Warnings of hysteresis for the EU economy

This is an updated blog post on the topic of hysteresis in the EU economy. The recession and financial crisis may lead to a permanent loss in potential economic output and a slower trend rate of growth in the future according to a study by the European Commission. The fall in potential GDP will be an example of hysteresis effects across the European economy and the cyclical downturn in output and jobs creates long term damage.

Hysteresis was defined well in a recent article in the Financial Times by Clive Crook

“Hysteresis is the the likelihood that lengthening spells of unemployment become self-perpetuating, as skills erode or grow irrelevant.”

The term is now being given a wider usage in exploring some of the long-term damage from a deep recession or a series of recessions such as double or treble-dips.

At the heart of the hysteresis argument is that a prolonged economic slump within the twenty-seven nations of the EU single market will lead to

*A steep rise in business failures
*A rise in structural unemployment together with a sizable number of people leaving the labour market permanently. A growing percentage of Europe’s unemployed have been out of work for at least six months.
*Some of the jobs in the housing and financial bubbles of the last ten years will never return - this poses a great challenge to labour markets of individual countries - notably Spain but also the UK.
*Sharp falls in capital investment spending by businesses
*Lower research and development with consequences going forward for the rate of innovation of EU companies in global markets
*A freeze on finance available for new business start-ups
* Problems for export businesses getting the trade credit they need to sell overseas
* The slump in property prices and associated negative equity / huge level of household debt is impeding geographical mobility of labour and making it harder to get many of the unemployed back into work
*A squeeze on state sector spending as governments must take steps to reduce their borrowing and debts - the sovereign debt crisis of 2009-10 is already causing many countries to introduce fiscal consolidation policies - in other words a tightening of fiscal policy designed to bring down debts at a early stage of the economic recovery,

“Empirical evidence of the effect of past economic and financial crises shows… that the economy will not return to its pre-crisis expansion path but will shift to a lower one. In other words, the crisis will entail a permanent loss in the level of potential output.”

Longer term demographic pressures will add to worries about the potential for economic growth - the welfare state of Europe’s member nations must grapple with the issues arising from rising life expectancy, low fertility rates and a shrinking working-age population.