Secular Stagnation, Unemployment Hysteresis and Monetary Policy in EMU: Scratches but Not Scars?

The strength of mutually reinforcing links between the demand and supply sides of the macroeconomy is an important issue for policymakers which has emerged from the financial crisis. The prevailing view that only cyclical policies influence the demand side, and structural policies affect the supply side has been challenged in two dimensions. Firstly, long periods of weak demand have the potential to lead to rising structural unemployment and a permanently lower capital stock – inducing hysteresis effects. Secondly, if one believes in the relevance of hysteresis in the form propagated by [Blanchard, Olivier J., and Lawrence H. Summers. 1986. “Hysteresis and the European Unemployment Problem.” In NBER Macroeconomics Annual, edited by Fischer, S., Vol. 1, 15–78. Cambridge: MIT Press], stronger demand fueled, for instance, by monetary policy may, as a corollary, be able to reverse such effects. This paper argues that the Blanchard and Summers type of hysteresis should, however, not be taken literally and not taken as the basis of one-to-one into recommendations for monetary policy and/or the monetary policy strategy. We show that bluntly pointing to the hard form of “reverse hysteresis” and implementing bold counter-cyclical monetary (and fiscal) policies to cope with hysteretic unemployment is neither necessary nor sufficient. Instead, we argue that it is necessary to refer to subtler forms of hysteresis, which are more compatible with the data. These subtler forms still leave some room for monetary policy to maneuver, but in a much more complex way. If long-term unemployment is stagnating even during an upturn, they may even serve as a basis to recommend a contractionary monetary policy stance. At the same time, however, inequality which is causing persistent or even permanent demand deficiencies becomes relevant as hurdle for lower unemployment in the hysteresis context. Seen on the whole, thus, a second wave of hysteresis-based research on monetary policy options following the first wave in the 1980s should clearly be on the agenda.