Richard Clarida, heavily tipped to be the new Fed Vice-Chairman, has propounded an interest rate theory of the “new neutral.” This states that the Federal Funds rate at full employment, when policy is neither loose nor tight, should revolve around an interest rate of 2% instead of the previous 4% — in other words zero in real terms, since the Fed’s inflation target is also 2%. With zero real interest rates as a target, achieved only at the top of the cycle, capital will receive no risk-free real return, but simply sit there, in infinite stasis, producing economic stability but no real growth. This approach has been tried before, by the Qing Dynasty of Imperial China, in power from 1644 to 1912.
To grow in terms of improving the living standards of its citizens, a capitalist economy needs a constantly increasing amount of capital, at least a sufficient amount to keep up with growth in the available labor force. However, if real interest rates are either zero or negative, there is no mechanism by which the amount of capital can increase. Borrowing merely increases the leverage in the system, but not its capital stock, while returns above the “risk free rate” are on average absorbed by the risks that go wrong.
Thus except for genuinely new “flash of genius” advances in technology, an economy with zero real interest rates is condemned to stasis. Sometimes, an increase in efficiency is discovered that increases output, but at other times, a foreign competitor makes a major domestic industry uncompetitive and over time eliminates it. Increases in productivity (which is normally defined as labor productivity) are very limited unless more capital can be applied per worker. In a zero-interest-rate society, Professor Robert Gordon’s stagnation thesis may be inevitable.
We have seen before a society that aimed at stasis in its technology, economy and living standards: in Qing dynasty China. In the dynasty’s last century, under notably incompetent rulers (with the shining exception of the Dowager Empress Cixi) Qing China was clearly in decline, in its place in the world, its share of GDP, its domestic living standards and its internal stability. However, in the previous centuries under the highly capable Kangxi (1667-1722) and Qianlong (1733-96) Emperors, China was a shining example of a wealthy and powerful, yet static society. Adam Smith described it well in “The Wealth of Nations:” “China has been long one of the richest, that is, one of the most fertile, best cultivated, most industrious, and most populous countries in the world. It seems, however, to have been long stationary. Marco Polo, who visited it more than five hundred years ago, describes its cultivation, industry, and populousness, almost in the same terms in which they are described by travelers in the present times.”
The Qing attitude to technological innovation was magnificently summed up by Qianlong’s letter to George III, delivered to his envoy Lord Macartney in 1793: “As your Ambassador can see for himself, we possess all things. I set no value on objects strange or ingenious and have no use for your country’s manufactures.”
Economic stability was thus the principal objective of the Qing emperors, just as it would be for a modern society with no growth in capital. However, Qing China did not achieve that objective, for one insidious reason: population growth. China’s population is estimated to have doubled from 150 million in 1650 to 300 million in 1800, and then continued to increase by a further 50% during the 19th Century.
Since the Qing Chinese economy was being maintained in a steady state, and population increased rapidly, Chinese living standards declined sharply during the 18th Century, with the Angus Maddison Project estimating GDP per capita in 2011 dollars declining from $1,066 in 1650 to around $750 in 1800. Real interest rates were not zero, but land was finite and there was no technological advance, so increasing population bore severely on available resources of food and raw materials.
In the modern West, the technological frontier is still advancing, albeit probably less quickly than fifty years ago. On the other hand, the “drag” of government regulation is also increasing, with environmental regulations in particular being a far greater destroyer of wealth than they were 50 years ago. Thus, if real interest rates are zero, and the capital base is not growing, but population is increasing as in the United States, expected to pass 400 million by 2058 on Census Bureau projections, the real wealth and living standards of the populace are almost certain to decline steadily.
If Clarida is confirmed as Fed Vice Chairman, and his colleagues are led to agree with him on interest rate policy, the U.S. is destined for a future of declining wealth, very much as in the decade 2007-16 but probably intensifying. Doubtless the over-leveraged will still prosper through artificially low interest rates, but that is a very small and unpleasant segment of the population.
Per capita, there are only two ways a country can become richer: by improving its technology and by increasing its capital base. Other methods, such as educating its workforce more or exploiting more natural resources, provide only temporary uplift (indeed, given the appalling quality and politically doctrinaire approach of most U.S. higher education, more U.S. students going to college undoubtedly reduces output, both actual and potential). U.S. technology continues to improve, albeit at a disappointing rate. However, the U.S. capital base, with zero interest rates, is not increasing, and is therefore declining on a per capita basis. Contrary to popular reporting, the massive $500-700 billion annual payments deficit makes this worse, not better, as real capital leaves the country while foreign money is attracted in mostly to fund the wholly unproductive Federal budget deficit.
Hence the U.S. needs positive real interest rates, higher than the current rate of population growth of about 0.7%, to give the capital stock per capita some chance of increasing. If you add in the balance of payments deficit of 4% of GDP, which is currently a drain on capital, the required level of interest rates becomes an almost unattainable real 4.7%, or a nominal 6.7% for the risk-free interest rate. Thus, two policy changes are needed for success: higher real interest rates and a lower or preferably zero balance of payments deficit.
Consider now the alternative policy of high real interest rates. Naturally, if rates are set too high, they suppress economic activity, as projects cannot be found that yield enough to be worth financing at the high rates. But short of that point, high interest rates are extraordinarily stimulating to the economy, since they increase the capital stock at the maximum possible rate. In U.S. economic history, for example, the late 1890s, the 1920s up to 1928 and the middle 1980s were all periods of very high interest rates. In Britain, the early 1820s were also a period of high real interest rates, with massive deflation as the country rejoined the Gold Standard. It is not a coincidence that all those periods in both countries were also periods of very rapid economic growth, and of productivity growth in particular.
Naturally, as the capital stock grows, the marginal productivity of additional capital declines: there are limits to how much capital per worker is needed. Thus, interest rates naturally declined after the high-rate periods mentioned above. However, at present the capital stock is depleted after a decade of ultra-low rates and balance of payments deficits, while much of the investment that has occurred has been unproductive. Hence a period of high real interest rates, with a Federal Funds rate of 6% or more, would be especially economically helpful at the present time, rapidly rebuilding the capital stock and allowing powerful economic growth to resume.
We are not however going to get such a period with Messrs Jerome Powell, John Williams and Richard Clarida running the Fed. The media have complained about the potential top Fed group’s lack of diversity, all being white male, but their real lack of diversity is in intellectual outlook. Not one of them has a proper appreciation of the huge damage done by prolonged “funny money” and the long-term economic benefits tight money and high interest rates can bring.
Song Dynasty China was one of the all-time peaks of human civilization. Qing China desperately tried to preserve that civilization through conscious stasis – and failed miserably to do so as its population inexorably increased. We must avoid the errors of the Qing, and that means avoiding zero or negative real interest rates, which erode the capital stock. New policy, and new people are needed at the Fed, and Clarida is not well qualified to be one of them. Without going outside the Fed’s magic circle, and while fulfilling the desire for “diversity,” what about Loretta Mester?
(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)