On Ray Dalio’s Great empires study

Ray Dalio has been for some time now on the camp that touts the inevitability of China’s ascent to superpower status. Given that Dalio is a great thinker, I’m willing to entertain the idea that the USA can lose its hegemony.

Ray Dalio – The Big Cycles Over The Last 500 Years – linkedin.com

In his study of the great empires and their cyclical nature, Dalio clearly pinpoints American’s peak in the late 50s. The Soviet Union for all its might and the fear it caused in the western hemisphere, only managed to be as powerful as 90s Japan. The British peak that had the most expansive empire ever was still significantly weaker than the American peak. Nazi Germany wasn’t even the peak of German power. That was in 1900. Setting aside these detours, what strikes the most in this Dalio’s study is the nose bleeding Chinese ascent and its imminent overtake of the USA.

Ray Dalio – The Big Cycles Over The Last 500 Years – linkedin.com

Dalio uses eight parameters to evaluate an empire’s relative standing from Education to Trade. Now, I don’t intend to replicate his breadth of study. Instead, I intend only to discuss what kind of goals China needs to accomplish in Military and Finance to become the superpower. The other two major criteria would be Domestic politics and Culture, but again I don’t want to write a book here, so I’ll limit myself. I’ll simply add that even if the USA is currently living what seems like extreme political unrest, it has already managed to survive worse and came on top. Today the USA is dealing with the apparent failings of capitalism with Covid and the ongoing shouting about sexism and racism after the despicable George Floyd murder. And yet, let’s not forget that Americans have a turbulent history and they’re still here. We don’t even have to go to the Civil War. In 1970, the National Guard shot unarmed students who were protesting the Vietnam War and the US ignoring Cambodia neutral stance. Imagine for a second that happening today.

When a superpower falls

If the USA were to lose its superpower status, we should have the Soviet Union as an extreme example of how quickly it can vanish in smoke. I argue that the soviets reached their peak in the beginning of the 60s – Dalio thinks it was more like 1975. Yuri Gagarin’s space orbit was in April 12th 1961. Hungary’s uprising was successfully subdued in 1956. Vietnam defeated France in 1954 and was then fighting directly against the Americans with soviet support. The soviet influence and military help was a major driver in the colonial wars for independence in Africa during this time. This soviet influence was pervasive in western left in the 60s. In 1962 the Soviet Union was preparing to install nuclear missiles in Cuba.

About 20 years later, the Soviet Union was in crumbles having already given up on the central planned economy with Perestroika. In 1991, the Soviet Union collapsed. A measly 30 years – or 16 according to Dalio’s peak – had passed since the soviets were winning the race to be the superpower to an implosion and a decade of terrible hardship for the Russians. There are reports linking the mess in Russia in the 90s to the alcohol epidemic that still harms the country.

Can the same happen to America and are we already in the middle of the western Perestroika?

USA king of the hill


Thought experiment

Considering how close the USA operates its military to the borders of these countries, what’s the equivalent in the other way? For example, there are NATO, ie American led, missile systems in Poland and in Romania. The distance from Poland’s missile defence system to mainland Russia – ignoring Kaliningrad – is a measly 800km. For Russia to have the same advanced position in relation to the USA, it’d have to have a missile system in Quebec, Canada. And Russia might even consider itself distant from the American military, when we think about the other great powers. Japan has over 55.000 American soldiers stationed inside its borders. The European Union has over 52.000. The equivalent would be for thousands of Japanese and European soldiers to be stationed in Washington DC. Even China can’t brag. The American navy patrols the Taiwan Strait, only about 40km from China’s mainland. These patrols happen routinely and on special dates, like the 1989 Tiananmen Square pro-democracy protests. The equivalent would be for Chinese patrols in the American Gulf Coast in sight of Americans on the beach in clear days.

If other nations had military positions as close to the USA as the USA has to them.

And that’s all I think is appropriate to discuss about the USA’s military hegemony. Asymmetric wars are a thing, sure, but let’s be real. Military confrontation between great powers is more and more a sustained breath to maintain the young soldiers angry in the right direction. We should all be much more scared that a young excited soldier does something out of boredom than a leader gets us all into MAD.

A case that despite the flamed rhetoric, leaders are aware of their countries’ limitations and don’t want war is Iran – which is a regional power. It now seems like a lifetime ago, but in January we were all scared that a possible nuclear war would happen, when the US killed Iran’s General Suleimani. My guess is that it would be easy for Iran to convince its army that war was necessary then. Yet, that didn’t happen. We are yet to see if Iran’s government was able to show its army that it got revenge. Its authority internally depends upon it.

The Soviet Union didn’t collapse because it was weak militarily. It was much more to do with the financial and economic burden of keeping a modern army.


Reserve currency

While the charts show the countries that produced global reserve currencies, we’ll also heavily reference China, which was a dominant empire for centuries, though it never established a reserve currency.

