Will the Dollar be replaced as the Reserve Currency?
My thoughts on The Changing World Order
Over the last 2 weeks, there’s been a new topic that’s gaining a lot of attention. Legendary investor and hedge fund manager Ray Dalio posted a video titled “Principles for Dealing with the Changing World Order” that has received more than 6MM views till now.
It’s an excellent video about the impending downfall of every major economy as we know it and how these evolving cycles happen on a regular basis - It also tells us how we can best prepare for what’s about to come!
When I started doing my own research independent from this, parts of what was discussed in the video began to make a lot of sense and I feel that some of these have a higher likelihood of happening than most of us think. So in this week’s issue, we will dive a little deeper into what the changing world order is, what we can learn from the past, and whether we should be changing our investment strategies based on this!
What is the Changing World Order?
Despite what some of you might initially assume, The Changing World Order has nothing to do with “The Great Reset”, “The Russia-Ukraine invasion” or anything that has happened in our lifetimes. Instead, it’s a repeating cycle of the rise and decline of global economies that’s occurred since the beginning of time, deciding the Reserve Currency of the world.
As Dalio explains, throughout history, there is an evolving conflict between “The Leading Economy” and “The Rising Economy” - both fighting for the spot of the economic superpower. One of the best ways to become the de facto superpower is when your currency is accepted as the world’s Reserve currency.
Reserve currency simply refers to the currency that’s most commonly accepted around the world and against which other currencies are pegged. Since the ending of World War II in 1945, the US dollar is considered to be the world’s reserve currency. It gave a strong and stable store of value and since world economies started transacting with the dollar, the U.S benefitted from a favorable exchange rate and more demand for the dollars.
But as Dalio points out, reserve currencies like this don’t last forever and change occurs every 100 or so years in what he calls “the big cycle”.
For example, France held the reserve currency from 1720-1815, Britain from 1815-1920, and the US has taken over the mantle since then. The question is: How long can we hold on to this and will the Chinese Yuan become the new reserve currency?! To answer this, we have to understand how the big cycle works.
The Big Cycle
Empires rise and fall in a regular pattern. This isn’t something that can be understood looking at the events happening in one’s lifetime - Rather, we have to look back at history to find that this has happened many times before! There is a definite trend that occurs over generations.
The Big Cycle is all about who is at the top of the World Order - a system of treaties and understandings that the leading economy puts in place, to decide how countries interact. How is the leader of the world order decided?
A country starts rising to dominance in the world order after it wins a big conflict, and this leads to a period of peace and prosperity where other countries do not want to challenge the dominant country. But this rise eventually leads to a peak - a period of stagnation with increasing costs of expansion, which creates a chance for rising economies to compete. When the costs of maintaining the empire lead to increasing debt and inflation, internal resentment and external conflict lead to the decline of the leading country. This process gives rise to a new winner, and the cycle repeats.
Let’s look at these three stages in a little more detail.
The Rise
The rise of a new country to power is usually initiated by a leader with vision and power, who displaces the ruling power. A leader has to gather support for his ideas and defeat the opposition (either by weakening or…uh… eliminating them) to rise to power. But the creation of a global superpower does not happen in a single individual’s lifetime. Just like an individual’s health can be by checking their vitals, the health of an economy can be monitored by checking certain metrics, such as:
A strong education system that cultivates character and promotes technological innovation
Higher economic output through the technology
Competitiveness in the global market due to increased output, resulting in a bigger share of world trade
Establishment of a financial center and military dominance
In the initial stages, the emphasis is on creating a good education system that triggers technological innovation. Over time, this leads to economic and military dominance. But for the empire to last across generations, leaders also put systems in place that will ensure the country works well, and that successors are chosen well.
There is a close nexus between the government and the wealthy, which was as true in the days of the Dutch East India Company and the British Empire, as it is true in the case of the American military-industrial complex.
The reach of the empire starts to span across the world, and more people start trading in the currency of the leading country as they see the possibility for better returns. This lets the leading country take on more debt and expand.
The Top
As more countries start investing in the leading economy, it leads to a financial bubble. A stage is reached where the prices charged by the leading country are way higher than other countries who can just copy their methods and charge lesser.
Values change across generations too - People who had to grind and fight to get to where they are would have children who grew up in much easier conditions, and they might decide to pursue leisure more than productivity.
Meanwhile, the leading country has to keep taking on debt to finance its expansion and a stage is reached where it might start borrowing from other rising economies. Though borrowing and spending more signals that an economy is strong, in the long term, it weakens the finances of the country. A stage is reached where it cannot borrow more.
