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 (1855-1935), 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

Hysteresis in Unemployment Rates

A common example of hysteresis is the delayed effects of unemployment, whereby 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. In order to understand hysteresis in unemployment, we must first explore the types of unemployment. In a recession, which is two consecutive quarters of contracting growth, unemployment rises.

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.

Natural unemployment is not the result of a recession. Instead, it is the result of a natural flow of workers to and from jobs. Natural unemployment explains why unemployed people exist in a growing, expansionary economy. Also called the natural rate of unemployment, natural unemployment represents people, including college graduates or those laid off because of technological advances. The constant, ever-present movement of labor in and out of employment makes up natural unemployment. However, natural unemployment can be from both voluntary and involuntary factors.

When workers are laid off due to a factory relocating or because technology replaces their job, structural unemployment exists. Structural unemployment, which is a portion of natural unemployment, occurs even when an economy is healthy and expanding. It can be due to a changing business environment or economic landscape and it can last for many years. Structural unemployment is typically due to business changes, such as factories moving overseas, technological changes, and lack of skills for new jobs.

Why Hysteresis Occurs in Unemployment

As stated earlier, cyclical unemployment is caused by a downturn in the business cycle. Workers lose their jobs when businesses conduct layoffs during a period characterized by low demand and declining business revenues. 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.

Hysteresis Due to 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

The recession experienced by the U.K. in 1981 is a good depiction of the effects of hysteresis. During the country’s recessionary period, unemployment rose sharply from 1.5 million in 1980 to 2 million in 1981. After the recession, unemployment rose to more than 3 million between 1984 and 1986. The turmoil of the recession created structural unemployment that persisted during recovery and became difficult to manage.

Special Considerations

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.