Athenian democracy was an experiment in direct democracy where the people did not vote for elected officials but rather voted on specific legislation. The Greeks are now poised to once again put direct democracy to the test. Following a week in which European policymakers seemingly took the necessary steps to help prevent a looming financial crisis—a 50% haircut on Greek debt, bank recapitalizations, and an expanded European Financial Stability Facility—the Greek prime minister unexpectedly announced a December or January public referendum to approve a second Greek bailout. We don’t yet know what the referendum will ask. Will Greek citizens be asked to vote on remaining in the euro or will they be asked to vote on additional austerity measures in exchange for further bailout funds? A large majority of Greek citizens are committed to the former, but they may be unwilling to accept the pain of the latter. Adding to the uncertainty, a parliamentary confidence vote scheduled for later this week could supplant the referendum. Because failure of the Greek parliament to support the existing government and/or failure of a vote for the second aid package would further damage the already reeling Greek economy, I expect the aid package to pass, but it will be too close for the markets to take calmly.
A rejection of the aid plan increases the risk of a forced and disorderly default (read: one that triggers the credit default swaps market) and increases the probability that Greece leaves the Eurozone. Following a 48-hour reprieve in the markets, the crisis is back on. Italian borrowing costs are surging. The Italian debt market, the world’s third largest, is the lynchpin. Contagion to Italy is an outcome to be avoided at almost any cost. Where is the European Central Bank? The ECB is the only transnational body capable of supporting the Eurozone financial system. As I have said before, the ECB appears committed to repeating the U.S. Federal Reserve’s mistakes during the Great Depression. It’s time for full-scale policy accommodations including an immediate move to a zero interest rate policy and a full-blown expansion of the ECB’s bond-buying program. If Greece’s exercise in direct democracy leads to the return of the drachma, the ECB better stand ready as the lender of last resort to the other peripheral countries. Only the fate of the global financial system may hang in the balance.