The third section is devoted to the concept of hysteresis, which seems to have been resurrected by mainstream economists. The fourth section deals with a number of miscellaneous issues, in particular the shape of the aggregate demand curve and the lack of a relationship between interest rates and public debt or deficit ratios.
I conclude with broad brushes about what ought to disappear and what might disappear from macroeconomic theory. Many others, such as Stiglitz and Mendoza have done an excellent job in pursuing this kind of exercise. Here I offer my idiosyncratic thoughts, starting with the reaction of economists to the crisis. It is well known that, just before the crisis, mainstream economists were bragging about how good their macroeconomic theories and policies had become. Just as the crisis was in the making, Olivier Blanchard , pp. A few years before, Robert Lucas , p. Has anything changed since the advent of the crisis?
The first view about economic theory and the Global Financial Crisis is that economic theory has nothing to do with it. This view is most entertained by economists who believe that the government should refrain from intervening in the economy and who believe that unfettered markets remove any imbalances and will keep the economy at full-employment equilibrium. However, even among people who hold more reasonable views, there is a belief that very little in economic theory or in economic policy needs to be changed.
Indeed several mainstream economists, as recalled by Mendoza , believe that mainstream macroeconomics can be easily repaired from within, or that the required modifications already existed before the crisis but were ignored. From this perspective, there is no other game in town … If you have an interesting and coherent story to tell, you can tell it in a DSGE model. Chari, as quoted by Garcia Duarte, , p. Simon Wren-Lewis , p. The second view about economic theory and the Global Financial Crisis is that economic theory was indeed a cause of the crisis.
This view is very much entertained by left-wing heterodox economists in general, for instance Heinz Kurz , but it can also be found among neo-Austrian economists and among orthodox economists, or at least among those that I like to characterize as dissident orthodox economists.
Neo-Austrian economists, in particular those working at the Bank for International Settlements, were quite critical of the New Consensus among mainstream economists even before the advent of the subprime financial crisis. For instance Borio and White argued early on that the move towards more liberalized financial markets and the increased reliance on market evaluations have increased the inherent pro-cyclical tendencies of asset prices and of the banking system, making it more vulnerable to boom and bust cycles, thus contradicting the apparent success of inflation targeting policies and creating large imbalances and credit swings.
After the crisis, White , pp. The strongest indictment of orthodox theory from the orthodox side was perhaps made by Willem Buiter, a former member of the Monetary Policy Committee of the Bank of England, and admittedly an early critic of the hypothesis of rational expectations. Critics of DSGE models do not only include heterodox economists and past recipients of the Nobel prize. Hope and Soskice , p.
In effect, they reject rational expectations. It is claimed that the main tool of central bankers, the DSGE model, was doing very well as long as the American or European economies were moving along the lines of the Great Moderation. There seems to be a consensus about the limited range of application of DSGE models. Charles Goodhart , p. Similarly, for Bernanke , p. Blanchard , p.
But this sounds like wishful thinking. There is a need for theories or models that take these dark corners as genuine components or likely possibilities. Still it seems that some economists are saying tout et son contraire. Take for instance the case of David Colander, who is usually deemed to be a mainstream economist by heterodox authors while being perceived as a key voice of the heterodoxy by the mainstream. Colander has been a long-time advocate of what he called the post-Walrasian approach, also presented as the complexity approach to macroeconomics.
A year later, Colander , p. The new Colander , p. There has also been a reversal regarding the worthiness of some concepts. For instance, there is now a great deal of renewed interest for the notion of hysteresis, a concept that mainstream economists such as Blanchard and Summers introduced in discussions about unemployment in the early s but that had nearly completely vanished with the apparent success of the Great Moderation, only to reappear with the prolonged aftermath of the financial crisis.
Some could even say that Blanchard has recanted from his previous stand on the state of macroeconomics. In a recent interview in the IMF Survey Magazine, he made the following statement, that seems to open the door to alternative views and in particular to views endorsed by long-time advocates of post-Keynesian economics:.
As a result of the crisis, a hundred intellectual flowers are blooming. Kaldorian models of growth and inequality.
Hysteresis in economic relationships: An overview
Some fundamental assumptions are being challenged, for example the clean separation between cycles and trends: Hysteresis is making a comeback. This is all for the best. In this interview Blanchard points out that the Global Financial Crisis has made a lot of people realize that what had become the established or fashionable theoretic approach in economics was not necessarily the best, and that it was time to go back to some of the ideas and models that had been set aside or abandoned in the past.
