Intro: Policies that are fundamentally positive in the long term can undermine growth in the short term by creating economic shocks that require large-scale readjustments by businesses leading to an initial decline in overall output before the recovery takes effect. Fiscal austerity measures are a prime example of where productivity-enhancing measures often expose the extent of an economy’s underlying distortions, creating near-term economic weakness.
Similar to how fiscal and monetary stimulus measures can create short-term growth at the expense of long-term wealth creation, prudent policy measures can initially exacerbate growth weakness in the short term. Economic medicine can make the patient feel worse before the recovery begins.
Rising interest rates can to negatively impact growth in the near term if central banks are forced to tighten policy from a previously excessively loose stance amid a weakening currency and/or surge in inflation (in which case nominal rates would have to rise significantly in order for real rates to rise amid rising inflation). The first thing to note is that it is the excessively loose policy to begin with rather than the tightening itself that is the ultimate cause of the weakness. By avoiding tightening the economic distortions would continue grow, and tightening brings this to an end. However, as real rates rise, it can create a shock to the economy causing a change in consumer spending patterns and profitability forcing a faster rebalancing of the economy than otherwise would be the case.
When governments cut spending from excessive levels it can result in a short-term growth slowdown even if the cuts are in wasteful areas that ultimately undermine long-term wealth creation. By avoiding cutting spending the wealth destructive policies would continue slowly undermining real GDP growth, and the cuts bring this to an end. However, as spending falls amid fiscal austerity measures, certain sectors that previously benefited from excessive spending are likely to suffer and it may take time until resources are shifted towards more productive areas to the ultimate benefit of the overall economy.
A good example is the former Soviet Union. Economic reforms initially caused a crash in real GDP as steel production cratered and it took time for resources to shift towards producing things more in line with consumers’ demands. Nonetheless, had the unproductive spending on steel production continued, the ultimate reset would have been even more catastrophic.
Structural reform measures can also undermine short-term growth for similar reasons as falling government spending. Policies such as removing fuel subsidies, allowing state enterprises to fail, removing preferential treatment to certain industries, can all occasionally undermine growth in the short term by forcing a shift in consumption patterns and corporate profitability which take time to adjust to. Over time the economy will tend to arrive at a more sustainable and productive structure reflecting improved economic freedom and fewer distortions.