After weeks of haggling, rows and finally compromise, European leaders proudly announced their latest rescue plan last week: cutting Greece’s debt, recapitalising banks, and ‘leveraging’ the remaining funds in the European Financial Stability Fund (FSF). Financial markets responded positively at first, but less vigorously than policymakers might have hoped.

Unfortunately, the Greek Prime Minister had one last card to play. Papandreou’s announcement last night that he would put the terms of the bailout to the Greek people in a referendum has sent markets back into freefall. At lunchtime on 1 November, the FTSE 100 was down almost 4% on the day; benchmark French and German equity indices were even lower. What is worse, spreads on euro area sovereign bonds have picked up again, with the benchmark yield on Italian 10Y bonds now at 6.3%. That is too high for Italy to cope with for very long.

To be fair to Papandreou, the latest bailout implies years more of austerity for Greece. Even with a 50% haircut on private investors’ holdings of Greek debt, and further tax rises and spending cuts, the debt-GDP ratio was still expected to be 120% of GDP by 2020, ie too high. The Greek Government has found it increasingly difficult to push austerity measures through parliament, and with almost a decade of retrenchment in prospect Papandreou may have seen no alternative to the referendum in order to win public backing.

The problem is, of course, that he could lose. Most Greeks want to stay in the euro; but most Greeks also want an end to the austerity that their Government has been forced to push through. The two are not quite mutually exclusive – technically, it may be possible to default on all your debt and still be allowed to remain in the euro. But much depends on the role of the ECB.

In particular, if Mario Draghi, the new ECB President, decides that Greek banks do not deserve ECB funding, then Greece may have no option but to drop out of the euro itself. And Draghi may not be inclined to support those banks if the Greek Government has just defaulted on its debt, which incidentally would leave a big hole in the ECB’s balance sheet. Shorn of outside support, the Greeks would have to reintroduce their own currency to support their banks, via the associated monetary and central bank policy options, and to hell with the consequences.

However, Draghi will know this as well. And he will also know that, if Greece goes, Italy will be next in line. With Ireland and Portugal still surviving on their existing packages, and Spain making greater efforts than Berlusconi, markets would punish his home country. With the ‘leveraged’ EFSF of €1trn now looking less and less likely, Europe cannot bail Italy out unless major governments are prepared to commit more money and capital, which they are not. A run on Italian banks could force the issue before politicians even manage to start talking about new plans and firewalls.

There is a chance that markets are getting ahead of themselves here. Papandreou could win the referendum, particularly if he tied it to euro membership and spelt out the problem with default – namely that it would imply even more austerity (a forced, balanced, budget) straight away. But the referendum will probably be held next year. And, in the meantime, markets are unlikely to respond well. Although his intentions may have been noble, Papandreou may just have signalled the collapse of the euro area as we know it.

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