Buiter , in the article referred to earlier, had mentioned as possible alternatives the works of behavioral economists, as well as that of Hyman Minsky, Stiglitz and Tobin. Alan Blinder , pp. As noted by Blanchard in the previous indented quote, there is a return of the concept of hysteresis and the possible rejection of models based on the assumption of stationarity around a trend. As Blanchard , p. In neoclassical CGE models, full employment is assumed, and the effects on output can only be achieved by efficiency or productivity gains that arise from specialization or the removal of what the modellers consider to be microeconomic distortions.
In DSGE models, it is assumed that the economy will necessarily come back to its potential output, which is essentially determined by the supply of labour, set by demographics and the height of the real wage. If any change in the rate of employment occurs, it can only arise as a consequence of a short-term deviation that will be wiped out over the long run.
In those models, just as in the neoclassical computable general equilibrium CGE models, output and employment can only be improved by the removal of rigidities and distortions, where relative prices play once again the essential role. Whether discussing neoclassical CGE or DSGE models, increases in employment will be driven through the labour supply function, with higher real wages inducing more consumers to drop their leisure time and increase the time they wish to devote to work. Whether we are talking of neoclassical CGE static models or of the dynamic stochastic equilibrium models does not matter: these mainstream models in general do not take into account that the new equilibrium resulting from some change or shock will be influenced by what occurs during the transition from one equilibrium to the next.
In other words, these models assume away path-dependence and hysteresis.
Hysteresis in economic relationships: An overview - Semantic Scholar
They assume away the possibility that demand-led factors will have an impact on the long-run equilibrium, for instance the long-run value of potential output or the long-run value of the natural rate of unemployment. They assume away the possibility that demand-led factors can change the slope of the trend growth rate of potential output over the long run.
Laurence Ball , p. This effect is temporary, however. This is illustrated with Figure 1. More recently, the Global Financial Crisis has clearly illustrated that quantity effects generated by demand-led factors have had a much greater role to play than price effects coming out from supply-side factors. This has been pointed out even by some authors, such as Lawrence Summers , who in the past had succumbed to the sirens of supply-led models.
Summers, as reported by Laurence Ball , p. This, he says, has occurred through a reduction in capital accumulation, a lower labour force participation rate, and a slowdown in the growth rate of productivity. I will briefly come back on this third cause in the text below. But these hysteresis effects have not only arisen as a consequence of the recent Global Financial Crisis. They have arisen in a majority of previous recessions.
Blanchard, Ceretti and Summers , in a study of over recessions, assess that more than two-thirds of them have led to a permanent gap between the previously estimated potential output and the after-recession estimate. Summers , p. Hysteresis, as it used to be mostly understood by some eclectic New Keynesian authors, and super hysteresis , as it was mostly advocated by post-Keynesian authors, are illustrated with Figures 2 and 3 respectively.
In Figure 2 the economy returns to its previous long-run growth rate, but the level of output does not go back to what it would have been without the recession. In Figure 3, the economy never goes back to its previous long-run growth rate — the case of super hysteresis.
In other words, as long as we accept that recessions are mostly caused by elements related to the demand side, and not to unexpected drops in productivity as argued by advocates of the real-business cycle theory, aggregate demand does have a feedback effect on the long-run supply side. As Stiglitz , p. Thus, to provide a compelling analysis of what is going on, we need models that are demand-led, possibly with the incorporation of some supply-side elements that will allow us to assess the possible effects on potential output.
There has always been a tradition in economics that kept rejecting the supply-led approach. It is well-known that the Keynesian tradition has put the emphasis on demand-led factors. This does not mean that supply factors are totally ignored. What it means instead, as implied by the following two statements from well-known Cambridge authors, is that the natural rate of growth is heavily influenced by the growth rate of demand. But at the same time technical progress is being speeded up to keep up with accumulation.
The rate of technical progress is not a natural phenomenon that falls like the gentle rain from heaven. When there is an economic motive for raising output per man the entrepreneurs seek out inventions and improvements. Even more important than speeding up discoveries is the speeding up of the rate at which innovations are diffused. When entrepreneurs find themselves in a situation where potential markets are expanding but labour hard to find, they have every motive to increase productivity.
The stronger the urge to expand … the greater are the stresses and strains to which the economy becomes exposed; and the greater are the incentives to overcome physical limitations on production by the introduction of new techniques. Technical progress is therefore likely to be greatest in those societies where the desired rate of expansion of productive capacity … tends to exceed most the expansion of the labour force which, as we have seen, is itself stimulated, though only up to certain limits, by the growth in production.
