stop taking on new debts, and start paying down old debts, you might expect the debt burden to decrease. But the opposite happens! Because spending is cut - and one man's spending is another man's income - it causes incomes to fall. They fall faster than debts are repaid and the debt burden actually gets worse. As we've seen, this cut in spending is deflationary and painful.

Businesses are forced to cut costs... which means less jobs and higher unemployment. This leads to the next step: debts must be reduced! Many borrowers find themselves unable to repay their loans — and a borrower's debts are a lender's assets. When borrowers don't repay the bank, people get nervous that the bank won't be able to repay them so they rush to withdraw their money from the bank. Banks get squeezed and people, businesses and banks default on their debts.

This severe economic contraction is a depression. A big part of a depression is people discovering much of what they thought was their wealth isn't really there. Let's go back to the bar. When you bought a beer and put it on a bar tab, you promised to repay the bartender. Your promise became an asset of the bartender. But if you break your promise - if you don't pay him back and essentially default on your bar tab - then the 'asset' he has isn't really worth anything.

It has basically disappeared. Many lenders don't want their assets to disappear and agree to debt restructuring. Debt restructuring means lenders get paid back less or get paid back over a longer time frame or at a lower interest rate that was first agreed. Somehow a contract is broken in a way that reduces debt. Lenders would rather have a little of something than all of nothing. Even though debt disappears, debt restructuring causes income and asset values to disappear faster, so the debt burden continues to gets worse.

Like cutting spending, debt reduction is also painful and deflationary. All of this impacts the central government because lower incomes and less employment means the government collects fewer taxes. At the same time it needs to increase its spending because unemployment has risen. Many of the unemployed have inadequate savings and need financial support from the government. Additionally, governments create stimulus plans and increase their spending to make up for the decrease in the economy.

Governments' budget deficits explode in a deleveraging because they spend more than they earn in taxes. This is what is happening when you hear about the budget deficit on the news. To fund their deficits, governments need to either raise taxes or borrow money. But with incomes falling and so many unemployed, who is the money going to come from? The rich. Since governments need more money and since wealth is heavily concentrated in the hands of a small percentage of the people, governments naturally raise taxes on the wealthy which facilitates a redistribution of wealth in the economy - from the 'haves' to the 'have nots'.

The 'have-nots,' who are suffering, begin to resent the wealthy 'haves.' The wealthy 'haves,' being squeezed by the weak economy, falling asset prices, higher taxes, begin to resent the 'have nots.' If the depression continues social disorder can break out. Not only do tensions rise within countries, they can rise between countries - especially debtor and creditor countries. This situation can lead to political change that can sometimes be extreme.

In the 1930s, this led to Hitler coming to power, war in Europe, and depression in the United States. Pressure to do something to end the depression increases. Remember, most of what people thought was money was actually credit. So, when credit disappears, people don't have enough money. People are desperate for money and you remember who can print money? The Central Bank can. Having already lowered its interest rates to nearly 0 - it's forced to print money.

Unlike cutting spending, debt reduction, and wealth redistribution, printing money is inflationary and stimulative. Inevitably, the central bank prints new money — out of thin air — and uses it to buy financial assets and government bonds. It happened in the United States during the Great Depression and again in 2008, when the United States' central bank — the Federal Reserve — printed over two trillion dollars. Other central banks around the world that could, printed a lot of money, too.

By buying financial assets with this money, it helps drive up asset prices which makes people more creditworthy. However, this only helps those who own financial assets. You see, the central bank can print money but it can only buy financial assets. The Central Government, on the other hand, can buy goods and services and put money in the hands of the people but it can't print money. So, in order to stimulate the economy, the two must cooperate.

By buying government bonds, the Central Bank essentially lends money to the government, allowing it to run a deficit and increase spending on goods and services through its stimulus programs and unemployment benefits. This increases people's income as well as the government's debt. However, it will lower the economy's total debt burden. This is a very risky time. Policy makers need to balance the four ways that debt burdens come down.

The deflationary ways need to balance with the inflationary ways in order to maintain stability. If balanced correctly, there can be a Beautiful Deleveraging. You see, a deleveraging can be ugly or it can be beautiful. How can a deleveraging be beautiful? Even though a deleveraging is a difficult situation, handling a difficult situation in the best possible way is beautiful. A lot more beautiful than the debt-fueled, unbalanced excesses of the leveraging phase.

