I’ve still got people in the comments pretty sure I’m mischaracterizing Krugman. So for posterity, here is Krugman explicitly calling for regulations that make firms poorer, arguing that they will boost employment during a liquidity trap:
As some of us keep trying to point out, the United States is in a liquidity trap: private spending is inadequate to achieve full employment, and with short-term interest rates close to zero, conventional monetary policy is exhausted.
This puts us in a world of topsy-turvy, in which many of the usual rules of economics cease to hold. Thrift leads to lower investment; wage cuts reduce employment; even higher productivity can be a bad thing. And the broken windows fallacy ceases to be a fallacy: something that forces firms to replace capital, even if that something seemingly makes them poorer, can stimulate spending and raise employment. Indeed, in the absence of effective policy, that’s how recovery eventually happens: as Keynes put it, a slump goes on until “the shortage of capital through use, decay and obsolescence” gets firms spending again to replace their plant and equipment.
And now you can see why tighter ozone regulation would actually have created jobs: it would have forced firms to spend on upgrading or replacing equipment, helping to boost demand. Yes, it would have cost money — but that’s the point! And with corporations sitting on lots of idle cash, the money spent would not, to any significant extent, come at the expense of other investment.
More broadly, if you’re going to do environmental investments — things that are worth doing even in flush times — it’s hard to think of a better time to do them than when the resources needed to make those investments would otherwise have been idle. [Bold added.]
So this is exactly what I said Krugman had been doing: He isn’t calling for arbitrary reductions in Aggregate Supply (or potential GDP or just “capacity” if you want to remain grounded in the real world and not mainstream models). He’s not pining for earthquakes, or secretly planting rumors of an alien invasion.
However, he really believes his 2011 model with Eggertsson, which says that in a depressed economy with a debt overhang blah blah blah, measures that reduce productivity will actually boost employment and output. So that what would normally be a strike against, say, an environmental regulation–which must be counterbalanced by its ostensible benefits in mitigating climate change damages–now turns into yet another reason to support it.
Last thing: The reason these ozone regulations would reduce capacity going forward is that they are a restriction on the production technology firms are legally allowed to use. So don’t just get hung up on them having to replace existing machinery; that mandate per se doesn’t reduce (potential) GDP, it just means that some of actual GDP is sopped up replacing a machine only because of the regulation. [UPDATE: Actually in a normal economy the replacement of the machinery would directly reduce potential GDP relative to the baseline counterfactual, to the extent that it displaced some private investment. In other words firms have to devote some of their investment just to comply with the regulation, which doesn’t boost their capacity, rather than investing in other things that would have increased productivity next year.]
However, it’s still true that going forward, even with the new machinery etc., firms have fewer options available to them in how they can combine resources to create goods and services. So the regulations permanently reduce Aggregate Supply (or potential GDP, or “capacity”) relative to the non-regulation baseline.