Money, Debt, Cycles, and the Historical Reasons for the Upcoming Dollar Erosion

The dollar - still a global reserve currency

1) Remember Gordon Gekko? Right, the outrageous, unrestrained, insatiable corporate-finance shark from Oliver Stone’s 1987 movie Wall Street. This guy, played by Michael Douglas, was manipulative, greedy and tough, enough so as to get up before sunrise and call up his young would-be partner to remind him that “money never sleeps.”

While immoral in his financial behavior, Gekko was one hundred percent right about how money works. It never rests, it always flows, from one place to another. Like the blood in the human body it ensures that the world economic system receives its “oxygen.” Like it or not, money makes exchange easy and offers a handy way to store wealth.

2) In his recent analysis of the changing world order, Ray Dalio has reflected on money, debt, and capital market cycles throughout history. From his point of view, cyclical development is typical of most areas of life. In other words, things that happened in the past will probably occur again in the future. Speaking of economy, this means that we can learn about the crises to come by studying the disasters of the past.

Ray Dalio is of course not the first to notice that there is such a thing as economic cycles. Though he doesn’t mention any economist in particular, it’s very likely that his ideas are based not only on his vast experience as an investor, but also draw on research carried out by scholars such as Irving Fisher, John Maynard Keynes, and Joseph Schumpeter, who studied the dynamics of debt, economic growth, and technological innovation.

What makes Ray Dalio’s outlook so special is the fact that he is not a scholar, but a hedge fund manager who analyzes long-term money and debt cycles in order to come to practical conclusions that could help him with his investments.

3) The examples Ray Dalio uses are related to the development of capitalism in the North Atlantic area beginning in the 17th century. One of his main concerns is the fate of three major reserve currencies, the Dutch guilder, the British pound, and the US dollar.

Looking at what happened to the guilder and the pound, which used to be widely accepted around the world for transactions and savings, and then lost their importance, he comes to the conclusion that the US dollar might be going the same way in the future—with profound implications for global capital markets.

Another of his historical comparisons has to do with the dramatic changes in monetary policy of the Federal Reserve that occurred in March 1933 under Franklin D. Roosevelt and in August 1971 under Richard Nixon. By defaulting on the government’s promise that people could turn in their money for gold, both presidents were able to ease the pressure on the US economy. As a consequence, the dollar lost part of its value, while the stock market soared.

Looking at these examples, Ray Dalio suggests that the recession of 2008 (and possibly that of 2020) has essentially obeyed the same mechanics. But is he right?

4) As you might have figured, the answer is yes and no at the same time. Ray Dalio certainly has a point when he talks about similarities in short-term consequences of the dollar devaluation. If the value of money is decreasing, people tend to look for other assets, be it securities or real estate. It’s also true that the discussed decisions of the US government had some positive effect on economic growth.

What Ray Dalio’s analysis fails to take into account are the differences between the situations he reflects upon. There are quite a lot of them. Here are just a few examples.

– As opposed to 1971 and 2008, the US dollar was not a global reserve currency in 1933.

– Roosevelt had to face the challenge of more than three years of harsh economic depression and aimed to fight deflation. Nixon, on the other hand, wanted to counter inflation, and secure America’s exorbitant privilege of controlling the world’s major reserve currency.

– In 2008 governments throughout the world acted very quickly to prevent the Great Depression scenario. The measures taken to provide cheap money and credit and support the economy seemed to help in the short run. But what about further consequences?

5) This is a point where Ray Dalio’s analysis doesn’t go far enough. If you look at the medium-term repercussions of government policies in 1933, 1971 and 2008, you’ll see that they were not the same.

In 1933, the government-induced dollar devaluation was part of a much bigger package of measures that created a whole new framework for the US economy, several parts of which are still effective. Even more important, six years later World War II started, the economy changed even stronger, and in 1945, after the war ended, the world economic system underwent a radical change.

The so-called Nixon shock in 1971 was a good deal for the president, who was re-elected with a vast majority one year later. But economically speaking, the 1970s are remembered as a time of high unemployment and uncontrolled inflation, partially caused by the 1973 oil crisis. Then Paul Volcker became the Federal Reserve chairman and raised the interest rates to 20 percent to curb inflation. And at some point in the 1980s Reagonomics began.

Finally, in 2008 the Federal Reserve, the European Central Bank, and the Bank of Japan drove interest rates under any imaginable threshold and kept buying government debt until they were up to their ears in it. It seemed to work. For more than a decade the economy was growing, start-ups run by 20-year-old college dropouts were raising cheap money, Donald Trump was about to be re-elected. Then the COVID-19 pandemic came along and all went down the drain.

6) In other words, the medium-term implications of government policies applied in 1933, 1971, and 2008 don’t have much in common. As I mentioned in a previous post, the number of factors that influence the outcome of any given historical situation is very high. And so, there’s little wonder that the results were different.

Ray Dalio’s point is that the long-term analysis of money and debt cycles enables him to anticipate the direction in which the economy will go. He actually claims that this perspective allowed his company to weather the storm in 2008.

If you look at their numbers, he must be right (though it worked much less for them during the pandemic). My point, however, is that knowing the overall direction might not be enough. Neither is focusing on money and debt. In our current economy capital markets are probably the single most important driver. But you also have to look at manufacturing cycles, disruptive technology, the environment, the demographics, the pandemics and, yes, the big politics.

To be sure, I’m not in the least as knowledgeable in financial investments as Ray Dalio. I suppose that even though his analysis of long-term economic patterns isn’t 100 percent accurate, it’s fair enough for a good bet on the stock market or wherever else he decides to put his money into. After all, that’s what a hedge fund manager is supposed to know how to do.

Ray Dalio’s recipe for these turbulent times is diversification. I guess he’s right, though history can always surprise us.

7) Last but not least, there is his prediction about the impending demise of the US dollar as the world’s most important reserve currency. In this case, the question is not whether it will happen, but rather how and when. Some people at the International Monetary Fund suggest that a “stealth erosion of dollar dominance” has already started.

In the 17th century, the Dutch guilder was pushed aside after a series of lost wars. The British won both World Wars in the 20th century, but were too depleted to hold up the pound’s paramount position in the global capital market. What will it take to keep the US dollar where it is after all the upheaval in international politics in 2022?

While you muse on it, you might be interested to have a look at what one of the “Founding Fathers” of the long-term economic analysis Nikolai Kondratiev had to say about cycles.

And don’t forget: Money never sleeps, pal.

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