I recently wrote an article on the situation in Greece, and mentioned the effects of hysteresis which I will expand upon in this blog article.

Hysteresis is a theory developed by the Keynesians to explain why laissez-faire economic policy may be damaging in the long run. Neoclassicalists would argue that during an economic downturn, when an external shock causes demand to fall, wages should be allowed to fall which would increase the international competitiveness of the economy so that exports can grow to increase demand and provide a boost to the economy fueling further growth until the economy is out of the slump and growing again. Even if we ignore the Keynesian argument that lower wages will further reduce consumption (because people have less money to spend and save instead – the paradox of thrift – for fear that they may lose their job in the future) and possibly investment (because there is lower demand which means reduced future profitability and “animal spirits” may be weak) we still have to consider the short-term effects that the economic downturn causes. Hysteresis is the argument that these short-term effects manifest themselves into long term problems which inhibit growth and make it difficult to return to pre-recession growth trends as the neoclassicalists presume.

These hysteresis channels are: skills atrophy, signalling effects, cognitive dissonance, capital depreciation and beachhead effects/trade penetration.

Skills Atrophy – unemployed workers will begin to forget their skills or at the very least lose productive efficiency as they forget particular ways of producing goods and services. This may mean that education is needed before output can expand, in some cases some skills may permanently be lost (perhaps not completely relevant to this discussion, but consider in Britain how many workers remain with textile skills, this is despite the UK being a world-lead in textiles only 30/40 years ago).

Signalling Effects – normally firms would hire workers who have had a steady employment history, as this is a useful signalling effect to show that they are reliable and skilled workers. During a recession workers may be put out of work, – made redundant – not due to their own failings but due to insufficient demand. Some workers may be employed by many firms during the course of a recession, with short periods of employment as firms only have limited amounts of work. To a firm hiring after the recession this could be a negative signalling effect, implying that the worker isn’t reliable. Therefore it becomes difficult for a firm to hire additional workers, they may need to expend greater effort into hiring decisions to consider whether a worker was unemployed due to his own deficiency, or due to the economic situation. This may explain why long term unemployment remains low, but shouldn’t be too great an obstacle if the economy is expanding quickly.

Cognitive Dissonance – simply stated this is when unemployed workers become so disillusioned with the labour force – and the fact that they are unable to find work – that they exit the labour market completely. This could manifest itself in a number of ways, it could be that some workers decide to emigrate and find work elsewhere: it is likely these workers would be lost forever, or at the very least would be difficult to get back. Some workers may decide to have a family, and thus exit the workforce for X period of time. Older workers may decide to take an early retirement, permanently exiting the labour market. Some may simply give up looking for a job, and thus are no longer statistically considered as unemployed but as not in the workforce. Fortunately these workers are easier to return to the labour market, as they may start looking for jobs when the economy speeds up and thus won’t significantly, or irreversibly, shift the LRAS curve left.

Capital Depreciation – over time capital goods (factories, machinery and equipment) depreciate: that is their condition is deteriorated through wear and tear. For example, factories may begin to crumble, IT equipment becomes outdated and tools begin to rust. This happens because during an economic downturn there is little incentive for firms to invest in replacing and fixing capital – demand is low so they don’t need to produce as much output. As a result, the long run aggregate supply curve has shifted left and even when output begins to pick up again, unemployment will persist because it will take time for firms to purchase new equipment and fix other capital to allow for a larger workforce.

Trade Effects – sometimes called trade penetration or a beachhead effect, this is when a downturn means that domestic producers lose ground to foreign competition. This could occur because domestic producers focus on the domestic market, perhaps they increase foreign prices to maintain profitability, fail to reduce prices significantly domestically and lose out to competition or fail to invest in R+D so they don’t develop the latest consumer products. Perhaps significant numbers of firms go bankrupt, such that foreign competition gets a stronghold. Whatever the cause, foreign competition erodes at domestic exporters and attacks domestic producers through cheaper imports. The result is that the foreign firm is selling more output and so may gain from economies of scale allowing it to produce even cheaper than competition and thus expand further. The effect of this is that domestic firms lose output share and thus lose economies of scale, hence making it more expensive to produce so eroding the price competitiveness of the firm. If domestic firms fail then it may be the case that unemployment rises, although presumably foreign firms would need to have some production/offices in the domestic economy which would mitigate job losses. In short, an economic downturn means domestic firms temporarily lose export and import market share to foreign competition, which means they lose economies of scale and are thus permanently at a disadvantage.

However, during an economic downturn we would expect the domestic exchange rate to depreciate which would make imports more expensive and exports cheaper. This could ameliorate the situation and prevent foreign competition from expanding output shares and gaining from economies of scale.

In short, these channels mean that unemployment could be persistently high even for a period after the external shock. It can be seen as a leftward shift of the long run aggregate supply curve meaning that the economy has permanently lost a chunk of output and that more resources will need to be expended to try and return the economy to its previous position and then expand further to increase living standards. This gives Keynesians an argument for government spending during economic downturns to restore aggregate output and prevent the hysteresis channels from taking effect.