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The price of Greek democracy

Robert Peston
Economics editor

media captionThe Greek prime minister's decision to give his voters the final say in a referendum has sent the markets reeling

It is easy to see why the Greek premier has announced a parliamentary confidence vote and plebiscite on the eurozone's latest bailout package.

He presumably takes the view that there is almost no chance of Greece going back to work unless and until the Greek people publicly endorse his and the eurozone's economic recovery plan.

If that plan is to be effective, it would impose major sacrifices on most Greeks, in the form of serious cuts in public services, higher taxes, a raised pension age and - perhaps most seriously - years of declining real wages.

But without the approval of the Greek people, without an end to crippling pervasive strikes, how on earth could this austerity be followed by economic recovery?

So although Mr Papandreou's decision to hold a referendum has shocked investors and eurozone leaders, to criticise him would be to argue both that democracy is a bad thing and (many would say naively) that a Greek revival could be possible in the teeth of opposition from Greek people.

Which brings us to what matters for the rest of us - what chance that the Greeks will vote yes to the rescue package?

Opinion polls wouldn't suggest there's a high probability of Mr Papandreou winning the day. But views can change.

What's in it for the Greek people? Well, their country is to receive an additional 100bn euro of bailout loans, so that it can continue to pay its bills. And there is a non-binding agreement with banks to cut what the Greek government has to repay them by half.

But this rescue package will deliver only a modest reduction in the back-achingly heavy burden of Greek indebtedness.

Even if all goes to plan in a fiscal sense - and it hasn't done that in Greece for years - the ratio of public-sector debt to GDP in Greece would still be 120% in 2020.

Which is still a good 20 percentage points above the ratio considered the upper limit for what would allow private sector and economy to thrive.

Or to put it another way, the rescue does not promise a bright new dawn for Greece any time soon. Or to put it another way, the only way for the referendum to be won by Mr Papandreou would be for him to demonstrate that the alternatives are far worse.

For the rest of the world, those alternatives look shockingly bad.

They could include, in no particular order of probability or potentially devastating impact on the stability of financial market, default by Greece, exit by Greece from the eurozone or a much more generous rescue deal.

Let's examine these.

A decision by the Greek government to renege on all its debts would impose huge losses on European banks, the European central banks and European taxpayers.

Such a default would raise the spectre of default by other over-indebted eurozone governments, which in turn would undermine the perceived solvency of some very big banks. We could be back in the territory of paralysis of the European financial system.

Or Greece might decide to quit the eurozone, so that the exchange rate would be able to fall to a level that would allow the Greek private sector to compete.

This could have the spurious attraction that it would mitigate the ostensible fall in Greek wages necessary for recovery.

But its impact on markets could be even worse than a default, it could be a default on steroids: if it became accepted that membership of the eurozone isn't forever, huge doubts would arise about the true value of hundreds of billions of euros of contracts.

All that said, it is possible that under threat of a no vote, eurozone governments could sweeten the rescue package. This would force banks to write off more of what they're owed and would impose losses on public-sector lenders to Greece, including the European Central Bank.

This might be the least worst option, but it would be painful for eurozone taxpayers and banks.

Unsurprisingly, therefore, European stock markets have tumbled - and shares in big banks are down around 10% or so.

All or any of these frightening scenarios would make it harder and more expensive for European banks to borrow - which has negative implications for European economic recovery and (in a worst case) could see a few banks falling over.

Nor is it especially comforting that Mr Papandreou's government could tumble before a referendum. Any immediate general election would be the equivalent of a plebiscite on the bailout deal, and would therefore be just as destabilising to markets.

All that said, last week's eurozone rescue package could unravel long before political events in Greece take their course.

All the uncertainty has again depressed the price of Italian government bonds, pushing up the interest rate which Italy has to pay to borrow to punitive and dangerous levels.

The gap between the interest rate paid by Italy and by Germany to borrow for 10 years is approaching an astonishing 4.5 percentage points - which, with Italian government debt equivalent to more than 120% of GDP, means Italy could find itself in a vicious spiral of debt-induced economic contraction.

A price is already being extracted by investors for the refusal of Germany to allow the eurozone's bailout fund to expand its resources to much more than a trillion euros, just about enough to refinance the maturing debts of Italy and Spain for a year or so, and provide a bit of support to banks and other financially challenged governments.

In other words, the putative remedy for the eurozone that was negotiated just five days ago in such dramatic circumstance - and which was supposed to be the definitive and final word on the subject - is in danger of disintegrating even before it goes before leaders of the G20 most powerful economies on Thursday and Friday for their blessing.