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How Hegemons Fall

Ray Dalio's five-stage model on the birth and death of empires.

Samuel Lee, 01/14/2014

A version of this article was published in the December 2012 issue of Morningstar ETFInvestor. Download a complimentary copy here.

Warren Buffett once said, "It's never paid to bet against America." The same could have been said for the United Kingdom before World War I or Rome before Commodus' reign. While extrapolating the historical trend line is actually a pretty good prediction strategy, it's not the way to make money. Fortunes are made (or preserved) anticipating big economic shifts, and successful prediction requires good theory. Buffett admits his expertise is not in timing macroeconomic shifts. Ray Dalio's is. And he thinks the United States is an empire in relative decline.

Dalio is probably the best macro investor alive. He has made a fortune anticipating once-in-a-generation shifts, such as the financial crisis, the subsequent bull market in bonds, and the eurozone crisis. His hedge fund Bridgewater Associates is now the world's biggest, and its Daily Observations newsletter is devoured by policymakers and investors alike (your faithful editor included, when he can get his hands on a copy). Most importantly, his reasoning is transparent and sound.

A quality that sets Dalio apart is how he attempts to understand the economic "machine" by studying distant or extreme scenarios, such as the Weimar Republic's hyperinflationary economic implosion and the decline of the British Empire. He's synthesized his research into a five-stage model on the rise and fall of empires. And he thinks the U.S. is in the final stage. The implications are fascinating.

Five Stages of Empire: The Rise, Then Fall
Dalio's model is generational. Each stage lasts about 30 years, progressing when the older generation either dies off or retires, allowing the younger generation to set the country's direction. To understand the U.S.' place in the arc of Dalio's model, let's look at each stage in turn.

Countries in the first stage, called early-stage emerging countries, "are poor and think that they are poor." For most people, staying alive is a struggle. Investment usually comes from abroad. Investors demand high returns on their capital as compensation for the big perceived risks. Foreign investors don't trust these countries to maintain the value of their currencies, so the countries peg them to gold or a reserve currency, or even adopt another country's currency wholesale. Much of Africa and parts of Asia and Latin America are in this stage and have been stuck there for decades.

Countries in the second stage, called emerging countries, "are getting rich quickly but still think they are poor." Productivity and income soar, but savings remain high and work hours long because people remember what it was like to be poor. They export more goods than they import and they undervalue their currencies to keep exports cheap. However, the currency peg keeps interest rates too low. As a consequence, debt/income and inflation rise. A country in this stage must eventually break the peg. When a big country goes through this stage, it typically becomes a world power. China is undergoing this transition.

Countries in the third stage, called early-state developed countries, "are rich and think of themselves as rich." Their per-capita incomes are among the highest in the world, and their priorities change to "savoring the fruits of life." They are seen as safe-haven investments. This describes the British Empire during the 19th century and the U.S. after World War II. These countries tend to have big armies to expand and defend their global empires.

Samuel Lee is an ETF Analyst with Morningstar.

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