Kaldor, , p. For instance, before the subprime financial crisis, in an interesting empirical study Leon-Ledesma and Thirlwall have shown that the natural rate of growth, which is at the heart of supply-side analyses, is in fact endogenous to the growth rate of actual output, providing evidence that the natural rate of growth rises in booms and falls in recession.
Their results, at which they arrive by finding the GDP growth rate that leaves constant the rate of unemployment, have been confirmed by a number of other empirical studies, using the same methodology, for other regions of the world. As an aside, it should be mentioned that most mainstream economists and policy makers interpret hysteresis as being something that only occurs on the downward side. A financial crisis or some other catastrophic shock is presumed to have bad hysteretic or super-hysteretic effects on the economy, essentially through the labour market, as unemployed workers are said to be losing their working skills.
This is to be contrasted to the post-Keynesian view, as presented in the above paragraphs, and as reflected in the numerous empirical works on the Kaldor-Verdoorn effect, whereby fast growth rates in manufacturing or more generally in GDP lead to an acceleration in the growth rate of labour productivity. For post-Keynesians, slower and faster growth in aggregate demand will induce effects on the possible growth rates of supply.
In the mainstream view, these effects only occur on the downward side, if at all, since it is sometimes argued that it is a fall in the growth rate of potential output that has generated the observed fall in the growth rate of aggregate demand. An interesting feature of the work of Blanchard et al. In other words, while an observer trained in New Classical economics could possibly argue that both the initial recession and the fall in future potential output had the same cause — a slowdown in productivity growth — the fact that recessions induced by restrictive monetary policy also lead to reductions in middle-run or long-run potential output shows that demand shocks also have a long-run negative impact.
This has all kinds of interesting policy consequences. First, obviously, if potential output depends on demand, then it must be that the NAIRU and the SIRCU the steady-inflation rate of capacity utilization are also influenced by demand factors. Before the crisis, several authors had provided empirical evidence that the NAIRU hypothesis had been falsified many times over and that it should be abandoned Storm and Naastepad ; Vergeer and Kleinknecht ; Mitchell and Muysken There were also some signs that institutions like the OECD — the champion of labour flexibility — was sometimes backtracking on its claims and on its systematic calls for labour market reforms.
Before the crisis, it was believed that unemployment rates in the US were lower than elsewhere because their labour market was more flexible. When unemployment rates in the US started to exceed those of most European countries it became evident that unemployment rates were high because aggregate demand at the time was low. Indeed, this is the conclusion of Tom Stanley , p. Still, within the context of European policies, calls for labour reform — a euphemism for lower real wages and less job security — continue unabated. A second consequence of the results obtained by Blanchard et al. It was always claimed by central bankers that restrictive monetary policies were good for the economy because by producing short-term recessions they would generate lower inflation rates and more efficiency, thus achieving higher output per capita in the long run.
Short-run pain was needed to achieve long-term bliss. The only question was whether the central bank could devise means, such as inflation targeting, by which the inflicted short-term pain could be reduced how the sacrifice ratio could be somewhat reduced.
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It was always denied that short-term recessions engineered by central banks could generate lower long-run potential outputs. Central bankers now start to recognize that imposing low inflation may inflict long-run and permanent costs; in other words, they admit the possibility of hysteresis. Furthermore, central bankers have been unable, after more than thirty years of intensive search, to provide any compelling evidence that low inflation is conducive to high productivity growth, in contrast to what was earlier asserted when anti-inflation policies were put in place as a follow-up to and replacement of monetarist policies.
The assertion was based on the special case of the s when high inflation rates were associated with a slowdown in productivity growth, but the negative relationship was never recovered afterwards. And of course, the subprime financial crisis has provided the clearest of demonstrations that low inflation rates could not guarantee financial stability, as it was once hoped. An interesting fallout from this rediscovery of hysteresis effects is the controversy that arose following the estimated effects of the economic program of the Democrat presidential candidate Bernie Sanders, as they were computed by Gerald Friedman a — an economist from the University of Massachusetts in Amherst.
Following the critique of Romer and Romer , he discovered to his dismay that the hysteresis and Kaldor-Verdoorn effects that he had assumed in his estimates were not part of standard modeling — that is, the kind of models that is used by the Council of Economic Advisers. His response to the critique illustrates well the importance of incorporating demand-led path dependence. If the Romers were right that the economy is at full employment at capacity utilization, and capacity utilization grows independently of the level of output, then there cannot be a lasting stimulus effect at a fully employed economy.