In a beautiful deleveraging, debts decline relative to income, real economic growth is positive, and inflation isn't a problem. It is achieved by having the right balance. The right balance requires a certain mix of cutting spending, reducing debt, transferring wealth and printing money so that economic and social stability can be maintained. People ask if printing money will raise inflation. It won't if it offsets falling credit.

Remember, spending is what matters. A dollar of spending paid for with money has the same effect on price as a dollar of spending paid for with credit. By printing money, the Central Bank can make up for the disappearance of credit with an increase in the amount of money. In order to turn things around, the Central Bank needs to not only pump up income growth but get the rate of income growth higher than the rate of interest on the accumulated debt.

So, what do I mean by that? Basically, income needs to grow faster than debt grows. For example: let's assume that a country going through a deleveraging has a debt-to- income ratio of 100%. That means that the amount of debt it has is the same as the amount of income the entire country makes in a year. Now think about the interest rate on that debt, let's say it is 2%. If debt is growing at 2% because of that interest rate and income is only growing at around only 1%, you will never reduce the debt burden.

You need to print enough money to get the rate of income growth above the rate of interest. However, printing money can easily be abused because it's so easy to do and people prefer it to the alternatives. The key is to avoid printing too much money and causing unacceptably high inflation, the way Germany did during its deleveraging in the 1920's. If policymakers achieve the right balance, a deleveraging isn't so dramatic.

Growth is slow but debt burdens go down. That's a beautiful deleveraging. When incomes begin to rise, borrowers begin to appear more creditworthy. And when borrowers appear more creditworthy, lenders begin to lend money again. Debt burdens finally begin to fall. Able to borrow money, people can spend more. Eventually, the economy begins to grow again, leading to the reflation phase of the long term debt cycle. Though the deleveraging process can be horrible if handled badly, if handled well, it will eventually fix the problem.

It takes roughly a decade or more for debt burdens to fall and economic activity to get back to normal - hence the term 'lost decade.' Of course, the economy is a little more complicated than this template suggests. However, laying the short term debt cycle on top of the long term debt cycle and then laying both of them on top of the productivity growth line gives a reasonably good template for seeing where we've been, where we are now and where we are probably headed.

So in summary, there are three rules of thumb that I'd like you to take away from this: First: Don't have debt rise faster than income, because your debt burdens will eventually crush you.

Second: Don't have income rise faster than productivity, because you will eventually become uncompetitive.

And third: Do all that you can to raise your productivity, because, in the long run, that's what matters most. This is simple advice for you and it's simple advice for policy makers. You might be surprised but most people — including most policy makers — don't pay enough attention to this. This template has worked for me and I hope that it'll work for you. Thank you.

(dramatic music) - [Ray Dalio] The changing world order. The times ahead will be radically different from those that we've experienced in our lifetimes, though similar to many times before. How do I know that? Because they always have been. Over my roughly 50 years of global macroeconomic investing, I've learned the hard way that the most important events that surprised me, did so because they never happened in my lifetime.

These painful surprises led me to study the last 500 years of history for similar situations where I saw that they had indeed happened many times before with the ups and the downs of the Dutch, British, and US empires. And every time they did, it was a sign of the changing world order. This study taught me valuable lessons that I'm going to pass along to you here in a distilled form. You can find the comprehensive version in my book, Principles for Dealing with the Changing World Order.

Let me begin with a story that brought me to this point, about how I learned to anticipate the future by studying the past. In 1971, when I was a young clerk on the floor of the New York Stock Exchange, the United States ran out of money and defaulted on its debts. That's right. The US ran out of money. How? Well, back then gold was the money used in transactions between countries. Paper money, like the dollar, was like checks in a checkbook in that it had no value other than it could be exchanged for gold, which was the real money.

At the time, the United States was spending a lot more money than it was earning by writing a lot more of these paper money checks than it had gold in the bank to exchange for them. As people turned these checks into the bank for gold money, the amount of gold in the US started to dwindle. It soon became obvious that the US couldn't keep its promises for all the existing paper money, so people holding dollars rushed to exchange them before the gold ran out.

Recognizing that the US was going to run out of real money, on Sunday evening, August 15th, President Nixon went on television to tell the world that the US was breaking its promise to let people exchange their dollars for gold. Of course, he didn't say it that way. He said it more diplomatically, without making it clear that the United States was defaulting. - [President Nixon] The strength of a nation's currency is based on the strength of that nation's economy.

