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Here we are again! The fourth quarter GDP numbers came in down and in January we got a massive tax increase. Doesn't this sound dysfunctional? The Republicans thought that refusing to increase the debt ceiling would give them great leverage to cut government spending and instead it led to a tax increase. American households and businesses don't know what to expect next so they restrain from spending and the economy limps along; lower tax receipts guarantee more and more deficits and a bigger national debt while Washington dithers.

The problem is that politicians and policy makers have confused two separate issues in fashioning fiscal policy and the net result is a sluggish economy and a ballooning national debt. Let's step back and look at those two issues.

The first issue is whether and to what extent deficit spending should be used to stimulate a sluggish economy. I thought that this issue had been settled a long time ago when I heard statements like "We are all Keynesians now" and "Deficits don't matter" coming from the Republican ranks. I think that there may be some legitimate debate about this issue but the evidence from around the world seems to confirm what we really knew all along - deficit spending, especially when the increased debt is monetized, tends to increase employment, reduce the danger of deflation and produce an overall increase in the GDP when inadequate demand is holding the economy back.

Notice that I have used the phrase "deficit spending"; an increase in spending paid for with higher taxes does not have this beneficial effect. It is the very "deficit" nature of the spending (the federal government spending more than it takes out of the pockets of its citizens) that has the stimulative effect on the economy. Simple mathematics reveals that you can create a deficit at least three ways: 1. spend more on government programs, 2. cut taxes, or 3. increase transfer payments. I tend to favor the latter two and will return to this theme later, but bear in mind that advocacy of deficit spending does not necessarily equate to advocacy of a "bigger" federal government.

Now let me turn to the second issue which is often confused with the first. The second issue is the question of exactly what we want the federal government to do and exactly what percentage of the economy we want the federal government to occupy. As noted above, this is very different from the first question and is more of a long-term policy question. You can have deficit spending without having a bigger government (if the deficit is created with tax cuts and transfer payments) and you can have a bigger government without deficit spending (if the increased government spending is paid for with tax increases).

The problem with the second issue is that it is almost always easy to come up with some argument for expanding the role of the federal government and it is very easy to find an interest group that will benefit from the expansion. Lobbyists, Congressmen, and interest groups form "iron triangles" in support of federal programs and the programs become eternal. This results in an inexorable increase in the size of the government as old programs are never abandoned and new programs are constantly added. It is not hard to find all kinds of wasteful and dysfunctional spending in the federal government; those of us who live in Washington can generate Kafkaesque stories about the flow of funds through the federal government which make visitors from around the country furious at tax time.

So the question becomes - what mechanism is available to prevent the Washington insiders from simply walking over to the Treasury with hefty bags and walking out with the bags stuffed with $50 bills? There is a very "common sense" answer to this question but unfortunately it is wrong. The common sense answer is that Congress should be required to balance the budget; if it wants to spend more money, it should be required to raise taxes and face the wrath of voters at the next election. After all, the rest of us have to balance our budgets; why shouldn't the federal government? And - in a very real sense - isn't the need to raise taxes the only real check on out of control spending in the federal government? Unfortunately this is the line of thinking which led to fights over the "debt ceiling" which, after generating much angst and a credit de-rating, finally resulted in a large tax increase just as the economy was going negative. As a result, we will probably stagger along for several more quarters and rack up bigger deficits than necessary because of the delay in an economic recovery.

So what can we do? How can we put some limit on the size of the federal government without relying on the bogeyman of national debt and deficits in a way which undercuts our ability to get out of a recession? I would divide the budget process into two parts - the "core" budget and the cyclical adjustment budget. The core budget would encompass most elements of federal spending and it would be limited to a certain percentage of normalized (full employment) GDP. An independent authority would select the GDP number each year and Congress would be required to keep federal spending below a certain percentage of that number. If Congress could not agree on a budget within the number, the President would have discretionary authority to cut spending in order to hit the target.

