It’s Easier To Increase Potential Output When Actual Output Is Near Potential

Via Brad Delong, Jane G. Gravelle and Thomas L. Hungerford ask “Can Contractionary Fiscal Policy Be Expansionary?” (PDF) and conclude that the reverse is more likely:

The results suggest that successful fiscal adjustments (as defined by the cyclical adjustment method) occurred when the economy was at or near potential output, that is, labor and capital resources were fully employed. Unsuccessful fiscal adjustments generally occurred when actual output was below potential output. The U.S. output gap for 2011 is considerably more negative than the average output gap for all unsuccessful fiscal adjustments and even those that began when actual output was below potential output. Almost nine out of ten fiscal adjustments beginning when actual output was below potential output were unsuccessful — fiscal adjustments beginning in a slack economy (such as the current situation in the U.S.) appear to have a low probability of success.


I would suggest that there’s a good general rule of thumb here. Every country, every state, and every city has some kind of efficiency-stymying policies in place. Generally speaking, changing these policies would be a good idea. By expanding potential output, you’d increase overall human welfare over the long term. And when there’s a recession, people start paying more attention to the fact of poor economic performance and may get interested in these questions. But as a rule, it seems to me that it’s going to be much easier to undertake efficiency-improving structural reforms when your economy is already operating at-or-near its potential. When unemployment’s high, inefficiency starts to look good to people. You worry that efficiency enhancing reforms will just throw people out of work, and get into the mindset that projects should be undertaken in the most labor-intensive way possible. If you already have full employment, this whole dynamic changes. People who lose their jobs can get new ones, and the fact that if we needed fewer people to make the things we’re already making that we could make even more things looks clearer.