Finance

Is Compromise Achievable?

Public and private sectors, and the dilemma for politicians

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This fall’s election divided the two parties into contrasting camps when it comes to solutions for our stalled economic recovery. One side espoused more government, the other side more benefits for the private sector. On the campaign trail, there seemed to be little middle ground. Yet compromise may be an economic ne-cessity for 2013, and it doesn’t have to be as difficult as it seems.

Two strategies – spending and tax cuts – have successful track records for creating growth, but government spending is fast money while the benefits of tax cuts are delayed. And neither policy alone can escape the problem of being too much stimulus altogether.

Economists who argue for government spending believe that more stimulus is needed to create demand and avoid another recession. They encourage public policy that takes advantage of extremely low interest rates to borrow and invest in the economy. Economists who oppose stimulus spending argue that this policy creates long term distortions in the free market system and can result in even bigger financial crises down the road. These economists feel lower taxes, less regulation, and smaller government will better encourage private investment and income producing activities.

Economic theory tells us that government spending is an effective tool to create immediate demand, while tax cuts and less regulation are better strategies for inspiring longer term growth. If politicians can see compromise sequence of complimentary policies rather than a clash of competing ones, they have a decent shot at creating a credible plan.

To start, political leaders should view the private and public sectors as two inextricably intertwined parts to a whole. Think of an old fashion two pan scale. The goal is to keep the two sides balanced. Sometimes one side gets weighed down more than the other. In this economic analogy, debt is often the culprit tilting the scales. For many years the private sector, including consumers and businesses, borrowed way too much, causing the private side of the scale to sink below public side. The obvious solution is for consumers and businesses to pay down their debt.

However, if implemented by itself, debt reduction can hurt the economy. When people pay off their mortgages, they tend to save some of their previous monthly payments, and when businesses pay off their loans, they are inclined to build up cash on their balance sheets. Add in the banks, who have restricted lending, and you have stalled growth. This reduced consumer spending and restricted lending may adversely impact the economy and result in the dreaded double dip recession.

In order to get the scale back in balance, the government needs to “dis-save”, or engage in deficit spending, while the private sector deleverages. One strategy is government stimulus packages. In the short run, this approach is effective because stimulus money in the hands of individuals tends to be spent and it can save jobs.

The problem is that stimulus funds, aside from those allocated for special infrastructure and health care programs, tend not to create new jobs. Most of the new jobs needed for growth are initiated by the private sector. Since consumers and businesses will be deleveraging for years, incentives in the form of tax cuts and other policies are needed to encourage longer term investment in people and new businesses.

As long as government debt on one side of the scale is offset by private deleveraging on the other, the system remains in balance. Fear of runaway deficits becomes valid if and when the scale cannot be tipped back the other way. At some point, the government has to start saving (reducing its debt) to balance new growth created in the private sector.

The challenge for the political parties in 2013 is not pitting the public and private sectors in a zero sum game but creating a credible timetable for the two parts of the whole to work in tandem and achieve balance. This means stimulus spending accompanied by tax incentives followed by smaller government.

The public and private sectors can not simultaneously accumulate unsustainable debt and overspend. For the compromise to be credible, look to see if politicians understand the importance of the synergy between public and private sectors and if they can get the tipping points right.

Betsey Purinton, CFP® is Managing Director and Chief Investment Officer at StrategicPoint Investment Advisors. You can e-mail her at bpurinton@strategicpoint.com.