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Bond investors tend to favor austerity programs, and here's why: The narrower the gap between what a government spends and what it collects in taxes, the likelier it will repay its debts. Countries that strive to balance their budgets are rewarded with lower interest rates on their debt. That's one reason the yield on Britain's 2-year notes has dropped from 1.5 percent to 0.4 percent over the past year. Likewise, yields on Italian government bonds fell after the country's new technocratic prime minister, Mario Monti, unveiled plans to get the country's finances in order. But the Bank of England and the European Central Bank can also claim much of the credit for the lower rates. The Bank of England has pushed yields down by actively buying bonds, a policy known as "quantitative easing." The ECB in December provided hundreds of commercial banks with nearly $640 billion in low-interest three-year loans. The banks used some of this money to buy Spanish and Italian government bonds, pushing yields lower. The central bank intends to make more bank loans later this month. But the bond-market exuberance may not last. Olivier Blanchard, chief economist at the International Monetary Fund, has said even bond investors can rebel against austerity, once they realize that government cutbacks can squeeze growth and cause debt burdens to rise. "There's no doubt that the strategies pursued in Greece, Portugal and Ireland have contributed to a dramatic increase in those countries' overall debt burdens," says Simon Tilford, chief economist at the Centre for European Reform in London.
"Strengthening public finances is a marathon, not a sprint, and it can only take place across a backdrop of reasonably healthy economic activity." The United States is taking the marathon approach, putting off serious budget cuts until the economy is stronger. What Europe needs, says Paul Christopher, chief international investment strategist at Wells Fargo Advisors, "is not austerity but economic reforms." Across Europe, economic growth is constrained by inefficiencies, such as rules that protect favored businesses from competition and generous retirement plans that cost too much and pull productive workers out of the labor force. But reform takes time that Europe can't spare. Analysis by the Kiel Institute for the World Economy in Germany suggests the outlook is hopeless for Greece. Researchers at the think-tank estimate that Greece would have to turn its annual budget deficit
-- now about 5 percent of GDP before debt payments -- into a daunting surplus of around 30 percent of GDP to return to financial health. "Greece will most likely not be able to get grip on its debt," write the institute's analysts David Bencek and Henning Klodt. Portugal, too, faces long odds, they found. The only way out, the University of Maryland's Morici says, is a breakup of the eurozone. Weak countries like Greece and Portugal must abandon the euro and reintroduce their old, less valuable currencies. The return of the weak Greek drachma and Portuguese escudo would make Greek and Portuguese products less expensive in foreign markets and allow them to get a rejuvenating economic boost from growing exports. The alternative, he says, is deepening pain and social instability. "The stakes are enormous," Morici says. "Unemployment could easily rocket above 30 percent in Greece for years. With the government having no real means to ease the pain, revolutionary conditions will prevail. Even now Greece is little more than a barn full of straw in the middle of a summer drought."
[Associated
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