If the capital asset pricing model is valid at all, then the potential gains from NGDP targeting are enormous.
First, let's consider the capital asset pricing model, which describes equilibrium returns to securities thusly:
Market beta is a product of two unmeasurable factors. (1) The expected amount of volatility in equity returns (in perpetuity) and (2) the aversion that the marginal investor has regarding exposure to that volatility. Since we can roughly measure Beta, but the two factors composing Beta can't be measured, and are conceptually vague, even while being intuitively obvious, CAPM, like EMH and so many other financial concepts is not falsifiable. That doesn't mean it doesn't reflect some basic and undeniable truths.
One way to think about it is to compare earnings from risk free bonds to equities (or other risky securities):
The Equity Risk Premium [E(Rm)] above, is the price for accepting an additional unknown variable - an uncertain x.
Think about the power of this idea, with regard to NGDP level targeting. All risk is described as market volatility. And NGDPLT, as conceived, practically eliminates market volatility (at least in terms of total earnings). Here is a chart of the share of GDI going to capital (minus corporate taxes and income of homeowners). This has ranged from about 16% to about 20% in the modern era. But, note that nearly all of the volatility comes from NGDP shocks. If we remove the cyclical shocks, the level of operating profits (interest plus net profit) is very stable. In a stylized version of NGDPLT, there is no market risk. Equity earns 5% more each year, because we determine that NGDP will grow through monetary policy, and proportional capital income, in equilibrium, will change very slowly. So, whatever aversion to risk there is, volatility is nil, and E(Rm) = Rf. The required return on risky assets = the risk free rate.
For the sake of discussion, let's limit this thought experiment to the domestic economy within the NGDPLT regime. Even if NGDPLT doesn't achieve perfect earnings stability (for the diversified portfolio), it would clearly move significantly in that direction. Here is a chart of 2 year changes in GDP and in Enterprise Value of Nonfinancial Corporations. A simple regression, by quarter, of these measures accounts for about 1/4 of changes in Enterprise Value. And, this is simply the real time change in GDP.
I have seen some reservations about NGDPLT because of the idea that equities exhibit unusual volatility, which is attributed to some sort of behavioral bias, fickleness, or serial correlation. But, in statistical terms, the jury is still out about whether markets reliably exhibit first or second order mean reversion. And, in practical terms, many former economies, which certainly didn't revert to the mean, lie in the trash bins of history. The notion that market values should not react to negative GDP shocks with lower growth expectations or higher equity risk premiums seems naïve to me. And, conceptually, the volatility in equity values that coincides with GDP shocks must be related to expected future GDP. NGDPLT eliminates that problem. There is no significant uncertainty about future GDP under NGDPLT. Even the volatility in equity values that can't be empirically attributed to GDP volatility, must be conceptually attributed to it.
So, what happens in an economy with a small Equity Risk Premium? First, I find it useful to tweak the concept of CAPM a little bit. Over time, I find that total real expected returns to unlevered corporate capital [Rf + E(Rm)] are fairly stable - reverting to around 8% over time for all nonfinancial corporations - maybe a bit less for S&P500 firms because of the lower liquidity premium. (Most fluctuations in equity values can be explained by changing earnings and changing growth expectations, not a wildly fluctuating level of required total returns.) So, instead of thinking of returns as additive, I think it might be more helpful to note that there is a fairly stable return to productive capital, and capital owners are trading risks when they share those returns. So, (in real terms) if Rf is 3% and E(Rm) is 5%, it might be better to think of it in terms of there being a 7% to 8% real return to unlevered corporate assets, and debt holders are willing to accept a 5% discount in order to eliminate cash flow volatility. (Note, when considering CAPM in terms of the equity premium, I use long term treasury bond rates as Rf, in order to match durations. If we use the short term rate, we end up creating all sorts of confusion by conflating maturity premiums with equity premiums. A series on subtle conceptual issues with CAPM and beta has been collecting dust on my to-do list.)
In the NGDPLT world, there is minimal cash flow volatility (for the diversified market portfolio), so there is no reason for a deep discount. In that case (again in real terms), we would expect to see a high Rf (say, 6%) and a low E(Rm) (say, 2%). What effect will this have on capital allocation? This means that the premium required for a high risk investment is very low. A zero beta investment would require a 6% real return, while a 2 beta investment would only require a 10% real return. In today's environment (Rf = 1% and E(Rm) = 6%), a zero beta project would require a 1% real return, compared to a 13% real return for a two beta project.
In the low interest rate environment, there is tremendous pressure to invest in low productivity projects. In the high interest rate environment, there is much more incentive to push capital into transformative, disruptive, risky ventures that will create, and gain from, high GDP growth. And, this is exactly what we see in the modern era. Low E(Rm), in the 1960s and 1990s, were associated with high growth. (Note, they were also associated with high compensation levels. Also, note that low E(Rm) came during periods where the business cycle had been tame.) Also, the 1960s and 1990s were associated with relative declines in real estate investment and valuations. Capital was being pulled, instead, into industrial and commercial production. Contrast this with the high E(Rm) 1970's and 2000's, where real growth declined, compensation sagged, and capital poured into real estate instead of commercial ventures.
Additionally, volatility of "y" would also decline, so the maturity premium would be lower. This would induce more investments into long term projects. And, fixed incomes and savers would benefit from high real risk free returns.
As I mentioned, during periods with low risk aversion in the late 1960's and late 1990's, total returns to productive capital have remained fairly stable. Most of the shift in risk premiums caused real Rf to move up, especially on the short end. So there was little maturity premium and little equity risk premium. So, we already have evidence of E(Rm) moving below 3% because of minimized NGDP volatility. These periods might have been associated with a slight reduction in required total capital returns, but even the extreme equity gains of the late 1990's were mostly due to high growth expectations. Real Rf (based on 10 year treasuries) was between 4% and 5% for most of the 1990's, before any equity premium would even be added.
In this last chart, the dark red line is the average annual deviation from 7% NGDP growth over the previous 5 years and the light red line is the standard deviation in NGDP growth over the previous 5 years. The light blue line is my estimated unlevered equity risk premium from the Fed's Flow of Funds report, and the dark blue line is Damodaran's equity risk premium for the S&P 500.
So, I wouldn't expect to see a huge effect on required returns to equity as a result of this regime shift, and I'm not sure we would see much of a shift in valuations in general, since NGDP growth expectations would be moderate, by definition (edit: although, if all these factors lead to higher RGDP growth expectations, valuations would rise). Instead, I would expect to see a huge shift in the types of investments that corporations make. Maybe we are too deterministic about past economic development. Would the technology boom have been as overwhelming in an environment with a 5% equity risk premium. Think of the amount of capital that was being invested into high risk ventures that depended on extreme economic and cultural developments and didn't promise payouts for years. Could those investments have been made in a 5% ERP context? I don't want to be hyperbolic, but I suspect that we underestimate this factor.
And, considering we have already seen E(Rm) fall into the 2%-3% range during these periods that were shaped by just a few years of lowered NGDP volatility, it doesn't seem outrageous to me to think that NGDPLT could be associated with 1%-2%.
NGDPLT could be absolutely transformative - higher growth, higher compensation, more risk taking, even though absolute returns to risk would be low.