In the Romer case, a stimulus can raise output only temporarily because output depends on capacity and the economy is always at or moving towards capacity. But, if the economy can be stuck at an unemployment equilibrium, if it does not move to a full employment equilibrium, or if a higher employment and output level can trigger a higher growth rate, then a Keynesian-style government stimulus can have lasting effects…. We might call this, the Keynesian-Kaldor case with equilibrium unemployment and growth dependent on the level of the output gap.
In the Keynesian-Kaldor case, a one year stimulus can lead to permanently higher output both by reducing unemployment and by raising the growth rate of capacity. Several other beliefs, that one would have thought were well entrenched in mainstream macroeconomics, have been questioned as a consequence of the financial crisis and its aftermath. One of them is the belief that the aggregate demand curve has the standard negative slope.
The desperate efforts of central bankers to stop prices from falling has clearly shown that central bankers for all practical purposes do not hold to the standard view that more flexibility in wages and prices is conducive to a better performance. In as self-adjusting system, with no rigidities, a recession should induce a fall in wages and prices. A reduction in the wage rate leads to a rightward shift of the aggregate supply curve from AS 1 to AS2 , and thus, with the standard negatively-sloped aggregate demand curve, this ought to lead to an increase in real output, here from Y 1 to Y 2.
Why then would central banks pursue all kinds of non-conventional measures to stop wages and prices from falling when a recession occurs? Obviously, as shown in Figure 5, if the aggregate demand curve is upward sloping instead of being downward sloping, then the actions of central bankers — putting aside the fact that several central banks are committed to inflation targeting and hence aim at low inflation rates — are much easier to understand.
In this case, a fall in wages and prices also shifts the aggregate supply to the right, but this time the lower wages and prices induce a decrease in the level of real output, which falls from Y 1 to Y 2 in Figure 5, as the equilibrium point moves from A to B.
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The downward flexibility in wages and prices does not engineer a recovery of output. Instead, it engineers mounting problems for those households and firms who have large liabilities, it leads to debt defaults and bankruptcies, as well as the destruction of output capacity. Modern macroeconomic theory, based on the New Consensus, relies on a presentation that highlights the rate of price inflation rather than the price level. In the not-so-distant past, the limits to monetary policy were being attributed to rigidities in real wages.
If the rate of inflation got close to or reached zero, it was argued that there was no room for real wages to decline in a downturn, because nominal wages were downwardly rigid and were unlikely to fall. With inflation at or close to zero, nominal wages and hence real wages would not fall when faced with a decline in nominal aggregate demand, and as a consequence firms would be forced to lay off workers, unemployment would rise, and real GDP would fall. The economy would need wage deflation to achieve potential output. The downward rigidity in nominal wages close to zero price inflation has now been replaced by the downward rigidity of nominal interest rates in the pantheon of neoclassical explanations of unemployment and economic stagnation.
This is the highly heralded zero-lower bound on nominal interest rates, or what Krugman has called, erroneously, the liquidity trap. With nominal interest rates at their zero-lower bound and once more with inflation rates at or near zero, real interest rates cannot be made to be negative enough to achieve the real rate of interest that would be needed to bring back the economy to potential output or full employment.
The nominal interest rate would need to be negative for the equilibrium real interest rate to be achieved. It has also been argued that unemployed people lose their skills during unemployment, which makes them less likely to again get jobs. If there is no hysteresis in unemployment, then for example if the central bank wishes to lower the inflation rate it may shift to a contractionary monetary policy , which if not fully anticipated and believed will temporarily increase the unemployment rate; if the contractionary policy persists, the unemployment rise will eventually disappear as the unemployment rate returns to the natural rate.
Then the cost of the anti-inflation policy will have been temporary unemployment. But if there is hysteresis, the unemployment rise initiated by the contractionary policy will never completely go away, and in this case the cost of the anti-inflation policy will have been permanently higher unemployment, making the policy less likely to have greater benefits than costs.
The experience of the United Kingdom since the early s counts against hysteresis as a determinant of the natural rate of unemployment, as unemployment fell much faster in the recovery from the early s recession than after the early s recession. An econometric study of fourteen OECD countries rejected the hysteresis hypothesis,  as did a study at the state level in the US. From Wikipedia, the free encyclopedia. This article needs additional citations for verification.
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