Ray Dalio – The Big Cycles Over The Last 500 Years – linkedin.com

Dalio clearly indicates a reserve currency as a criteria for an empire and also says that China never established the yuan as such. If a condition to be a superpower is for its currency to become a reserve, then China still seems way off and, what is more, it might not have the incentives to let it happen. A reserve currency can be an exorbitant privilege, but it also comes with downsides. For China these downsides might be too much.

The upside is clear. American current account deficits are preposterous by world standards, but acceptable for itself because it can just print away new dollars and the world accepts them. In exchange, the world sells real goods to the US. This is beneficial for the world, because then it can take these dollars and trade internationally. Additionally, the US budget deficit is financed by the world as a way to park their dollars.

If we lived in a pre-Bretton Woods world, this wouldn’t be so problematic for a superpower contender like China. Then, major currencies were backed by gold and so international trade was also backed by gold. Logically, gold was the reserve currency.

It doesn’t seem likely that we’ll be returning to backed-currencies, but that’s where I think the US can lose its grip on the trophy. As Dalio indicates, every currency ultimately gets devalued to extinction and the dollar has been on the path of devaluation for decades. A sign of that is the surge in gold. Since January 2015 to June 2020, it has been better to buy a dead metal that produces nothing!, than buy into Berkshire Hathaway with all its industrious American companies, wise capital allocation and human ingenuity. 5 years of human progress vs a shiny metal and the metal is winning.

Gold vs S&P500 vs Berkshire Hathaway vs PSI20 (month to month)

There are several initiatives by Russia, China and the European Union to establish an alternate world currency. That’s an ongoing effort since Charles de Gaulle, so I think it’s safe to say that so far the attempts to replace the dollar have been unsuccessful. It’s so bad that when the European Union wanted to take a stance against Trump’s America sabotaging the Iran Nuclear Deal, it only managed to propose a confusing barter system of trade. Even that is being postponed to oblivion and so shielded from US sanctions that it’s almost useless.

Instex, which stands for “instrument for support of trade exchanges”, was registered this week, and will act as a proposed payment channel from Europe to Iran, and vice versa. It will not be fully operational until later this year. Iran will be expected to establish a parallel organisation. If the scheme works, it is likely to be most useful to small- and medium-sized firms with no links in the US.

Europe sets up scheme to get round US sanctions on Iran – Guardian
Triffin dilemma

A reserve currency is so good that becomes bad, and we face the Triffin dilemma. Simply stated, the USA must supply the world with dollars to keep the Bretton Wood’s monetary system operating. This supply comes from a current account deficit in the USA’s budget, ie a deficit to the world, but at the same time it must project an image of fiscal responsibility to gain the world’s confidence in its currency. That’s the dilemma. To feed the world with dollars and lose its trust or be fiscally prudent and lose the reserve status. Let’s not forget that a current account deficit is a tremendous social and political domestic destabilizer as we are witnessing in the USA.

For a country, a current account deficit usually means that huge swaths of workers are deemed too expensive and the goods they would produce are instead imported. Given the tacit agreement in China that the CCP is tolerated as long as people continue to prosper economically, it’s a high gamble to let its citizens import and thus create unemployment. The CCP really likes things to be stable.

Current account China vs USA – link

China has been building its industry for decades and now deals with overcapacity in many of its state firms, like steel, shipyards, coal, etc. There’s bloat in employment, ie employment for the sake of appeasing the population. China’s way out of the Great Financial Crisis was to make big public investments in infra-structure to keep its state firms busy. This came with an enormous buildup of debt and the consequences are still to be fully felt.

China’s Great Wall of Debt, Dinny McMahon, 2018

In his book China’s Great Wall of Debt, Dinny McMahon, makes a nice case for why China is already with big problems internally. To increase it with the burden of being the consumer of the world to take down the dollar is improbable. In 2016, China GDP per capita was $8.000. It is still very far from being a rich nation. On top of that, its population is growing old fast and now the problem seems to be that China gets old before getting rich, keeping itself permanently in the middle income trap.

One interesting step for China was the recent agreement with Saudi Arabia to trade oil in yuan instead of dollars. Still, if the world doesn’t get excess yuan from trade, then it won’t be the reserve currency.

Yuan being the reserve currency is less likely than the demise of the dollar and the emergence of a neutral international currency.

Impossible trinity

Still on the importance of a reserve currency to become a superpower, China needs to confront the Impossible trinity.

Impossible trinity – link

A country can have two of these three at most:

  • Free capital flow
  • Fixed exchange rate
  • Sovereign monetary policy

Basically, China is opting for option C, which means capital controls. This also excludes the yuan from being used to trade internationally. The economic and social cost of letting capital flow freely is not pain free for China. If capital is allowed to move about and then comes a crisis, China will be left with the emerging market curse of seeing capital fleeing in the worst time. And right now we’re witnessing what seems to be THE crisis of all crisis with covid.

