Hysteresis in Economics

Background

Hysteresis, borrowed from physics, refers to the phenomenon where the state of a system depends on its history. In economics, it specifically denotes the memory effect of economic systems where past events influence future outcomes.

Historical Context

The term hysteresis originated in the physical sciences to describe systems, such as ferromagnetic materials, that do not immediately relax to an equilibrium state when external forces are applied or removed. Over time, economists adopted the concept to explain persistent unemployment and other macroeconomic anomalies that could not be easily addressed using traditional equilibrium theories.

Definitions and Concepts

Hysteresis in economics is the property of a dynamic system to retain a memory or lagging effect, where previous events influence subsequent ones. This path dependence suggests that a system’s history determines its current state, especially prevalent in situations where after a shock, the system’s new equilibrium differs significantly based on the shock and subsequent adjustments.

In behavioral economics, hysteresis also plays a role in the asymmetric perception of gains and losses. Here, disutility from a loss outweighs the utility from a comparable gain, meaning the overall utility of an individual going through a cycle of gains and losses is diminished compared to someone who experienced no change.

Path dependence property and disutility from loss— these terms underpin the concept of hysteresis in economics.

Major Analytical Frameworks

Classical Economics

Typically, classical economics does not account for hysteresis effects. The classical view assumes that markets are self-correcting and that shocks result in temporary deviations from equilibrium rather than long-term changes.

Neoclassical Economics

Similar to classical economics, neoclassical theory maintains that economies tend to return to a natural equilibrium after shocks without persistent effects, largely neglecting the hysteresis phenomena.

Keynesian Economics

Keynesian economists, in contrast, consider hysteresis relevant, especially in labor markets. They explain persistent unemployment rates even after economic recovery, arguing that high unemployment can become entrenched, creating a ’new normal.'

Marxian Economics

Marxian economics might address hysteresis in the context of capital accumulation and labor dynamics, emphasizing the lasting socio-economic impacts of shocks and structural changes in the economy.

Institutional Economics

Institutional economists focus on how institutions and rules shape economic behavior over time. For them, hysteresis can explain how institutional changes lead to long-lasting effects on economic systems, beyond the influence of immediate shocks.

Behavioral Economics

Behavioral economics provides a rich context for hysteresis by examining how individuals’ preferences and utility are affected by past experiences. The concept is crucial for understanding why individuals may exhibit loss aversion and how such behavior impacts broader economic trends.

Post-Keynesian Economics

Post-Keynesian perspectives often incorporate hysteresis to explain how economies undergo fundamental shifts after significant events, particularly in labor markets and inflation.

Austrian Economics

Austrian economics may touch upon hysteresis from the angle of how entrepreneurial discovery and market processes are influenced by historical contingencies and past knowledge.

Development Economics

Hysteresis is critical in development economics when evaluating how past colonialism, policy decisions, or economic conditions can have long-term impacts on a nation’s growth trajectory.

Monetarism

Monetarist approaches generally downplay the importance of hysteresis, focusing instead on how changes in the money supply influence economic stability over time, though they might recognize persistent inflation or unemployment resulting from prolonged policy errors.

Comparative Analysis

The understanding and application of hysteresis vary widely across economic schools of thought. While classical and neoclassical economists often overlook it, Keynesian, institutional, and behavioral economists provide nuanced explanations and policies that account for hysteresis.

Case Studies

1. Unemployment in Europe (1980s-1990s): Persistent high unemployment rates despite economic recovery sparked debates on hysteresis.

2. 2008 Financial Crisis: Post-crisis analyses emphasize hysteresis effects as economies took years to recover, altering the labor market and financial institutions permanently.

Suggested Books for Further Studies

1. Hysteresis Effects in Economic Models by George M. Constantinides
2. The Economics of Imperfect Labor Markets by Tito Boeri and Jan van Ours
3. Behavioral Finance: Psychology, Decision-Making, and Markets by Lucy Ackert and Richard Deaves

Related Terms with Definitions

• Path Dependence: The concept that historical events and decisions significantly shape current policy outcomes and economic conditions.
• Disutility of Loss: The idea that losses bring negative satisfaction, which is often greater than the positive satisfaction gained from equivalent gains.
• Equilibrium: The state in which market supply and demand balance and variables remain stable absent external shocks.