Hysteresis in the field of economics refers to an event in the economy that persists even after the factors that led to that event have been removed or otherwise run their course. Hysteresis often occurs following extreme or prolonged economic events such as an economic crash or recession. For instance, following a recession, the unemployment rate may continue to increase despite growth in the economy and the technical end of the recession.
Key Takeaways
- Hysteresis in economics refers to events that persist into the future, even after the initial causes have been removed.
- Hysteresis can include the delayed effects of unemployment, where the unemployment rate continues to rise even after economic recovery.
- It can indicate a permanent change in the workforce from the loss of job skills, making workers less employable even post-recession.
Understanding Hysteresis
The term hysteresis was coined by Sir James Alfred Ewing, a Scottish physicist and engineer, to refer to systems, organisms, and fields that have memory. In essence, the consequences of some input are experienced with a certain time lag or delay. For example, iron maintains some magnetization after it has been exposed to and removed from a magnetic field. Hysteresis is derived from the Greek word meaning a coming short or a deficiency.
Hysteresis in economics arises when a single disturbance affects the trajectory of the economy. The specific reasons for hysteresis vary depending on the precipitating event. Post a market crash, for instance, many investors are reluctant to reinvest due to their recent losses, leading to a prolonged period of depressed stock prices not due to market fundamentals but investor attitudes.
Types of Hysteresis in Economics
Unemployment Rates
A common example of hysteresis is the delayed effects of unemployment. The unemployment rate can continue to rise even after the economy has begun recovering. Such cyclical unemployment rises when the economy is underperforming and falls during expansions.
When the economy re-enters an expansionary phase, it is expected that businesses would re-hire the unemployed and reduce the unemployment rate towards its natural level. However, hysteresis argues otherwise, suggesting that as unemployment increases, people may adjust to lower living standards and become less motivated to return to work. Consequently, employers demand more from their existing workforce before expanding their staff, further delaying reductions in unemployment rates.
Economic Output
Output hysteresis occurs post-economic downturns when businesses reduce investment and productivity. This leads to a decline in the overall productivity of the economy. Even when the economy recovers, it may struggle to regain its previous growth trajectory due to reduced investments. Governments and central banks may need targeted policies to encourage investment, foster innovation, and enhance productivity to counteract these lasting impacts.
Credit Markets
Following a financial downturn, banks often tighten credit as they navigate increased risks. Credit market hysteresis is characterized by the prolonged nature of these tightened conditions even post-crisis. Risk-averse lending practices perpetuate a persistent credit crunch, obstructing both businesses and individuals from accessing necessary financing, hampering overall economic recovery.
Inflation
Inflation hysteresis arises when extended periods of high or low inflation shape future expectations. Persistently low inflation can lead to a belief that this trend will continue, making it challenging for central banks to maintain price stability. Expectations can become entrenched, complicating the implementation of effective monetary policies.
Technology
Hysteresis in unemployment can also emerge when businesses switch to automation during economic downturns. Workers lacking the skills to operate new technology may remain unemployable as the economy recovers. Companies will hire fewer employees, contributing to structural unemployment and raising the natural unemployment rate. Hysteresis highlights a permanent workforce change, where job skills loss lowers employability even post-recession.
Example of Hysteresis
A striking example of hysteresis in the modern economy is the COVID-19 pandemic. While the Public Health Emergency status ended in May 2023, many economic responses are still being felt into 2024. The pandemic caused widespread job losses, particularly in sectors hit hard by lockdowns. As a result, the leisure and hospitality industry employment rates are still recovering to pre-pandemic levels.
Supply chain disruptions during the pandemic also led to inflationary pressures. Despite easing rate hikes and monetary policies, the average monthly inflation rate in 2023 remained high, influenced by previous disruptions. Similarly, consumer behaviors reshaped by the pandemic, such as a shift towards online shopping, have not fully reverted, embodying economic hysteresis.
How to Prevent Hysteresis
Economies encountering recession and hysteresis employ economic stimulus to combat cyclical unemployment. Expansionary monetary policies, such as lowering interest rates, can help stimulate economic activity. Expansionary fiscal policies may include increased government spending in heavily impacted regions or industries.
Long-term issues like skill displacement due to technological advancements may require job training programs to address hysteresis. Structural reforms, anticipating potential hysteresis sources, can enhance economic flexibility and resilience, mitigating long-term impacts.
What Are the Types of Hysteresis Relevant to Financial Markets?
Hysteresis in financial markets manifests in various forms, including credit market hysteresis, investor sentiment towards inflation, and manufacturing output.
Can Hysteresis Be Mitigated Through Structural Reforms?
Preemptive structural reforms, including labor market adjustments, regulatory changes, and initiatives promoting innovation, can mitigate the impact of economic shocks. However, long-term policies often carry higher risks compared to short-term strategies.
What Are the Long-Term Consequences of Banking Sector Hysteresis?
Banking sector hysteresis can lead to cautious lending practices even post-crisis, contributing to a prolonged credit squeeze. Consumers and businesses face challenges in obtaining loans, jeopardizing economic recovery.
What Role Does Public Debt Hysteresis Play in Fiscal Sustainability?
Public debt hysteresis limits a government’s fiscal flexibility. High levels of debt necessitate ongoing servicing costs, constraining spending in other critical areas, leading to prolonged hysteresis.
The Bottom Line
Hysteresis in finance underscores the enduring impact of past economic events on current market states. Shocks and disruptions, such as financial crises, can lead to persistent effects, influencing market behavior, credit conditions, and long-term economic performance.
Related Terms: recession, economic cycle, unemployment rate, expansionary policies, structural unemployment
References
- James Alfred Ewing. “On time-lag in the magnetisation of iron”. Royal Society, 1890.
- The White House. “Fact Sheet: Actions Taken by the Biden-Harris Administration to Ensure Continued COVID-19 Protections and Surge Preparedness After Public Health Emergency Transition”.
- Bureau of Labor Statistics. “Leisure and Hospitality Projected to Mostly Cover Pandemic-Driven Employment Losses”.
- U.S. Inflation Calculator. “Current U.S. Inflation Rates: 2000-2024”.
- National Library of Medicine. “How Consumer Behaviors Changed In Response to COVID-19 Lockdown Stringency Measures: A Case Study of Walmart”.
