The Fed is maintaining its current policy, acknowledging a lack of clarity in how the economy is evolving, while damping down its growth forecasts. This lack of clarity stems in part from what Fed Chair Jerome Powell calls potential “tariff inflation’’ associated with President Trump’s on again off again tariff policy. At the same time, the president has also been engaged in a war of words with Mark Carney, Canada’s new Prime Minister, about Canada becoming the 51st state of the U.S. These events are all part of the changing world order, a critical concept of vital importance.
Ray Dalio, manager and the founder of the hedge fund Bridgewater Associates, has developed a framework for identifying and analyzing the dynamic processes underlying the changing world order. Given that Bridgewater is the largest hedge fund in the world, there is good reason to apply Dalio’s framework to shed some light on the Fed’s actions, the president’s tariffs, and the relationship between Canada and the U.S.
Analyzing The Changing World Order: External Conflict
Dalio’s framework features five dynamic forces, identified from past changes in power balances between world powers. He applies these forces to assess the current balance of power, mainly to the U.S. and China. His analysis provides indicators showing the degree to which China’s global position lies below that of the U.S. but is increasing, while that of the U.S. is decreasing. When the power gap, now in favor of the U.S., goes from being positive to being negative, the world order changes.
The first of Dalio’s five forces is external conflict, meaning conflict between countries. This conflict can be military, but might also be economic and political. Dalio points out that during the last two decades, China has dramatically improved in four specific areas: military, trade, innovation and technology, and education. All four are constituent elements of the balance of power.
Military issues might underlie the current frictions between Canada and the U.S. Steve Bannon provides some insights in an interview with Toronto Sun political columnist Brian Lilley. Bannon was a key adviser to President Trump during the president’s first term. Bannon is also a Navy veteran, and his comments focus on naval strategy. He explains the president’s approach in terms of a coherent strategy to protect the U.S., as China and Russia grow in strength. The heart of the strategy involves U.S. control over North America, and to a lesser extent South America. It is a hemispheric strategy.
As a result of climate change, melting ice in the Arctic is opening up sea lanes. Bannon points out that looking ahead, China and Russia will develop cold water ports in the Arctic that challenge Canada’s ability to protect its northern provinces. He points out that Russia has already made strides in this regard, and China has described itself as an Arctic nation. Bannon’s view is that Canada lacks the military strength to defend itself against these two powers. He doubts that Canada will be able to count on support from Europe, which has underinvested in its own defense. Only the U.S., he suggests, will be able to provide the military resources to protect the Canadian north, as the Arctic melts. He describes Canada’s northern borders as its soft underbelly.
President Trump’s remarks about Canada becoming the 51st state have greatly angered Canadians. In this regard, Bannon suggests that Canadians are myopic about the future threat they face from China and Russia, and urges them to change. He also suggests that Canada begin serious discussions with the U.S. on how to create a partnership to address the threat. Such a partnership, Bannon points out, need not entail Canada becoming the 51st U.S. state. I would add that for decades Canada and the U.S. have worked together in the North American Aerospace Defense Command.
President Trump has also interest in acquiring Greenland, for reasons similar to his military focus on Canada. As for Panama, Bannon explains that the U.S. regaining control of access to the canal, serves to prevent passage by Chinese and Russian ships between the Atlantic and Pacific oceans, in case of conflict.
Bannon comments on the need to pay attention to the amount of time the president devotes to the U.S.-Canada relationship. He states that it is considerable, and that the president has a lot of items on his agenda, implying that the president attaches great importance to having a hemispheric oriented long-term global strategy.
The hemispheric focus also offers some insight into President Trump’s treatment of Ukraine and its president, Volodymyr Zalensky. In respect to his view of a new world order, with an America First policy, the president acts as if he regards Ukraine will be in the Russian sphere of control.
Besides the military component, Dalio’s framework also includes trade, innovation and technology, and education. Tariffs on Chinese products are consistent with the framework. Tariffs on Canadian and Mexican products are more difficult to explain. One possibility is that the latter are being used to exert leverage, as the U.S. seeks to execute its hemispheric military strategy.
Innovation and technology are priorities for the president, as reflected in the front row presence of technology executives at the president’s inauguration. Education appears not be an administration priority, with the administration proposing deep cuts at the National Science Foundation, National Institutes of Health, and National Oceanic and Atmospheric Administration. The president has also announced plans to dismantle the Department of Education.
The relative shift in education between the U.S. and China is far from new. Dalio documents that the percentage of the world’s majors in Science, Technology, Engineering, and Mathematics in China is now above 30%. The corresponding percentage for the U.S. is a bit above 10%. These figures represent a dramatic reversal from 1980, when the figure for the U.S. was about 30% and for China about 5%.
Debt Cycles, Short-Term And Long-Term
The second of Dalio’s big forces is the cyclical behavior associated with debt, in respect to both the short-term and in the long-term. Dalio refers to the business cycle as the short-term debt/money cycle. The long-term debt cycle is the cumulative effect of consecutive short-term cycles.
The Fed is facing the prospect of both recession and an uptick in inflation stemming from the imposition of tariffs. In consequence, it is maintaining its interest rate target for now, to see how events develop. Former Treasury secretary Larry Summers warns that if the president maintains his current approach to tariffs, the risk of recession in the near term is very high. The Tax Foundation estimates that the president’s tariffs, without retaliation by foreign countries, will reduce US GDP by 0.4%. Trade wars involve retaliation. Looking back to the president’s first term, the Tax Foundation estimates that the trade war tariffs initiated in 2018 and 2019, and continued by President Biden, have reduced long-run GDP by 0.2%.
Greg Ip, the chief economics commentator for The Wall Street Journal, writes that both Wall Street and Main Street have misjudged the president. They had believed that during his second term, President Trump would attach great importance to the stock market and short-term economic growth, just as he did during his first term. However, the president has instead signaled that he gives little weight to the stock market’s decline and that he would not rule out an imminent recession. In this regard, Ip mentions a comment by the president that Chinese leaders have a very long planning horizon, much longer than in the West.
In respect to the long-term debt cycle, Dalio has been warning that within the next three years, the U.S. needs to reduce its deficit from over 7% of national income to about 3%. Dalio argues that deficits of that magnitude typically produce negative growth spirals because of the large interest payments needed to service the high debt. This view is supported by enlightening analysis from economist Jessica Riedl.
Currently, national income is about $28 trillion, of which 7% is about $2 trillion and 3% is about $840 billion. The gap is close to $1.2 trillion. Closing that gap will not be easy, and will require a combination of lower government spending and higher taxes. With respect to spending, according to Washington Post journalist David Ignatius, the efforts of Elon Musk’s DOGE team to reduce waste would need to focus on the defense budget, rather than the agencies they have thus far targeted. Riedl makes this point even more strongly.
As to taxes, the Tax Foundation points out that the president’s plan to extend the expiring 2017 Tax Cuts and Jobs Act would decrease federal tax revenue by about $4 trillion over the next decade. The president’s promise to eliminate taxes on tips, overtime, and Social Security will augment that number.
Behavioral economics, which focuses on psychological obstacles to rational behavior, looms large here. Present bias is the trait of being unable to muster the willpower to avoid destructive buy now, pay later behavior. Present bias lies at the heart of America’s growing deficit problem. Policies that reduce tax revenues move the deficit needle in the wrong direction, at a crucial stage of the changing world order. Conceivably, it will be America’s failure to deal with its deficits, rather than military conflicts, that will trigger the change to a new world order dominated by China.
During the presidential campaign, President Trump emphasized that one of the key benefits from tariffs would be the generation of revenue for the Treasury. According to the Committee for a Responsible Federal Deficit, the president’s tariffs on China, Canada, and Mexico would generate $139 billion in 2025, and $1.5 trillion over the next decade. The net effect of the tax revenue decrease and tariff revenue increase is still in the wrong direction.
There is a macroeconomic equation which stipulates that the sum of national savings and the trade deficit be equal to the sum of investment and the government deficit. Tariffs can increase reduce the trade deficit. The U.S. trade deficit is currently just under $1 trillion. Reducing it would lower the amount the country currently effectively borrows from the rest of the world. For a given savings-investment gap, the government deficit would need to decline by the same amount as the decline in the trade deficit.
Conclusion
External conflicts and debt cycles comprise the first two big forces in Dalio’s theory of the changing world order. Both are highly salient in the current environment. Polarized politics, the impact of natural disasters, and productivity gains from technology comprise the other three big forces in Dalio’s framework. The first two contribute negatively to the U.S. position in the competition between the U.S. and China, while the third appears to be positive.
Changes in the world order occur infrequently. If the past is prologue, the future will feature considerable instability. For this reason, it is critically important to have a coherent, systematic framework to interpret how unfolding events reflect the changing world order.
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