Bryan points to a Scott Sumner’s monetarist credo.

Think of it as a simplification of the Taylor rule. The Sumner Rule is, if the consensus forecast of nominal GDP growth is below 5 percent, then loosen up. Presumably, if the consensus forecast is above, say, 7 percent, then tighten up.

Sumner writes,

When the growth rate of nominal GDP falls sharply there is always a severe recession.

Here is the latest data (subject to revision) for percent changes at an annual rate:

Quarter Nominal GDP Real GDP
2008 q2 4.12 2.83
2008 q3 3.35 -0.51
2008 q4 -5.77 -6.34
2009 q1 -2.87 -5.49

In the second quarter, we are a bit below the Sumner rule for nominal GDP, but basically we are doing OK. In the third quarter, we drop to 1.65 percentage points below the Sumner Rule, but real GDP growth plunges by twice as much. Then both nominal and real GDP collapse further. Sumner’s story for the third quarter would be that people saw the drop in nominal GDP growth coming, and so real GDP growth fell.

Suppose the Fed had adopted a policy of all-out expansion to try to maintain nominal GDP growth of 5 percent. Also, for fun, suppose no bailouts and no stimulus–that is, no other policies to fight the crisis. What would have happened?

Without bailouts, presumably we get more bank failures–and Freddie and Fannie go under. The Fed meanwhile buys up short-term government debt until the interest rate hits zero, then goes to work on intermediate and long-term government debt, and if those rates hit zero it starts in on mortgage securities.

My guess is that in the short run, nominal GDP and real GDP fall anyway. I just don’t think that the private economy can re-allocate employment and consumer demand that quickly. Without the bailouts, there might be more panic and job loss in the financial sector, but less panic and an earlier return to profitability in the nonfinancial sector. Overall, my guess is that a durable recovery would have started sooner, but I do not think that the Sumner Rule could have prevented a short, sharp recession.

An interesting thought-experiment, though.