Papandreou Wheels out a Trojan Horse

Greek Prime Minister George Papandreou lobbed a bombshell into efforts to cobble together a grand scheme to fix the European financial crisis and put countries like Greece, Portugal, Spain – and most notably Italy – on a firmer financial footing.

Just days after the major eurozone countries agreed in principal on a recipe of reform, debt forgiveness and austerity, Papandreou surprised all sides with plans for a referendum that ostensibly provides an up-or-down vote on the grand bail-out deal, but which tacitly may increase Greece’s ability to renegotiate a better deal.

A referendum, in effect, gives the Greek public a chance to decide whether it approves measures for additional austerity in return for substantial, but not necessarily adequate, debt relief. Advocates claim further deep cuts in government spending are needed to patch up the economy. Critics of the austerity approach to economic reform argue it is the wrong medicine because it will further contract the economy, increase unemployment and civil strife, and take a decade or more to work through.

“The Greeks have not done very well out of the deal of last week,” says Wharton finance professor Franklin Allen. “Their debt still remains at high levels, they have a significant austerity program to implement and they have a loss of sovereignty from the EU [European Union] officials that will be stationed in Athens.” It is unlikely that a referendum would approve of the terms of the bailout and negotiated partial default. “A loss would give any Greek government considerable power to renegotiate and get the public and private sectors to forgive the debt. There is always the Argentinian option out there as well. So we will see.”

Regarding that option, some austerity critics also argue that Greece should give up the euro – perhaps only temporarily – and reintroduce the Greek drachma, which would allow for a deep currency devaluation, while also defaulting on much of the country’s sovereign debt. After the big economic hit that would follow such moves, exports and other drachma-denominated business – such as tourism – would surge and, relatively quickly, pull the economy back into positive growth. The precedent, say critics: Argentina, which 10 years ago defaulted on its bonds, dropped its dollar peg and let its currency float. The result was a deep, but relatively short, recession and a much devalued currency, which boosted exports, followed by a decade of growth at twice the rate of Brazil’s rate. However, at present some 70% of Greeks oppose abandoning the euro.

But if Greece were to unilaterally follow the path of Argentina, it could have devastating effects on European sovereign and bank debt, starting most importantly with Italy, and could spark another global financial crisis, Allen said. On Tuesday, Italian bonds were trading at record-high interest rates, in a clear sign of investor anxiety.

Notes Wharton management professor Mauro Guillen, regarding Papandreou’s call for a public vote: “This could be the silliest thing a PM has ever done, or it could be smart if it helps build a coalition behind reform in Greece. It could also accelerate Greece’s exit from the euro, and a possible Argentina-like scenario.”

Questions about a possible withdrawal from the eurozone, adoption of Argentina-like measures, and a host of other crucial issues around this crisis are the subject of this just-published, comprehensive Knowledge@Wharton interview with Allen and Guillen titled: The Euro Zone of Denial Hits the Wall.

You can also read this report — a discussion on the euro – titled, Will the U.S. and Europe Rise Again? — with professors Allen, Richard Marston and Kent Smetters.

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