And the American economy is by far the strongest in the world. Accordingly, I have directed the secretary of the treasury to take the action necessary to defend the dollar against the speculators. I have directed Secretary Connally to suspend temporarily the convertibility of the dollar into gold or other reserve assets, except in amounts and conditions determined to be in the interest of monetary stability and in the best interest of the United States.

- [Ray] I watched in awe realizing that money as we understood it was ending. What a crisis! I expected the stock market to plunge the next day, so I got on the exchange floor early to prepare. When the opening bell rang, pandemonium broke out, but not the kind I expected. The market was up - way up - and went on to rise nearly 25%. That surprised me because I never experienced a currency devaluation before. When I dug into history, I discovered that the exact same thing happened in 1933 and had the exact same effect.

Then, paper dollars were also linked to gold, which the US was running out of because it was spending more paper money checks than it had gold to exchange for them. And President Roosevelt announced on the radio that he would break the country's promise to exchange dollars for gold. - [President Roosevelt] It was then that I issued the proclamation providing for the national bank holiday. And this was the first step in the government's reconstruction of our financial and economic fabrics.

The second step, last Thursday, was the legislation promptly and patriotically passed by the Congress confirming my proclamation and broadening my powers so that it became possible in view of the requirement of time to extend the holiday and lift the ban of that holiday gradually in the days to come. This law also gave authority to develop a program... - [Ray] In both cases, breaking the link to gold allowed the US to continue spending more than it earned simply by printing more paper dollars.

Since there was an increase in the number of dollars without an increase in the country's wealth, the value of each dollar fell. As these new dollars entered the market without a corresponding increase in productivity, they went to buy lots of stocks, gold and commodities, and hence caused their prices to rise. As I studied more history, I saw that the exact same thing happened many, many times before. I saw that since the beginning of time, when governments spent much more than they took in taxes and conditions got bad, they ran out of money and they needed more.

So, they printed more, a lot more, which made its value fall and made the prices of most everything, including stocks, gold and commodities rise. That's when I first learned the principle that when central banks print a lot of money to relieve a crisis, buy stocks, gold and commodities because their value will rise and the value of paper money will fall. This printing of money is also what happened in 2008 to relieve the mortgage-driven debt crisis, and in 2020 to relieve the pandemic-driven economic crisis.

And it almost certainly will happen in the future. So, I suggest that you keep this principle in mind. These experiences gave me another principle, which is, to understand what is coming at you, you need to understand what happened before you. That principle led me to study how the roaring twenties bubble turned into the 1930s depression, which gave me the lessons that allowed me to anticipate and profit from the 2007 bubble turning into the 2008 bust. All these experiences led me to develop an almost instinctual urge to look to the past for similar situations to learn how to handle the future well. Changing orders.

(man whistles) (machine beeping) Over the last few years, three big things that hadn't happened in my lifetime prompted me to do this study. First, countries didn't have enough money to pay their debts, even after lowering interest rates to zero. So their central banks began printing lots of money to do so. Second, big internal conflicts emerged due to growing gaps in wealth and values. This showed up in political populism and polarization between the left, who want to redistribute wealth, and the right, who want to defend those holding the wealth.

And third, increasing external conflict between a rising great power and the leading great power, as is now happening with China and the United States. So, I looked back. I saw that all these had happened together before many times and nearly always led to changing domestic and world orders. The last time this sequence happened was from 1930 to 1945. What exactly is an order? You might ask. It's a governing system for people dealing with each other.

There are internal orders for governing within countries, typically laid out in constitutions. And there is a world order for governing between countries, typically laid out in treaties. Internal orders change at different times than world orders, though whether within or between countries, these orders typically change after wars. Civil wars within countries, international wars between countries. They happen when revolutionary new forces defeat weak old orders.

For example, the US internal order was laid out in the constitution in 1789 after the American Revolution, and it is still operating today, even after the American Civil War. Russia got rid of its old order and established a new one with the Russian revolution in 1917, which ended in 1991 with a relatively bloodless revolution. China began its current internal order in 1949 when the Chinese Communist Party won the civil war.

You get the idea. The current world order commonly called the American world order, formed after the allied victory in World War II when the US emerged as the dominant world power. It was set out in agreements and treaties for how global governance and monetary systems work. In 1944, the new world monetary system was laid out in the Bretton Woods Agreement and established the dollar as the world's leading reserve currency.