The cyclical adjustment budget would be completely separate and would be a program of short-term deficit spending to stimulate the economy. It would consist primarily of tax cuts (aimed at the middle class), transfer payments (such as the extension of unemployment benefits) and revenue sharing (direct payments to state governments). The revenue sharing would be based on a simple formula derived from the population in the most recent census with no strings attached. It would be designed to obviate state tax increases and the layoff of state and local government employees. These programs would phase out as the economy recovered.

Let me explain how this would work with an example. An argument could be made to turn over the production, repair and distribution of footwear to the federal government. Although it seems absurd, Washington lobbyists would not find it hard to marshall arguments in favor of this program: 1. better shoes would reduce a number of health problems and cut down on Medicare expenditures, 2. shoe soles could be designed to permit better identification of shoe prints in criminal investigations, and 3. inner city youth spend too much money on shoes. I think I know how most of us would feel about having the federal government do this, but here is the most important point I am trying to make: The decision about whether or not to have a federal footwear program should not depend upon whether the economy is in a recession and needs a stimulus at the time the decision is made.

The Republicans have made hay with the debt/deficit issue, but it has resulted in significant tax increases at the worst possible time. The Democrats have been allowed to expand the federal government - probably permanently - because the Republicans have been unable to separate the two issues described above. It is time to tell the American public the truth and to work together on a sensible fiscal policy which will get the economy out of the ditch and be functional in the long term.

Needless to say, I am not optimistic that we will get there. Instead, we will likely lurch along from debt ceiling debate, to sequestration deadline, to budget fix and the economy will move slowly up in fits and starts. What this means is that, in the absence of sensible fiscal policy, monetary policy will bear the full burden of engineering an economic recovery. This means that the Federal Reserve will have to maintain its expansive policy for a considerable time - likely stretching out until 2017. Pouring liquidity onto this mess will gradually lead to recovery because of increased spending due to the "wealth effect" and increased investment due to lower borrowing costs. But it will continue to take a great deal of liquidity and the assurance of very low interest rates for a very long time to have these effects. Low interest rates and increased liquidity are blunt instruments in the effort to achieve full employment, but they may be all we have.

We all might be better off if fiscal policy were rationalized but, until it is, we must realistically analyze the investment landscape as it is, not as we might like it to be. Low interest rates tend to drive up the price of financial instruments generating yield. With continuing low rates, investors will be desperate for yield and the rally in yield instruments will continue. Certain stocks are likely to benefit and these include business development companies (BDCS), electric utilities, real estate investment trusts (REITs), master limited partnerships (MLPS) and dividend-paying stocks in general. BDCs generally provide dividends of 8-12% with a modest potential for appreciation. Mortgage REITs provide even higher yields and equity REITs have substantial potential for appreciation, although they generally pay lower yields. Regulated electric utilities have had a great record of steady and slowly increasing dividends. Many dividend stocks - including Apple (NASDAQ:AAPL) - which now yields 2.3% (more than 10 year Treasuries) - will be perceived as better yield vehicles than bonds. Some companies in these categories will also benefit from low borrowing costs. Thus, a prolonged period of ultra low interest rates virtually guarantees a continued investor migration into these stocks. Investors will come out ahead even if the prices of some of these stocks decline somewhat because the added yield will provide offsetting benefits. The recent tax changes in response to the potential "fiscal cliff" will lock in the tax advantages of dividends over interest payments and this will add impetus to the investor migration into these stocks (investors should note that BDC and REIT dividends are generally taxed as ordinary income).

Some names I like here are Two Harbors Investment (NYSE:TWO) (yield -17.6%; a hybrid mortgage REIT), Horizon Technology Finance (NASDAQ:HRZN) (yield -9.0%; a BDC), Seagate Technology (NASDAQ:STX) (yield - 4.1%; a dividend stock) and Arbor Realty Trust (NYSE:ABR) (yield - 6.2%; a non-agency mortgage REIT). As time passes and rates stay low, the cost of staying out of these investments will become prohibitive. There is considerable room on the upside for these investments as long as the current policy mess persists in Washington.

Disclosure: I am long AAPL, HRZN, TWO, ABR, STX. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Source: How To Fix The Fiscal Mess