How Hegemons Fall

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.

Countries in the fourth stage, called late-stage developed countries, are becoming "poorer and still think of themselves as rich." In this stage, debt/income rises in a self-reinforcing cycle. Debt stimulates income and asset price growth, which in turn stimulates even more debt. However, research and development and capital spending decrease; budget and trade deficits increase. Infrastructure is old and less well-maintained. In other words, late-stage developed countries eat the seed corn, setting themselves up for slower growth. In the last few years of this stage, bubbles are frequent because investors extrapolate from recent trends. This stage ends when debt/income can no longer rise; incomes can no longer support bigger debt service.

In the final stage, "countries go through deleveraging and relative decline, which they are slow to accept." The self-reinforcing debt cycle now kicks in reverse: Private actors begin paying down or defaulting on their debts, leading to falling income and asset prices, encouraging more defaults and faster debt repayments. The first phase is dominated by defaults, what Bridgewater calls an "ugly deleveraging." Stocks do terribly; safe-haven bonds soar. Depending on how much monetary and fiscal stimulus is applied, the deleveraging can transition to a "beautiful" phase, where debt monetization, austerity, defaults and wealth transfers from the haves to have-nots are well-balanced. Typically, governments run deficits to make up the slack; central banks slash interest rates to both stimulate the economy and ease the burden of debt service.

How We Got Poorer
It's clear the U.S. from at least 1980 to 2007 was in stage four. Look at our total debt/GDP over time. Since 1980, it rose in two steep jags: first, in the mid-1980s, when the government deregulated financial markets and ran massive deficits and the Federal Reserve began lowering interest rates to bring us out of the Volcker recession; and second, in the 2000s, when the Fed once again aggressively lowered interest rates to prop up the post-dot-com-bubble economy, and the government once again ran massive deficits.

Debt is not bad when productively invested. But that's not what we did. We ate the seed corn. We didn't feel the need to save as much because our stock portfolios and houses were rising. Personal savings hit a post-World War II low at the peak of the housing bubble.

The massive amount of debt the U.S. economy is laboring under will likely take decades to pay off. With more resources going back to paying off creditors, growth will be slower than it otherwise would have been. PIMCO calls it the "New Normal." Dalio calls it a "deleveraging process." Economists call it a "balance-sheet recession."

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Twilight
Dalio's model predicts a decades-long period of relative decline for the U.S. as it deleverages and the eventual graduation of China and other emerging markets from stage three to stage four. Because the U.S. is so rich and China is so big, chances are China will not catch up to the U.S.' average income during this process. The U.S. is not going to turn into a banana republic, either.

The deleveraging phase can be quite graceful, in fact. The U.K. was even more indebted after World War II than the U.S. is today. The British borrowed massively to fund nonproductive (but necessary) goods: guns, boats, tanks, and airplanes to fight the Nazis with. Its total debt/income ratio reached over 400%. How did they pay everything back? They didn't. The U.K. devalued its currency, suppressed real interest rates, and let inflation run a bit. It didn't liquidate its debt with a hyperinflationary bang, but rather let economic growth outpace debt growth over several decades.

I expect the same from the U.S. Not a big bang, but a long slog of low real interest rates and slow debt growth. Investors scared of the debt worry too much about the wrong things: vivid, hyperinflationary scenarios, in which the government's machinations ruin the economy. We have to account for the incentives and the knowledge of our policymakers. Our central bankers do not benefit by driving the economy into the ground. They also know that the debt problem can be slowly defaulted on without throwing the economy into turmoil, so that's likely the policy they'll continue to pursue.

Investment Implications
Intriguingly, it turns out that a deleveraging country's stocks can do quite well. Bridgewater notes British equities returned 13.3% annualized from 1947 to 1959, a period of "beautiful" deleveraging.[1] On the other hand, Japan's equity markets struggled for over two decades since their bubble popped and they entered an "ugly" deleveraging, which they haven't exited yet (though this may be changing with Shinzo Abe's shock-and-awe campaign of fiscal and monetary stimulus coupled with structural reform).

And even with low yields, bonds can do well. If you can leverage up bonds to match the volatility of stocks, you would have received midteens returns in both ugly and beautiful deleveragings because of capital gains from rolling down the yield curve and deflationary surprises[1]. This analysis was why Bridgewater was bullish on Treasuries after the financial crisis, a time when everyone else thought yields would rise. However, if you can't leverage up bonds, they don't offer much return.

Finally, regardless of the type of deleveraging, gold did well against the deleveraging country's currency. Unsurprisingly, Dalio is a big fan of gold. He argues it's a form of money. Many rich-world central bankers don't agree, but, according to data from the World Gold Council, Russia has been a net buyer of gold every quarter since 2007, and both China and India dramatically increased their gold reserves in 2009.

The biggest implication of the U.S. in deleveraging may be the U.S. dollar losing reserve-currency status. Dalio argues the status accounts for much of the income gap between the top-earning country and other rich countries. Economist Barry Eichengreen notes the U.S. dollar went from being a negligible part of world trade in 1914 to surpassing the British pound sterling by 1924. If the Chinese put their minds to it, there's a good chance they could make the renminbi competitive with the dollar as a reserve currency. Like the U.S. dollar in 1914, the renminbi today is backed by a faster-growing, less-indebted nation, though it's not easy to transact with because of China's capital controls. But as China moves away from export-led growth, it will likely allow capital to move in and out of its borders more freely and encourage the use of the renminbi as a way to settle transactions. This has already begun. The transition will erode the value of U.S. dollars and bonds, but it will help U.S. equities because their exports will become more competitive in the world market.

1) Bob Prince, Karen Karniol-Tambour, Jason Rotenberg, and Lawrence Minicone. "Asset Class Returns in Deleveragings." Bridgewater Daily Observations. 2012.

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