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It’s time to start rooting for a default by Greece. Much good can come from such bitter medicine. That’s because a default in bond payments by Greece will awaken the public and help ignite a new trend toward fiscal responsibility in democracies worldwide, including the United States.

Greece, Portugal, Spain, Italy, the UK, Japan, California, New York and New Jersey have one thing in common: their governments continually borrow more and more money faster than the growth of net tax revenues. But the politicians in these locations are not to be blamed.

They are merely expressing the will of the people. Across the developed world, consumers have developed a taste for borrowing more and more in their personal lives. When able, consumers drive their debt levels ever higher, interrupted only by the recent credit contraction, with discipline provided by newly sober lenders. We can not blame the politicians for governments’ debt spiral. Government officials who raise taxes are predictably turned out of office. So, the fiscal position of governments deteriorates progressively. They borrow more and more because they can.

Sovereign debt and local government debt typically are assigned high bond ratings and are thought to have a low chance of default. That's because governments always have the option to raise taxes to raise more revenue. But, now we are undergoing a crisis that is rooted in democracy. We want to run our government finances like we run our personal finances. Irresponsibly. At some point the bond market will discipline all profligate governments, just as the credit card companies and mortgage lenders have reined in consumers during the recession.

Crunch time is here and now for Greece. The bond market will not lend them any more money, except at extremely high interest rates. So, Greece awaits a bailout loan from the European Union. If it does not come through, that nation will be forced to actually raise taxes, cut spending or default on its debt. The problem is that it takes time to raise taxes or cut spending, while default looms every time a debt maturity date arrives and the debtor must repay a large amount of principal. Up to this point, like subprime homeowners facing a rate increase, governments typically have tried to pay off the old debt by issuing new debt. But that avenue is closing fast for Greece.

In much better shape are the individual states in the U.S. Unlike Greece and other nations, states must balance their budget every year. Typically, states which undergo fiscal crises each year first kick the can down the road by adopting budget gimmicks, like postponing pension payments or raiding their special purpose funds. Eventually, these gimmicks run their course and there are no more to be found. At that point the state government must raise taxes or cut spending, or some combination of both.

So, at the state level, the problem cannot get too far out of control. California and New Jersey do get by each year. Granted, public services in these states are deteriorating. but the requirement that state operating budgets be balanced does keep them afloat, financially speaking. And state governments in the U.S. will soon benefit from increasing tax revenues as the national economic recovery proceeds and gathers steam. The next crunch time for state issued bonds will be postponed until the next recession shrinks tax revenues, and that point is likely years away.

Unlike the individual states, national governments are under no constitutional constraints that limit their fiscal irresponsibility. They are free to run budget deficits. Hence the crisis in Greece and the looming crisis in other countries. One would think that solving the problem is simple: cut profligate spending and raise taxes. But that just hasn't happened yet. At any hint of cutting public jobs or wages, unions take to the streets in Greece and the politicians cave in. This morning brought news that pilots in Greece’s Air Force are calling in sick to protest proposed cuts. It is very tough, politically, to make cuts in such an atmosphere. And how many politicians today are brave enough to raise taxes - either in Greece, or in the U.S., for that matter? The fiscal condition of national governments is deteriorating, aided and abetted by the effectiveness of their democracies, in which consumers’ debt addiction spills over into public policy.

But herein does lie the solution. Eventually, governments will HAVE to cut spending and/or raise taxes. The alternative is to default on their debt. Upon that occurrence, the problem goes away for awhile, since the burden of making debt payments is lifted. But, every government which has defaulted has eventually gotten its fiscal house in order and secured new credit in the international markets. So, default does seem to give birth to fiscal responsibility. Just like being on the receiving end of a military attack builds political support for going to war, a bond market default can stimulate fiscal improvements, like tax increases or spending cuts, which never would have been undertaken in the absence of a crisis.

So we await the probable default of Greece, after which they will cut spending and/or raise taxes. Can Portugal, Spain, Italy, Japan, the U.K. and the United States be far behind? One would hope that Greece will provide a lesson for the others and that the other democratic countries, including the United States, will find the political will to cut spending and/or raise taxes to head off the developing fiscal crisis. If not, the bond market will do it for us.

Investment implications:

State issued long term bonds are not attractive. State bonds probably will escape default, at least until the next recession (even California). Budget season is about to start in the states and will result in further cuts in spending. Then, increased tax revenues will accrue. But the downside of these bonds lies in their interest rate risk, which means that long term bonds lose value as rates rise. A further concern is inflation risk, as inflation erodes the purchasing power of both the principal and the fixed interest payments. Over the next few months, opportunity exists for capital gains in those bonds whose value has been hurt by fears of default, like those of California. But, by 2011, the value of all long term bonds will suffer as interest rates and inflation both rise. So investors may be tempted by the current relatively high yields of some long term munis, but the risks of loss of value are too high to make these investments attractive.

U.S. Treasuries are to be avoided. They face potential declines in value right now, as their relatively low interest rate has been kept down by a “flight to quality.” This phenomenon will abate as the worldwide economic recovery proceeds. There will be occasional bumps up in value as Greece and other governments flirt with default, but the overall trend of Treasury rates will be higher (toward 4.5% - 4.75% for the 10-Year), and the value of existing long term Treasuries will decline.

Treasury Inflation-Protected Securities (TIPS) should be bought by those who insist on garnering a risk-free return. They are most suitable for retirement accounts, since the rate of inflation drives the principal value of these bonds higher each year and that increase in value is taxable income in the year it accrues, even though the investor does not receive that money until she sells the TIPS or they mature. Investors who choose this investment may buy them directly from the Treasury, or indirectly through various mutual funds or exchange traded funds (ETFs), such as Ishares Barclay’s TIPS Bond ETF (NYSEARCA:TIP), or Pimco 15+ Year US TIPS Index ETF (NYSEARCA:LTPZ), or Pimco 1-5 Year US TIPS Index ETF (NYSEARCA:STPZ).

Disclosure: No positions

Source: Time to Start Rooting for a Greek Default