The Decline
When a country cannot borrow anymore, it can either default on its debts (yeah, right) or just print more money - This is the option that’s always chosen. Printing more money starts causing higher inflation, and this triggers resentment within the population. The difference between the rich and the poor is so high that a revolution can happen eventually - either peacefully in a political manner, or violently - weakening the country further.
This is an opportunity for another country to attack, and international conflict is a lose-lose situation: The leading country can neither afford to fight and lose, nor can it retreat and cede power. As such conflicts proceed, other countries start reconsidering which side to support and start selling off the reserve currency. With its reserves drying up, the leading country loses the status of Reserve Currency.
Conflicts like this decide the new world leader, and such transitions can last for twenty years or more! The question is: Are we in such a transition now?
What it looks like for America
Objectively speaking, Ray Dalio does have a point. From his perspective, there’s a measurable output for each country as a reserve, and there are 8 factors to consider: Education, Technology, Competitiveness, Output, World Trade, Military Strength, Financial Center, and Strength of Their Currency.
The US has begun to decline from its peak in the 1950s in terms of these metrics, and China looks like a contender. Even back in 2020, China and Russia created a financial alliance to reduce their dependency on the US dollar. China has also been reducing the number of settlements to the US dollar, maybe due to increased tariffs on Chinese Goods. The US has seen a slight decline in its Reserve Currency status over the last 10 years, and estimates for China’s economy to overtake the US are quite close by.
BUT - It is not enough if China has a large economy. World countries have to be willing to use the Yuan as a reserve currency, and in that respect, 40% of global trade and 80% of cross-border transactions still use the dollar as opposed to the Yuan which accounts for only 3% of global transactions according to a Charles Schwab analyst.
Though the US dollar has declined, the amount is small compared to the volume of transactions, and it doesn’t look like there is a viable alternative for a reserve currency. Another interesting possibility is a world without reserve currencies where people exchange money in the currency pairs of their countries, with no global reserve currency. As Federal Reserve Chair Ben Bernanke said in 2016, “The rising wealth of other nations doesn't spell doom for the U.S. It doesn't mean the U.S. is getting poorer—just that other nations are getting richer.”
The model of a Reserve currency and a leading country might not make sense in an increasingly decentralized world. Senator Rand Paul has even gone so far as to say that Bitcoin could one day replace the world’s reserve currency if people lose faith in Government Institutions, with El Salvador already promoting it as legal tender. Though that’s quite a drastic assumption, it does show that there are alternatives to the way that history has always operated till now, with geographical borders and localization not playing the deciding role.
Conclusion
In terms of my overall thoughts on The Changing World Order, I see Dalio’s point. You can’t argue with the fact that so far, we’ve seen a drastic change in power every 100-250 years since the beginning of the Roman Empire. Obviously, the fact that 80% of all US dollars were printed in the last 22 months while China’s economy is poised to outpace the US by 2030 isn’t exactly confidence-inspiring. Especially when high energy prices increase the risk of an upcoming recession…
But, a lot needs to happen if America’s role in world trade is to be undermined and a new reserve currency is to emerge. A black swan event like this isn’t something we can predict. The very fact that we are aware of these patterns now and that we can act in a slightly different way to prevent history from repeating itself is reassuring.
In Dalio’s words,
History won’t always repeat itself, but it will rhyme.
As much credit as I’d like to give for this, in the short term - it’s still better to focus on the aspects we can control: Like making sure you save your income, having a diversified portfolio, keeping a stable career, and investing consistently, regardless of what’s happening.
That way, you’re not going all in gold for 20 years, while significantly underperforming the market, but you still get to enjoy the appreciation of a global portfolio. That’s the reason why I’ve been allocating 10% of my entire account to an International ETF, and, another 5-8% to bitcoin and Ethereum - because we don’t know what’s going to happen, another economy could very well surpass the US, and, at the end the day, it’s anyone’s guess.
Dalio sums up the video by reiterating on the health metrics that can be used to assess a country’s vitals: Education, Technological Innovation, Economic Output, etc. By focusing on these and working on fixing these at an individual and a collective level, we can recognize which part of the Big Cycle we are in and prepare accordingly.
See you next week with another deep dive!
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Really thank you! You are a daily source of inspiration, thanks for teaching me what it means to save and invest.
Thanks Graham! Arguing for gold- which I also stack- and Bitcoin too- Bitcoin is rising and falling with the market as seen in March 20 and Gold kept stable or even rises when the market drops. Do you think the gold price is manipulated? I heard this theory before and as you know China and Russia bought huge amounts of Gold for the past years. Best, Daniel