Greek debt: Europe at the crossroads

Sarkozy and Merkel agree last-ditch compromise in desperate bid to avert catastrophic default

Faced with the looming threat of global economic meltdown, the leaders of Germany and France buried their sharp differences over the worsening Greek debt crisis yesterday and issued an urgent call for EU agreement on a new rescue package for the financially stricken country.

Chancellor Angela Merkel and President Nicolas Sarkozy made their appeal after a three-hour meeting in Berlin to discuss the crisis as the Greek Prime Minister reshuffled his cabinet in an effort to show that his government could face down the political calamity provoked by his country's economic woes.

Insisting that both she and Mr Sarkozy wanted European agreement on a new rescue package for Greece at the EU leaders' summit at the end of next week, Ms Merkel said: "We have to find a solution as soon as possible. We have spent the whole of May and most of June discussing the same problem without reaching agreement."

In an effort to calm the markets, both leaders pledged their support for the government of George Papandreou. "I have spoken to him on the phone, he is ready to fight. I am very confident that Greece can master the crisis," Ms Merkel said.

Greece needs an urgent instalment of €12bn from its €110bn emergency loan granted last year to avoid defaulting on debts due for repayment over the coming months.

A fresh loan now being discussed by the eurozone could be worth as much as €100bn. While that appears to be a staggering amount, analysts believe that while the total cost of a full-scale Greek default is incalculable, domestic financial systems in Europe would be severely affected. French banks hold Greek debt worth €56bn, the German exposure is €34bn, but the real fear lies in the unknown.

Yesterday's Franco-German summit had been preceded by major differences between the two countries. Ms Merkel had insisted that as part of any long-term solution, the banks should be obliged to buy back some of their loans to allow Greece more time to pay. But France strongly objected, arguing that it could destabilise its own banking industry. News of the German plan prompted the ratings agency Moody's to lower the credit rating this week of the three largest French banks – Crédit Agricole, BNP Paribas and Société Générale.

Ms Merkel and Mr Sarkozy appear to have buried the hatchet. They jointly announced that any private sector involvement should be voluntary. "We will do everything to sustain and support the euro," Ms Merkel insisted, in what appeared to be a climbdown on her part. "We want the involvement of private investors to be completely voluntary and the conditions must be worked out jointly with the European Central Bank."

Mr Sarkozy described her change of heart as a "breakthrough". He insisted: "France and Germany hold the same position on the Greek question." Their comments caused the euro to bounce back and strengthen against other currencies yesterday.

Germany's hitherto uncompromising stance was provoked by widespread domestic discontent over the Merkel government's handling of successive eurozone crises. Ms Merkel's administration has been portrayed in mass-circulation newspapers as a government which forces ordinary German taxpayers to come to the rescue of "failed" countries like Greece.

Yesterday,it emerged that Germany's reluctance to provide more financial aid for Athens had prompted the eurozone head, Jean-Claude Juncker, to intervene personally on Greece's behalf. Mr Juncker described the proposals to force private banks to get involved as "dangerous". He added: "This could provoke the most serious risk that all three rating agencies will declare a credit event. Then there are big risks of contagion for other countries."

Mr Juncker also dismissed proposals to wait until September before agreeing on an aid package for Greece. "We simply cannot allow this," he told Berlin's Der Tagesspiegel newspaper.

Mr Papandreou's failure to secure a government of national unity meant that he was forced yesterday to turn to his main political rival in the ruling Socialists, Evangelos Venizelos, to shore up the government.

A veteran of Greece's bitter internecine politics, Mr Venizelos, who was appointed Finance Minister, effectively assures the Prime Minister the internal support he will need to pass the new package of austerity measures that he failed to get through parliament earlier this week.

"The country must be saved and it will be saved," said Mr Venizelos, who moved from Defence. "I am leaving defence today to go to the real war."

The outgoing Finance Minister was among a number of technocrat outsiders – new faces brought in by Mr Papandreou to "completely change" Greek politics – and his departure marks the end of that effort and the return of old party heavyweights from the Socialists' compromised past.

While Mr Papandreou struggled to put a positive spin on the reshuffle, talking of "encouraging growth", it was clear he had to turn to the old guard in order to secure their support for the second wave of austerity measures required by the IMF and the EU.

In the short term the new Finance Minister should see party dissenters come back into line and get the government through a no-confidence motion in parliament early next week, but analysts expect him to try to oust his boss from the leadership at elections that would likely follow the passage of the new austerity measures.

Crisis in Greece

The violence

Demonstrators clashed with riot police, when more than 20,000 took to the streets of Athens to protest against the government's proposed austerity measures

The sacrifice

Later, the Greek PM George Papandreou appeared on television to announce that he was to form a new government to push through a new financial package

The deal

As part of the deal, Papandreou promoted his fierce political rival Evangelos Venizelos to the role of Finance Minister in a desperate bid to help push through austerity measures

The rescue?

German Chancellor Angela Merkel and French President Nicolas Sarkozy met in Berlin after their governments disagreed publicly over the steps needed to stabilise the ailing Greek economy