Hysteresis in economics describes situations where a temporary shock has permanent or very long-lasting effects. The usual example is a deep recession: if people who lose their jobs stay unemployed for a long time, their skills fade, their contacts weaken and employers become wary of hiring them. When the economy recovers, many never return to work, so unemployment stays higher, or output lower, than it would have been without the downturn. The past, in other words, changes the economy's future path.
The term is borrowed from physics, where it describes how some materials, such as magnetised iron, keep part of a change after the force that caused it is removed. In economics it was popularised in the 1980s to explain why European unemployment kept rising after each recession instead of returning to earlier levels. Hysteresis challenges the standard view that the economy always drifts back to a fixed natural rate of unemployment and a fixed long-run trend.
Hysteresis in plain terms
Imagine walking across a lawn. One crossing leaves no trace; the grass springs back. But if many people take the same short cut every day for weeks, a bare path appears, and it stays even after people stop walking there. The temporary traffic has left a lasting mark.
A long downturn can do the same to an economy. A short dip is quickly forgotten. A deep and long slump wears paths into people's lives and into businesses: workers drift out of the workforce, factories close for good, and investment that never happened leaves the economy with fewer tools than it would otherwise have had.
Origins of the idea
The most cited early paper is "Hysteresis and the European Unemployment Problem" by Olivier Blanchard and Lawrence Summers, published by the NBER in 1986. They noted that unemployment in several European countries had climbed from low single digits in the early 1970s to around 10% by the mid-1980s and showed little sign of falling back. They proposed an insider-outsider explanation: wages are set mainly to suit workers who already have jobs (insiders), so people who lose their jobs (outsiders) have little influence and can stay excluded. Earlier, the economist Edmund Phelps had also argued that the natural rate could depend on the history of actual unemployment. Related ideas appear in the work of Paul Krugman and Richard Baldwin on trade, who used the term for the way a strong currency can push exporters out of foreign markets permanently.
How hysteresis works
- Skill loss. People out of work for a long time lose skills and work habits, reducing human capital and making them less attractive to employers.
- Labour force exit. Long-term jobless people may become discouraged workers or move into economic inactivity, shrinking the workforce.
- Stigma and screening. Employers may treat long gaps in a CV as a negative signal.
- Lost investment. Firms cut investment and research during recessions, leaving a smaller capital stock and slower productivity growth.
- Business failures. Viable firms that close in a credit squeeze take know-how and customer relationships with them.
Evidence
Studies by IMF economists Valerie Cerra and Sweta Chaman Saxena, among others, found that output losses after financial and banking crises in many countries tended to persist rather than being fully recovered. After the 2008 financial crisis, output in the United States, the UK and the euro area stayed well below pre-crisis trend lines for years, and estimates of potential output were revised down. Economists debate how much of this was hysteresis and how much reflected a slowdown in productivity that had begun before the crisis. Some evidence also points the other way: when US unemployment fell to very low levels in the late 2010s, many people who had been out of the labour force returned to work, suggesting that damage can partly be reversed by strong demand.
Policy implications
If hysteresis is important, the cost of a recession is much larger than the temporary loss of output, because it lowers the economy's future path. This strengthens the case for prompt and forceful action through monetary policy and fiscal policy in downturns, and against premature tightening or austerity. In a 2016 speech, then Federal Reserve Chair Janet Yellen asked whether running a "high-pressure economy" for a time could reverse some of the supply-side damage from the Great Recession. Active labour market programmes, retraining and job-retention schemes, such as the UK furlough scheme and German short-time work during the 2020 pandemic, are also partly designed to limit hysteresis by keeping workers attached to jobs.
Critics argue that running the economy hot carries inflation risks, and that structural reforms to improve labour market flexibility matter more than demand. Others note that hysteresis makes it hard to measure the output gap or the NAIRU, because both move with past events. Hysteresis is also linked to structural unemployment: a cyclical problem left untreated can turn into a structural one. Because policies act with delays, discussed under policy lags, the timing of any response matters as much as its size.