A reserve currency is a currency that is commonly accepted around the world, and having one is a key factor in a country becoming the richest and most powerful empire. With a new dominant power and monetary system established, a new world order begins. These changes take place in a timeless and universal cycle that I call the big cycle.

I'll start with a quick overview, then give you a more complete version and then direct you to my book if you want more. As I studied the 10 most powerful empires over the last 500 years and the last three reserve currencies, it took me through the rise and decline of the Dutch empire and the guilder, the British empire and the pound, the rise and early decline in the United States empire and the dollar, and the decline and rise of the Chinese empire and its currencies, as well as the rise and decline of the Spanish, German, French, Indian, Japanese, Russian, and Ottoman empires, along with their significant conflicts as measured in this chart.

To understand China's patterns better, I also studied the rise and fall of Chinese dynasties and their monies back to the year 600. Because looking at all these measures at once can be confusing, I'll focus on the four most important ones, the Dutch, British, US and Chinese. You'll quickly notice the pattern. Now let's simplify the form a bit. As you can see, they transpired in overlapping cycles that lasted about 250 years with 10 to 20 year transition periods between them.

Typically, these two transitions have been periods of great conflict because leading powers don't decline without a fight. So, how am I measuring an empire's power? In this study, I used eight metrics. Each country's measure of total power is derived by averaging them together. They are education, inventiveness and technology development, competitiveness in global markets, economic output, share of world trade, military strength, the power of their financial center for capital markets and the strength of their currency as a reserve currency.

Because these powers are measurable, we can see how strong each country is now, was in the past, and whether they're rising or declining. By examining the sequences from many countries, we can see how a typical cycle transpires. And because the wiggles can be confusing, we can simplify it a bit to focus on the pattern of cause-effect relationships that drive the rise and decline of a typical empire. As you can see, better education typically leads to increased innovation and technology development, and with a lag, the establishment of the currency as a reserve currency.

You can also see that these forces then declined in a similar order, reinforcing each other's decline. Let's now look at the typical sequence of events going on inside a country that produces these rises and declines. In a nutshell, the big cycle typically begins after a major conflict, often a war, establishes the new leading power and the new world order. Because no one wants to challenge this power, a period of peace and prosperity typically follows.

As people get used to this peace and prosperity, they increasingly bet on it continuing. They borrow money to do that, which eventually leads to a financial bubble. The empire's share of trade grows. And when most transactions are conducted in its currency, it becomes a reserve currency, which leads to even more borrowing. At the same time, this increased prosperity distributes wealth unevenly. So the wealth gap typically grows between the rich "haves" and the poor "have-nots".

Eventually, the financial bubble bursts, which leads to the printing of money, an increased internal conflict between the rich and the poor, which leads to some form of revolution to redistribute wealth. This can happen peacefully or as a civil war. While the empire struggles with this internal conflict, its power diminishes relative to external rival powers on the rise. When a new rising power gets strong enough to compete with the dominant power that is having domestic breakdowns, external conflicts, most typically wars, take place.

Out of these internal and external wars come new winners and losers. Then the winners get together to create the new world order. And the cycle begins again. As I looked back, I saw that these cause and effect relationships drove the cycles of rises and declines all the way back to the Roman empire. I saw how the stories of each one of these cycles blended together with others before, during, and after in the same way as each individual story blends with others to make the epic 500 year story that is our collective history.

And like human life cycles, no two are exactly the same, but most are similar. They're driven by logical cause and effect relationships that progress through stages from birth to strength and maturity to weakness and inevitably decline. However, that's like saying a person's life cycle takes 80 years on average without recognizing that many are much shorter and many are longer. While age can be a good indicator of future longevity, a better way is to look at health indicators.

One can do that with empires and their vital signs too. I found that by watching the indicators of power change, I was able to see what stage a country was in, which helped me to anticipate what was likely to come next. Now, I'll take you through the big cycle in more detail. Give me 20 minutes and I'll give you the last 500 years of history and show you the similar patterns across the Dutch, British, US and Chinese empires. 500 years of big cycles.

(wind whooshing) I'm going to describe the typical cycle by dividing it into three phases. The rise, the top, and the decline.

