Thursday, March 9, 2023

Business cycles impact growth trend - hysteresis

 


There is the trend in economic growth and then there is the business cycle which fluctuates around the trend. Many economists think of these as separate questions or issues. Figure out the trend and lock that into your thinking. It is usually associated with demographics and productivity and around 2%. Around the trend, there will be cycles. Unfortunately, life is more complex. The recession of today will have an impact on the long-term growth of tomorrow. Hysterersis studies the longer-term impact of these shorter-term cyclical shocks. Many economists call this the scarring from past events. 

How do we think about economic scarring? During a recession, business close, firms must change strategies, households lose wealth. If a business goes bankrupt, it does not matter if growth returns, the firm is gone.  A lost job cannot be immediately solved if an industry shrinks. Training will take time and wages may not return to old levels.

Similarly, during the pandemic, business operations changed, and they are not going to return to the pre-pandemic world. We are seeing this type of scarring with central business real estate. We have recovered but the traffic through downtown office building will not be the same. Markets will have to adjust, and this may not be seen in macro aggregates.  

The study of hysteresis is now the cutting edge of business cycle analysis, and it should be the cutting edge of macro investment research. There is a fundamental change in the pricing of assets if there is scarring that will change productivity and long-term growth. Businesses must see these changes and adapt. Governments must see these changes and adjust policies to offset scarring effects. Policies of just providing financial support may not be sufficient if there is persistent scarring.

The world is non-linear, and there are endogenous effects from shocks that impact growth. An issue is whether these shocks are permanent or just persistent and whether they can be overcome through changes in behavior and policies. Regime switching can be more involved than just identifying the phases of a business cycle.

Who are the winners and losers, post-recession or post-shock? Market sectors may be fundamentally changed. For example, the excess valuation of digital companies during the pandemic may not return. The poor valuations of energy companies may be reversed given the knowledge of energy scarcity sick the Russia-Ukraine War. 

See "Hysteresis and Business Cycles" for the pure academic macro perceptive on this issue.

No comments: