By Ray Dalio via Linkedin

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Ordinarily, politics and economics influence each other with economics being more of a driver on politics than politics is on economics—e.g., bad economic conditions normally lead to political changes—and normally we don't need to pay much attention to politics to get the economics and markets right. However, there are times when politics becomes the most important driver. History has shown us that these times are when there is great economic, social, and political polarity within a country and there is the selection of populist leaders to fight for “the common man" in a battle against “the elites." These conditions exist now. The 1930s were the last time this happened in the developed world and globally.

As we described in the study we did on populism (accessed here), our examination of this phenomenon made clear that the conflicts between the common man and the elites typically take place a) during times of economic stress due to wealth and opportunity disparities, b) when the common man believes that the country’s core values are being threatened by foreigners, and c) when government seems so dysfunctional that radical change is widely believed to be necessary. Those conditions typically lead to a strong-minded, confrontational fighter being brought to power to represent the underserved constituency, typically by pursuing more nationalistic, protectionist, and militaristic policies, which typically leads to more domestic and international conflicts. In some cases it led to democracies becoming dictatorships, and wars.

I am not saying that we are on that path, but I am saying that it has to be watched out for because if it is in the works, it is a really big deal. In watching out for it, in the early stages of a new populist administration, the main thing to look for is whether conflict moves to the point that it is detrimental to the effectiveness of government and the economy. The potential for government to become dysfunctional is unique in democracies because the relatively open checks and balances system (which, under normal conditions, is a strength of the system) and because the free media (which is normally a strength of the system) can operate in a way to incite emotional conflicts rather than encourage orderly resolutions of conflicts through the legal system. Even when it is operating well, the legal system can move very slowly, dragging out the period of conflict rather than leading to the prompt resolution of it. These conditions can reinforce emotional and antagonistic polarity because the goal of beating the opposition supersedes the goal of working together to try to find compromises that are good for the country as a whole, and that can create a self-reinforcing downward spiral. That has to be watched out for because, if it were to occur, it would have profound implications for economies, capital flows, and markets. Right now there is a whiff of it in the air.

In my opinion, the trend toward conflict leading to greater dysfunctionality, leading to greater conflict, in a self-reinforcing way is increasingly apparent in the US and UK. Over the last 24 hours we’ve seen developments in the US (pertaining to the issues surrounding Jim Comey's testimony) and the UK (concerning no UK party having a ruling majority and the threat of a left populist leader emerging). While in both cases, so far, the political and legal institutions and systems have worked as intended—e.g., Special Counsel appointed and electoral system delivering a rebuke of a sitting government—nonetheless these developments entail the risk that political conflicts will lead to reduced government effectiveness in these two countries at especially challenging times for each of these countries (e.g., for the UK exiting the union and needing to redefine its economic and geopolitical place in the world, and for the US needing to clarify its domestic and international directions).

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