Fiscal Policy, Potential Output, and the Shifting Goalposts

Abstract

This paper studies the negative loop caused by the interaction between pessimistic estimates of potential output and the effects of fiscal policy in Europe during 2008–2014. We argue that policymakers’ reliance on overly pessimistic views of potential output led to a large adjustment in fiscal policy. Contractionary fiscal policy, via hysteresis effects, caused a reduction in potential output that in part validated the original pessimistic forecasts and led to a second round of fiscal consolidation. The paper concludes by discussing alternative frameworks for fiscal policy that could avoid this negative loop in future crises.