Ray Dalio is an American billionaire hedge fund manager and philanthropist. He started Bridgewater Associates out of his two-bedroom apartment in New York in 1975 and under his leadership, the firm has grown into the fifth most important private company in the US according to Fortune Magazine.
The enclosed information is taken from Ray Dalio’s book: The Changing of World Order – Why Nations Succeed and Fail. It is a particularly long piece, but it is worth reading as it discusses the relationship between assets and money, particularly in times of debt crises.
It is also the case that all reserve currencies in the past have ceased to be reserve currencies, often coming to traumatic ends for the countries that enjoyed this special privilege.
Chapter 2 – Appendix – The Changing Value of Money
Printing and Devaluing Money Is the Easiest Way out of a Debt Crisis
While people tend to think that a currency is pretty much a permanent thing and believe that “cash” is the safe asset to hold, that’s not true because all currencies devalue or die and when they do cash and bonds (which are promises to receive currency) are devalued or wiped out. That is because printing a lot of currency and devaluing debt is the most expedient way of reducing or wiping out debt burdens.
All Currencies Have Been Devalued or Died
Think about holding currencies (which is the same as holding cash) in the same way as you would think about holding any other assets. How would you have done in these investments?
Of the roughly 750 currencies that have existed since 1700, only about 20% remain, and of those that remain all have been devalued.
In 1850 the world’s major currencies wouldn’t look anything like the ones today. While the dollar, pound, and Swiss franc existed back then, most others were different and have since died. In 1850 in what is now Germany, you would have used the gulden or the thaler. There was no yen, so in Japan you might have used a koban or the ryo instead. In Italy you would have used one or more of the six possible currencies. You would have used different currencies in Spain, China, and most other countries. Some were completely wiped out (in most cases they were in countries that had hyperinflation and/or lost wars and had large war debts) and replaced by entirely new currencies. Some were merged into currencies that replaced them (e.g., the individual European currencies were merged into the euro). And some remain in existence but were devalued, like the British pound and the US dollar.
What Do They Devalue Against?
The most important thing for currencies to devalue against is debt. That is because the goal of printing money is to reduce debt burdens. Debt is a promise to deliver money, so giving more money to those who need it lessens the debt burden. How this newly created money and credit then flow determines what happens next. Increases in the supply of money and credit both reduce the value of money and credit (which hurts holders of it) and relieve debt burdens.
At times when the central bank is faced with the choice of a) allowing real interest rates (i.e., the rate of interest minus the rate of inflation) to rise to the detriment of the economy or b) preventing real interest rates from rising by printing money and buying those cash and debt assets, they will choose the second path, which reinforces the bad returns of holding “cash” and those debt assets.
The chart below shows spot currency returns of the three major reserve currencies in relation to gold since 1600. While we will examine these in depth in this study, for now I would like to focus your attention on both the spot currency returns and the total returns of holding interest-earning cash in all the major currencies since 1850.
As shown in the next two charts, devaluations typically occur as relatively abrupt declines during debt crises that are separated by periods of currency stability during periods of prosperity.
Here are some notable takeaways:
- Since 2000 the value of money has fallen in relation to the value of gold due to lots of money and credit creation and because of interest rates being low in relation to inflation rates. Because the monetary system has been a free-floating monetary system there have not been the abrupt breaks that there have been in the past; there has been a more gradual and continuous devaluation in which low or in some cases negative interest rates did not provide compensation for the increasing amount of money and credit and the resulting (albeit low) inflation.
By the mid-1950s, before that devaluation, the dollar and the Swiss franc were the only currencies worth even half of their 1850s value.
Since 2000 we have seen a more gradual and orderly loss of total return in currencies when measured in gold, consistent with the broad fall in real rates across countries during those decades.
In summary the basic picture is that:
- The average annual return of holding interest-earning cash currency since 1850 was 1.2%, which was a bit lower than the average real return of holding gold, which was 1.3%, though there were huge differences in their returns at various periods of time and in various countries.
- In about half of the countries since 1850 you would have received a positive real return for holding bills, in half a negative real return, and in cases like Germany you would have been totally wiped out twice.
- Most of the real return from holding interest-earning cash currency came in the periods when most countries were on gold standards that they adhered to because they were in prosperous periods (e.g., in the Second Industrial Revolution and in the post-1945 boom when debt levels and debt-service burdens were relatively low and income growth was nearly equal to debt growth) until near the end of that long cycle.
- The real (i.e., inflation-adjusted) return for bills since 1912 (the modern fiat era) has been -0.2%. The real return of gold during this era has been 2.2%. During this period you would only have made a positive real return holding interest-earning cash currency in about half of the countries, and you would have lost meaningfully in the rest (losing over 2% a year in France, Italy, and Japan, and losing over 15% a year in Germany due to the hyperinflation).
The next chart shows the real returns of holding gold throughout the period from 1850 to the present. As shown, from 1850 until 1971 gold returned (through its appreciation) an amount that equaled the amount of money lost to inflation, with the exception of Germany, though there were big variations around that average such as those previously described (e.g., until the 1930s currency devaluations and the end of World War II devaluations of money that were part of the formation of the Bretton Woods monetary system in 1944). Gold stayed steady in price while money and credit expanded until 1971. Then in 1971 currencies were devalued and delinked from gold so there was a shift from a Type 2 monetary system (e.g., notes backed by gold) to a fiat monetary system.
That delinking of currencies from gold and going to a fiat monetary system gave central banks the unconstrained ability to create money and credit. In turn that led to high inflation and low real interest rates that led to the big appreciation in the real gold price until 1980-81 when interest rates were raised significantly above the inflation rate, which led currencies to strengthen and gold to fall until 2000. That is when central banks pushed interest rates down relative to inflation rates and, when they couldn’t push them any lower by normal means, printed money and bought financial assets, which was supportive to gold prices.
