The Malign Long-Run of a Crisis — Hysteresis in Economic Crisis Reserarch

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[Fazit, deutsch: Eine Betrachtung, die mich nachdenklich macht: Wirtschaftskrisen haben kurz- und langfristige negative Folgen. Die kurzfristigen Effekte sind offenkundig. Doch wenn darauf verzichtet wird, einer Krise umgehend entgegen zu wirken, vertiefen sich ihre langfristigen schädlichen Folgen. Eine Wirtschaftspolitik im Stile des neoliberalen Laissez Faire verzichtet auf ein schnelles, wirkungsvolles Einlenken. Damit vertieft sie die Krise kurzfristig, und sorgt dafür, dass sie ausgedehnter verläuft als nötig, womit Hysterese provoziert wird, eine durch bessere Wirtschaftspolitik vermeidbare Verlängerung der Belastungen und Probleme, die von der ursprünglichen Krise angestoßen werden.]

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As I have noted many times, the costs of recession are both immediate and long-term. The immediate impacts are the lost incomes from rising unemployment as output gaps widen.

Also, working hours usually decline, participation rates fall and productivity slumps.

The longer term costs are then realised as the growth path flattens out due to the interruption to capacity building as investment stalls and the skill atrophies in the labour force.

Imposing fiscal austerity during a downturn — [a major feature of the Euro as demanded in the Maastricht Treaty] — magnifies these short- and long-run costs. Which is why it is lunacy to invoke discretionary fiscal deficit cuts in the name of some misguided notion of intergenerational fairness (reducing debt burden for children type misguided notions).

The fiscal austerity ensures that the grandchildren suffer diminished prospects relative to what might have been.

My early work in the mid-1980s, which was a critique of the neo-liberal mainstream arguments about ‘natural rates of unemployment’ was focused on developing the concept of hysteresis.

 Hysteresis:

This is the idea that where you [are] is a product of where you have been. It is an important concept in economics because it undermines the mainstream notion that the long-run is independent of the short-run.

For the layperson, this might be represented by the claim that pursuing some low inflation target no matter how much unemployment is created is not a problem because in the ‘long-run’ the unemployment will be at the ‘natural rate’ anyway. Of[ ]course[,] the notion is nonsense.

The long-run is thus never independent of the state of aggregate demand in the short-run. There is no invariant long-run state that is purely supply determined. History is a series of interlinked (co-dependent) short-runs.

By stimulating output growth now, governments also help relieve longer-term constraints on growth – investment is encouraged and workers become more mobile.

The problem compounds though, because the supply-side of the economy (potential) is influenced by the demand path taken and the longer is a recession (that is, the output gap), the broader the negative hysteretic forces become.

At some point, the productive capacity of the economy starts to fall towards the sluggish demand-side of the economy and the output gap closes at much lower levels of economic activity.

The following diagram is a stylised representation of how the demand-side and supply-sides interact following a recession to which helps us understand the long-run losses that arise if recessions are not prevented.

Unlike the mainstream macroeconomics approach, which assumes that the ‘long-run’ is supply-determined (by technology and population growth) and invariant to the demand conditions in the economy at any point in time, the diagram shows that the supply-side of the economy responds to particular demand conditions.

In terms of the following diagram, the potential output path is denoted by the green solid line noting the dotted green segment is tantamount to our red line in the above graph.

The potential output is the level of real output it would be forthcoming if all the available collective capacity (including Labour and equipment) was being fully utilised.

The diagram assumes, for simplicity, that potential real GDP assumes some constant growth in productive capacity driven by a smooth investment trajectory up until the point where it starts to flatten out.

If we assume that at the peak the economy was working at full capacity – that is, there was no output gap – then we can tell a story of what happens following an aggregate demand failure. The solid blue line is the actual path of real GDP.

You can see that the output gap opens up quickly as real GDP departs from the potential real GDP line. The area A measures the real output gap for the first x-quarters following the Trough.

As the economy starts growing again as aggregate demand starts to recover (perhaps on the back of a fiscal stimulus, perhaps as consumption or net exports improve) after the Trough, the real output gap start[s] to close.

However, the persistence of the output gap over this period starts to undermine investment plans as firms become pessimistic about the future state of aggregate demand.

At some point, investment starts to decline and two things are observed: (a) the recovery in real output does not accelerate due to the constrained private demand; and (b) the supply-side of the economy (potential) starts to respond (that is, is influenced) by the path of aggregate demand takes over time.

Remember investment has dual characteristics. It adds to demand (spending) in the current period but adds to productive capacity in the future periods. It thus influences aggregate demand (now) and aggregate supply (later) – and that interdependency is crucial for understanding hysteresis.

As the recession endures, the capital stock of a nation either remains static or in extreme cases (such as in Greece) it will contract.

The pessimism by firms begins to reduce the potential real output of the economy (denoted by the divergence between the solid green line and the dotted green line).

The area B denotes a declining output gap arising from both these demand-side and supply-side effects. At some point, actual real output reaches potential real output – meaning the output gap is closed – but the overall growth rate is much lower than would have been the case if the economy has continued on its previous real output potential trajectory.

The entrenched recession [has] thus not only caused major national income losses while the output gap was open but is also made that the growth in national income possible in this economy is much lower and the nation, in material terms, is poorer as a consequence.

Moreover, the inflation barrier (that is, the point at which nominal aggregate demand is greater than the real capacity of the economy to absorb it) occurs at lower actual real output levels.

The estimated costs of the recession and fiscal austerity are much larger than the mainstream will ever admit.

The point of the diagram is thus that the supply-side of the economy (potential) is influenced by the demand path taken.

Those who advocate austerity and the massive short-term costs that accompany it fail to acknowledge these inter-temporal costs.

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