The rise. Successful new orders that rise, both internal and external, are typically started by powerful revolutionary leaders doing four things. First, they win power by gaining more support than the opposition. Second, they consolidate power by converting, weakening, or eliminating the opposition so they don't stand in their way. Third, they establish systems and institutions that make the country work well. And fourth, they pick their successors well, or create systems that do that, because a great empire requires many great leaders over several generations.

At this stage soon after winning the fight, there was typically a period of peace and growing prosperity because the leadership is clearly dominant and has broad support so no one wants to fight it. During this phase, leaders within the country have to design an excellent system to raise the country's wealth and power. First and foremost, to be great they must have strong education, which is not just teaching knowledge and skills, but also strong character, civility and work ethic.

These are typically taught in the family, schools and religious institutions. That provides a healthy respect for rules and laws, order within society, low corruption, and enables them to unite behind a common purpose and work well together. As they do this, they increasingly shift from producing basic products to innovating and inventing new technologies. For example, the Dutch rose to defeat the Habsburg empire and become superbly educated.

They became so inventive that they came up with a quarter of all major inventions in the world. The most important of which was the invention of ships that could travel around the world to collect great riches and the invention of capitalism as we know it today to finance those voyages. They, like all leading empires, enhanced their thinking by being open to the best thinking in the world. As a result, the people in the country become more productive and more competitive in world markets, which shows up in their growing economic output and rising share of world trade.

You can see this happening now as the US and China are roughly comparable in both their economic outputs and their shares of world trade. As countries trade more globally, they must protect their trade routes and their foreign interests from attack. So they develop great military strength. If done well, this virtuous cycle leads to strong income growth, which can be used to finance investments in education, infrastructure, and research and development.

They must also develop systems to incentivize and empower those that have the ability to make or take wealth. In all of these cases, the most successful empires used a capitalist approach to develop productive entrepreneurs. Even China, which is run by the Chinese Communist Party, used a form of this capitalist approach. (cash registers ringing) Deng Xiaoping, when asked about this, said, "It doesn't matter if it's a white cat or a black cat, "as long as it catches mice."

And "it's glorious to be rich." To do this well, they must develop their capital markets. Most importantly, their lending, bond and stock markets. That allows people to convert their savings into investments, to fund invention and development and share in the successes of those who make great things happen. The Dutch created the first publicly listed company, the Dutch East India Company, and the first stock market to fund it, which were integral parts of the system that produced massive wealth and power.

As a natural consequence, the greatest empires developed the world's leading financial centers for attracting and distributing the world's capital. Amsterdam was the world's financial center when the Dutch were preeminent, London when the British were on top, New York is now, and China is quickly developing its financial centers. Most importantly, the capitalists, the governments and the military must work together.

Not only did the Dutch work well together, they were one in the same. The Dutch East India Company was granted a trade monopoly from the government and had its own officially sanctioned military to go out into the global markets to make and take wealth. The British followed with the British East India Company and had a similar coordination of their government, business and military operations. The US Military Industrial Complex followed suit, as does the Chinese system today.

As the country becomes the largest international trading empire, its transactions can be paid with its currency, making it the preferred global medium of exchange, and because their currency is so widely accepted and frequently used, people around the world want to save in it, making it the preferred store hold of wealth. And thus the world's leading reserve currency. The guilder was the world's main reserve currency when the Dutch led world trade.

The pound was when the British led. And the dollar has been since the US led. Naturally, China's currency is increasingly being used as a reserve currency. Having a reserve currency enables the empire to borrow more than other countries. That advantage is huge. Think about it. People all over the world are eager to save and hence lend back their currency to the empire. Countries without a reserve currency don't have that.

And when the empire runs out of its own money, remember the United States in 1971, they can always print more. The exorbitant privilege afforded by the empire's reserve currency leads borrowing to increase and the beginning of a financial bubble. This series of cause and effect relationships, leading to mutually supportive financial, political and military powers, bolstered by the borrowing power of a reserve currency, have gone together since history began to be recorded. All the empires that became the most powerful in the world followed this path to the top.

While in the top phase, most of these strengths are sustained, embedded within the fruits of their success are the seeds of their decline. As a rule, as people in these rich and powerful countries earn more, that makes them more expensive and less competitive relative to people in other countries who are willing to work for less. At the same time, people in other countries naturally copy the methods and technologies of the leading power, which further reduces the leading power's competitiveness.

For example, British ship builders had less expensive workers than Dutch ship builders. So, they hired Dutch designers to design better ships that were built by less expensive British workers, making them more competitive, which led the British to rise and the Dutch to decline. Also, as people become richer, they tend not to work as hard. They enjoy more leisure, pursue the finer and less productive things in life, and at the extreme, become decadent.