The Value of Currencies in Relation to Goods and Services
In about half of the currencies interest-rate-earning cash provided a return that was above the rate of inflation, in the other half it provided bad real returns, and in all cases, there were big and roughly 10-year-long swings around these averages. In other words, history has shown that there are very large risks in holding interest-earning cash currency as a storehold of wealth especially late in debt cycles.
Ray Dalio – The Changing World Order – Chapter 2 – Money, Credit, Debt and Economic Activity
Since one person’s spending is another person’s income, that cutting of expenses will hurt not just the entity that is having to cut those expenses but it will hurt the ones who depend on that spending to earn income. Similarly, since one’s debts are another’s
assets, that defaulting on debts reduces other entities’ assets, which requires them to cut their spending.
That is because having a reserve currency allows the country to borrow a lot more than it could otherwise borrow which leads it to have too much debt that can’t be paid back which requires its central bank to create a lot of money and credit which devalues the currency so nobody wants to hold the reserve currency as a storehold of wealth.
What is money?
Money is a medium of exchange that can also be used as a storehold of wealth.
By medium of exchange, I mean that it can be given to someone to buy things.
1) most money and credit (especially the fiat money that now exists) has no intrinsic value,
2) it is just journal entries in an accounting system that can easily be changed,
3) the purpose of that system is to help to allocate resources efficiently so that productivity can grow, rewarding both lenders and borrowers, and
4) that system periodically breaks down.
As a result, since the beginning of time, all currencies have either been destroyed or devalued.
Throughout history central governments and central banks have created money and credit which weakened their own currencies and raised their levels of monetary inflation to offset the deflation that comes from the deflationary credit and economic contractions.
There is an old saying that “gold is the only financial asset that isn’t someone else’s liability.” That is because it has widely accepted intrinsic value, unlike debt assets or other assets that require an enforceable contract or a law to ensure the other side will deliver on its promise to deliver whatever it promised to deliver (which when it’s just “paper” currency that can easily be printed isn’t much of a promise). When countries were at war and there was not trust in the intentions or abilities to pay, they could still pay in gold. So gold (and to a lesser extent silver) could be used as both a safe medium of exchange and a safe storehold of wealth.
It is important to understand the difference between money and debt. Money is what settles claims—i.e., one pays one’s bills and one is done. Debt is a promise to deliver money.
When governments print a lot of money and buy a lot of debt so the amounts of both money and debt increase, they cheapen money and debt, which essentially taxes those who own it to make it easier for debtors and borrowers. When this happens enough that the holders of this money and debt assets realize what is happening, they seek to sell their debt assets and/or borrow money to get into debt that they can pay back with cheap money. They also often move their wealth to other storeholds of wealth like gold, certain types of stocks, and/or somewhere else (like another country that is not having these problems). At such times central banks have typically continued to print money and buy debt directly or indirectly (e.g., by having banks do the buying for them) and have outlawed the flow of money into inflation-hedge assets and alternative currencies and alternative places.
Then Comes the Flight Back into Hard Money
When taken too far, the over-printing of fiat currency leads to the selling of debt assets and the earlier-described bank “run” dynamic, which ultimately reduces the value of money and credit, which prompts people to flee out of both the currency and the debt (e.g., bonds). They need to decide what alternative storehold of wealth they will use. History teaches us that they typically turn to gold, other currencies, assets in other countries not having these problems, and stocks that retain their real value.
Typically at this stage in the debt cycle there is also economic stress caused by large wealth and values gaps, which lead to higher taxes and fighting between the rich and the poor, which also makes those with wealth want to move to hard assets and other currencies and other countries. Naturally those who are governing the countries that are suffering from this flight from their debt, their currency, and their country want to stop it. So, at such times, governments make it harder to invest in assets like gold (e.g., via outlawing gold transactions and ownership), foreign currencies (via eliminating the ability to transact in them), and foreign countries (via establishing foreign exchange controls to prevent the money from leaving the country). Eventually the debt is largely wiped out, usually by making the money to pay it back plentiful and cheap, which devalues both the money and the debt.
To review, in the long-term debt cycle, holding debt as an asset that provides interest is typically rewarding early in the cycle when there isn’t a lot of debt outstanding, but holding debt late in the cycle when there is a lot of it outstanding and it is closer to being defaulted on or devalued is risky relative to the interest rate being given. So, holding debt (e.g., bonds) is a bit like holding a ticking time bomb that rewards you while it’s still ticking and blows you up when it goes off.
Ray Dalio – The Changing World Order – Chapter 4 – The Big Cycle of the United States and the Dollar, Part 2
The ability to print money and have it accepted by the world, which is an ability that only a major world reserve currency country (especially the United States) has, is the most valuable economic power a country can have. At the same time, a country that does not have sizable reserves (which is the position the US is in) is highly vulnerable to not having enough “world money.” That means that the US is now very powerful because it can print the world’s money and would be very vulnerable if it lost its reserve currency status.
As has been the case with the Dutch guilder and the British pound, the status of the US dollar has significantly lagged and is significantly greater than other measures of its power. That means that if the US dollar were to lose its reserve status and significantly depreciate in value it would have a devastating effect on the finances of those countries holding those reserves as well as private-sector holders of dollar-debt assets. Who would be the winners? Those with dollar-debt liabilities and those with non-dollar assets would be the big winners. In the concluding chapter, “The Future,” we will explore what such a shift might look like.