Hysteresis
Hysteresis in economics refers to the dependence of equilibrium outcomes on the path of past events, so that temporary shocks can have permanent effects. The term is borrowed from physics, where it describes systems whose state depends on their history. In macroeconomics, hysteresis is most often applied to unemployment and to the effects of demand shocks on potential output.
Hysteresis in Unemployment
The most prominent application concerns unemployment. In the natural rate framework, a temporary rise in unemployment caused by a recession should be reversed as the economy recovers, leaving no lasting effect. Hysteresis challenges this view: if a recession raises unemployment for a prolonged period, the natural rate itself may rise, so that unemployment remains permanently higher even after the original shock has passed.
Several mechanisms can generate hysteresis. Long-term unemployment erodes skills and attachment to the labour market, reducing the employability of the unemployed, a process sometimes called the deterioration of human capital. Insiders, those with jobs, may use their bargaining power to maintain high wages, excluding outsiders. Employers may use unemployment history as a signal of productivity, making it harder for the long-term unemployed to find work.
Policy Implications
Hysteresis implies that the costs of deep or prolonged recessions are larger than the temporary output losses that conventional analysis suggests. It also implies that demand management has lasting effects: a policy that prevents unemployment from rising may also prevent the natural rate from increasing. Conversely, a policy that allows unemployment to rise may permanently damage the economy's productive capacity.
The implication for policy is that prompt and decisive action to limit the duration of downturns may be warranted, and that the distinction between cyclical and structural unemployment is less clear-cut than conventional analysis assumes. Active labour market policies that preserve attachment to work can mitigate hysteresis.
Hysteresis in Other Contexts
Hysteresis has been applied beyond unemployment. It has been used to explain the persistent effects of shocks on trade patterns, as firms that exit export markets may not re-enter, and on investment, as forgone investment reduces the capital stock and potential output. It has also been applied to inflation and to the effects of exchange rate movements on trade balances.
In each case, the common theme is that temporary shocks can shift the economy to a different long-run position, so that history matters and the economy does not return to its previous path.
Empirical Evidence
Evidence for hysteresis, particularly in European unemployment, has been influential in shaping the debate about the sources of persistent joblessness. Empirical work has examined the relationship between the duration of unemployment and re-employment prospects, the behaviour of the natural rate over time, and the persistence of the effects of recessions. The evidence suggests that hysteresis effects are real but vary in magnitude across countries and periods.
Insiders and Outsiders
The insider-outsider theory explains how unemployment can persist through the wage-setting behaviour of employed workers. Insiders, who have jobs and bargaining power, may set wages above the market-clearing level, keeping outsiders unemployed. Because insiders are not affected by the unemployment of outsiders, the wage premium can persist.
This mechanism generates hysteresis: an increase in unemployment raises the number of outsiders, but does not by itself reduce insider wages, so unemployment remains high. Policies that weaken insider power or that raise the employability of outsiders can reduce persistent unemployment.
Long-Term Unemployment and Employability
Prolonged unemployment erodes skills, reduces contacts, and sends a negative signal to employers. These effects reduce the probability that the long-term unemployed find work, and may strengthen the prejudice against them, generating a self-reinforcing cycle. The deterioration of human capital is a central mechanism through which temporary shocks produce permanent effects.
Active labour market policies, including training, job search assistance, and subsidised employment, aim to maintain or restore employability. Their effectiveness varies, but evidence suggests that well-designed programmes can reduce long-term unemployment and its persistence.
Hysteresis and the Natural Rate
In the hysteresis framework, the natural rate is not a constant but a function of history. A period of high unemployment can raise the natural rate, so that the economy settles at a higher unemployment level even after demand recovers. This modifies the conventional distinction between cyclical and structural unemployment and implies that demand shocks can have supply-side effects.
The implication for monetary and fiscal policy is that preventing large increases in unemployment may have lasting benefits, and that allowing unemployment to rise may impose costs that persist beyond the initial downturn. The appropriate policy response depends on the strength of the hysteresis effects.
Debates and Evidence
Debate continues about the magnitude of hysteresis and about the mechanisms that generate it. Some evidence attributes persistent unemployment primarily to institutional factors, such as the level and duration of unemployment benefits and the structure of wage bargaining. Others emphasise the dynamic effects of demand shocks and the deterioration of skills. The consensus is that hysteresis is real but that its importance varies across countries and periods, and that it should be considered in the design of stabilisation policy.