Hysterical about hysteresis

April 11, 2012

Economists at times fancy themselves scientists – and they like to borrow from scientific lingo to lend their theories some extra gravitas.

The U.S. unemployment crisis is a case in point. There is a long-running debate among economists as to whether the bulk of joblessness is cyclical, resulting from a lack of demand in a depressed phase of the business cycle, or structural, the product of more fundamental issues such as skills mismatches. The latter problem is more intractable, economists say, and less amenable to treatment via an easy monetary policy.

Nearly three years into the economic recovery, the jobless rate remains at a historically elevated 8.2 percent. Moreover, the economy has only made up about 3.6 million of the nearly 9 million lost during the recession. Against this backdrop, there is widespread concern that the U.S. economy might soon reach a point of what economists call (and here’s where the science comes in) “hysteresis.” In physics, the concept is defined as follows:

The retardation of an effect when the forces acting upon a body are changed (as if from viscosity or internal friction); especially : a lagging in the values of resulting magnetization in a magnetic material (as iron) due to a changing magnetizing force.

In economics, the term refers to the possibility that prolonged periods of cyclical joblessness, if left unchecked, could become structural as workers skills are eroded and their attachment to the labor force fades.

Fed Chairman Ben Bernanke highlighted that risk in a recent speech to business economists:

If progress in reducing unemployment is too slow, the long-term unemployed will see their skills and labor force attachment atrophy further, possibly converting a cyclical problem into a structural one.

In a research note last month, Jan Hatzius at Goldman Sachs laid out the case for why the Fed would eventually ease monetary policy further by alluding to the prospect of hysteresis:

Fed officials believe that the level of economic activity and employment is still far below potential. This means a large number of individuals are involuntarily unemployed, which not only causes hardship in the near term but may also translate into higher structural unemployment in the long term. This creates an incentive to find policies that speed up the return to full employment.

Bernanke, for his part, argued that even if most of the joblessness turns out to be structural in nature, that only reinforces the need for urgent action – though perhaps in areas outside monetary policy.

We should not conclude that nothing can be done. If structural factors are the predominant explanation for the increase in long-term unemployment, it will become even more important to take the steps needed to ensure that workers are able to obtain the skills needed to meet the demands of our rapidly changing economy.

 

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