What is Greece doing?
Just now the Greek prime minister Georgios Papandreou announced that he wants to conduct a referendum if Greece is going to accept the EU financial aid. This came as a surprise to everybody, as just last week the European countries came to a first agreement on the financial aids after a long struggle. The markets are not so fond of Papandreou's move and indices are plummeting as I am writing this. Respecting the will of your population is not a bad thing in itself, but a referendum in such a heated environment with street protests all over in Greece resembles tossing a coin instead of making a rational decision. Papandreou's government will have to inform it's citizens about the implications of their decision, and I hope people will think and decide carefully. My feeling is that the Greek government wants to dodge the responsibility for their bad decisions in the past and later blame the population for whatever decision they take in the referendum.
The options, as I see it, are harsh austerity measures on all fronts in case Greece accepts the aid and stays in the euro zone, or the revival of the drachm and bankruptcy. Both options are at first viable ways out of the situation, and I'll try to analyse what could happen in either case, maybe identifying a preferable solution.
Staying in the zone
Four things will be necessary to get out of debt: A debt cut as an incentive to pay back the debt at least partially instead of going bankrupt right away, reducing government spending, increasing government income and improving the efficiency of the Greek economy in order to keep an acceptable standard of living for the population. The debt cut is already agreed on, but the remaining three steps are politically problematic. The main hindrance is a deep-rooted culture of corruption, tax evasion and clientele politics in Greece: Decisions are not made based on what would be better for the country, but what would be better for the decision maker and his friends. Once such a system is fully established, it is hard to remove because the network of corruption includes judges, prosecutors and high government officials who would be the first in line to fight corruption and tax evasion. They will be preoccupied with saving themselves instead of fighting the rot in their own ranks.
The only way here is to fight the corruption from top to bottom. This means that Papandreou will first have to fight corruption in his own government, which may sever him from a lot of important figures that support him. Does he have enough people around him who are loyal to Greece? If not, there's no hope and Papandreou will fall soon.
Fighting corruption, reducing government spending and increasing government income have to be backed up with stimulating the Greek economy in order to fight unemployment and keep an acceptable standard of living for the population. Only the private sector can create income from which to draw taxes and pay salaries to workers. Greece has to attract foreign capital, support export-oriented industries to fight the foreign trade deficit, educate people and train them for jobs that are needed, and also invest into infrastructure — which is difficult if you up to your neck in debt. Again, improving government efficiency is a key factor because slow and unreliable bureaucracy hand in hand with corruption repel investors and make life hard for domestic companies.
Leaving the zone
It would mean that foreign investors can pretty much kiss their money goodbye. Probably (I'm just guessing here) the foreign debts will be converted to drachm at a rate dictated by the Greek government, and the expected gradual depreciation of the drachm with respect to dollar and euro will devalue the debts. This step would therefore be strongly against the interest of any country or institution that lent money to Greece or Greek companies. For me it is still a question how the debts of Greek companies, as opposed to government debts, would be handled.
The diminishing buying power of the drachm can be a chance for Greece: The country becomes more attractive for investors because of lower levels of income, and export-oriented industries and tourism are bolstered by a weak drachm. Problem here is the EU membership, which pretty much forbids tariffs for trade within the EU. It means that the price of many goods in drachm will increase as the exchange rate of the drachm drops relative to the euro. Similar things have happened in north America, where international trade has increased the price of corn in Mexico, hurting the Mexican population.
On top of that, Greece still as a foreign trade deficit, which means that the effect of increased price of imported foreign goods outweighs the benefit for the own export-oriented industries. And, again, it is the private sector that ultimately creates value in an economy, and a strong private sector needs an efficient and reliable administration as well as good infrastructure and educated workers.
The reduced international debts will only provide a short-term relief if the deficit remains: Taking new foreign debts will be much more expensive, and "printing drachms" just lets the value of the drachm spiral down into a deep inflation.
In summary, reintroducing the drachm is not going to solve any problems. Such a step may be beneficial in some situations, but in case of Greece with it's foreign trade deficit and continuing accumulation of debts it only makes the situation worse. The way out of the crisis is the same in any case: Fighting corruption and tax evasion, making the administration more efficient, and stimulating the economy. Money for military and "presents" to diverse interest groups should be diverted into education and infrastructure. And Greece has to become a reliable partner for foreign investors and other EU countries to ensure support during this time of crisis.
Papandreou's move is therefore clearly in his own interest by putting the responsibility for any kind of measures to the voters and not to him and his government. He also seeks to win time, probably trying to save him and his buddies from the bloodbath in the awaiting fight against corruption and tax evasion. But at the same time he's gambling with his country's future, as leaving the euro zone is definitely not a good option for Greece. Instead, he is hurting the relations to other EU countries and also private investors, destroying any trust into the willingness of the current administration to take the necessary measures.
The debts to Greece are lost at least partially in any case, and a debt cut along with financial aid and political pressure to solve the domestic problems are probably the best way to recover at least some of the loans to Greece and Greek companies. The damage to other EU countries and companies could be severe on the short run if Greece reintroduces the drachm because of writing off the debts of Greece, but the strong economic position of other EU countries would soon allow them to recover. If other countries like Italy, Portugal, Spain or Ireland however follow the path of Greece it would severely weaken the EU. I believe that sticking together and helping out each other is in the interest of all European countries.