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.”