Hysteresis in the periphery
Recently, financial markets around the world have undergone a sharp correction in response to fears of an eventual tapering in the Federal Reserve’s Quantitative Easing program. The reaction was spurred by Ben Bernake’s, Chairman of the Federal Reserve, comments to the press that QE will be slowed if unemployment falls to 7% and inflation remains within their target. Cautiously this may be sooner than expected as the US economy is beginning to show sustained periods of healthy increases in employment growth.
However, the same cannot be said for the European Union. GDP in countries in the periphery continues to decline, with Italy suffering a 2.4% decline and Greece a 5.6% decline in the first quarter of 2013. Alarmingly it’s Italy’s worst recession in 20 years. With this persistently poor performance, comes the danger of hysteresis. Economies faced with a prolonged period of economic contraction, are argued to suffer a permanent loss of total output over time. This is usually accompanied by rising prices and higher unemployment.
Hysteresis in the periphery area of Europe will arguably be caused by youth unemployment. In Greece and Spain, youth unemployment has now reached over 50%. Amongst college graduates in Spain, only 40% will go on to find a job in their field, with many others accepting jobs far below their attained qualifications. Consequently, as many of Europe’s skilled labourers retire at an increasing rate, there will be a huge hole left by young graduates who don’t have the requisite skills or experience to fit the position.
Youth unemployment and the Philips Curve
The Philips Curve can demonstrate the harmful impact of persistent youth unemployment on prices and the natural rate of unemployment in the long run. As demonstrated in Graph 1.1, it represents the trade-off between prices and employment, as opposed to other conventional models that show the relationship between prices and output. For example, a 1% increase in employment may lead to a 2% increase in prices.
The main cause of hysteresis is workers exiting the labour force and the destruction of physical capital as firms liquidate assets. Using the Philips Curve, this can be illustrated as a series of adverse supply side shocks as the economies productive capacity shrinks, leading to cost inflation. In the short run workers expectation are slow to adjust to changes in prices, and therefore real wages remain fixed. In the long run workers press for wage increases when they become aware their real wages have fallen. As illustrated in Graph 1.2, in the long run total output of the economy falls. This is accompanied by a rise in the short run Philips Curve which responds to the decline in long run output and increasing inflation by workers raising real wages.
The social costs of high youth unemployment are both devastating and unavoidable. The Periphery is already experiencing mass youth and student demonstrations and violent social unrest. The longer term implications appear to be more dire. With young individuals out of work, they’ll be denied of necessary skills and experience that can only be learnt on the job. The slow erosion of a skilled labour force in the Periphery will lead to the shrinking of vital industries demanding highly qualified workers. With an ageing population, government expenditure may rise to unsupportable levels and lead to an eventual default on sovereign debt.
Rising prices and wages
Price rises represent another significant danger for the periphery economy. If the theory is proven correct and these economies face ongoing inflation above central bank targets, the periphery economies may find it even more difficult to increase economic activity. The most obvious danger is central banks tightening monetary policy in an effort to get inflation back within their targets. However, one of the most alarming scenarios is a stubborn cycle of price and wage increases.
The problem of rising wages and prices manifest itself most prominently in global trade. Italy is already an example of this, whose excessively rigid labour market and growing inflation is making it more difficult for the country to compete against cheaper imports. In conjunction with an expensive Euro compared to its competitors, rising wage and prices will almost destroy the periphery economies competitive cost advantage in key exporting and trade exposed industries.
The way out
EU policy makers need to show as much vigour in addressing high levels of unemployment as does its American counterparts. A possible way things can be turned around is through structural reform. In Italy especially, politicians need the conviction to overcome unionist pressure and decentralise an overly rigid labour market. More broadly, any reform that can counter the ongoing and future decline in productive capacity should be welcomed.