Values change from generation to generation during the rise to the top from those who had to fight to achieve wealth and power to those who inherited it. (boy groans) (boy blows raspberry) They're less battle heartened, steeped in luxuries and accustomed to the easy life, which makes them more vulnerable to challenges. The golden era of the Dutch empire (glasses clink) and the Victorian era of the British empire (glasses clink) were such high prosperity periods like this.

As people get used to doing well, they increasingly bet on the good times continuing and borrow money to do that, which grows into the financial bubbles. Naturally, the financial gains come unevenly. So, the wealth gap grows. Wealth gaps are self-reinforcing because rich people use their greater resources to reinforce their powers. For example, they give greater privileges to their children, like better education, and they influence the political system to their advantage.

This causes the gaps in values, politics, and opportunities to grow between the rich "haves" and the poor "have-nots". Those who are less well-off feel the system is unfair, so resentments grow. But as long as the living standards of most people are still rising, these gaps in resentments don't boil over into conflict. Having the world's reserve currency inevitably leads to borrowing excessively and contributes to the country building up large debts with foreign lenders.

While this boosts spending power over the short term, it weakens the country's financial health and weakens the currency over the long-term. In other words, when borrowing and spending are strong, the empire appears very strong, but its finances are in fact being weakened. The borrowing sustains the country's power beyond its fundamentals by financing both domestic over consumption and international military conflicts required to maintain the empire.

Inevitably, the cost of maintaining and defending the empire becomes greater than the revenue it brings in. So having an empire becomes unprofitable. For example, the Dutch empire overextended around the world and fought war after increasingly expensive war with the British and other European powers to protect its territory and trade routes. The British empire similarly became massive, bureaucratic, and lost its competitive advantages as rival powers, particularly Germany, soared, leading to an increasingly expensive arms race and world war.

The US has spent about eight trillion dollars on foreign wars and their consequences since September 11th, and trillions more for other military operations and for supporting military bases in 70 countries, and it still isn't spending enough to support its military competition with China in the area around China. In this cycle, the richer countries eventually get deeper into debt by borrowing from poor countries that save more.

It's one of the early signs of a wealth and power shift. This started in the United States in the 1980s when it had a per capita income 40 times that of China's, and started borrowing from Chinese who wanted to save in dollars because the dollar was the world's reserve currency. Similarly, the British borrowed a lot of money from its much poorer colonies and the Dutch did the same at their top. If the empire begins to run out of new lenders, those holding their currency begin to look to sell and get out rather than to buy, save, lend, and get in, and the strength of the empire begins to decline. The decline.

The decline comes from internal economic weakness together with internal fighting or costly external fighting or both. Typically, the decline comes gradually and then very suddenly. When debts become very large, and there is an economic downturn, and the empire can no longer borrow the money necessary to repay its debts, the financial bubble bursts. This creates great domestic hardships and forces the country to choose between defaulting on its debts or printing a lot of new money.

It always chooses to print a lot of new money. At first gradually, and eventually massively. That devalues the currency and raises inflation. For the Dutch, this was the financial crisis brought about by financial excesses and paying for the Fourth Anglo-Dutch War. Similarly, for the British, it was paying for its financial excesses and its debts from the two world wars. And for the US, it's been three cycles of debt, finance, booms, and busts since the nineties with the central bank stepping in each time with stronger measures.

When the government has problems funding itself, when there are bad economic conditions and living standards for most people are declining, and there are large wealth, values, and political gaps, internal conflict between the rich and the poor, as well as different ethnic, religious, and racial groups greatly increases. This leads to political extremism that shows up as populism of the left or the right. Those of the left seek to redistribute the wealth while those of the right seek to maintain the wealth in the hands of the rich.

Typically during such times, taxes on the rich rise and when the rich fear their wealth and wellbeing will be taken away, they move to places, assets, and currencies they feel safer in. These outflows reduce the empire's tax revenue, which leads to a classic, self-reinforcing, hollowing out process. When the flight of wealth gets bad enough, governments outlaw it. Those seeking to get out begin to panic. These turbulent conditions undermine productivity, which shrinks the economic pie and causes more conflict about how to divide the shrinking resources.

Populist leaders emerge from both sides and pledge to take control and bring about order. That's when democracy is most challenged, because it fails to control the anarchy, and it is when the move to a strong populist leader who will bring order to the chaos is most likely. As conflict within the country escalates, it leads to some form of revolution or civil war to redistribute wealth and force the necessary big changes.

This can be peaceful and maintain the existing order, but it's more often violent and changes the order. For example, the Roosevelt revolution to redistribute wealth was relatively peaceful and maintained the existing internal order, while the French revolution, the Russian revolution, and the Chinese revolution were much more violent and led to new internal orders. This internal conflict makes the empire weak and vulnerable to rising external rivals who, seeing this domestic weakness, are more inclined to mount a challenge.

This raises the risk of great international conflict, especially if the rival has built up a comparable military. Defending one's self and one's empire against rivals requires great military spending, which has to occur as domestic economic conditions are deteriorating and the empire can least afford it. Since there is no viable system for peacefully adjudicating international disputes, these conflicts are typically resolved through tests of power.

As bolder challenges are made, the leading empire is faced with the difficult choice of fighting or retreating. Fighting and losing is the worst outcome, but retreating is bad too as it cedes progress to the rival and signals that the empire is weak to those countries that are considering which side to be on. Poor economic conditions cause more fighting for wealth and power, which inevitably leads to some kind of war.

Wars are terribly costly. At the same time, they produce the tectonic shifts that realign the new orders to the new realities of wealth and power in the world. When those holding the reserve currency and debt of the declining empire lose faith and sell them, that marks the end of its big cycle. Of the roughly 750 currencies that existed since 1700, less than 20% now exist, and all of them have been devalued. For the Dutch, this happened after their defeat in the Fourth Anglo-Dutch War, when they weren't able to repay the massive debts they built up during it.

This led to a run on the bank of Amsterdam and a desperate sell off, forcing massive money printing, which devalued the currency and the empire into irrelevance. For the British, this happened after World War II, when despite their victory, they could not repay the massive debts they borrowed to fund their war effort. This led to a series of money printing, devaluations, and selloffs in the British pound as the US and the dollar emerged dominant and created a new world order.

At the time of this recording, the United States hasn't yet reached this point. While it has massive debt, spends more than it earns and funds this deficit with more borrowing and printing huge amounts of new money, the big sell off in dollars and dollar debt hasn't yet begun. And while there are great internal and external conflicts occurring for all the classic reasons, they've not yet crossed the line to become wars.

Eventually out of these conflicts, whether they're violent or not, come new winners who get together and restructure the losers' debts and political systems and establish the new world order. Then the old cycle and empire ends and the new one begins and they do it all over again. That's a lot of detail I just threw at you to paint a picture of how the typical big cycle transpires. Of course, not all of them transpire exactly this way, but most largely do, so much so that it seems like the stories of rises and declines stay essentially the same and the only things that change are the clothes the characters wear and the technologies they use. So, where are we heading?

The future. Most empires have their time in the sun and inevitably decline. Reversing a decline is difficult because that requires undoing a lot that's already been done, but it's possible. By looking at these indicators, it's pretty easy to see which stage of the big cycle an empire is in, how fit it is, and whether its condition is improving or worsening, which can help one estimate how many years it has left. Still, these estimates aren't precise and the cycle can be extended if those in charge pay attention to their vital signs and improve them.

For example, knowing that a person is 60 years old, how fit they are, whether they smoke or not and a few other basic vital signs, one can estimate the person's longevity. One can do that with empires and their vital signs too. It won't be precise, but it will be broadly indicative and give clear direction on steps to take to increase longevity. It's most often the case that a nation's greatest war is with itself over whether or not it can make the hard decisions needed to sustain success.

As for what we need to do, it comes down to just two things - earn more than we spend, and treat each other well. All other things I mentioned - strong education, inventiveness, being competitive and all the rest - are just ways of getting at these two things. It's easy to measure if we're doing them. So like people who want to get fit, let's get on the program and improve our vitals. Let's do that individually and collectively.

My goal for sharing this picture of how the world works and a few principles for dealing with it well is to help you recognize where we are and the challenges we face, and to make the wise decisions needed to navigate these times well. Since there is a lot more to discuss and we are out of time, you can learn more in my book Principles for Dealing with the Changing World Order. And I look forward to continuing this conversation at economicprinciples.org and on social media. Thank you, and may the force of evolution be with you. (dramatic music)