Senior Adviser, Chatham House; Chair, University College London; Independent Non-Executive Director of Jones Lang LaSalle (USA) and ICE Benchmark Administration

This article originally appeared on the Financial Times A-List blog.

The big debate of 2012 will be over the role of government in the economy.

Although this sounds like an economic issue, it is really about politics. There is no economically optimal size of government. Voters must choose whether they prefer high public sector spending and generous entitlements coupled with higher taxes to pay for them, or modest public provision and basic entitlements along with lower taxes and therefore more take-home pay. The ongoing financial crisis provides stark evidence that the current model of high public sector spending financed by growing public sector debt has hit the buffers.

The US election campaign is already taking shape around this issue. The Republican candidates seem determined to outdo each other in their opposition to government spending, whether for healthcare or road repairs. Their arguments vary with their political stripes. The more moderate point to the inefficiency and low quality of public sector services. The more extreme think it is immoral for government to confiscate people’s income through taxation for anything other than 'pure' public goods such as defence. They believe individuals should have the right to keep their income and spend as they choose, rather than having choices made by bureaucrats.

On the Democratic side, Barack Obama is fighting to maintain his healthcare reform and extensions to unemployment compensation. But he continues to claim that such entitlements can be financed by higher taxes only on 'millionaires and billionaires'. Few economists support that view. More importantly, the polls show that the public is very concerned about rising government debt and sceptical that higher deficits will stimulate growth.

Despite this heated pre-election debate, the US may be able to fudge the issue for a little longer. There are still willing buyers of US debt in Asia and, if 2012 brings more financial shocks, the dollar will benefit from safe haven flows. But Europe is running out of time and it starts from a worse position. Taxes are already so high that they depress growth, both by making Europe an uncompetitive location for many businesses and through what economists call the 'deadweight loss' they impose on the economy. This problem is compounded for eurozone members, which cannot adjust by depreciation.

Meanwhile welfare spending and public sector employment now benefit so many voters that it is hard for politicians to win backing to cut them. The social contract that underpins democracy requires compromise. But the political debate will grow more confrontational in 2012. This will be the year that the financial crisis turns into a number of political crises.

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