Hysteresis: Definition in Economics, Types, and Example

What Is Hysteresis?

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. After a recession, for example, the unemployment rate may continue to increase despite growth in the economy and the technical end of the 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 other words, the consequences of some input are experienced with a certain time lag or delay. One example is seen with iron: 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 course of the economy. The specific reasons for hysteresis vary depending on the precipitating event. That said, the persistence of a market malaise after the event has technically passed is most commonly attributed to changes in the attitudes of market participants due to the event. After a market crash, for example, many investors are reluctant to reinvest what cash they have on hand due to their recent losses. This reluctance translates to a longer period of depressed stock prices due to the attitude of investors rather than the market fundamentals.

Types of Hysteresis in Economics

Unemployment Rates

A common example of hysteresis is the delayed effects of unemployment where the unemployment rate can continue to rise even after the economy has begun recovering. The current unemployment rate is a percentage of the number of people in an economy who are looking for work but can't find any.

When a recession occurs, cyclical unemployment rises as the economy experiences negative growth rates. Cyclical unemployment rises when the economy performs poorly and falls when the economy is in expansion.

When the economy re-enters an expansionary phase, it is expected that businesses would start re-hiring the unemployed and that the economy’s unemployment rate would start declining towards its normal or natural unemployment rate until cyclical unemployment becomes zero. This is the ideal scenario, of course. However, hysteresis tells a different story.

Hysteresis states that as unemployment increases, more people adjust to a lower standard of living. As they become accustomed to the lower standard of living, people may not be as motivated to achieve the previously desired higher living standard. Also, as more people become unemployed, it becomes more socially acceptable to be or remain unemployed. After the labor market returns to normal, some unemployed people may be disinterested in returning to the workforce. Last, and most significantly, employers themselves have undergone significant pain during a downturn and will be more likely to demand more of remaining workers before taking on the larger costs of adding to their workforce.

Economic Output

Output hysteresis can happen in the aftermath of economic downturns. It's the decline in investment and productivity when businesses curtail their investment activities during recessions. It often results in a reduction in the overall productivity of the economy.

The consequences of this diminished productivity can extend beyond the recessionary period. In practical terms, this implies that even when the economy begins to recover, it may struggle to regain the growth trajectory it maintained prior to the downturn. For instance, companies may be hesitant on committing long-term capital or being the first to introduce a new product to markets.

In the aftermath of economic downturns, governments and central banks must not only focus on short-term stimulus measures to address immediate economic challenges but also consider strategies to revive and sustain long-term growth. Mitigating output hysteresis may involve targeted policies aimed at encouraging investment, fostering innovation, and enhancing productivity in order to counteract the lasting impacts of economic contractions.

Credit Markets

Following a financial downturn, the initial response of banks is often to tighten credit as they deal with increased risks and uncertainties. However, what distinguishes credit market hysteresis is the prolonged nature of these tightened conditions even after the crisis has abated. Banks, potentially hesitant by the experiences of the crisis, may remain risk-averse. They may be cautious with their lending practices and perpetuating a persistent credit crunch even though that may not necessarily be required.

This sustained restriction in credit availability has far-reaching implications for economic actors. Businesses find it challenging to secure the necessary financing for investments, expansion, and daily operations. Individuals face difficulties accessing credit for essential purposes like home purchases and education. The consequences of credit market hysteresis extend beyond the immediate post-crisis period, acting as a drag on the overall economic recovery.

Inflation

Inflation hysteresis emerges when extended periods of either high or low inflation shape expectations for the future. When inflation remains persistently low, for example, it can instill the belief that this trend will continue. This can lead to expectations of ongoing low inflation and can make it hard for central banks striving to maintain price stability.

Central banks may rely on the public's expectations of future inflation to guide their policy decisions. In cases of inflation hysteresis, where expectations become entrenched, it becomes more challenging for central banks to implement effective monetary policies. Central banks may enact policies they think are best; however, the general public may latch onto inflation beliefs that perpetuate beyond what is actually happening.

Technology

Hysteresis in unemployment can also be observed when businesses switch to automation during a market downturn. Workers without the skills required to operate this machinery or newly installed technology will find themselves unemployable when the economy starts recovering. In addition to hiring only tech-savvy workers, these companies will ultimately hire fewer employees than before the recessionary phase. In effect, the loss of job skills will cause a movement of workers from the cyclical unemployment stage to the structural unemployment group. A rise in structural unemployment will lead to a rise in the natural unemployment rate.

Example of Hysteresis

A tremendous example of hysteresis in the modern economy is the COVID-19 pandemic. On May 11, 2023, the Biden Administration ended the Public Health Emergency status of the crisis. However, many of the economic responses taken during the pandemic are still being felt into 2024.

The pandemic caused widespread job losses, particularly in sectors like hospitality and travel that were hit hard by lockdowns. The Bureau of Labor Statistics projects the leisure and hospitality industry will employ just over 16 million individuals by the year 2031. This would eventually compare closely to the 16.6 million individuals employed in 2019, though the point is the lag in market response.

The pandemic has also led to inflationary pressures. For example, supply chain disruptions have increased the cost of goods, and these cost increases have often been passed on to consumers in the form of higher prices. Note that despite easing rate hikes and monetary policy, the average monthly inflation rate of 4.1% in 2023 was still the third highest average of the millennium (behind only 2022 and 2021, respectively).

The last example related to the pandemic relates to consumer preference. There were many barriers presented to in-person shopping or consumption due to health restrictions. As a result, most Americans turned to online shopping. With those barriers largely removed post-pandemic, there's a lot of evidence that shows post-pandemic consumer behavior has changed. This can loosely be defined as hysteresis as, with the barriers removed and market conditions largely where they were pre-pandemic, consumers have not yet returned (and may not return) to what the trend was before.

How to Prevent Hysteresis

Economies that are experiencing a recession and hysteresis, in which the natural rate of unemployment is rising, usually employ economic stimulus to combat the resulting cyclical unemployment. Expansionary monetary policies by central banks, such as the Federal Reserve, can include lowering interest rates so as to make loans cheaper and help stimulate the economy. An expansionary fiscal policy might also include increases in government spending in regions or industries that are most affected by unemployment.

However, hysteresis is more than cyclical unemployment and can persist long after the economy has recovered. For long-term issues, such as a lack of skills due to workers displaced by technological advances, job training programs might be helpful to combat hysteresis.

The Bottom Line

Hysteresis, in the context of finance, refers to the lasting impact of past economic events on the current state of financial markets. It highlights how shocks and disruptions, such as financial crises, can lead to persistent effects, influencing market behavior, credit conditions, and overall economic performance over an extended period.