Decades ago, George Selgin used the term ‘productivity norm’ to describe the intuition behind NGDP targeting (although his proposal was slightly different than simple NGDP targeting.) The basic idea was that the price level should move inversely to productivity shocks, keeping the dollar flow of spending (per capita) relatively stable.

I’d like to illustrate the intuition with a simple (and admittedly unrealistic) example, and then you tell me whether it has any relevance for today.

Consider the restaurant industry. Suppose a sudden shock cuts restaurant productivity in half. What might that shock be? Suppose people suddenly become very anti-social and prefer to sit at least 6 feet away from other restaurant patrons. Restaurant capacity falls sharply.  What is the new long run equilibrium?

Restaurants are a competitive industry, so in the long run we can expect the relative price of restaurant meals to double. Because of 50% lower productivity, it’s now more costly to produce meals. And in competitive industries, price equals marginal cost in the long run.

What about the nominal price of meals in the short run? That depends on monetary policy. So what sort of nominal price change might lead to the least short run disruption?

In my view, there’s a lot to be said for having the nominal price of restaurant meals double at the same time that the long run relative price is doubling. After all, we are assuming that because of the public’s anti-social behavior, the number of patrons per restaurant will fall in half. If the nominal price doubles, then restaurant revenue will remain roughly stable in nominal terms.

In that case, the average citizen will spend exactly the same amount on restaurant meals as before. They’d buy half as many meals, at twice the price. That means their non-restaurant spending would not need to change.

In addition, the average restaurant owner would earn the same nominal income, and thus have the same ability to repay their nominal debts. The average restaurant would not go bankrupt, and thus they would not have to shut down.

Of course things might not work out so smoothly, it depends on the elasticity of demand for restaurant meals. But the basic idea is that if you keep the flow of nominal spending stable, or along a stable growth path, then productivity shocks do not by themselves lead to debt crises. In aggregate, firms earn just as much revenue as before the productivity shock. So while some individual firms will have more trouble repaying debts (think cruise ships), the average firm will not have more difficulty repaying nominal debts.

In contrast, if the central bank responds to the negative productivity shock by allowing NGDP to fall sharply, you will have a severe debt crisis.  Most debts are nominal.

Former Fed governor Jeremy Stein once argued that financial excesses could be better addressed with monetary policy than regulation, because “monetary policy gets in all the cracks.” Tight money discourages everyone from borrowing, whereas regulation will miss many excesses.

Stein was wrong; tight money cannot address financial excesses without tanking the economy, as the Fed learned in 1929-30. But his money “gets in all the cracks” argument actually does apply to monetary policy during a productivity crisis. Right now, the government seems to have given up on monetary stimulus, and instead plans to bail out a bunch of individual firms. But that will never work; they cannot possibly address a problem this massive on a case-by-case basis. Many smaller firms will go bankrupt. And if they were all bailed out, the fiscal cost would put an enormous burden on future taxpayers.

In contrast, monetary stimulus is (as a first approximation) costless. There is no burden on future taxpayers. And it gets in all of the cracks. Monetary stimulus is like a rising tide that lifts all boats. Some boats (i.e. firms) won’t be lifted far enough to avoid bankruptcy, but with stable NGDP growth the average firm will be just as able to repay nominal debts as before the productivity shock.

Right now, NGDP level targeting has two huge advantages over the current bailout policies being discussed:

1.  It’s way cheaper.
2. It’s way more effective.

So why not adopt NGDPLT?  It’s probably too late to prevent a big drop in Q2 NGDP, but there’s still time to boost longer-term prospects.

PS.  I know that my example is oversimplified, as I ignored multiple costs such as labor, etc.  I was trying to get at the intuition with a simple example, as the argument for NGDP targeting still holds if we make restaurant cost functions more complex.