The USA can just ignores this trinity and let things go. It has free capital flow and a sovereign monetary policy, not even caring about a fixed exchange rate. That’s the thing, if you have a reserve currency, why exchange it?

Capital wars

Capital deepening and the infinite supply of cheap labor

Capital deepening is the tendency for capital per worker to increase, which results in a productivity increase. If you get a second monitor at work, that’s capital deepening in the expectation that you become more productive. This is also true for countries. In order to become more productive and hence to grow its economy, capital must be deepened.

China’s great advantage was the almost infinite supply of cheap labour. These were the days when foreign companies set up huge factories in China and just let its cheap labour pay for itself. The product would then be exported. Ironically, Hong Kong and Taiwan were two of the biggest foreign direct investment (FDI) sources in the early years of China’s economic rise.

In the early years of the reform era, FDI into China was mostly dominated by such export-oriented investment. That export-oriented FDI came mainly from other Asian economies that had pursued export-led growth but whose domestic labor had become too costly to compete with Chinese labor. In particular, Hong Kong and Taiwan, with their geographical proximity and cultural ties to China, became the prime source of such FDI inflows. In 1992, combined FDI from Hong Kong and Taiwan accounted about 78 percent of total inward FDI, with Hong Kong alone accounting for 68.2 percent.

China’s approach to capital flows since 1978 – Congressional Budget Office – link

As a consequence of a rising economy, China’s labour became more expensive. There’s still a big inflow of rural workers that are willing to sell their labour cheaply in the factories, but the great urbanization is mostly done. To keep these more expensive workers productive, more capital must be invested to produce goods that have more value.

Socially this is a big reason for apprehension about China’s chances of becoming the superpower. Can China succeed in maintaining social stability in a society where there are more productive workers able to get the benefits of increased capital investment and still many are labouring for almost nothing?

Capital’s best buddy – where does all this capital come from?

Could China self-finance? Well, maybe it could, given that the Chinese are savers. However, the banking system serves to give loans below market price to state firms, in effect subsidizing them. This is obviously detrimental for savers who get low interest on their savings. Such a situation leads to over-investment in housing to get a capital return. In turn, that has been driving the housing market in China to pocket bubbles not just in Tier 1 cities but also down the ranking.

The need in credit is more needed in the Chinese SME, which are ignored by Chinese banks as too risky and too un’state firm’.

In addition to low labor costs and the potential of a large market, some researchers suggest that the sharp rise in China’s FDI inflows over the past decade may also have reflected deficiencies in China’s domestic capital markets. Private firms in China have little access to external financing because most funds are funneled to state-owned enterprises. In particular, private firms have faced discrimination relative to state-owned enterprises, both from the banking system (in terms of loan decisions by state-owned banks) and the equity market (in terms of approval of stock listings.)

China’s approach to capital flows since 1978 – Congressional Budget Office – link

This need for capital is not just financial but also technical. Domestic savers, even if Chinese banks funneled their deposits to SME, can’t supply this technical capital. FDI can.

If Chinese workers are now too expensive for export products, and capital through automation is already on a level of needing less cheap labor, then why invest in China? Obviously the answer is the Chinese consumer market. With this bait, China has been able to get foreign capital to invest domestically.

Since the mid-1990s, however, the fact that Chinese consumers have grown wealthier has made the enormous market potential of China an increasingly important factor in attracting FDI. Thus, direct investments from North America and Western Europe, which are heavily tilted to horizontal investments (i.e., investments whose products are intended to service the Chinese domestic market), have grown more sizable.

China’s approach to capital flows since 1978 – Congressional Budget Office – link

This capital investment with the Chinese consumer in mind has however some problems. For China to keep this inflow of capital, it seems only logical that it must stop favoring its own champions against these foreign companies. That means letting the state firms consolidate to be able to compete. It should also let foreign capitalist companies do what they need to do: produce ever more efficiently and allocate profits. That means a private sector with jobs less secure and private profit rising immensely. Even with this promise of bounty, capital still favors the US much more than China. The S&P500 now has a PE of 22 (July 2020), which implies a nominal return of 4,5% and a real return of about 2,5%. Such a paltry return means that capital still goes to the US, despite the promise of the Chinese consumer. China would need a major change of mindset of world investors to get this capital. As Dalio points out, great empires fall when capital flees. That happened to the Netherlands and to Britain.

All this to say…

…that I’m looking forward for Ray Dalio’s next chapters where he’ll explain how China will overtake the USA. I’m sure I’m missing something.


Ray Dalio – The Big Cycles Over The Last 500 Years – linkedin.com

China’s Great Wall of Debt, Dinny McMahon, 2018

Lyn Alden – https://www.lynalden.com/trade-deficit/

China’s approach to capital flows since 1978 – Congressional Budget Office – link


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